Free Trade on Trial - What are the Lessons for Economists?

This election season in the US there has been an extraordinary and disturbing trend at work: vilifying free trade as a "job killer". The main front runners in both political parties in this Primary season are all apparently questioning free trade as a way to garner more votes.

So although in January 2015 Ted Cruz said "I am a full-throated advocate of free trade. Free trade benefits America, produces jobs,

produces economic growth and it is good for our country", he has gone on record saying that he is not in favor of the Trans Pacific Partnership (TPP).  The front-runner on the Republican side, Donald Trump says that the Trans Pacific Partnership (TPP) is a "terrible, terrible deal", and that he would cancel most of the existing trade deals as well as building a wall between the US and Mexico. And lastly, John Kasich has said that "I think that we have, in some ways, been saps. We can't have people coming in here and dumping stuff and destroying our jobs in this country. That's where I grew up! I grew up with steel workers."

On the democratic side, Hillary Clinton also opposes the Trans Pacific Partnership (TPP), But probably the most vehement anti free trader in the Primaries has been Bernie Sanders. He has gone on record saying that "Let’s be clear: the TPP is much more than a “free trade” agreement. It is part of a global race to the bottom to boost the profits of large corporations and Wall Street by outsourcing jobs; undercutting worker rights; dismantling labor, environmental, health, food safety and financial laws; and allowing corporations to challenge our laws in international tribunals rather than our own court system".

So what is going on here? Why is one of the biggest trends of the last 3 decades now being questioned and vilified by our leading politicians? Well, there is plenty of analysis in the press (see here in the FT and here in the New York Times, for example), but we need to ask 4 basic questions here:

i) why is free (or freer) trade regarded as a good thing by economists?
ii) why is there now so much opposition to free trade among politicians?
iii) what would happen if we implement some of the suggestions coming from both ends of the political spectrum?
iv) what lessons can we as economists learn from this?

So first, why is free trade regarded as a good thing by economists?. As I explain in my Principles classes, the Ricardian theory of trade says if you have a comparative (relative) advantage in doing something, you should specialize and focus on doing exactly that thing. The unfortunate part of free trade is that if you don't have a comparative advantage in a specific good or service, then the theory says you should let someone else do it and import the good or service. The obvious implication is that people will lose their jobs. And that means that as barriers to free trade have come down over the past 60 years that we will lose jobs in certain industries. But that is not the end of the story - trade theory goes on to point out that in any country the gainers from trade could compensate those with losses from free trade, and we would still be better off. It is this second part that doesn't get taught in the textbooks or emphasized enough.

But what does this mean exactly? It means that from a macro perspective, the gains coming from the industries that can take advantage of comparative and expand to dominate international markets will make more income for the country than the loss in income from declining industries which will eventually be eliminated. Of course, that is the idea behind some of the government "adjustment programs" which usually accompany free trade deals: the government provides money to help workers transition out of an industry where the country does not have a comparative advantage into an industry where the country does have a comparative advantage. This extra transition spending should be temporary, as the dynamic adjustment to a new free trade deal causes workers to move from one industry to another. That is the theory at least.

So now we can answer the second question: why is there now so much opposition to free trade among politicians? One of the UK's leading politicians of the 1980s, Norman Tebbit coined an unfortunate phrase relating to the sectorally unemployed: "on yer bike". What he meant was simply if there isn't any work where you currently live, move to where there is work. The problem with this as relates to the economic theory is that workers often do not like to move - and particularly in a country as big as the US. The loss of social networks established over years, the uprooting of children from schools that they like, often the loss of property values as major parts of certain states see everyone trying to sell at once if the town or city is not industrially diversified, and the different cultural norms in different parts of the country, are all good reasons why we observe inertia in labor mobility. And much of this loss of jobs has come because by and large the US does not have a comparative advantage in manufacturing - that sector has been in long term decline, as it has in many developed countries.

If States are not industrially diversified, there is no doubt that there will be pain - hence the so-called "rust belt" in the central US States, the fisheries in the Atlantic provinces in Canada, the dockyards of Glasgow in Scotland, and the garment industries of North Carolina are all good examples. This pain is clearly one of the festering scars of free trade policy in advanced economies around the world. So if you are a politician campaigning in these States where there has been a decline in specific industries, it is natural that you'll get votes if you oppose free trade - so politicians such as Donald Trump, Bernie Sanders and Hillary Clinton all know that if they are to have a chance of winning in these States they need to argue against free trade, and so they do. 

This leads into the third question. Donald Trump has advocated rejecting the Trans-Pacific Partnership (TPP - which I regard as a coalition type free trade deal against the emergent trading might of China), and said he would raise tariffs by 45% against all goods coming in from China and other countries that he deems to be unfair. I am assuming that the Transatlantic Trade and Investment Partnership (T-TIP) with Europe will also be on the ropes too, Bernie Saunders has also said that he would only do "fair trade" deals, where this is defined as trade where wages and environmental standards are roughly equivalent to those in the US. That implies that Saunders would be against TPP, but would actually be in favor of T-TIP. But it implies that a Saunders Presidency would see international trade collapse with the developing world ( - what a lot of economists call "North-South" trade).  Either of these two scenarios are not good for US economic prospects, as it implies that free trade deals which the US stands to benefit from, would possibly not come to pass, and also that we will see other countries erecting trade barriers against our goods and services.  

What lessons can economists (and the general public) draw from this?  

First, I think that from a theoretical standpoint we need to expand our proselytizing about free trade to make politicians and the general public understand better where the economic argument comes from, and how it needs to come as a complete package rather than just a narrow focus on the benefits. What we have failed to do as economists is recognize the costs, and how best to mitigate those costs. 

Second, what can we do in the policy realm?  It should mean that any free trade deal needs to come with a whole raft of moving grants and loans, retraining grants and loans, and pension and Social Security "top-ups" for those laid-off workers who are deemed to be close to retirement age). But I hear my economist friends saying - "but that might make the international rearrangement of production no longer economic, so that comparative advantage cannot fully operate.  Well my argument would be "so be it".  These are people's lives you are talking about, and government and business instigated policy changes should come with transitional arrangements that protect those that are most vulnerable.

Third, we need to be much more aware of the regional industrial specialization that occurs in the US when making trade deals - perhaps States could be given notice that a free trade deal will happen and then some kind of fiscal transfer can be arranged to help it generate new industries within it's borders. In this sense regional policy and trade policy are much more related than economists have recognized in the past.  

And lastly, and probably the most important lesson that can be learned from this, is that economists need to be much more vocal about these public policy issues, and suggest ways in which the well-being of all our citizens can be improved, or at least maintained.

My thoughts on economic prospects for 2016

Welcome to 2016, and of course a very Happy New Year to all my blog readers!  As usual at this time of year, I like to reflect on the events of 2015 and what 2016 might bring in terms of the global macroeconomy and the capital markets in general.

So let’s start our global tour by first looking at the US. 2 factors were surprising in 2015: firstly the continuing fall in oil prices down to the mid-$30s – of course the fall started in 2014 but it has continued to fall as OPEC’s indecision has weighed on the oil markets; and secondly, the lack of any Fed tightening until December, despite the fact that there were expectations that rates would rise much earlier in the year.  All this suggests that growth in the US will, if anything, accelerate in 2016, and it implies that the US economy will continue to perform well as the country settles into the later part of the business cycle. Although some regard 2015 as a lackluster year, the markets are really not a good reflection of the surprising resilience of the US consumer, who is not only saving more, but also is spending more, but notably on different types of products than previously.  In particular, the tech sector still has strong potential growth given that this remains a comparative advantage for the US, and the housing sector continues to perform well, as the demand for housing is still masked by unreasonably strict credit conditions and the fact that ageing boomers are living longer and therefore inheritances are being delayed to the younger generations.  The Biotech sector has had a miserable year in terms of stockmarket performance, and this will likely continue and if anything worsen until the US elections are over, as drug pricing remains a politically divisive issue.  

In terms of the increase in interest rates, the Fed has made it clear that it will likely hike rates 4 times next year, which, as I stated in my last blog, likely reflects the fact that the Fed wants to normalize and realizes it has fallen behind the curve in terms of adjusting rates to appropriate rates ahead of the next downturn in the economy.  In other words, the Fed has prioritized rate hikes over withdrawal of quantitative easing (QE), which still leaves a lot of extra funds sloshing around the financial system.  Most financial market economists have forecast fewer rate hikes, and therefore little likelihood that the US dollar will further strengthen, but I think that this is a mistaken view – the Fed knows that January 1^st sees a raft of increases in minimum wages across the country, and so wage pressures are picking up, which coupled with extremely loose monetary policy implies that inflation pressures will likely build in the US economy, which will justify the rate increases, plus the fact that the QE will still largely be in place will also continue to act as an economic stimulus.  The wild card here though is the US dollar, which could appreciate, capping any inflationary pressure due to import price pass through to items like clothing and retail items, and also putting further dents in export performance by US multinationals. Any fall in the US dollar would therefore work in the opposite direction – to likely stimulate exports, adding to economic growth, but raising import prices thereby leading to greater certainty regarding Fed interest rate hikes.  Another potential factor stimulating the US economy will be largely dependent on Congress going forward – the Trans-Pacific Partnership or TPP.  If this does get passed by Congress and signed into law, the impact could be significant in the latter part of 2016. 

Next, let’s move on to Europe.  For 2015 Europe has had a good year in economic terms, with the exception of a few countries (for example Greece and Portugal), but near all-things non-economic in Europe have not gone according to plan in 2015.  The reason for the good news is largely down to the ECB and Mario Draghi’s “whatever it takes” QE, which has spurred stronger economic growth in the euro area core and periphery, giving stockmarkets such as Germany’s and Ireland’s a pretty good year.  The depreciation of the euro appears to have had little effect on import prices, largely because any increase in non-oil import prices has been more than offset by the (much) lower oil and other commodity prices. This is the reason that I have heard many economic commentators say that Europe is now “mid-cycle” compared to the US’s “late-cycle” position, but I think that although Europe lags behind the US in terms of business cycles, there is an “international business cycle” effect which does tend to tie Europe closely to the US business cycle – in other words, I think that Europe, although it has struggled to record significant economic growth rates, still only lags marginally behind the US in terms of its (natural) business cycle.  Given the ECB’s continuing stimulus through QE, the less fiscally profligate economies in Europe will continue to do well in 2016.  On the Transatlantic Trade and Investment Partnership (T-TIP) with the US, I think this will get put on hold in 2016, given the Presidential elections.

One side note on Europe here concerns the UK in 2016.  In the UK, there is a referendum planned on continuing membership of the European Union (EU) in June, in which Prime Minister David Cameron will make the case for sticking with the EU (but continuing to stay out of the euro). There are various forces in the UK now aligned against continuing membership of the EU – that is one reason why the UK stockmarket is down for 2015 when most EU stockmarkets are up over the same year.  Obviously the outcome of this referendum on the EU will colour the performance of the UK economy and of the UK stockmarket in 2016.

The Japanese economy saw continued signs of response from the QE being tried there by Prime Minister Shinzo Abe, but the US dollar’s strength coupled with the yen’s weakness meant that unhedged returns were muted, despite the fact that the Nikkei was up by over 9% last year.  Given the continuance of QE in Japan and Abe’s reforms, Japanese growth should be positive again, and that should lead to further stockmarket gains, although the direction of the currency is less certain in 2016, as the yen is now seen as more of a “safe haven” currency, and could be buoyed by inflows from China.

Turning to China, although markets there were positive over the previous year (up over 9%), the continuing devaluation of the yuan will sap confidence over “directed” economic policy.  Furthermore, as global growth will be under par as a whole, China will continue to slow, and this will be reinforced by the collapse in Chinese investment. I would expect the Chinese stockmarket could be down significantly in 2016, particularly if the Chinese government does not stimulate the economy.  In India, if Modi can continue to push through meaningful reforms, then the stockmarket could be one of the better performers in 2016.

Other than the major economies already covered above, I believe that unless there is an escalation conflict in the Middle East, oil prices will continue to be extremely low in the first part of 2016 and may move even lower than the high $30s, but in the second half of the year, there will be some rebound in prices as bankruptcies in the US leads to less supply on world markets.  In terms of commodity prices, they will continue to be weak into the first half of 2016, but once again, there could be some rebound in the second half as there is “overshooting” which leads to bankruptcies in this sector.