When secular stagnation meets protection

One of the surprises of the Great Recession period since 2008 has been that global protection against free trade has increased only slightly, in sharp contrast to the enormous spread of trade controls during the Great Depression from 1931-34.

This period of opposition to autarky might, however, be coming under threat. Two of the three candidates left in the American presidential race are clearly protectionists. Although Hillary Clinton, the likely winner, has always leaned towards free trade agreements, she has recently hedged her previous support for the Trans Pacific Partnership because of the developing political climate.

Betting markets think there is a 30 per cent chance of a President Trump. He has called for a 45 per cent tariff, no less, on imports from China. His presumptive nomination, according to Edward Luce, overturns decades of Republican support for free trade.

And he would have a lot of sway in this area, because the usual checks and balances in the US political system do not really apply in the case of protectionist trade policy. In that field, the president has been accorded unusual powers to act, ever since President Roosevelt’s Reciprocal Trade Agreements Act in 1934.

Currency “Manipulation” and Monetary Policy

Even under Barack Obama, who is clearly a convinced proponent of free trade deals, the US has been edging nearer to interference in trading relationships, under the guise of “currency manipulation”. Two weeks ago, the US Treasury reported that five of America’s largest trading partners – China, Japan, Germany, Taiwan and Korea – might be guilty of some aspects of currency manipulation, though no partner transgresses on all the criteria used by the Treasury.

The legislation does not specify the action that should be taken by the US government against a currency manipulator, but it clearly might include direct controls over imports into America.

Furthermore, the US Treasury is making it very clear that excessive reliance by foreign economies on monetary easing will not be accepted, especially if this devalues their exchange rates against the dollar. Instead, these countries are expected to use other measures to support growth, including fiscal expansion.

In particular, Japan is clearly coming under this type of pressure prior to the G7 Summit in Shima on 26/27 May. This may explain the Bank of Japan’s decision to eschew monetary easing last month, despite clear signs of recession and returning deflation in the economy.

These linkages between exchange rate policy and trade policy have happened many times before, notably in 1931-34. According to the definitive academic work on the spread of protection in the 1930s by Barry Eichengreen and Douglas A. Irwin, the countries that opted for direct controls over imports and capital flows were those that had decided to remain on the Gold Standard, following the UK decision to suspend gold and devalue sterling in September 1931. It was the lack of viable alternatives to stem recessionary forces, in the face of devaluation by Britain and related economies, that induced the Gold Standard bloc to resort to trade controls.

Any comparison between then and now is certainly extreme, but it is possible to discern some shades of similarity. In early 2016, the US discovered that deflationary forces in Japan and the eurozone, alongside the consequential monetary easing by the Bank of Japan and the ECB, caused an appreciation in the dollar that the US economy could not withstand. This punctured the myth that the Federal Reserve could proceed without due regard for deflationary forces overseas.

Global Spread of Secular Stagnation

Furthermore, the intellectual climate is also changing, and not just among labour market economists, who now frequently argue that trade with China has permanently damaged employment in the US. The Keynesian macro-economists who support Hillary have usually been devout free traders, but this may be changing. They have previously tended to analyse the risks from deflation and secular stagnation within closed economy models, but they are developing new multi country models which might result in a more legitimate role for protection (see this excellent explanation by Greg Ip.)

For example, Lawrence Summers (with Gauti Eggertsson and Neil Mehrotra) has produced an analysis of “Secular Stagnation in the Open Economy”, which shows how a liquidity trap in one part of the world can be transmitted to a previously unaffected nation.

Countries in deflation and secular stagnation (eg Japan, Germany and possibly China) run trade surpluses that drive capital inflows into the US and a rising dollar. The US cannot respond by cutting interest rates once the zero lower bound is reached, so it gets dragged into deflation.

If the surplus countries try to devalue their currencies by unconventional monetary easing, this simply transfers even more demand away from the US [1].

The strongly preferred policy response to this dilemma is international policy co-ordination and expansionary fiscal policy, but direct interventions in trade, to switch expenditure back to the US, become more defensible than in standard models. As an example of the potential drift away from open economies and globalisation, Paul Krugman, generally a free trader, now says that he is unenthusiastic about an extension of free trade through the TPP, though he is still some way short of arguing for more protection.

Implications for Investors

What should investors make of all this?

First, the US political and intellectual climate has cooled towards extensions of trade deals like the TPP and the transatlantic version, the TTIP. President Obama will be fortunate to get these through, even in the lame duck session of Congress in November, when the politically “impossible” sometimes happens. The potential gains from extra trade will therefore be lost.

Second, even without an outright shift towards protectionism under a President Trump, the US is making it more difficult for countries like Japan and the eurozone to combat deflation by easing monetary policy through more quantitative easing, especially if there is any suspicion that this is intended to devalue their currencies. Global monetary policy may be less able to respond to deflation threats, unless the US Fed joins in. Policy co-ordination becomes far more important than central bankers usually admit.

Third, the mainstream Keynesian macro-economists whose thinking normally influences the Fed’s staff are now viewing secular stagnation as an international issue, which could drag the US into a global liquidity trap, even if America is not in such a trap now. This reduces the long term equilibrium real rate of interest in the US, as FOMC members have been recognising this year.

Fourth, in a renewed global or American recession, the “tail risk” of a major spread in protectionism could all too easily become reality.

I will discuss the economic effects of protectionism another time.

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Footnotes

[1] Ricardo Caballero et al have published similar work, and John Cochrane has responded to them.