Populism, Trade And The Markets

Summary

• Much of our prosperity in general and shareholder returns in particular depend on the global economic order of relatively free trade and capital flows.
• That order has been singled out as the source of stagnation by an increasingly populist movement.
• While there are indeed groups left behind from the disruption caused by trade, it is far from the only disruption in a capitalist system that is powered by creative destruction.
• What can be done to take the wind out of the sails of the populist and preserve the world economic order turns out to depend on the type of populism.

We are not sure all investors appreciate enough how much their gains, especially gains in the shares of big international economies depend on an international order that guarantees near free flow of goods and capital.

Big international companies are supported by complex international supply networks that are fine-tuned, lean, and very vulnerable to disruption. We have seen what an earthquake in Japan or flooding in Thailand can do to the supply of critical electronic parts, hobbling whole sectors, and this is just one example.

We tend to take this world economic order for granted, but the world has seen a rise in populism that threatens this world economic order, as it could lead to protectionism and a decline of the common institutions that underpin it.

The threat comes from those that are deemed not to benefit from this world order, but we think the negatives are overblown.

This is a serious issue also for investors, many of the large capitalized stocks they invest in have benefited enormously from this global economic order of relatively free flows of capital, goods, services and know-how.

Any serious sand in the wheels here and things could become considerably more awkward for the big multinational corporations and their shareholders, so we take this issue with some keen interest.

We already see some of the damage emerging in Britain as a result of Brexit, which was the product of a populist backlash. From Yahoo:

British factories were left out of a demand-driven surge in activity across much of Asia and Europe in June, as weakness in sterling failed to translate into export growth, surveys showed.

And from the Guardian:

One third of non-British workers are considering leaving the UK, with highly skilled workers from the EU most likely to go, according to new research into the impact of Brexit on the jobs market. The consultancy firm Deloitte found 47% of highly skilled workers from the EU were considering leaving the UK in the next five years. In a report on Tuesday, it warns of serious implications for employers, raising the pressure on ministers to come up with sensible immigration plans and to find ways to improve the skills of UK workers and make better use of robots in the workplace.

It's noteworthy that not even the decline in sterling (the main economic positive of Brexit) was enough to compensate, and these are really just some of the negatives, there are many more (we keep track of some).

Which is why we are reading respected economists, such as Dani Rodrik, who has become sort of specialist in the field, with keen interest. His latest take provides some of the economics behind the backlash:

Rodrik argues convincingly that this is by no means the first populist backlash against globalization. Indeed, he reminds us that the term originated:

from the late 19th century, when a coalition of farmers, workers, and miners in the US rallied against the Gold Standard and the Northeastern banking and finance establishment.

But today:

populism spans a wide gamut of political movements, including anti-euro and anti-immigrant parties in Europe, Syriza and Podemos in Greece and Spain, Trump’s anti-trade nativism in the US, the economic populism of Chavez in Latin America, and many others in between. What all these share is an anti-establishment orientation, a claim to speak for the people against the elites, opposition to liberal economics and globalisation, and often (but not always) a penchant for authoritarian governance.

Rodrik goes on to explain some of the rise of populism with the help of a long-established economic theorem called the Stolper-Samuelson theorem (see here for an excellent introduction from The Economist). In its most simple (two goods, to factors of production) version it produces significant distributive effects from opening up to trade.

These effects are at the expense of labor in the country where labor is scarce (versus capital) as trade allows a country like the US to concentrate on capital intensive sectors.

However, this model is too restrictive and detached from reality but Rodrik argues that there is one result from Stolper-Samuelson that is

extremely general, and which can be stated as follows. Under competitive conditions, as long as the importable good(s) continue to be produced at home – that is, ruling out complete specialisation – there is always at least one factor of production that is rendered worse off by the liberalisation of trade. In other words, trade generically produces losers. Redistribution is the flip side of the gains from trade; no pain, no gain.

Rodrik also notices that the redistributive effects of trade liberalisation tend to get larger as the trade barriers become smaller

The ratio of redistribution to net gains rises as trade liberalisation tackles progressively lower barriers.

Muddy picture

However, reality seems to be harder than the neat world of Stolper-Samuelson ('SS'), there are a number of empirical data points and developments that are in contradiction with SS.

• Open countries where labor didn't lose
• Automation much more important
• Wages stagnant before trade with poor countries became significant, and across the board even in non-tradable sector, which is much bigger.
• Relative wages and employment figures haven't performed like SS would have it

Other countries, generally smaller and hence more open to trade haven't seen the stagnant wages:

There are studies that show that automation has been much more important in producing job losses in manufacturing, for instance, according to a study by Ball State University, 87% of manufacturing job losses can be ascribed to automation, 13% to trade. Rodrik acknowledges this at the end of the article:

it is important to emphasise that globalization has not been the only force at play -- nor necessarily even the most important one. Changes in technology, rise of winner-take-all markets, erosion of labour market protections, and decline of norms restricting pay differentials all have played their part.

Also, employment patterns haven't exactly obeyed Stolper-Samuelson either, here is Krugman:

But the numbers didn’t seem to work. Around 1990, trade with developing countries was still too small to explain the big movements in relative wages of college and high school graduates that had already happened. Furthermore, trade should have produced a shift in employment toward more skill-intensive industries; trade should have produced a shift in employment toward more skill-intensive industries; it couldn’t explain what we actually saw, which was a rise in the level of skills within industries, extending across pretty much the entire economy

In addition to that one should note that wages started to stagnate way before trade with low-wage countries like China became economically significant, and wages stagnated also in the much larger non-tradable (service) sector.

Trade war?

Still, we could find ourselves at the edge of significant deterioration of the international trade climate, as we're not quite reassured by this, from Business Insider:

Axios reported Friday that Trump and top administration officials recently discussed imposing massive tariffs on major exporters of steel. The tax would be about 20% and could be expanded to other goods such as paper, semiconductors, aluminum, and large household appliances, the report said. In the Thursday discussions at the White House, Axios reported that the sentiment in the room was 22 against the tariffs and three in favor — along with Trump himself. The plan is backed by chief strategist Steve Bannon, Commerce Secretary Wilbur Ross, White House National Trade Council chair Peter Navarro, and senior policy adviser Stephen Miller. While the move would be aimed at punishing China, Axios wrote that officials told Trump major allies such as Canada, Germany, Japan, Mexico, and the UK would be affected. Axios wrote that more than three-quarters of those present at the meeting told Trump the tariffs were a bad idea, but Trump remained supportive because it would excite his base of supporters.

For now, cooler heads seem to prevail but starting major trade disruptions to excite a base of supporters isn't something we look at with confidence. One should also realize this, perhaps, from the same article:

"Our steel imports, for the most part, come from friendly nations," he said, noting Western Europe, Japan, South Korea, and Canada. Branstetter said that, if those imports were 20% more expensive, US firms would be limited in how competitive they could be in both US and global markets with regard to every "Made in America" product they produce that uses steel. Among those industries, the auto and construction industries would be most negatively affected, he said. "So for every steel job this policy measure 'saves' in Pennsylvania, you'll lose two auto industry jobs in Michigan," he said.

And while the entry of China into the WTO did cause problems for certain US manufacturing industries it's benefits have not gotten equal attention recently, from VOX:

US consumers gained from China’s WTO entry through lower prices on varieties of manufactured goods that Chinese firms were already exporting in 2000 and continued to export in 2006; and through access to new varieties. We take account of both these components in constructing US manufacturing price indices for each industry. Our results show that the aggregate US manufacturing price index fell by 7.6% between 2000 and 2006 due to China’s WTO entry.

Decomposing this total effect into a price and variety component, we find that two-thirds of the aggregate effect comes from lower prices. All of this price effect is due to China lowering its own input tariffs, which results in lower prices of Chinese goods exported to the US and also lower prices of competitor firms in the US, both foreign and domestic. These lower competitor prices arise due to US firms accessing cheaper intermediate inputs from China, which lowers their own marginal costs; lower markups of competitor firms due to competition from China; and due to exit of the more inefficient firms that were unable to compete with China.

Why single out trade?

This is a question we have posed ourselves, given that it's only part of the story, and likely not the main part. Rodrik offers an explanation of sorts:

Sometimes international trade involves types of competition that are ruled out at home because they violate widely held domestic norms or social understandings. When such “blocked exchanges” (Walzer 1983) are enabled through trade they raise difficult questions of distributive justice. What arouses popular opposition is not inequality per se, but perceived unfairness.

This is a question we have posed ourselves, given that it's only part of the story, and likely not the main part. Rodrik offers an explanation of sorts:

Sometimes international trade involves types of competition that are ruled out at home because they violate widely held domestic norms or social understandings. When such “blocked exchanges” (Walzer 1983) are enabled through trade they raise difficult questions of distributive justice. What arouses popular opposition is not inequality per se, but perceived unfairness.

It's a little cryptic but we assume he means that it's not trade as such, but unfair trade practices that lend it particularly well to a populist backlash.

Rodrik's article offers another link, although he himself doesn't seem to be aware of it. He distinguishes between left-wing and right-wing populism. The latter:

is easier for populist politicians to mobilise along ethno-national/cultural cleavages when the globalisation shock becomes salient in the form of immigration and refugees.

Left-wing populism runs more across the social-economic divide, and while it is also very critical of international trade, the right-wing variant is perhaps more sensible to influences from abroad, such as unfair (or perceived as unfair) trade practices.

This actually hits on something which Fareed Zakaria argued, quite convincingly (our emphasis):

The Democratic economic agenda is broadly popular with the public. More people prefer the party’s views to those of Republicans on taxes, poverty reduction, health care, government benefits, and even climate change and energy policy. In one recent poll, 3 in 4 supported raising the minimum wage to $9. Seventy-two percent wanted to provide pre-K to all 4-year-olds in poor families. Eight in 10 favored expanding food stamps. It is noteworthy that each of these proposals found support from a majority of Republicans. The Democracy Fund commissioned a comprehensive study of voters in the 2016 presidential election, and one scholar, Lee Drutman, set out his first key finding: “The primary conflict structuring the two parties involves questions of national identity, race, and morality.” Focusing on the people who voted for President Barack Obama in 2012 and then Donald Trump in 2016, Drutman found that they were remarkably close to the Democratic Party on economic issues. But they were far to the right on their attitudes toward immigrants, blacks and Muslims, and much more likely to feel “people like me” are on the decline.

Safety net

If populism was just driven by economic factors there would be a natural way out in the form of a better safety net to protect people not only from the disruptions of international trade, but also from the (more important) disruptions of automation and the general creative destruction produced by capitalism.

There is plenty of evidence that actually works, and Rodrik argues this as well:

In principle, the gains from trade can be redistributed to compensate the losers and ensure no identifiable group is left behind. Trade openness has been greatly facilitated in Europe by the creation of welfare states. But the US, which became a truly open economy relatively late, did not move in the same direction. This may account for why imports from specific trade partners such as China or Mexico are so much more contentious in the US.

Given the well sourced quote above from Zakaria, welfare state redistribution policies are surprisingly broadly popular in the US. However, if trade is more bound up with national identity and immigration, these type of solutions are probably less useful (apart from what they might do to underlying economic dynamics).

If it's just the disruption from trade than a better safety net seems a logical answer (and countries like Denmark, with its activating labor market policies, have shown that this doesn't necessarily come with a heavy economic price), especially since protectionism comes with its own economic costs.

Conclusion

Trade and globalization offer just one source of labor dislocation, and not the most important one. Capitalism by its nature brings revolutionary change through creative destruction where jobs, crafts, communities and whole sectors decline and perish because of constant new companies, technologies and business models.

So in terms of pure economics, protectionism only protects for a small part of the disruption and it brings its own heavy cost which falls on consumers in the form of higher prices and businesses in the form of disruption to their supply networks.

These costs can escalate if the international institutions that underpin the global economic order start losing legitimacy which could be the end of the world as we know it and would bring large cost and complexities upon international business, and by extension, its shareholders.

Some (by no means all) European countries have shown that the hard edge of the disruption can be softened with a fairly generous (but activating) safety net, and surveys have shown such policies would actually be surprisingly popular in the US.

However, if the populist turn against trade and globalization is part of an assertion of national identity these policies aren't likely to take the wind out of the sails of the populists. An unraveling of the global economic order can't be ruled out.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.