Understanding free trade

A past member of the UK’s monetary policy committee once told me that they got much more intelligent questions from committees of the House of Lords compared to committees of the House of Commons. This should not be too surprising, as there are some people with considerable knowledge and experience in the Lords.

Below is an excerpt from the conclusions of a recent Lords EU Committee Report (HT Frances Coppola)

“The notion that a country can have complete regulatory sovereignty while engaging in comprehensive free trade with partners is based on a misunderstanding of the nature of free trade. Modern FTAs involve extensive regulatory harmonisation in order to eliminate non-tariff barriers, and surveillance and dispute resolution arrangements to monitor and enforce implementation. The liberalisation of trade thus requires states to agree to limit the exercise of their sovereignty. The four frameworks considered in this report all require different trade-offs between market access and the exercise of sovereignty. As a general rule, the deeper the trade relationship, the greater the loss of sovereignty.”

There you have, in one calm and measured paragraph, the contradiction at the heart of the argument put forward by Liam Fox and others that leaving the EU will allow the UK to become a ‘champion of free trade’. You cannot be a champion of free trade, and have sovereignty in the form of taking back control.

It is not a contradiction, of course, if you are happy to accept the regulatory standards of the US, China or India. That appears to be the position of Leave leaders like MP Jacob Rees Mogg. Ellie Mae O’Hagan spells out what this may mean in practice. Lead in toys - bring them in so we can sign a trade agreement with China. And you can be sure that this will be the nature of the discussion every time a trade deal is signed. In each case we will be told that we have to accept this drop in regulatory standards, because British export jobs are on the line.

This is the point of Dani Rodrik’s famous impossible trilemma: you cannot have all three of the nation state, democratic politics and deep economic integration (aka free trade). His trilemma replaces sovereignty, by which in meant in this context the nation state being able to do what it likes, by democracy. In the past I have always found this problematic. Surely a democracy can decide to give away a bit of its sovereignty in return for the benefits of international cooperation (in the form of trade deals, or indeed any other kind of international cooperation). After all, every adult in a relationship knows that this relationship means certain restrictions on doing just what they would like.

At first sight, it would seem as if the Brexit vote shows Rodrik is right. Democracy voted to take back control, which means reducing trade integration. But I think it is becoming increasingly clear that this is the wrong interpretation. Voters were told they could take back control and be no worse off, and polls make it clear that message was believed by many Leave voters. As it becomes clear that people will be worse off, as depreciation induced inflation cuts real wages, opinion is changing. Polls already suggest that if the vote was held again, we would get a different result. Polls also suggest more voters want to prioritise favourable trade deals in negotiations, not curb immigration. Over the next year or two this will only intensify, as prices rise, as companies make plans to leave the UK, as the problems caused by declining immigration emerge, and as the UK’s weak negotiating position becomes clearer.

Leavers know this, hence the attempts to remove any kind of democratic oversight from the Brexit process. At present MPs appear transfixed by the light of the Brexit vote, even though most know Brexit is an act of self harm. But it was utterly predictable from the day that Corbyn was re-elected that we would see a revival of the Liberal Democrats. As they chalk up election victories, it might just be possible that we could yet see some democratic oversight of the Brexit process. [1]

To see a model of what could and should happen, look to Switzerland, where referendums are part of political life. In February 2014 Switzerland voted to restrict immigration from the EU, even though this jeopardised their trade relations with the EU. Since then the EU has insisted that its bilateral trade deals with Switzerland depend on free movement. As a result the Swiss parliament has backed down, and just passed measures which greatly diverge from the referendum proposal, even though in Switzerland referendums are (unlike the UK) meant to be constitutionally binding.

So we see in Switzerland, and perhaps we will see in the UK, that parliamentary democracy can be compatible with trade integration. Rodrik is right that deep trade integration (the pressures from which will continue, as Richard Baldwin outlines) puts pressure on the ability of nation states to decide on their own laws, but a democratically negotiated compromise is possible. (After all, national languages are a barrier to trade.) Perhaps the examples of the UK and Switzerland suggest two things: first that these negotiated compromises should be out in the open rather than done behind closed doors, and secondly that what is very difficult to mix are trade integration with national referendums.

[1] The conventional logic is that MPs would go along with Brexit because the Remain vote is concentrated in too few constituencies. But outside Scotland the Leave vote is now split three ways (Conservative, Labour and UKIP). Labour may mock the LibDems as Brexit deniers, but as the LibDems get the votes not only of people who deeply care about being part of Europe (see the surge in Remain identity noted here) but also of those that voted Leave but are now getting concerned, they will be the ones with the last laugh.

The unique blindness of some commentators on the right

Janan Ganesh of the FT talks about the unique moral arrogance of the left. They have too often “impugned the motives of Conservatives”. He says that “the reality of politics in a rich, modern country is that parties are squabbling over marginalia”. He is wrong, and should get out more.

For example, take the issue of benefit sanctions. No doubt he might say that sanctions existed, and indeed the regime was tightened, during the Labour government. But the reality is that something very horrible, and morally shameful, is currently going on. The number of sanctions per claimant remained below 4% from 2000 to 2010. In 2013 it peaked at above 7%, and in 2014 was between 5% and 6%. Behind these statistics are a wealth of examples of where sanctions have been applied for minor infringements, and have ignored excellent reasons like the death of a spouse, or the long que at the jobcentre. Frances Coppola gives these and more examples here.

She points out that Department of Work and Pension (DWP) guidance states “It would be usual for a normal healthy adult to suffer some deterioration in their health if they were without essential items, such as food, clothing, heating and accommodation or sufficient money to buy essential items for a period of two weeks…” Sanctions often operate for 4 weeks or even longer. It is causing people to become homeless, and children to go hungry. This is not “marginalia”.

The current sanctions regime is one of the main causes of the increased use of food banks in the UK. Yet Ganesh instead likes to focus on inaccurate use of foodbank data. The DWP says that the sanctions regime is important in providing incentives to get people back to work. But is there any evidence that it does this? You would think that the department would have produced some evidence by now, although one of the comments on Frances’s post (and yes, we cannot know it is genuine) suggests why we have not. Yet this did not deter the department. They put out on their website (now unsurprisingly withdrawn) quotes and a picture from ‘Sarah’ who had been sanctioned and as a result had been encouraged to produce a CV. The only problem was that Sarah was completely fictitious.

There is widespread talk of jobcentre staff being put under pressure to sanction. The relevant select committee of MPs has asked for an inquiry, but this has been refused. Benefit sanctions are just one of a range of policy mistakes by this department that is causing real harm to the disadvantaged, and will continue to do so. All these problems were quite clear before the election, but the Prime Minister has kept Iain Duncan Smith in post. George Osborne has been happy to feed off the stigmatisation of benefit claimants stoked by the tabloids.

So please, Mr. Ganesh, no more lectures about moral arrogance on the left. Not, at least, until you have recognised what is actually happening to many of those who are unfortunate enough to be claiming benefits administered under this government, and the government’s apparent indifference to that.

The wheels on the bus

I have an image in my mind. Its a bus running downhill, and its brakes have failed. There are four men in the front cab. The two men in the middle are both trying to control the steering wheel to keep the bus on the road. The man to their right has control of the accelerator, and is pushing on the gas hoping this will crash the bus to the right. The fourth man to their left controls nothing, but as his pleas to stop pressing the accelerator fall on deaf ears, he begins to wonder whether it would be better for the passengers to grab the wheel and crash the bus to the left. The three other drivers do not agree on very much, except that it is all the fault of the guy on the left, and now appear to be thinking about throwing him off. As the bus hurtles downhill swerving from side to side, its passengers are battered, some injured, and a few are jumping off.

I do not need to explain the symbolism. I tried to change the image to explain why the man on the right refuses to stop pressing on the accelerator of growing primary surpluses, but gave up because the real reason is that he wants to crash the bus anyway. (The argument that the Eurozone’s rules do not allow debt write-offs is just nonsense.) Otherwise I think the image works well. The two men in the centre represent Tsipras and maybe Hollande. Hollande is saying that if only you would let me have the wheel (‘structural reform’) all would be well, but in truth the main reason the passengers are being injured (unemployment and welfare cuts) or are jumping (migration) is the speed of the bus.

The central question is whether the men in the middle are delusional. By keeping the Greek economy on the road that is the Eurozone are they only going to prolong the agony with the same inevitable crash which is Grexit?

There is only one reason for optimism that I can see, although it assumes yet further reductions in Greek living standards. The hill the bus is travelling along will begin to flatten out and the road might even start to rise as Greece becomes more competitive in terms of price. I outlined here why that has not yet boosted the Greek economy to the extent it has in Ireland, but if unemployment remains at or above 25% Greece should get even more competitive. Instability and unwise Troika interventions may delay the process, but eventually the tourists will come. The Eurozone does contain a natural correction mechanism: it is just slow and painful.

If this does eventually lead to sustained growth in Greece, it does not excuse what has gone before: recoveries do not justify recessions, and government profligacy does not have to imply a 25% fall in GDP! However this correction mechanism is not bound to succeed, if it is countered by another dynamic, which is one that has been and continues to be imposed by the Troika. That dynamic is austerity chasing primary surpluses when that austerity makes the economy shrink. Macromodels would probably tell us which dynamic will win out, but they will not factor in a deterioration in the financial position of banks (already not good as Frances Coppola points out) as the economy stagnates, and the deteriorating social and political situation that austerity brings.

So the eventual outcome still depends on the decisions of the Troika. It always has of course. The truth that their apologists find so uncomfortable is that the Troika has been in charge of the economy since 2010, and therefore is responsible for the mess we are now in. The idea that all would be well if only Greece had undertaken every item of structural reform they specified (and a lot was done) is just silly. Now it appears as if it is all the fault of the former Greek finance minister, because he dressed funny, or kept wanting to talk about economics, or did some contingency planning - it is so absurd you couldn’t make it up.

One ray of hope offered by Anatole Kaletsky is that now “ritual humiliation” has been achieved, the Troika will be more forgiving. I wish he was right, but this argument fails to account for the German finance minister who clearly believes that exit is the best option. He wants the bus to crash for the sake of the other cars on the road. An optimistic view would be that the shock [1] of what was done to Greece a few weeks ago will bring others to their senses, and Schäuble’s influence on the Eurogroup (and strangely the IMF) will decrease. I fear the larger truth is that the non-German bloc in the Eurozone does not have an alternative economic vision to offer (although it clearly exists), and will never face Germany down.

[1] Link added 31/07

The Eurozone Scandal

Imagine that it was revealed that 10% of the European Union budget (the money that goes to the EU centre to fund the common agricultural policy and other EU wide projects) had been found to be completely wasted as a result of actions by EU policymakers. By wasted I do not mean spent on things that maybe it should not have been spent on (rich farmers, inefficient farmers, infrastructure projects whose costs exceed benefits etc), but literally money that went up in smoke. Imagine the scandal. Heads would roll, and some might find themselves in jail.

10% of the EU budget is about 0.1% of EU GDP. Yet sums at least ten times that figure are currently being wasted in the Eurozone, as a result of actions by Eurozone policymakers. Here is the latest OECD assessment of output gaps across eleven Eurozone countries, for both 2013 (blue) and 2014 (red).

A negative output gap means that output could be the amount of the gap higher without raising inflation above target. Of course Greece is a nightmare, and things in the other PIIGS are really bad, but the output gap in the Netherlands is around 3%, in France over 2% in 2014, and even in Germany the output gap exceeds 1%. Estimating output gaps is an imprecise science, but gaps of at least this size are consistent with inflation well below target (currently 0.3%). So output could be at least 1% higher across the Eurozone with no ill effects. This is the equivalent of the entire EU budget going up in smoke.

Sometimes negative output gaps are the result of shocks which were not anticipated by policymakers (like the financial crisis). Sometimes they are engineered by policymakers to bring inflation down. It is unfortunate that these things happen, but they always have. However the output gaps we have in the Eurozone today are neither of these. Instead they have been created by policymakers for no good reason. That is why they can be called a scandal.

At this point you might think I’m being unfair. Surely this is all about tight fiscal policy required to bring down government debt. I agree that it is all about fiscal policy, and in particular the crazy fiscal rules imposed within the Eurozone. However where is the urgent need to bring down debt outside the periphery? The OECD estimate that the primary structural budget balance in the Eurozone will be a surplus at around 1% of GDP in 2014 compared to a deficit in the OECD as a whole of just over 1%. So even if you think that we need austerity to bring deficits down rapidly - which I do not - why should policymakers in the Eurozone be doing this so much more quickly than in the UK, US or Japan? To achieve this goal, they are wasting resources on a colossal scale.

If you think anything has changed as a result of Juncker’s ‘E315 bn’ investment plan, you should read this post from Frances Coppola. As she makes clear, there is not a penny of new EU money in this proposal. Instead money earmarked for existing projects is being used to provide insurance to private sector investment (which may or may not happen). There are so many issues with this kind of stimulus. Besides those raised by Frances, there is also the question of how to prevent firms simply getting insurance for schemes they would have undertaken anyway, and how exactly will the Commission select when to allocate its insurance. Those of a neoliberal persuasion who think government is bad at spending its money cannot feel any more comfortable with the government selecting what private sector projects to back. However a scheme like this will come as no surprise to someone like George Monbiot, who thinks states are increasingly being used to serve corporate ends. 

Equally embroiled in this scandal are those making monetary policy decisions at the ECB. Here I can simply defer to an excellent post by Ashoka Mody. In particular he points out why it is misleading to simply look at the ECB’s balance sheet as an indicator of the force of unconventional monetary policy. There is an important difference between creating money to bail out failing banks, as the ECB has done, and creating money to buy bonds to force down long term rates, which is Quantitative Easing (QE). He argues that the “ECB is set to remain—by far—the central bank with the tightest, most conservative monetary policy among the major central banks.” I thought I would quote the following paragraph in full, for reasons that will be clear to regular readers.

“Others play by the rules of the cognitive frame. Thus, despite the serious concerns with the June 5th measures—documented carefully by my Bruegel colleagues—journalists have no interest in asking ECB officials: “What exactly are we waiting for?” The financial markets have no interest in public policy: once the rules are set, they seek opportunities for short-term bets. On July 9th, the International Monetary Fund’s Executive Board somewhat incredulously concluded: “Directors welcomed the exceptional measures recently taken by the European Central Bank (ECB) to address low inflation and strengthen demand, as well as its intention to use further unconventional instruments if necessary.” Belatedly, on November 25th, the OECD became a lone official voice calling for more urgent steps.“

To those who say that QE, as operated by the BoE or Fed, would have limited effectiveness in the Eurozone, I have a lot of sympathy. However there is a relatively simple way of making QE much more effective and predictable, and that is for central banks to create money not to buy financial assets but to transfer directly to citizens, which Friedman called helicopter money. John Muellbauer calls this QE for the people. Conventional QE involves buying a large amount of assets with potential losses for the central bank (if the asset price falls) but uncertain effects on demand. Helicopter money involves small transfers with a certain loss to the central bank but much more predictable positive demand effects. [1]

As an institutional innovation, helicopter money has two major drawbacks in countries with their own central bank. [2] First, why innovate when you can implement exactly the same policy through existing means: in macroeconomic terms helicopter money is equivalent to QE plus tax cuts when you have inflation targeting. Second, a fiscal stimulus in the form of temporary additional government spending is likely to be more predictable in its impact than transfers or tax cuts, because you eliminate the uncertainty caused by how much of the transfer or tax cut will be spent.

But if countercyclical fiscal policy is effectively illegal in the Eurozone, these objections do not apply. QE for the people may have additional legal merits within the Eurozone. The ECB is constrained to some (uncertain) extent in its ability to buy government debt. But, as John Muellbauer suggests, mailing a cheque to every EZ citizen using electoral registers would seem to circumvent these legal difficulties.

One objection to the ECB embarking on ‘QE for the people’ is that it goes well beyond the remit of a central bank. [3] Yet the ECB appears to have no qualms on that score: besides routine references for the need for fiscal consolidation and ‘structural reform’, the letter discussed by Paul De Grauwe here shows the ECB requiring detailed changes to labour market regulations and institutions in Spain. So you have to ask why is it OK for the central bank to override the democratic process in this way, but giving money directly to the people is somehow beyond the pale.

If you think that mailing a cheque to every voter in the Eurozone as a solution to continuing recession sounds too good to be true, then you have just rediscovered why recessions caused by demand deficiency when inflation is below target are such a scandalous waste. It is a problem that can be easily solved, with lots of winners and no losers. The only reason that this is not obvious to more people is that we have created an institutional divorce between monetary and fiscal policy that obscures that truth. It was a divorce that did a reasonable job in steering the economy in normal times, and it might discourage fiscal profligacy when demand is strong, but since 2010 it has led to a scandalous paralysis in the Eurozone.  

  

[1] These losses are notional only, as the central bank is not in the business of making money. They matter only if they compromise the ability of the central bank to do its job of controlling inflation in the future. There are various ways that danger can be avoided, but my point here is that costs to the central bank can arise with any form of QE.

[2] Central banks routinely pass the profits they make (through seigniorage) to governments. So the innovation is that the central bank rather than the government decides how to disperse this money.  

[3] Another objection is that, because the ECB is free to define its own targets, changing the monetary policy framework to target the level of nominal GDP would be a better innovation. I agree this would be a useful innovation. I would argue that it would be better still to allow countercyclical fiscal policy, because only this can deal with country specific shocks. But if, for whatever reason, these changes are ruled out, then a helicopter drop should be implemented. If you are a market monetarist, think of it as an insurance policy.