Free trade is under threat

by Michael Collins, Investment Commentator at Fidelity International

August 2016

Donald Trump, the Republican presidential nominee, went to an aluminium recycling plant in Pennsylvania in June and declared that globalisation “has left millions of our workers with nothing but poverty and heartache”. His solution is to renegotiate trade deals, torpedo US participation in a proposed trade pact among 12 Pacific countries including Australia, threaten to pull out of the World Trade Organisation and slap sanctions on China to stop its currency manipulation and “illegal activities” tied to trade.[1]

Democrat nominee Hillary Clinton knows the appeal of such anti-trade talk. The paperback version of Clinton’s memoir, Hard Choices, accordingly, is missing the passage from the hardback edition where she boasted of her efforts to win US support for the Pacific Rim trade pact, which Clinton once praised as the “gold standard” of trade deals.[2]

Within three days of the UK vote to leave the EU, French Prime Minister Manuel Valls effectively killed an EU-US trade pact by saying “talks aren’t going in the right direction”. In Australia’s latest parliament, protectionist-leaning independents and minor parties hold pivotal positions, forewarning of steps to prop up uneconomical local manufacturers.

Trade barriers kill more jobs than they preserve, squander taxpayer money, strain government finances, hamper productivity growth and suppress living standards. Yet they are festering at their fastest pace since 2008, according to the WTO.[3] While economists and pro-trade bodies can rail all they like about the case for free trade, it appears a losing argument for the foreseeable future. After three decades of lifting billions of people out of poverty in developing countries, boosting living standards overall in the advanced world and knitting closer the international community, the flaws of international trade have made the free flow of goods and services across borders politically toxic.

The undermining of perhaps the most fundamental tenet of globalisation, which can be the defined as the free movement of goods, capital and people, undercuts the neoliberalist creed that has steered advanced liberal democracies since the early 1980s. For to attack free trade is to attack free markets, the essence of neoliberalism. The worry for investors is that the upending of this anything-goes ideology leaves nothing in its place.

Globalisation is hard to unwind and anti-free-trade populism isn’t thriving outside the developed world, it must be said. Such populism is even retreating in Latin America as more centrist leaders have assumed power recently in Argentina, Brazil and Peru; even Communist Cuba is opening up. But then Latin Americans have seen the damage illiberal populism can do; Venezuela’s decent into chaos is the latest warning on where such mistakes head. In Asia in December, Asean leaders created the Asean Economic Community to encourage freer trade and help companies shift production into neighbouring countries. The five-member East African Community has similar aims. Protection levels on goods around the globe are low anyway so the issue is about avoiding higher barriers rather than lowering them. Authorities have weapons such as anti-dumping powers to attack illegal trade practices. Clinton, if president, would probably make few protectionist moves of significance, even if she doesn’t ratify the Trans-Pacific Partnership. Higher tariffs would engender the inflation central banks are seeking anyway. Trade agreements between two or only a few countries don’t amount to much in any case in terms of enhancing living standards, many, including Australia’s Productivity Commission,[4] argue, so why mourn their failure to materialise? But it’s what’s happening in advanced countries that sets the climate for the global picture. At a time when global trade is growing at its most sluggish pace since the first half of the 1980s,[5] the world can ill afford a surge in western protectionism. Politics point to this outcome, however. 

Two political ills

Free trade is built on the belief that everyone is better off when people, companies and countries specialise in what they are most efficient and then exchange their output for what others do best. The problem with this theory of comparative advantage is that it comes with some flaws. In intellectual terms, it doesn’t account for the capital assets junked and the workers made permanently redundant when they lose out to a shift in comparative advantage against them.[6] But trade’s problems are more political than intellectual. In political terms, free trade’s central problem is that its benefits are so widespread they can be hard to detect but its costs are concentrated and easy to spot.

The political blowback against trade is manifesting itself in two main issues. The most-pressing is trade’s role in widening inequality within countries and, to a lesser degree, between countries, even as it boosts material wealth overall. Serbian-born economist Branko Milanovic has identified that one of the biggest non-winners of free trade and globalisation as the lower-middle class in advanced countries.[7] Milanovic found that between 1998 and 2008 the real income gains for the lower-middle classes in rich countries, those between the 75^th and 90^th quartiles of global wealth charts, were “essentially nil” while everyone else but the world’s poorest 5% benefited.[8] These less-well-paid people in Western Europe, Japan and the US are the source of hostility for globalisation that shows up in support for populist parties and causes, from Brexit to Trump. The winners of globalisation have been the world’s richest 10% and Asia’s poor and middle class. (Milanovic’s chart is called the “elephant chart” because showing globalisation’s winners and losers ranked by their wealth results in a line resembling an elephant raising its trunk. The non-winners in the west are at the base of the trunk.)[9]  

The second political drawback of free trade is how it erodes sovereignty. Global trade agreements demand harmonisation between countries. These pacts standardise laws and regulations on such things as intellectual property, pharmaceutical price-setting, investor-dispute mechanisms, labour standards and product safety. They give rise to supranational bodies such as the World Trade Organisation and the EU. This is all at the cost of self-determination through democratically elected parliaments. If the UK vote to leave the EU showed anything (apart from the contempt people hold for experts) it’s that voters are prepared to pay an economic cost for democracy and sovereignty. The secrecy by which preferential trade deals are negotiated, the fact that companies are consulted but not the wider community, and the ability these deals give companies to sue governments for changes that harm them (such as the Philip Morris actions against the Australian government for its plain-packaging laws on cigarette packets) only make free trade more politically lethal.[10]

Oversold?

Neoliberalism as a term traces its origins to German economist Alexander Rüstow who coined the word in 1938 to suggest a middle path between laissez-faire economics and market planning. While the meaning of the expression has changed over time, neoliberals favour market-based competition while advocating a limited role for government outside of protecting private ownership and wealth. By the time the ideology gained credence in the 1980s it included pushing for unregulated labour markets, free capital flows, the privatisation of state assets, limited government, low taxation and a belief in trickle-down economics. Neoliberalism is defined as much by what it opposes (regulation on private enterprise, excessive welfare and collective bargaining) and by what it ignores; namely, inequality. If neoliberalism were to be defined in one word it would be globalisation. It was especially associated with the globalisation of finance from the 1980s (whereas free trade has thrived since World War II). Its most-famous ideological proponents include Austria’s Friedrich Hayek and Milton Friedman. Its most well-known practitioners were Ronald Reagan, Margaret Thatcher and Chile’s Augusto Pinochet. If neoliberalism were to be linked to one organisation outside of political parties and academia it would be the IMF, which has imposed neoliberal solutions on many defaulting countries.

The IMF employs 2,400 people so it speaks with many voices. Still, it staggered many when three IMF economists in June released a paper in the body’s flagship Finance & Development publication questioning whether neoliberalism has been “oversold”. The economists looked at the worth of free capital movements and rigid control over government finances to curb the size of the state and found their benefits “seem difficult to establish”, “the costs in terms of increased inequality are prominent” and “increased inequality in turn hurts the level and sustainability of growth”.[11] The authors support the IMF’s recent decision to rescind its support for austerity, a similar conclusion to that of the OECD,[12] and backed the IMF’s call for capital controls where appropriate because “no fixed agenda delivers good outcomes for all countries at all times”.

Such a non-ideological conclusion harks to the big question left by the decline of neoliberalism: What comes next? The answer might well centre on the fact that many countries that industrialised successfully under capitalism were not besotted with neoliberalism. Singapore and South Korea are but two countries in east Asia that have developed under forms of capitalism where businesses including exporters operate under state control and receive government aid. Investors can probably look forward to a more pragmatic form of capitalism replacing neoliberalism. Hopefully, it will be pure enough to embrace free trade but sensible enough to help its losers.

Financial information comes from Bloomberg unless stated otherwise.