NN IP: Politics is likely to continue to trump economics

The quiet days of the Great Moderation...

Over the past few months it has become clear that the point at which we can say that “all is quiet on the political front” is still not on the horizon. Politics used to play a relatively minor role in the years immediately preceding the Great Recession of 2008/09. Markets did of course get excited about US presidential elections and the start of the Gulf war, and there was probably some volatility when France and Germany decided the fiscal rules applied to others because they themselves could be trusted to do the right thing in 2003. Still, back then, a substantial and potentially persistent negative spillover from political uncertainty into the real economy and markets was a phenomenon pretty much limited to emerging markets. The chief reason that politics played only a minor role in developed markets during the Great Moderation is, of course, that moderation itself. It caused markets to believe that the era of high real growth and low inflation would continue forever; i.e., when contemplating the distribution of future economic outcomes, the horizon always look pretty good. This was all the more so because markets believed that a downturn was only a temporary dip in this sunny climate. An important reason for this is that they assigned almost mythical powers to central banks when it came to the ability of monetary policy to stabilize the business cycle. Some pundits even contemplated whether the business cycle was a thing of the past. Still, in 2008 this animal came back with a vengeance and said that reports of its death were greatly exaggerated. 

Meanwhile, fiscal policy remained very much in the background during the Great Moderation as its main focus was on maintaining a low debt-to-GDP ratio, with Japan as the notable exception – but then Japan should have served as a warning about the limits of monetary policy at the time. Hence, there were no big political debates about whether austerity or fiscal expansion was the correct fiscal recipe. All mainstream parties more or less agreed and this also applied to the views held on the importance of the institutional framework in which the economy operates. The view was actually that this framework was not that important in the end. After all, markets were seen as self-creating, self-regulating, self-stabilising and self-legitimating. This “fatal conceit” led European policymakers to believe they could get away with only creating a single currency and central bank for the region as a whole and then rely on market discipline and (supply side) policy competition to create spontaneous economic convergence. In the end, they got quite the opposite. In fact, divergence was pretty much baked into the Maastricht Treaty cake. Capital flows within an incomplete monetary union have a natural tendency to become destabilizing. At some point there is always a region where expected returns are seen as being higher than in other parts of the monetary union. This invariably leads to the build-up of substantial imbalances whose subsequent digestion is a painful process. In a complete monetary union such as the US, there are sufficient real economy and public sector redistribution mechanisms to prevent this boom-bust cycle. This is why we never talk about destabilizing capital flows between, say, Florida and California. 

In short, a large degree of consensus in the political arena combined with a very good and consistent macro performance ensured that political uncertainty did not play a large and persistent role between the mid-1980s and 2008. Actually, one political development had a big and persistent effect but it was decisively positive. The end of the Cold War and the collapse of communism ushered in a period which some even called “The End of History”. The essential idea was that the Western model of democracy and freedom under the Rule of Law would soon be applied to much of the world and that the US would be the dominant power acting in the spirit of enlightened self-interest to promote and protect this model. Once again there was a “fatal conceit” here, which is to believe that one set of institutions fits all countries; i.e., there was no regard for the idea that differences in national preferences and circumstances could well give rise to different optimal institutional set ups.

...gave way to the era of political uncertainty

This consensus broke down after 2008 because the economic pillar supporting it collapsed. Economic growth was sluggish for many years and inflation fell persistently below central bank targets. This shattered the myth of central banks as guardians of economic stability. As a result, the distribution of future economic outcomes appeared to make a big bearish shift with a lower mean, a higher variance and a much bigger downward skew. Not surprisingly, this led to a sharp increase in voter dissatisfaction as well as heated debates in the political arena about which policies were needed to remedy the situation. In the end, central banks saved their economies by moving further into unconventional territory than anyone could have imagined ten years ago. In doing so they partly served as a substitute for the policy paralysis which often resulted from the detrimental mix of rising political fragmentation and suboptimal economic outcomes. In our view they did the best they could but none of them, not even the Fed, has succeeded in pushing the economy under its watch back to the pre-crisis nominal GDP path. Whether this would have been possible with a more benign policy mix will remain a matter for debate for a long time. Our view is that we could well  live in a world of higher productivity growth and higher bond yields if the right policy mix had been implemented. 

That said, the fact is that from a cyclical perspective things have been pretty good over the past two years. Unemployment rates in DM space are coming down very fast and GDP growth has been pretty solid. One could of course argue that the gains have been unevenly distributed as the labour share of GDP remains around multi-decade lows. On the other hand, consumer confidence is hovering around multi-decade highs and tighter labour markets should cause at least some improvement in the labour share. In addition, higher productivity growth should also support real wage growth. A few years ago, we believed that a strong economy would be sufficient to cause the populist tide to wane but the situation is obviously much more complicated than that. Of course, the most recent surge in populism took place in Italy, a country that has been stagnating for two decades, which indeed suggests that growth is an important part of the story. However, Trump was elected while the US economy was doing pretty well, and in a booming economy like Germany’s, some mainstream politicians are also taking an increasingly populist stance.

Forces behind the populism still alive and kicking

These examples are just an indication that regional and/or global institutional frameworks as well as immigration are important drivers of populism. About two months ago we discussed how the question “Who rules the nation state?” is a pretty crucial one in this respect. A sharp increase in trade and financial integration requires countries to submit to an increasingly large and invasive set of common rules. Of course, if one assumes that there is such a thing as “best practice” in institutional design this should not be a problem. Indeed, for a very long time many academics and policymakers believed “best practice” did exist and it was known as the “Washington consensus”. This set of principles more or less denies or overrules differences in history, voter preferences and economic circumstances that exist between countries. As a result, different countries may well have different optimal institutions. In a way, populist parties are trying to correct for this in a revolutionary way by advocating to push the global rules aside and gear domestic institutions completely towards domestic preferences and circumstances. In doing so, they completely ignore the substantial, albeit often not immediately obvious, benefits of an international rule-based order. Europe is a case in point here. It has a history of war between nations, while the existence of the EU and its predecessors has been an important reason why the continent has known peace for more than 70 years now. What’s more, populists also ignore the fact that the revolutionary change they advocate can be extremely costly in economic and financial terms. 

The argument of “taking back control of the nation state” is perhaps more relevant for the right-wing populists. The left-wing populists have an additional reason for grievances with the prevailing set of institutions, which is essentially that the Washington Consensus is pretty much the wish list that people like Ronald Reagan and Margaret Thatcher would have drawn up in the 1980s. The main issue for left wing populists is that the income distribution has shifted in favour of the owners of capital and knowledge over the past three decades. To a considerable extent this development can be ascribed to the combined shocks of globalisation and technology which made both physical and human capital relatively more scarce. The important thing to bear in mind is that such persistent shifts in income distribution will change institutions over time. The winners will gain more political power, enabling them to change the economic and political rules of the game in their favour. This political dimension will tend to enhance widening income inequalities. While it is true that the losers are greater in number, they are also subject to a collective action problem: it is difficult to organize themselves strongly enough to provide a counterweight. Viewed from this angle, populism can be seen as an attempt to correct the imbalance in a revolutionary way at the risk of a big overshoot. 

Populists may have a point when they say that the Washington Consensus tends to ignore or even enhance widening inequality essentially because it deems this not to be a problem at all. In that view of the world, free markets will eventually allow the benefits for the winners to trickle down into gains for the losers as well. However, international institutions such as the IMF have now come around to a different view and advocate active policies to reduce inequality. In the end, this will be to the benefit of the winners as well. After all, too much inequality will lead to rent-seeking, i.e. devoting resources to the political process in order to change the rules of the game in the way described above. This will act as a drag on overall productivity growth (these resources are not used productively and the change in the rules favours issues such as too much concentration in certain industries). What’s more, widening income inequality contributes to the global savings glut and all problems that follow from it, most notably low equilibrium real rates. In addition to this, too much inequality is detrimental for social and political stability as we have seen in various DM economies over the past few years.  In the specific context of the euro area, one can say that the prevailing fiscal and banking institutions are to a considerable extent a translation of the Washington consensus to the European context. After all, the emphasis is very much on fiscal austerity, strict adherence to the rules, structural reform, the application of market discipline, etc. Meanwhile, there is too little regard for the fact that all EMU countries are in the same monetary boat and that strict adherence to common rules must be balanced by certain solidarity mechanisms.

This tension between global rules and local preferences has made itself painfully felt at the ballot box over the past few years. In a sense, immigration is just another expression of this problem. The peculiar thing here is that many ardent proponents of globalisation were always in favour of reducing barriers to trade and capital flows but much less so about reducing migration barriers. Of course, there is more than just the economic calculation involved here. History shows that the assimilation of different cultural backgrounds into one nation need not be a problem at all. The US is the clearest example of this, and the driving force was the shared hope of a better future and the idea that there was enough space and opportunity for all to realise this. Nowadays, a non-negligible share of the electorate is afraid that their national identity will be diluted by the inflow of migrants with different customs and different ideas. At the same time, these voters feel that immigration is an additional financial burden on public finances which are already under pressure due to real or imaginary austerity needs.