The road to conflict is paved with financial crises

In a couple of recent posts (here and here), I discussed how the rising popularity of right wing nationalism in Europe, the US and Australia could be the final trigger to massive global conflict, much like the 1930s leading up to WWII.

But if worldwide conflict does truly erupt, it may not be between nations, or on traditional battlefields. It may be between civilians on our very streets. Societies in Europe, the US and Australia are becoming increasingly polarised, and these conflicts have already started spilling over into the street. Nationalistic groups across Europe are criticising the EU and demanding a halt to what they see as dangerous mass immigration. And social justice groups such as Occupy Wall Street and Black Lives Matter are opposing what they see as entrenched economic and societal discrimination.

Keep in mind that I am not making any value judgements on the merit any of these groups’ causes – I’m only saying that their grievances have spilled over into active protests, if not actual Parliamentary representation.

And these groups are not entirely separate. In fact, there have been occasions in Australia where so called ‘anti-racism’ groups have clashed with anti-Islam/ anti-immigration groups, one group often protesting in direct response to the other.

I am nervous that a single event, such as a terrorist attack in a Western country, could trigger a series of truly violent and destructive riots between anti-immigration and ‘anti-racism’ groups all over the Western world. And governments will be caught in the middle, unsure as to which side of their polarised society they should be submitting.

And as it turns out, it’s not a coincidence that these events so closely resemble the 1930s.

A recent study (summary and full paper) by Manuel Funke, Moritz Schularick and Christoph Trebesch, assessing 144 years of data in 20 rich countries over more than 800 general elections, more than 100 financial crises and historical data on street protests, discovered that there is a very strong link between financial crises and the subsequent growing popularity of right wing nationalist groups. Specifically, in the five years following a financial crisis, far-right votes grow by about one-third – this means actual Parliamentary representation.

This is unsurprising, as the study explains, given the fact that financial crises, unlike normal recessions or even severe non-financial macroeconomic shocks, negatively impact not just employment, but also asset values (property, stock markets). Consequently, the pain of financial crises tends to be greater, and the recovery weaker and more prolonged. Furthermore, financial crises are often viewed as the direct result of the failure of a specific group – governments, banks, etc., rather than external events such as oil price shocks, natural catastrophes or wars, for which it is harder to attribute blame to a specific group. Financial sector bailouts and disputes between creditors and debtors that are more inherent in financial crises are also likely to cause more widespread social dissatisfaction than non-financial shocks, as well as the potential for rising inequality following a financial crisis.

This causes the disenchanted and disaffected to seek out someone to blame, abandoning the major centre-left and centre-right political parties that they see as having failed them, and jumping on the bandwagon of the attractive easy solutions offered by radical right wing nationalist (and sometimes xenophobic) parties (radical left wing parties also grow in popularity, but to a lesser extent). And not just at the political level – street protests, including general strikes, violent riots and anti-government protests increase in number as well.



This is why now, following the biggest financial crisis since the Great Depression, we see the rise of right wing nationalist parties in Europe blaming the EU for, among other things, perceived excessive immigration. Far right and far left populist parties have doubled their vote shares in Britain, France, Finland, Sweden, Portugal and Japan. On average, the far-right vote share approximately tripled between 2004 and 2014 across Europe (from 5% to 15%). Of particular note in European elections are:

·         Austria’s Freedom Party at 35.1% of the vote

·         The Swiss People’s Party at 29%
·         The UK Independence Party (UKIP) at 28%
·         The Danish People’s Party at 27%
·         Front National in France at 25%
·         Hungary’s Jobbik at 21%

And though several of these shares have declined since 2014, they are still much higher than their pre-crisis levels.

Brexit too was driven by dissatisfaction with the EU and perceived excessive immigration from Poland. In the US, Trump’s success was, at least partially, due to his capitalisation on/ fuelling of anger towards Mexico, China and the establishment’s trade policies. Even in Australia, where the GFC was largely avoided, their two major centre-right and centre-left parties have experienced shrinking majorities following the increasing popularity of Pauline Hanson’s nationalist One Nation party, Nick Xenophon’s populist party, and “more crossbench odds and sods” (The West Australian, Centrists up against history, 12 December 2016).

On average, street protests also more than double following a financial crisis, especially anti-government demonstrations (as opposed to violent riots or general strikes), and recently especially in Greece and Spain.

And this is a pattern consistent over history. The most obvious examples are during the interwar period in Germany and Italy, but also elsewhere around the world:
·         Following the post-WWI global recession and the Italian banking crises of the early 1920s, Mussolini gained 19.1% of the vote in 1921 and about 65% in 1925
·         Following the breakout of the Great Depression, the Nazis gained 18.3% of the vote in 1930 in Germany, over 30% in 1932 and over 40% in 1933
·         Far right parties gained in Belgium in the 1930s, e.g. the Rexists and the Flemish National Union
·         Denmark’s National Socialist Workers’ Party in the 1930s
·         Finland’s Patriotic People’s Movement
·         Spain’s Falange
·         Switzerland’s National Front
·         The UK’s Independent Labour Party and National Liberal Party which both broke away from the Labour and Liberal parties respectively before the 1931 election
·         Australia's New Guard, the Emergency Committee of South Australia in 1931 and other groups, and WA’s vote to secede from the rest of Australia (which obviously didn’t take)
·         Canada’s Reconstruction Party and the Social Credit Party, both in 1935
·         The US’s Wisconsin Progressive Party.

But there was also similar growth in nationalistic sentiments and government representation following the Scandinavian financial crises of the late 1980s/ early 1990s:
·         The right-wing populist Norwegian Progress Party increased their share of the vote from 3.7% in 1985 to 13% in 1989 – two years after the crisis broke out
·         The Danish Progress Party grew from 3.6% to 9% over the same period
·         Right wing parties in Sweden grew from less than a 1% share before their 1990 crisis to 6.8% in 1991, including the right wing populist party New Democracy
·         Italy’s North League won 55 seats in the first election after the outbreak of the 1990 crisis.

These trends tend to last for about a decade from the crisis, which means we may still have a couple of years of right-wing nationalism and street protests left. Furthermore, given this rise in the power and number of other (right wing) parties and decline in centre-left and centre-right parties, governing becomes much more difficult because no one party controls sufficient power to achieve their party’s goals. Consequently, the public becomes even more disenchanted with the establishment, sowing the seeds of potential disastrous international conflicts when governments and the public start looking for international scapegoats for their troubles. So ironically, this disenchantment with the establishment actually has the potential to create more problems than it solves, especially in a post-crisis environment when decisive government actions are required, slowing the recovery even further.

This really does highlight the importance of macroeconomic management, not just in maintaining and furthering economic well-being, but also in maintaining political stability. Delayed and (in the case of their austerity policies) counter-productive economic responses to the GFC and sovereign debt crisis in Europe caused deep economic contractions, price deflation and soaring unemployment, sowing the seeds of significant political tensions, with the rise of right-wing nationalist parties very much threatening to pull the EU apart. In the US however, despite being ground-zero for the GFC, their economy was largely kept afloat with swift and strong monetary responses. Australia too was largely sheltered from the GFC. But for both the US and Australia, inadequate fiscal stimulus has arguably led to a more prolonged and less complete recovery than ideal, as well as their own brands of inward-looking nationalism. And the additional pressure this fiscal impotence has put on monetary policy to keep the economy afloat – and arguably inadequate financial market reforms – could be causing greater problems down the line.

History really does like to repeat itself. Is it too late to nip this in the bud before everyone turns their back on the world?

Trumponomics

The new wave of protectionism

Donald Trump’s latest strategy for keeping US businesses from leaving the US, at best, is a risky strategy with questionable benefits, and at worst, will trigger a wave of global protectionism that will leave the entire world unambiguously worse off.

For those unaware, Donald Trump recently managed to keep the air conditioning company, Carrier from shifting all its furnace plant operations to Mexico (some of its operations are still closing/ shifting) by threatening to impose a tariff on anything it might subsequently try to export back to the US. Furthermore, in order to keep it operating in the US, the company received a $7 million tax incentive from the State of Indiana (The West Australian, December 3-4 2016, p.42).

As a general rule, I am opposed to the use of tariffs and subsides. They tend to be anti-competitive tools intended to support inefficient industries, when the wider economy and country would often be better off transitioning out of such industries and into others in which they hold greater advantage. There are, of course, exceptions. In other words, under very specific circumstances, Donald Trump’s strategy may actually pay off for the US.



First is the ‘infant industry argument’ – the idea that certain industries, with temporary support from the government (investments, tariffs, etc.), will be able to invest in new technologies and processes, become more efficient, and eventually stand on their own, generating wealth and benefits for society that outweigh the costs of the initial government support.

There are supposed success stories for this argument, including the US itself, which developed an internationally powerful manufacturing industry in the 19^th century on the back of a significant tariff wall (much to the dismay of British manufacturers who were consequently losing market share), supposedly justifying this protection (at least from the US’s perspective). Furthermore, if the government hadn’t provided this protection, the costs of setting up such an industry may have been too great for any private entity in the young and developing US to bear, and the industry may never have existed in the US.

There are however, just as many (if not more) failures. In Argentina for example, at the start of the 20^th century, the country prospered on the back of its traditional advantage in agricultural exports and reliance on foreign capital and imported technology. But following the shocks to these advantages/ dependencies from WWI and the Great Depression, the government subsequently sought to transition the economy towards a more self-sufficient urban industry-based economy. Unfortunately, Argentina lacked the skilled and educated workforce, and the financial and technological capital to sustain such industries. And its abandonment of export markets and foreign capital hindered its traditional agricultural industries. Consequently (and also as a result of perpetual domestic political turmoil, including six military coups and numerous economic crises), Argentina has declined from one of the top 10 richest countries in the world at the start of the 20^th century (ahead of France, Germany and Italy), with an income per head in line with the OECD, to the 53^rd richest country today with an income per head roughly half that of the OECD.

Consequently, there is great risk in Donald Trump attempting to ‘pick winners’ in the hope that these industries will invest in themselves and eventually become productive enough to pay back these investments in the form of greater economic activity, tax revenue and social harmony. This is especially true because, in a country like the US, with its enormous and developed financial markets, potentially profitable industries such as these should draw the attention of private finance, without the need for government. The fact that these private entities desired to leave the US suggests that the private sector no longer has confidence in its profitability in the US. Why should Donald Trump think that he knows better?



The second argument that may support protectionism as beneficial for the US is the idea that countries of sufficient size and power that are able to influence global price levels just by their existence could potentially impose a tariff on imports that the rest of the world would simply have to bear on the US’s behalf. Because of the US’s bargaining power in the global economy, they may be able to force the rest of the world to pay that tariff without the US having to bear any of it in the form of more expensive import prices. Consequently, the US would benefit via increased government revenue, but at the expense of the rest of the world, who now pays a tax on the goods/ services that they export to the US.

Even Australia could arguably exploit this strategy. Australia accounts for 58% of the global iron ore trade and 65% of its coking coal trade (The Australian, December 3-4 2016, p.28). If Australia were to impose a tax on its iron ore and coking coal exports (export taxes are uncommon but not unheard of), given Australia’s domination of this market, the rest of the world may have to absorb that tax for Australia, resulting in Australia benefitting from greater tax revenue at the world’s expense.

Consequently, market power can allow certain players to break the rules of the game, benefitting at the rest of the world’s expense.

BUT …

These benefits can quickly be undone (and reversed) if the rest of the world retaliates. If other countries start imposing their own taxes on imports from/ exports to the US and Australia, this kind of trade war could very easily cause the entire world collectively (including the US and Australia individually) to be worse off than if they’d all just obeyed the rules of free trade from the start. Even if other countries would have been better off playing by the rules and letting the US or Australia get away with cheating, politics doesn’t always generate rational responses, especially when countries feel cheated (case in point, Brexit and the election of Donald Trump). Keep in mind also that the US may be the biggest economy in the world, but the rest of the world economy combined is over three times bigger than the US and over 50 times bigger than Australia. So with a little cooperation, the rest of the world could surely beat the US in a trade war (and certainly Australia).

Even if it doesn’t escalate to a full trade war, belligerence like this from the US or Australia could (in the space of just a few years) cause other countries to search elsewhere for suppliers and customers that don’t impose such penalties on international trade. Like I said, the US is only 24% of the global economy, so the rest of the world could surely, without too much trouble find alternative import and export markets. Australia certainly, would have to worry about Brazil, a significant iron ore competitor, attracting major miners like BHP and Rio Tinto if Australian operations become uncompetitive.

Consequently, even with the dominant market power the US has (and even Australia in some industries), these advantages aren’t necessarily permanent – especially over the longer term and when such powers exploit their position to everyone else’s disadvantage.



A third example of where protectionism could be justified is to ease the transition of an economy away from one industry, rather than having it disappear rapidly. When an industry employs a great number of people, it may be justified to protect that industry from complete and swift ruin, albeit not indefinitely, thereby giving the industry’s employees sufficient time and support to transition elsewhere, rather than forcing them to do so overnight. Even Adam Smith, the father of modern economics and the poster boy of capitalism, conceded something similar in his famous text, The Wealth of Nations:

“The case in which it may sometimes be a matter of deliberation, how far, or in what manner, it is proper to restore the free importation of foreign goods, after it has been for some time interrupted, is, when particular manufactures, by means of high duties or prohibitions upon all foreign goods which can come into competition with them, have been so far extended as to employ a great multitude of hands. Humanity may in this case require that the freedom of trade should be restored only by slow gradations, and with a good deal of reserve and circumspection. Were those high duties and prohibitions taken away all at once, cheaper foreign goods of the same kind might be poured so fast into the home-market as to deprive all at once many thousands of our people of their ordinary employment and means of subsistence. The disorder which this would occasion might no doubt be very considerable.”

Even though Adam Smith was referring to the only gradual removal of protectionism, not the temporary imposition of protectionism, economies moved and developed at a much slower pace during Smith’s time. Consequently, he may not have foreseen how modern technology and innovation could drive an entire industry to disappear from one country rather rapidly, otherwise he may have extended his above protectionism concession further.

Even so, the key point in this concession is that protectionism is temporary and not intended to keep a declining industry within one country indefinitely. And I am unaware of how permanent Trump intends his strategy to be, or whether he understands how very easy it is for such protectionist measures to get out of control and be extended well beyond their initial intended scope.



Trump’s attempt to save any business or industry that the private sector has already chosen to not save smacks of arrogance. Furthermore, any benefits the US can obtain from protectionism by exploiting its global market power could very easily result in retaliation or a global transition away from the US entirely. And if history is any guide, there is a great risk that such measures will extend well beyond their intended scope, causing widespread economic damage the world over – and even the US is unlikely to be immune.