Discussions at a conference in Washington

I was at a conference in Washington during the first week of January. I discussed 3 themes that represent uncertainty in 2017. Here are the main points I discussed.

The first was about interest rates and the possible contagion effect from the US to the Euro Area. Here are the different points I mentioned

The starting point is related to the low momentum seen in world trade. Trade between countries is no longer a source of impulse as it used to be in the past. This means that every country has to generate its own growth. It’s no longer efficient to expect an improvement elsewhere in the world to provoke a stronger growth dynamics. In other words, every country’s growth depends mainly on the strategy that is developed locally.

Therefore the role and the management of the domestic demand are key to create an impulse on economic activity. Since 2014 fiscal policies are almost neutral, they have no strong impact on the current business cycle.In other words, the growth profile is very dependent on the private domestic demand momentum. Since the crisis, its profile, in the US and in the Euro Area, are lower than what we used to see in the past (see page 14 here). To boost consumption and investment, central banks have adopted very accommodative monetary policies. Their target was to limit transfers from the present to the future. The incentive for that were very low interest rates. Therefore, as far as the domestic private demand follows a low profile, monetary policies will have to remain accommodative. The Federal Reserve and the ECB have followed the same strategy.

What has changed?

In the US with the president-elect, a large tax cut is expected. It will be supportive for the domestic private demand. Its size could be around US 6Tr on 10 years. For the median household, it could increase the income after tax by 2%. It will also be positive for domestic companies that cannot optimize their fiscal scheme (what is seen for large companies). They will take advantage of the lower corporate tax rate (from 35% to 15%). The domestic private demand momentum should therefore be stronger in 2017. The role of Federal Reserve will dramatically change. Its strategy is no longer conditioned by the necessity to maintain low interest rates as domestic demand is boosted by the fiscal policy. In other words, the policy mix is more balanced and the model will gain in efficiency.

The Fed which wanted to have some leeway in the management of its strategy in order to be able to react in case of a negative shock on the US economy. The US central bank will have this opportunity. That’s why the Fed’s target rate will increase in 2017 at least twice.
The expected stronger business cycle in the US will provoke a di-synchronization of the business cycle on both side of the Atlantic.

In the Euro Area, the ECB will have to keep interest rates low in order to be supportive for the domestic private demand. This has not changed in Europe. This means that I expect a larger spread between US rates and Euro rates. It used to be 150 basis points since 2015; it is now around 220 bp. It could go higher and the adjustment could be through a higher US dollar exchange rate. I think that rapidly the Euro/US exchange which is currently at 1.05 could plunge below 1 in a foreseeable future. This sort of situation was seen at the beginning of the 80’s. Business cycles’ profile were different, the spread was large, larger than now, and the US dollar was very strong (see the graph here)

The new framework in the US doesn’t mean that the economy is out of the secular stagnation model. With just this stimulus, it will create a stronger business cycle but it will not generate a structural break. Since Q2 2009 GDP growth is barely above 2% on average (2.1% to be precise at annual rate) which is way below what was seen since WWII. The inflation rate remains low and as a consequence interest rates will stay low by historical standard. There is a need for more investment to boost productivity at the macroeconomic level in order to converge to 2.5%. This is not done yet.

The second question was on Trumponomics and to be more specific on the trade policy and on the job’s policy.
I thought that the withdrawal of the US from the TPP was the signal send by the President-Elect to postpone discussions on trade policy. It seems that it is not sufficient and that the relation with China could be the source of tensions.
The US trade policy will be dependent on two elements: tweets that can spontaneously change the picture and the fact that the US president by himself can take measures on tariffs without going through the Congress approval. It means that it can go very quick.

What would be the consequences of that?

1 – The current world trade momentum is low. In October it was up by 0.6% in volume (compared to October 2015). Before 2007 its long term growth was 7%. Higher tariffs would be a negative shock for it. World trade was no longer a source of impulse but it could become the source of a slowdown.

2 – If there are tariffs we have to anticipate retaliations from China and probably from other countries as a shock on Chinese external trade would have consequences on main Chinese partners. This would be other Asian countries but also Germany.

3 – The chain value that characterized many products would be broken. The chain value concept is to say that a product depends on production and conception from different countries in different regions of the world. A negative shock on world trade would damage this chain value, weakening the trade for an extended period.

This situation would not necessarily lead to a recession as it has sometimes been mentioned. But it would be a large source of uncertainty.

In 1930 the Smoot Hawley tariffs came while the global economy was weak. It has increased the probability of a recession. Higher tariffs would have a negative impact on the global economy but the current situation is not weak enough to fall into a recession.

There is another point I wanted to mention. One part of the policy that can be perceived from the President-Elect is the fact that he wants to keep jobs in the US specifically in the manufacturing sector. His intervention was seen on Carrier, Ford and on other manufacturing companies (jobs in the service sector cannot be outsourced on the same scale so it’s less important). Three remarks on this point

1 – There is a kind of nostalgia that can be seen everywhere on jobs in the manufacturing sector. Blue collars of the 60’s will never come back. Most of the jobs that have been lost in the manufacturing sector are the consequence of innovation in the production process, not a consequence of globalization.

2 – In the 60’s, productivity gains were distributed to blue collars through high wages. This is no longer the case as factories have a very different type of employment. There are less blue collars and less people. People are more educated than in the 60’s on average. They are paid on a higher basis than in the 60’s but the global labor cost is lower. This means that productivity gains are distributed through lower prices but also and mainly as dividends. The unbalanced distribution of income and wealth that was discussed notably by Piketty and others has its roots in this framework. It is not fair.

3 – The third question here is to wonder if a government is better placed than companies to allocate resources. Usually companies are close to their market and therefore more efficient to allocate jobs. But may be the world has changed

Geopolitical Risks was the third source of discussions.

There were two different remarks here

The first is that what was perceived as geopolitical shocks in 2016 will become real in 2017. That was the case for the Brexit and also for the US presidential election. Financial markets have reacted a lot to the two events but the real impacts will be seen in 2017. Theresa May, the UK prime minister, wants to exit from the European Union before the end of March 2017. And it will probably be a hard Brexit; in other words she said that costs will be high but they really want to be independent from the EU. The access to the single market will no longer be automatic and the European Passport rule will change. If the change of rules is brutal it can lead to a recession in the UK. But that’s the price for independence. The risk also is to have a high inflation rate leading to a loss in purchasing power. That will not be good for the average consumer.
For the US President-Elect, the change is expected after January the 20th. It will be particularly interesting for the economic policy and how non-economic environment will change. On the economic side, we wait for tax cut plan, what will be done on investment in infrastructure and how it will be financed, what will change on the banking regulation and finally what will change for the US in its relation with its economic and political partners. On the economic side, discussions on tariffs with China and Mexico will probably be managed in the beginning of the mandate.

The second remark was on the political side of this new policy. During his campaign the President-Elect said that he didn’t consider defense on Europe as a free lunch. Europe will have to pay more. Nevertheless the perception is that the balance of strength will dramatically change between the US and Europe and that relationships will become weaker. We can expect a political reaction from Germany and especially from Angela Merkel. A new framework has to be created in Europe in order for it to keep its independence. This point is also very important if the new US administration adds tariffs on Chinese products. As it could have a strong impact on China and on to Germany (China is a large trade partner for Germany).
Germany has two reasons to act. The first is related to the change of perception in their environment after the potential fracture on the US external policy. US will not be considered any more as the savior it was since WWII as it will no longer guarantee Europe and it attacks China on its economic basement. The second remark is that in this specific environment, Germany will need a strong Europe. It needs to have a strong France, a strong Italy and a strong Spain to extend its growth.

It has to count on French government to make a real political change (the French / German couple is still very important for Europe). Nevertheless, in the short term, the risk is to have someone like Marine Lepen, whose strategy is to exit from the Euro Area and from Europe, as President of France. That’s the main source of risks in Europe. If Germany wants a more political framework it will not be manageable for Germany alone. In case of French exit the risk is the end of the Euro Area but also of the European Union.

In other words, there is an opportunity for Europe to create a new political body which would be the result of the change in the US strategy while Putin is putting pressure everywhere on Europe. The main risk is nationalism and populism in Europe at elections in 2017. Europe has general elections in the Netherlands and in France during spring and in Germany in September.
If Europe doesn’t catch the opportunity of this new framework and if populism become strong (with separatist people) then Europe will only be little countries and no more a big framework as it used to be since 1957. In that case this could be the end of Europe. The result would be very weak countries with impossibility for each of them to have an impact on the trend of the world.

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