Monday, July 9, 2018

The US Should Sign a UK Free Trade Agreement Now

The Trump administration should make it a top priority to sign a free trade agreement (FTA) with the United Kingdom as soon as possible.  Although Donald Trump and many of his key advisors are rightfully highly skeptical of FTAs, the UK at this moment presents a different sort of opportunity. A US-UK FTA would be good for the US economy, good for the international economy, good for US foreign policy, potentially good for the UK economy, and ultimately (although they may not admit it) good for the European Union.

The last two decades, the age of hyperglobalization, have been a sort of kabuki play where, under the claim that globalization will make the world better off, politicians disown responsibility for the behavior of their national economies and turn over control of the key levers of economic management to multinational corporations. Those corporations have pursued the profit-maximizing policy of moving production to low-wage, low-regulation centers while continuing to market their products to rich countries. The result has been income stagnation, unemployment, and underemployment in advanced countries, especially those, like the US and UK, that have taken a passive approach to trade and their industrial sectors. 

One way some nations have avoided the negative consequences of hyperglobalization is to run a persistent trade surplus. Bear with me because the economics are worth understanding. The surplus means their production exceeds their consumption. So even if they are losing some of their industrial production and some jobs to lower-wage nations, by managing their trade carefully (and often in violation of the WTO rules of “free” trade), they can ensure they are still building productive capacity at home and keeping their people gainfully employed, especially in high-wage manufacturing. The two nations that have led the world in this strategy are China and Germany.  China’s current account surplus peaked in 2015 at $304 billion, while Germany’s current account surplus was the world’s largest in 2017 at $287 billion according to recent press reports.

Germany’s leadership in current account surplus is no accident; it is the result of policies to hold wages in check, support export industries, and raise savings rates that began in 2003 with the Hartz Reforms and have continued since then.  They have also benefited from an undervalued euro. Since trade must balance for the world as a whole, other nations must run deficits to counterbalance Germany’s large surplus. Actually other nations have three choices: (1) they can out-save, out-compete, and out-export Germany, thereby shifting the burden of a deficit onto a third country; (2) they can run a deficit, which means their productive capacity declines; or (3) they can shrink their economy to cut back on imports and balance their trade, thereby reducing their national income, while again shifting the deficit onto a third country. 

China has chosen option 1. It has out-Germanied Germany. (My suspicion is Germany carefully monitors its deficit with China to keep it small via the use of what are known as non-tariff barriers.) The US and the UK have chosen option 2: they run very large, persistent deficits (26 years for the US, 31 years for the UK).  This means that productive capacity shrinks, foreign debt rises, unemployment and underemployment rise in depressed areas but—as free trade economists never tire of telling us—consumers (at least those with good jobs) enjoy lower consumer prices thanks to cheap imports. This is selling your future for a mass of iPhones and cheap Asian T-shirts. 

Figure 1: Yin and Yang. Germany and China run large, persistent surpluses, build manufacturing capacity.
US and UK run large deficits, suffer de-industrialization, wage stagnation.

But option 3 is where the story really gets interesting.

President Trump has said time and again that the US runs a $150 billion deficit with the European Union. Although our president is not usually inclined to understatement, in this case he is grossly understating the problem—and looking at the wrong metric. The key figure to look at is not for the EU but the Eurozone, the 19 nations that share the single currency. The figures here are much larger. Back in 2007, at the height of the last economic recovery, the Eurozone was running a very small $30 billion current account surplus. Germany had a large $233 billion surplus, but the other 18 nations offset that with a $203 billion deficit. Back then, a European could have justifiably said to an American: “Sure, Germany is running a huge surplus and robbing the rest of the world of productive capacity, but it’s not America’s problem. Almost the entire cost of this policy is being borne by the rest of the Eurozone.”

But all that changed with the Great Recession of 2008-9 and the Eurozone financial crisis of 2009. In that crisis, four nations that were running large deficits, the so-called PIGS, Portugal, Italy, Greece, and Spain, suddenly found they could no longer borrow money. The “rescue” plan orchestrated by Germany (with a keen regard for the balance sheets of German and French banks), forced these four countries to shrink their economies and their deficits. This is my option 3 above: instead of continuing to run a deficit and support the exports of the surplus nations by piling up more debt (the US/UK solution), the PIGS were required to shrink until they ran surpluses. The net result was that the Eurozone’s surplus with the world skyrocketed to $429 billion in 2016!  This is a much larger figure than the number Trump quotes. Spain went from a deficit of $143 billion to a surplus of $24 billion, a huge adjustment for a mid-sized nation which still has many poor and capital-poor regions, while Italy went to a surplus of $50 billion.  These painful adjustments were a direct result of the euro framework, in which all 19 countries gave up independent national monetary policies and agreed to abide by a common monetary policy managed by the European Central Bank (and dictated by Germany). 

Figure 2: Surplus uber alles. Eurozone surplus skyrocketed as Germany and Brussels forced austerity on other Eurozone members. Non-Eurozone EU members avoid austerity and continue to run deficits. 

Today, the option 2 countries like the US and UK are caught between the Scylla and Charibdis of China and the Eurozone, each running surpluses on the order of $300B-$400B a year. This forces the US and the UK to run deficits, see their productive capacity erode, workers (and former workers) grow disgruntled and populism stalk the land. 

What to do? President Trump has been haranguing Angela Merkel to change German policy. Auto tariffs might bring her to the table for serious talks. But there is a better way. If we could detach some of the other Eurozone members from Germany and its zone, we would reduce the zone’s surplus.

If the US offered to sign a free trade agreement with Britain today, consider the consequences: we would say that despite our suspicion that FTAs have not in general been good for US industry, we are ready to sign one with the UK because the UK genuinely does not manage its trade to maintain a surplus. It genuinely believes in free, fair, and reciprocal trade, making it a good partner for the US. By excluding the UK from our steel, aluminum, and upcoming auto tariffs, we would provide an incentive for multinationals to locate production in the UK. Two of the largest investors in Britain’s auto industry are Volkswagen and BMW. The message to Germany and German industry would be clear: locate production and jobs in Britain and you will be more competitive than producing in Germany.

This would be like a slap in the face with a cold wet herring for the German government. Siemens recently announced it would be building London tube trains in Britain. BMW makes 200,000 Minis a year in Britain. German companies would double down on these investments. German workers (i.e. voters) would be furious. 

But it gets even better. Think of how this news would be received in a PIGS country like Italy. Italian politicians and business leaders would reason that if they left the Eurozone and committed publicly to free trade and getting their surplus down, they too could sign onto an FTA with the US. Like the UK, Italy has a glorious history in carmaking (and is building some lovely Alfa Romeos right now).  We would tell the Germans that we are not against the Eurozone per se—but we are against it being a vehicle for them to run surpluses against the rest of the world. Getting the Eurozone to reduce its surplus would not solve all the US and UK economic problems on its own—but it would give us both some breathing space to implement constructive trade and industrial policies. 

Another point in favor of this strategy involves defense spending. President Trump is trying hard to get European nations to respect the NATO agreement and increase their spending on defense. But they are dragging their feet. The UK is the only major European nation currently meeting the 2% NATO target (see Figure 3). The US could make it clear that FTAs are only available to nations that meet this threshold. The carrot of tariff-free access to the US market will be a more powerful incentive than a (non-credible) threat to withdraw US military support. 
Figure 3. UK is the only large European nation to meet the agreed NATO 2% target. Cash-rich Germany spends less in percentage terms than poor, struggling nations like Montenegro and Croatia. Source: NATO via The Times of London.

Germany and France might denounce this US policy as deliberately seeking to weaken the European Union. Our answer should be that our policy is designed to strengthen the EU by bringing them to their senses. Only if all nations agree to allow trade to tend towards balance can the world achieve equitably shared economic growth. Germany has proved it can inflict economic pain on its own Eurozone members or its non-EZ trading partners. Either approach is an unstable situation that will lead to crisis. It has once already and more euro crises are inevitable. 

The world is increasingly recognizing that hyperglobalization leads to economic decline for most rich nations and some poor ones too. Recent elections in Italy and Mexico show more and more electorates are recognizing this reality. The Trump administration needs to spread the message that national governments have an obligation to take ownership of their nation’s economic welfare. 

The Tory Party in Britain, like a deer frozen in the headlights of Brexit, is refusing to accept the challenge of a new start for the British economy. Instead it twists and turns over a range of so-called “customs union” proposals which are little more than polite names for a craven crawl-back to Brussels. Even the so-called “hard Brexit” proposals from Tory hard-liners for just walking away from the EU are devoid of any substance on how to kick-start the British economy. After 100 years of painful economic decline, this is what the Midlands, the North, Scotland, and Wales are looking for (and why they voted for Brexit two years ago). 

A US-UK FTA could be a starting point for both countries to work towards industrial renaissance. The UK needs to focus on building successful companies in industries where it has a competitive advantage (once the artificial handicaps like the overvalued pound sterling and the undervalued euro have been removed). For President Trump and the US, a US-UK FTA could include rules on exchange rates and trade balances (multilateral and bilateral) that ensure that no one side gains too much for too long. It could include the sunset provision that the Trump administration has been trying hard to insert into the NAFTA agreement.

In short, a US-UK FTA could become a model for the world: a New Model Trade Agreement, designed explicitly to allow and encourage both sides to benefit, and with real safeguards to alter terms if benefits are not shared. Some will say this is not free trade. And they will be right. This is strategic trade. Strategic trade is how nations prosper. It is the future for all industrial nations. 


  1. Nicely done, Jeff. Some very interesting ideas well worth thinking about. John

  2. Coherent and persuasive. Would you be kind enough to leave agriculture out of the US/UK FTA? That would deny US farmers a splendid opportunity, but the UK won't ever accept US agricultural standards, nor should it allow its own farming industry to be wiped out by doing so according to your own principles. To follow suit with their own US bilats, the PIGs would have to leave not just the Eurozone but the EU, which even their most anti-Brussels politicians are incapable of contemplating, as the Greeks demonstrated. Otherwise you're on to something as the UK government's attempts to cling to the EU seem doomed.

    1. Thanks David. Yes, personally I would be very happy to leave ag out of all FTAs. As you say, the UK wouldn't want its farmers wiped out by American industrial agriculture and each nation is entitled to protect its agriculture for social reasons and/or if it views that industry as an essential part of its national character. I think another area where mainstream economics has gone wrong is in the constant refrain that free trade=more choice. That may be true in some industries, but there are industries where free trade leads to a race to the bottom and near-monopolies that reduce choice. Agriculture is that kind of industry and there are two countries, the US and China, trying to turn food into a least-common-denominator mass consumption industry. Europe should protect itself from that homogenization. I'll paste in links to two articles out today that illustrate the problem. Italian farmers are worried that Canadian competition could hurt their cheese industry. It's not only current incomes but the long-term brand value of brands like parmagiano and gran padova. As another example, here in the US, American cheeses are allowed to call themselves "cheddar". They are bland and usually awful. It's hurt the brand value of the real thing. I suspect that was negotiated in some sort of awful trade deal by some multinationals. On the other hand only real Roquefort can call itself Roquefort over here, and I'm sure that helps maintain the value for the French producers. Americans respect (and pay a lot of money) for Roquefort.

      Final thought: although I feel strongly about traditional farming and traditional food, I don't think the Trump administration does. As we approach the mid-terms they are going to work hard to try to prise open some foreign markets to throw US farmers a bone. They are even throwing Larry Kudlow into the negotiations, and he is harder to swallow than a pound of American cheddar!