Out really means out – why Britain should reject the “WTO option” even under Hard Brexit

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The sheer amount of ignorance in British public discourse about how trade works is one of the most disappointing lessons from the whole sorry Brexit drama. As a Remainer I have no qualms in picking out the likes of Dan Hannan as an example of this, whose comprehension of the subject (and of economics in general) seems to have been plucked from half-remembered A-level text books, or, at a stretch, incidental discussion from reading History at Oxford. Amongst his favourite refrains is that which tells us that “at least we will still have WTO to fall back on”. Yet of all the options, this is probably the very worst. In the event of Hard Brexit, Britain should actually reject the WTO too.

This is not the place to get into the minutiae of what the WTO actually is or how it works. There are plenty of people who have written in easier detail that I can about this. Instead there are two common misconceptions about the WTO which need to be digested before we even get onto whether it is good for Britain or not. The first is that the WTO is not actually about regulating tariffs; its core notion is that of making sure that everyone abides by the Most Favoured Nation (MFN) principle, meaning that however you structure your trade (higher tariffs, lower tariffs, no tariffs) you must at least treat everyone the same. Clearly, this is a starting point on lowering tariffs but it does not actually reduce tariffs in and of themselves. Secondly, the WTO is not a single set of regulations, but rather applies to each country differently depending on their schedules of entry. In other words, upon joining the WTO, each country basically agrees to its own unique set of tariffs and commitments.

The blog referred to above gives the helpful example of shoes – a sector in which the UK happens to be an exporter:

8% is charged by the EU on shoes imported from all other WTO members (except under a free trade agreement, such as EU-Japan, or preferences on shoes from developing countries). The import duty rate in other countries will be different. The US’s import duties on shoes vary from duty-free to around 10% or higher. Japan charges 20%–30% duty on many shoe imports.

In other words, the WTO does not set monolithic rules, even at a lowest common denominator, as many casual observers seem to believe. The reason I highlight this is to emphasise that the WTO is not some magic bullet for providing a minimum level of trade freedom. It is merely a mechanism for getting countries to discuss ways to lower tariffs. How much each country has to commit to upon entry to the WTO is, much like any other trade deal or indeed any other non-deal trading relationship (which is how most trade is done), dependent on their economic strengths. A larger economy, offering both greater consumption power and usually some irreplicable exports, will always get a better “deal” out of the WTO as a whole (or any other trade negotiation such as an FTA) than a smaller economy. With or without the WTO, with or without an FTA. That is just the way life works.

Moreover, the WTO largely does not cover services, which matters for Britain. After all according to the ONS, British services exports constituted 44% of total exports in the 2017-2018 fiscal year, representing a trade surplus of +£107bn (+€124bn) compared to the trade deficit of -£139bn (-€161bn) in goods. Contrast this with Germany, France and Italy for instance who have a trade surplus in goods and deficit in services. Yet if you delve into the WTO’s website to look at something like architectural services, something Britain has had some success at, you will find the following wording:

Currently, architectural and engineering services, like all services are included in the new services negotiations, which began January 2000. Principles of trade in architectural and engineering services are contained, like for all services, in the GATS.

In other words, nothing has been agreed. The same wording applies to everything else including finance, law, advertising and so on. GATS itself, the precursor to the services agreement, is essentially toothless. As a result, you might have noticed that prior to the Brexit referendum in 2016 nobody anywhere had been talking about the WTO for almost a decade. Instead, partly in order to cover services, most countries have gone on to think about regionally integrated trade deals like ASEAN, the TPP, APEC, the East African Union, Mercosur and, er, the EU.

The problem for Britain is that the WTO is an unfinished project. People seem to forget that the intention for global “free trade” was supposed to be a multi-step process, starting with the trade in goods before moving onto the trade in services, tackling non-tariff barriers and eventually encompassing freedom of labour and capital. The trade in goods came first, naturally, because in the era in which the GATT discussions commenced, most economies including the OECD were still ones that made stuff. There was no real asymmetry in economic structure at that time and if anything, GATT and WTO were forecast to open up emerging markets to developed nation goods such as industrial equipment whilst the latter continued to develop their basic industries such as agriculture and natural resources.

However over the course of time this changed. The OECD became notably more services-based, including in their export mix. On the other hand the emerging markets, led by China, came to dominate the manufacturing industry not just at the low end but increasingly at the higher ends too – Korean autos for instance, Chinese industrial equipment and so on. It was therefore imperative that the next phase of global “free trade”, that of services, was completed – but it never was. The Doha Round, in the back of everyone’s memories, collapsed ignominiously. China’s accession to the WTO in 2001 on these ossified terms has probably contributed significantly to its rise and America’s comparative decline. It certainly led to Trump. If you are a modern economy, the WTO is probably bad for you.

We have not even touched on the specifics of how and whether Britain could easily join the WTO and on what conditions. The likelihood is that Britain could join pretty quickly – if it did so exactly on the current EU schedules (ie the 8% tariff for shoes above). But as noted, each set of schedules was designed to suit a specific economy and the existent schedules suit the EU as a whole. With a focus on protecting agricultural exports for instance, they are probably not ideal for Britain. If it wanted to join on a different, bespoke set of schedules, this would require agreement from all WTO members which would almost certainly throw up objections both legitimate (British government subsidy for financial services for instance) and illegitimate (Russia or Argentina purposefully creating trouble). Furthermore this would require time, unlike the replication of the EU schedules – the shortest period of time for a WTO accession has been several years.

This brings us to the central conclusion that if Britain goes through with Hard Brexit, it would be better to reject the WTO altogether and act unilaterally. The WTO as it exists today suits some countries like Germany and China and Japan, but specifically ill-suits the UK given the commitments Britain would have to make on accepting manufactured goods but getting no such commitments on services in return. Neither is Britain a big enough an economy to enter into renegotiations to remake the rules in its own favour, as the Quadrilateral could. Moreover, rushing into the WTO would actually undermine Britain’s ability to strike independent trade deals as most of what it has to offer – a market for consumer goods – would be given up already. Leverage in bilateral negotiations by trading goods access for services access, would be eliminated including with the EU.

Indeed in recognition of Britain’s place as a middle-sized economy, it makes more sense to try and protect certain industries, even at the cost of near-term price increases.  Whilst signing up to the WTO does not restrict Britain’s ability to lower tariffs, it would prevent the country from strategically increasing tariffs where necessary, for instance incubating industries struggling to find their feet after seventy years in the wilderness. The fact is that a vibrant SME sector really only exists in economies that have reached a critical mass in exports such as the US, Germany and Japan. For all other economies, creating national champions is a better guarantee of long-term economic survival (more of this in future posts).

Brexit is a political, not an economic, debate. That political choice should be made on its own merits, but decisions about trading relationships need to be clear-headed afterwards. Relying on the WTO sounds like a short-cut for preserving some stability for British trade, but it is a false friend. The reason why nobody else pays attention to the WTO anymore is the same reason why Britain must abandon it too – if indeed it actually ends up with Hard Brexit come 29 March.

The Lessons of History – why confabulation may be worse than amnesia

It is normal for any society to look back to their past for paradigms of “greatness”. In Will and Ariel Durant’s masterful work The Lessons of History, they wrote that:

To break sharply with the past is to court the madness that may follow the shock of sudden blows or mutilations. As the sanity of the individual lies in the continuity of his memories, so the sanity of a group lies in the continuity of its traditions; in either case a break in the chain invites a neurotic reaction.

In other words, a grasp of history is important and as a historian myself, I am quite skeptical of those in public life who clearly do not have or act on such a grasp – Tony Blair in the build-up to the Iraq War being a case in point.

But what is the right history to look to? What of the rich tapestry of our past really tells us about the tenets of our national character? History will always be twisted to aid politics; but the current ahistoricism amongst the governing classes has I believe reached something of a new low – and it matters for policy. Reaching for the correct memory is as important as having memories at all.

Britain, for instance, has an imperial history which as a nation it has yet to move on from despite the best efforts of the PC brigades. The signs of it – from the remnants of actual empire (now reduced to the Falklands and Gibraltar) to the permanent seat on the UNSC – still pervade much establishment and tabloid newspaper thinking. But whereas many British subconsciously see the height of empire as the regal majesty of the Delhi Durbar, the real Britain was something altogether less dignified. The British character, I would submit, is one of unruly mobbishness at heart which can be seen throughout society from football hooligans through to the Bullingdon Club – perhaps the best representations of contemporary life being the social diversity of rioters in 2011, and the undignified rush to loot cargo from a sinking ship in 2007.

Hooligans

British hooliganism – two sides of the same historical coin

Rather than harking back to formal empire therefore, the British memory should look more to the Gordon Riots, to Clive of India and James Cook, than to parades at Spithead. Because in this riotous assembly, were also the seeds of Britain’s real greatness: as privateers and traders, entrepreneurs and innovators rather than organisers. In the 18th century Britain stumbled across empires in India and America, and created the Industrial Revolution; arguably, as soon as Britain’s organization skills were brought to bear in the 19th century, the Empire started its decline.

America, too, has the Anglospheric trait of tending towards natural lawlessness as shown by moments such as Hurricane Katrina (in contrast to an example like Fukushima). But there is a deeper romance to the American story as told in elementary schools across the land, of idealism, diversity and tolerance. This too, though, is misremembered. America became great not because of its tolerance, but because of its moments of judicious intolerance and plain ruthlessness – against indigenous people, against Britain, and later against Japan and the Soviet Union (the fraught relationship with Britain was the theme of a 2005 paper of mine). Yes, there were waves of immigration which fed into the so-called “melting pot”, but America would be much less of a country today had it been run with the kinder, gentler governance associated with neighbouring Canada for instance (even if this may also be exaggerated).

Some Americans will not like to see this as the basis of their history, but the reality is that the country’s “manifest destiny” – to rule the continent and then the world – was not built on being nice to people. The American Revolution was not mainly a principled stand of Enlightenment values, but an opportunistic socio-economic power grab by one set of elites from another*. There is a reason why Andrew Jackson, until recent events, was held high in the pantheon of bank notes. And this memory, tinged with a harsh edge and violence, is every bit as important for the country as self-congratulatory myths about the Founding Fathers or Abraham Lincoln. Just as Britain is more Clive than Hardinge, so America is more Jackson than Lewis and Clark.

Jackson Lewis Clark

Andrew Jackson,  Meriwether Lewis and William Clark

As an example of how these falsified memories impact policy, let us take the rhetoric surrounding immigration, an issue applicable to both the US and Britain. The common liberal mantra is the fallacy that “this country was built on immigration!”, a cry heard around hipster cafes from Primrose Hill to the West Village. Factually true, but rather irrelevant. Yes, there has been plenty of immigration in the past, although few have come close in scale to what has occurred in recent years. Yes, immigrants by and large contribute enormously to skills, ambition and demographics in both these countries. But it is not immigration itself which has been good; it is appropriate amounts of immigration when building on a platform of strong host culture. It is an “and”, not an “or” – the tired, poor, yearning huddled masses in the US would be nothing had not the violent ruthlessness of mostly white, protestant Anglophone Americans established a country of enormous land and resources. In other words, there are two pillars to this story of progress, not one:

  1. preserve a coherent indigenous identity;
  2. then add immigration as needed.

But the one-dimensional appreciation of history from those that dominate the media and education misses all this. Immigration is put on a pedestal in and of itself, as though it somehow generates positive impacts on a standalone basis. National identity is practically a dirty word – or has been captured by cynics who believe it can be watered down to nothing by adding foreign elements into the mix via the “we were all immigrants once” fallacy. To do this is the sow the seeds of destruction for any nation-state. Just as Blair had no regard for the longer sweep of history in the Middle East, so also the likes of Corbyn or Pelosi for their own country (although strangely Bernie Sanders actually did – and consequently struggled with certain corners of Liberaldom).

But the point is this: whether we are talking about British lack of self-discipline or American violence, these are not actually bad characteristics. People should not be judging these with opprobrium – they can be positives which lead to other strengths. Anglo-American consumerism and short-term thinking helps the whole world in terms of innovation and just plain growth. If Americans did not love spending money so much, the rest of us would not have iPhones. A planet of Germany’s and Japan’s would achieve nothing. Finding a place in the world is partly about adapting – but only on the basis of recognizing what one’s inherent strengths are. Politicians should not be complaining about these characteristics or still less, try to change them. They should be trying to harness them in productive ways – opportunism becomes enterprise, violence becomes robustness. The world certain needs all of these.

I will finish on a macro view. A former boss of mine once asserted that there are three types of competitiveness in the corporate world: price, quality and innovation. Capture one, and you will survive; capture two, and you will succeed; capture all three and you will rule the marketplace. Countries are not dissimilar, and it is no surprise that the one nation which comes closest to an adequate level of all three is also the only hyperpower – America. Historically, even during the Industrial Revolution, Britain was not known for quality, but rather for inventiveness in products and processes. Since emerging, Germany always had a superior record on pure quality, but they have rarely created anything completely new. Nations have their place; national identity will be a determinant of it.

Britain, post-Brexit, needs to thoroughly reflect on which of these features it possesses and how it pursues them (in my opinion, clearly led by innovation not quality)**. It may seem obvious to say that she needs to see herself as an underdog, yet shockingly few statesmen have really digested this fact. America, in this period of potential decline, also needs to rediscover which qualities it still has. Problems like the rise of China and the new “community of empires” will not solve themselves. But for either country to successfully confront their dilemmas, a closer examination of the collective, subconscious social memory is needed; for without it, we face the insanity Durant outlined so long ago.

 

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* Perhaps this will be a major point of debate, but as something of a historian in the era (see eg my 2005 paper on the Anglican Bishop Controversy) the American Revolution was by and large a moment when local elites, separately in Boston and Virginia, found Britain a convenient scapegoat for directing local discontent against. By the 1740s, ports such as Boston and the southern backcountry were facing, for the very first time in colonial history, economic stagnation and the rise of an underclass. A war (The French & Indian) put this on hold, but by 1763 the Boston families and the Tidewater oligarchies needed to stir a conflict for their legitimacy. They got one with Britain, and this, much more than tiresome debates about Lockean Liberalism vs Republicanism (rf Bailyn, Pocock et al), or “taxation without representation”, lies at the heart of the rebellion – and partly explains the surprisingly strong loyalist sentiment throughout the war.

** I will also add that one of the only intelligible and plausible post-Brexit British identities I have heard comes from a potential future guest blogger here, namely that Britain could become an Israel – in other words, a medium-sized maverick which punches above its weight simply through unpredictability. Better not decommission those nuclear weapons, in which case.

The End of Entrepôts – why the future is big, not small

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Photo: Lord Lugard with the Legco in 1909

It is one of the most oft-repeated fallacies in modern politics that the future is destined to be ever smaller and fragmented. One only has observe the fetishization of breakaway movements such as Scotland or Catalonia and hear the accompanying, knowing murmurs telling us that in political terms at least, atomization is the way of the future – small is beautiful. Some still reach further back, summoning up the collapse of the Soviet Union as proof that all large entities must collapse.

This is completely at odds with reality, on a number of levels. First, recent history has, far from being driven by a narrative of devolution, instead been dominated by the rise of “big countries” which in turn are resurrecting their own brand of Great Power relations. The corresponding decline in relevance of smaller entities is pronounced – most noticeably in the shape of individual European nations which have seen their weight fall off considerably. The 2010 Copenhagen agreement, where Obama sidelined the Europeans to reach straight for emerging giants, was an early sign of this; the gradual extinction of the Quadrilateral in determining trade policy was another.

Indeed in my 2013 paper on China and multilateralism, I noted that the world is if anything heading towards a new “community of empires”, with both the foreign and domestic policies of China, Brazil and India joining the US and Russia in pursuing an unrelentingly imperial logic. In response, those outside of their orbit are banding together to form what are prima facie trade blocs, but which are in reality the beginnings of something much more. Whether the European Union, ASEAN or Mercosur, nation-states are ceding sovereignty slowly but surely for the express purpose of aggregating their power in the world beyond. Even in unexpected corners of functioning humanity such as East Africa, union is the name of the game. Status and size do not have a linear correlation; as one reaches critical mass, the relationship becomes exponential. A power ten times as large as its neighbours is far more than ten times as important.

At the heart of this is a simple thesis: in the long run, the power of any country will be determined by the size of its population (with a shared identity – more of that another time), somewhat adjusted for a country’s natural resource base. In the long run, all else is mere noise. Yes, certain countries or civilisations may exercise disproportionate power for a period of time, even centuries. This can have any number of causes but often it is because of temporary technological disparities – temporary because in the long run, all technology will permeate meaning that we arrive back at where we started: population. Any vision of a world where the largest population blocks are not the most important countries must be premised on a smaller, more nimble country actively and exploitatively keeping larger population blocks subject. This was a kernel of much of European colonialism of the 19th century (which should not be conflated with a general model of imperialism exercised in human history).

Now in the long run, as Keynes says, we are all dead. So does it matter? I would say yes it does, particularly for those living in and around the rising powers of Asia such as China, Indonesia and to a lesser extent, India. Because some of these changes are no longer concerns for the long term, but coming to maturity now.

One lesson is this: the age of entrepôts such as Hong Kong and Singapore is fast coming to an end. In the future, there will be no space for such outposts any longer, at least in their current form. This is because the very existence of such centres is a lingering post-colonial legacy, based on an economic system that is now no longer extant. City-states like Singapore thrive because they are a form of offshoring, and the offshoring they offer is reaching the end of its useful life.

We should be crystal clear that offshoring has two forms: there is offshoring for work a country does not want to do, and offshoring for work it cannot do. On the one hand, there is what we classically understand as “offshoring” where one jurisdiction offers a cheaper way of producing goods and services for a richer one – offshoring from below. Textiles in Bangladesh fall into this, as does the core of China’s economic rise during the 1990s and 2000s. The second form is what hubs such as Hong Kong, Singapore, Dubai and even London offer to an extent – offshoring  from above. They provide capabilities that other poorer, less developed countries cannot do themselves.

The problem is that much of the world is catching up. There is precious little that can be done in Hong Kong today that cannot be done in China; yet Hong Kong really only exists to serve the Chinese economy, much as some lament its progress to becoming “just another” Chinese port. Singapore is safer for the moment, but it is still implausible to imagine that Malaysia, much less Indonesia, will allow the island to remain an offshoring hub for high value-added industries such as finance. As with China, they will end up doing everything themselves. The post-colonial legacy of substantially inadequate skills and infrastructure will be bridged, if not today, then tomorrow. At that point, the city-states will have precious little left. This is a problem not faced by Bangladesh – but then no-one wants to be Bangladesh. There is a reason why entrepôts barely exist in the OECD and if they do, they service a tiny, marginal sliver of their neighbours’ economic life as Jersey or the British Virgin Islands do. It is because there is no room at the top.

Britain suffers from many of the same issues. Plenty have lauded the supposed rebirth of the British automotive industry, and in a few instances, this is well justified. But for every Aston Martin or Morgan, where real value-add and R&D is achieved in the UK, there is a far bigger presence of Nissan or Toyota. The latter however, are essentially a little Bangladesh model – investment into the UK occurs not because of any inherent capabilities, but because we are marginally cheaper and have fewer regulatory restrictions (unionization etc) than regional neighbours. This is not much of a national dream.

The other side of the UK is that of the entrepôt. Here I am referring to her services exports – but not the headline-grabbing financial services sector, which will be pretty easily replicable elsewhere, but rather industries such as advertising, publishing, design and architecture which are more genuinely unique. And one can tell that they are unique, since whereas the UK can barely export any financial services to the big empire economies of the US or China, it sells large quantities of stylish design. The problem is, this is nowhere near enough to support an independent UK – the idea of the UK becoming a “Singapore of Europe” is beyond fanciful, as I have noted before.

Singapore has been conspicuous in how strongly it clings to and pushes for ASEAN. And the reason is clear: if ASEAN does not succeed in binding the region together, Singapore will soon have nothing to offer its larger neighbours. Only a union of sorts will allow it to continue holding a position of import. Hong Kong’s commercial residents have long acquiesced to the fact that it will have to be another Chinese city, albeit one offering some special rules and playing a specific role. Hong Kong’s flagship airline’s troubles reflect the decline of hub-and-spoke trade in favour of point-to-point, and are a microcosm of how the whole economy is developing. Dubai will play off the inability of regional giants to pull their weight (Iran, Egypt and Turkey) but if and when they do, it too will face the same problems of reinvention.

But the old model of “Singapore” is a complacent and condescending anachronism – and those pushing the model for countries like Britain are living a sheer fantasy.

China is reinventing the equity markets – and Britain’s aspirations are shrinking

First, the exposition:

  1. Exuberance for equity as a class of investment reflects how confident a given society is in their future; preference for fixed income indicates the opposite
  2. China has been reinventing the equity markets for some time now, becoming the first country since the rise of the US to really have the risk appetite for it
  3. In doing so it is breaking the convention of maturing countries in the region (Japan, Korea, Taiwan) as well as ageing civilisations such as Europe
  4. As with so much else, China is the new America

The above can be seen in a number of ways. Consider this: despite the scare stories about rising Chinese debt, it is in fact equity (both institutional and private capital) which has mostly funded fixed asset investment in recent years – averaging 66% over the last decade versus just 52% over the decade before. Anecdotally too, we know that all around us in China new startups have no problems accessing micro-equity from friends and family for the most spurious of businesses.

Self-raised funding as a % of fixed asset investment in China, 1995 – 2016

Self-raised funds.png

Source: National Bureau of Statistics

Note: the NBS splits out five categories of funding for FAI, namely Government Budgetary Funds, Domestic Loans, Foreign Investment, Self-Raising Funds and Other Funds. It is reasonable to assume that Self-Raising Funds constitutes equity investment, and that a portion of Foreign Investment may also do.

Likewise, institutional equity and equity linked investments account for a higher proportion of Chinese asset allocation than their East Asian peers – and are more reminiscent of the US in approaching 60% of allocations. Conservative Japan and Korea are the reverse. Small wonder then, that annual stock turnover in China is far higher than other markets (around 5.0x compared to c. 1.5x in the US, Korea and Japan) given the limited supply of listed equity.

Equity proportion of total non-cash household financial assets, 2016

China vs peers portfolio allocation.png

Source: Goldman Sachs Investment Research, 2016

Again, this reflects the fundamentals of not only an economy, but the society on which it sits. Buoyant equity markets reflect confidence not just in business, but in the system and the role of a country in the world. This is especially true when we think about equity provided by the retail markets, either through stock markets, or its proxies, or through earlier stage funding such as seed and venture funding where China is now the world’s second largest market. The basic principle is that when tomorrow seems like it will be better than today, people will gamble.

China still has a long way to go, of course. Its stock market capitalization per capita at c. US$6,000, still lags its peers and is just one thirteenth that of the US (and no, PPP is not appropriate here). Its private equity market, though already Asia’s largest, still has some way to catch up also at only one-third of North America. Nonetheless, China seems to be well placed to pick up the baton from the US of driving the whole culture of equity and all its attendant benefits.

And it matters. The point about equity is not just that it is one source of funding, but rather that it is a source of long-term funding and seeding for growth. A country that begins preferring fixed income to equity is giving up on its future, but also giving up on the idea of being a leader in innovation and technology. It is no coincidence that America has been the world’s great equity proponent for the last century and the cradle of  most technology; or that China is following in its footsteps. These are the hallmarks of “big countries” that make their own rules and are a force in the world.

On the other hand, a country like the UK should be very worried indeed: equity in portfolio allocations has declined alarmingly from well before the 2008 crisis. This reflects some ageing – but the ageing profile is less severe than many of its neighbours. Rather, I believe it reflects a psychological retreat from aspiration.

Changes in broad strategic asset allocation for UK plans, 2003 – 2017

UK asset allocations

Source: Mercer European Asset Allocation Survey 2017

This, much more than Brexit or the reduction of blue water navy capacity, indicates the decline of British aspirations. On a recent podcast, someone asked “but how close is China to really producing an Apple?”; the curt reply came, “how close is Britain?”, alluding to the even greater absurdity of such a prospect. If this continues, Britain will certainly no longer be a “big country”.