Is the NAFTA Deal Only Trump Theater?

By Roy C. Smith

Donald Trump announced last Monday that at a Mexican trade deal had been agreed and Canada, our second largest trade partner after China, had until Friday to get on board or be left out. Trade deals are hard to analyze unless you can get deeply into the weeds, but the essence of this one seems to be to favor auto workers in both countries whose wages would increase, and to require more car production in the US.

Mr. Trump had previously led us to believe that the NAFTA renegotiations had been put off until after the mid-term elections. The surprise announcement seems to have been driven by the need to get the deal signed by the unpopular Mexican president Enrique Peña Nieto before his successor, socialist Andrés Manuel López Obrador, takes office on Dec. 1, 2018.  

The original NAFTA deal, proposed and developed by George H. W. Bush but supported and rammed through by Bill Clinton, was more popular with Republicans than Democrats. It was a free trade proposition in which overall trade would benefit but some industries, like autos, would probably lose jobs. Most economists looking at the 25-year old agreement believe NAFTA has been a net positive contributor to US economic growth. This deal, however, reverses direction, favoring one industry at the expense of overall economic growth. The Financial Times said it would be destructive of longstanding supply chains of major car companies that would lead to higher cars prices, which might work to the advantage of European and Asia car manufacturers selling in the US.

It is not at all clear that the Canadians can accept the terms presented as a fait accompli by Friday, which would effectively terminate NAFTA unilaterally by executive order.

The Canadians may come up with some sort of fudge to get by the Friday date, but the Trudeau government has strongly objected to the revised dispute resolution provisions of the new agreement that weakens Canada's ability to resist unilateral tariff changes made by the US, such as the newly imposed tariffs on steel and aluminum. Gains to the US from the Mexican agreement would be minimal, but Canadian trade and investment would be stymied by tariffs, confusion, disputes and a political disaffection that could take years to rectify.

So, is this it? Will trade policy by executive order stand, or will checks and balances render Monday’s announcement meaningless?

Well, the North American Free Trade Agreement was not established by executive order in 1993, it was incorporated in a statute passed by Congress in accordance with provisions in the US Constitution granting Congress express authority to establish tariffs and regulate commerce with foreign nations. According to Senator Pat Toomey (Republican from Pennsylvania), “a president can no more repeal NAFTA than he can repeal ObamaCare or create a new NAFTA without Congress’s approval.”

Further, existing law requires the president to notify Congress 90-days in advance of signing any trade agreement. Friday, by which time the Canadians must adopt the revisions or be excluded, is 90-days before December 1, when President Lopez Obrador takes office in Mexico. Obrador, has been neutral on NAFTA so far, but could easily find fault with it if it ends up on his desk to be signed.  

By Dec 1, the 2018 mid-term elections will have been decided, with a new Congress to be seated on Jan. 1, 2019, which many observers believe will increase the number of Democrats in the House of Representatives, if they don’t end up controlling it.

Even though the revised NAFTA plan would satisfy some labor unions, it is highly unlikely that Democrats in the House would vote for it if it came to a vote before Jan. 1. There are only eight days when the House and Senate are scheduled to be in session from Dec. 1 to Jan. 1. Mr. Trump may be able to force some Republicans in the House to vote for it, but it is questionable whether there would be enough Republican votes to get it done without Democrat support. Nor is the departing Speaker of the House, Paul Ryan, likely to be willing or able to get such a vote through. And, the Republican majority in the Senate is too small to cover for dissenters like Sen. Toomey to pass a bill, assuming the Democrats did not invoke the filibuster rule requiring 60 votes to pass.

If Congress fails to act and Mr. Trump signs the agreement, with or without Canadian participation, it will not be long before a federal court rules that it is unconstitutional and must make its way to the Supreme Court. Until it does, the agreement cannot go into effect. If it gets to the Supreme Court, the more conservative members in the majority are unlikely to take the view that the powers clearly granted to Congress by the Constitution are to be set aside in favor of the executive branch.

Surely Mr. Trump knows all this. The odds of getting the deal he announced through are very low. So, why did he do it this way? It can only be that it’s an effort to influence the mid-terms to get his base excited and vote to maintain control of the House for the remainder of his term.  But even if he does preserve his majority in the House, he is still constrained by the checks and balances put into the Constitution to restrain excessive executive power.

Lessons from the Turkish Lira Crisis

By Roy C. Smith

Turkey is the world’s 17^th largest economy by GDP ($850 billion in 2017), bigger than all but six of the 28 EU countries, and just a bit smaller than Spain. It is the largest and most modern economy of the Middle East, and last year it grew at 7% (more than China). It is also a NATO member.

Last week, however, the Turkish lira dropped 20% against the US dollar, bringing its year to date decline to 46% and igniting fears of a financial crisis in the country. This is because Turkey has $460 billion (53% of GDP) in “external debt” (i.e., denominated in currencies other than the lira, mostly US dollars), about half of which is private sector debt. Approximately $30 billion of this debt is estimated to come due this year when it must be repaid or refinanced in global capital markets.

The plunge in the value of the lira has made meeting maturing dollar payments much more expensive for borrowers, and foreign banks more reluctant to roll the loans over. The cost of credit insurance on Turkish debt increased by 20% just in the last week (higher than Greece or Pakistan) as the probability of wider debt default increased.  Bloomberg reports that Turkish banks are in the process of restructuring more than $20 billion of distressed corporate debt.  

Investors have shown concern about investment conditions in Turkey even before the powers of strongman President Recep Tayyip Erdogan were further increased after his recent reelection. To retain his political support, Erdogan has been an aggressive driver of the economy, promoting large debt-financed construction projects and forcing interest rates down to encourage growth, despite rising inflation that reached 15.9% in July. Erdogan’s increasingly populist and nationalist policies have eroded relations with the EU (which Turkey has sought to join for many years) and the US. Indeed, the sharp drop in the lira in the past week was attributed to Donald Trump’s doubling tariffs on Turkish steel and aluminum exports to the US because of Erdogan’s refusal to release an American pastor charged with participating in the 2016 unsuccessful coup attempt against Erdogan.

Mr. Trump’s action may have sparked a market reaction to a changed political-economic outlook for Turkey, but sooner or later the underlying facts would have brought about a similar response. Markets react, however, not just to changed information but also to changed psychological factors – anticipating what other investors will do to get out ahead of a panic.

Turkish stocks have dropped 20% since the beginning of the year, not a panic yet. But markets are now worried that one could happen if the economy drops into recession, bankruptcies increase and strain the banking system already weakened by the falling lira (and banks having to refinance their own maturing dollar debts). Under these conditions the banks will have nowhere to turn but to the government.

But the government has foreign debt coming due also, which it will only be able to rollover at much higher interest rates. Yields on 10-year lira bonds are already at 21%.

This is what happened in the Greek crisis in 2010 that took years and more than $320 billion in three bailouts by the Eurozone countries to bring to a minimal level of resolution. But the Turkish economy is about four times larger than Greece’s and there is no Eurozone community to cushion Turkey’s problems.

To try to avoid a financial crisis the Turkish central bank pushed up local interest rates to a growth-killing 18% in June. The drop in the lira has caused many Turkish investors and bank depositors to try to get their money out of the country into something safe. Repaying foreign currency debt that banks won’t rollover has strained Turkey’s foreign exchange reserves, but these reserves are quite small and may soon be exhausted. When they are, the country will have little choice but to either default on all its foreign debt (which takes several years of recession and austerity to remedy) or to call on the International Monetary Fund for assistance, which only comes with harsh economic remediation measures, to restore normal conditions.

There are a few lessons to be found in these events.

One.  Whether they prefer it or not, all countries are bound together by their use and dependence on global capital markets. These now represent about $300 trillion of market value that is subject to changing investor concerns. Emerging market countries like Turkey have benefited enormously from access to this source of funding for its economic development. Denied foreign credit, most countries are subject to reductions of growth rates, market values and general prosperity. But to retain access to foreign credit, countries must conform to acceptable economic and political norms. Turkey’s relatively high growth rate in recent years was financed by foreign capital, but access to this capital involves accepting the norms and disciplines associated with it.

Two. Too much foreign currency borrowing is dangerous for emerging market countries. Access to it can be denied suddenly if global financial markets lose confidence in the country, for whatever reason. When it does, big trouble inevitably follows. And, contagion to other countries can occur when a major country is under pressure. The Turkish situation has not led to wide contagion yet; the JP Morgan Emerging Market Bond Index is down 9% from the beginning of the year, and down 5% since July, but not in contagion range. However, signs are already visible that foreign investors are extracting money from Argentina, Indonesia and some other countries with problems like Turkey’s.

Three.  US tariffs and sanctions can make things substantially worse. They can be powerful particularly because they can halt dollar funds flows of various types that connect countries to the global economy.  Because of the size of the US market for goods and services, and because the US dollar is used to enable more than 70% of foreign trade, US sanctions are by far the most potent of all as Iran, Russia, North Korea, and Cuba have experienced. 

Four. But, especially because they are potent, sanctions (or tariffs imposed in lieu of sanctions) can be dangerous too for those that impose them. Sanctions aim to weaken countries and induce them to behave differently, but the behavior change cannot happen quickly. Sanctioned countries first respond politically by threatening retaliation (ineffective) and to replace imports with locally manufactured goods (impossible in the short to mid-term).  Mr. Erdogan has said Turkey will not yield to US pressure, though it has little capacity to resist. But reversing sanctions can take years to play out (Cuban sanctions have been in place for more than 50 years), during which time the targeted countries suffer economic hardship, and relations deteriorate significantly. These results interfere with other political goals and intentions of the sanction imposers. It can hardly be in the US interest to cripple the Turkish economy to such an extent that is driven into the arms of the Russians or Chinese, NATO is weakened, and/or tumultuous “Arab Spring” regime-change conditions emerge with uncertain consequences.

Five. No matter how authoritarian a government may be, it can be brought to its knees by the consequences of the withdrawal of foreign credit. After the run on the lira, President Erdogan blamed it on the actions by Mr. Trump and threatened retaliation and other measures. He has also disclaimed the idea of requesting assistance from the IMF. But he is in the grip of a major crisis that will only get worse if he avoids coming to terms with it. Market forces are more powerful than he is, though apparently, he doesn’t know that yet.

Brexit’s Doldrums before the Storm

By Roy C. Smith

This past week I have been reading email comments from a group of establishment Brits who have been discussing a recent petitioning for a second referendum on Brexit by the Independent newspaper. Though the idea was proposed a year ago by former prime minister Tony Blair (because of the poor quality of the Brexit debate prior to the vote), Blair has been sufficiently discredited by his endorsement of George W. Bush’s Iraq war that the thought never went very far. But after a year of Brexit gridlock, a dramatic slowdown in the UK growth rate to 1.3%, one of the EU’s lowest, and fear that achieving no agreement by March 2019 would make it all worse, has moved public concern over Brexit to the point of entertaining radical moves, which a second referendum would be.

Why radical? Because Teresa May has said “Brexit means Brexit,” and there is no going back. The people voted, so that’s it. That and the fact that agreeing to a second referendum would almost certainly result in May being replaced as Conservative leader or losing a vote of confidence in Parliament that would bring in Labour.

Comments from the email group have been erudite, diverse, and witty. All express frustration that an event as important to the future of the UK as Brexit should be hostage to entrenched political stalemate. May’s dilemma is that whatever both sides of her Conservative Party might accept would not be acceptable to the EU. The public too remains sharply divided over whether Brexit would be good for them or not. No matter what happens, several emailers have noted, half the country will still be unhappy. And yet, say some who have been summering outside the UK, as important as the matter is to the Brits, no one in the US or Europe seems to care very much about it.  

The Independent’s editorial that proposed the second referendum was accompanied by a petition to be submitted to the government. In a week, over 400,000 signatures in favor of a second referendum were gathered. A Reuters poll on July 30, showed two-thirds of Britons now believe that Brexit will be a “bad deal” for the UK, and 50% support a second referendum. The poll also reported that 48% said if there was another vote they would choose to remain in the EU, 27% said they preferred to leave the EU even without a deal, and only 13% supported the Prime Minister’s plan announced after a cabinet meeting ultimatum at Chequers last month.

In June, the governor of the Bank of England, Mark Carney, said that the cost of Brexit so far was about £900 per household, as GDP had shrunk by 2.1% over what had been forecast two years earlier. Another report in July by consultants Oliver Wyman and law firm Clifford Chance estimated tariffs of £31 billion per annum on goods imported from the EU and £27 billion on UK exports would adversely affect the supply chains of both UK and EU manufacturers. The IMF said it was worried about inflationary pressures in an economy with near full employment, bringing back memories of the painful period of “stagflation” in the 1970s. These realizations have caused new capital investment plans in the UK to be cancelled or deferred.

Ms. May has also said UK taxpayers would be obliged to pay the EU approximately £35 billion for past unfulfilled commitments as part of the “divorce settlement.” The net financial effect of all this is to lower growth over an extended time and reduce funds available for health and other public services. None of this was known or expected by voters at the time of the original referendum in 2016. British voters, concerned about their own futures, apparently are now starting to pay attention to the economic forecasts, which the die-hard Brexiters brush aside as “fake news.”

The Economist and some other commentators, probably including most of the email group, have come out for a “soft Brexit,” which means staying inside the common market and accepting EU immigration and some other policies. This would mean avoiding tariffs on “goods,” but also keeping an open border with Ireland. “Services” could be outside the EU rules, which the City of London would like. Immigration is a contentious issue but overblown for political purposes. In 2017, 311,000 non-EU immigrants arrived in the UK (0.5% of the population), though net immigration from all countries was 227,000.  Even so, the hardcore, deeply resistant to the notion of a dominating European political union that would swallow British sovereignty, won’t buy the soft version. Rather than compromise they are willing to end up with no deal at all.  

The Independent’s second referendum idea is gathering support from former political big wigs from both sides. Even though it might be the best and most responsible road to take now that information about the real Brexit has been circulating for a couple of years, the May government seems unlikely to undertake it. If she should fall in a vote of no-confidence a new election would result, which likely would place socialist Jeremy Corbyn in charge of the next government. There is no indication yet that Corbyn would initiate a second referendum either, but the Independent’s move may create grass-root political pressure that could force his hand.

American’s observing all this should have some sympathy for the email group and the rest of the British public concerned about a suicidal course of action set in motion by a minority of true believers. We face mid-term elections that are thought to be a second referendum on Donald Trump and his commitment to tariff wars, retreating from international agreements, and immigration policies that harm the economy and are greatly disproportionate to the illegal entry volumes that currently exist.  Recent US polls show that only about a third of “independent” voters currently support the president, and nearly half of American registered voters now claim to be independent. Polls also find that 88% of Republican voters still solidly support Mr. Trump, suggesting that he totally controls his party, but there are plenty of silent dissidents. In mid-term elections, first term presidents usually lose seats in the House of representatives. Republicans will have to lose 23 seats to lose control of the House, something Democrats regard as more than likely. But, it will be a test of grass root support across the country for the Trump persona and agenda.

Trump’s election was the second of two shocks in 2016, the other being the Brexit vote. In both cases the polls had it wrong, and an underlying sense of anxiety and anger shaped both outcomes.  Now we are about to test the waters in the US after two years of Mr. Trump, and in the UK as to whether the government can deliver an acceptable Brexit outcome. In both cases, we can anticipate stormy times after the summer doldrums.