18 July 2016
The New Populists
We have entered a new political age. The parties that dominated politics 75 years or more are in retreat everywhere, and new insurgent movements are in the ascendance. In the Netherlands, the PVV tops the polls; in France it is Marine Le Pen’s Front National. In the US, the Republican Presidential nominee is Donald Trump, and the Democrats nearly elected Bernie Sanders. In the UK, the established political order – the Conservative and Labour Parties – remain entrenched, but only at the expense of the country’s ejection from the EU, and the rise of Jeremy Corbyn as Labour Party leader.
Some of these parties and movements are left wing, some are right wing, but what unites them is a combination of nationalism, opposition to free trade, immigration, globalisation and scepticism of the “elites”. In other words, these are the parties of the discontented.
This piece looks at the rise of the discontented: Why is it that in so many countries there is such a reaction against the established orders? What are the economic drivers behind their rise? And finally, what are the long-term consequences of this political shift.
No Embarrassment of Riches
For much of the post war period, developed countries – and their citizens – had it pretty good. Unemployment was negligible, crime low, and each generation successively richer. A German, Japanese or American father could look down on his children and feel confident that their lives would be better than his.
But then something changed. The children of the 2000s ceased being wealthier than their parents. And while incomes had apparently risen, so had the prices of petrol, of energy and of rent. While families of the 1970s could survive – or even prosper – with one working parent, it now required two. Young people were leaving college with ever larger amounts of debt and failing to find the kind of secure, well paid jobs their fathers had.
We see these trends wherever we look. Take the US, generally considered (by us in Europe at least) to have been the most successful developed economy in the world in the recent past. According to the US Federal Reserve, real median household income is down almost 10% since peaking in 1999. That’s an unprecedented reduction, and is all the more shocking in the context of a country where headline GDP growth has been relatively strong.
Real Median Household Income, United States, 1980-2014
The longer term trend is not much more encouraging. In 1978, real median household income in the US was $50,184; 36 years later it had increased at less than 0.2% per year, to reach $53,657.
While we do not have longer term data for the UK, the short-term trend is identical to the US. Real median household incomes – as the chart below shows – are down around 8% from the pre-crisis peak.
UK, Real Median Household Earnings, 2004-2014
Source: UK Government Family Resources Survey, 2014/15
This is not just a problem with the Anglo-Saxon world. Take Japan: despite Abenomics, money printing, and the like, real disposable income remains stubbornly stuck in a downward trend.
Japan, Workers Real Disposable Income, 2003-2016
Note: Index, 2003=100
There is less data available for Europe, and in particular, there is little information on median incomes. According to the German Federal Statistical Office, personal real median income rose from €18,309 in 2008 to €19,582 in 2013, but this is just one country, and we’d note that Germany has been an economic outlier in Europe. Instead, we would focus on unemployment rates across the Eurozone, which – except in Germany – are still well above pre-crisis levels.
Change in Unemployment Rate, Percentage Points, 2015 vs 2007
Eat the Rich
The average person, in the US, Japan, the UK or much of Europe, is meaningfully poorer than they were pre-crisis. What is strange, however, is that GDP numbers do not catch this decline. The chart below shows the change in per-capita GDP compared to 2007 for a selection of countries:
GDP Per Capita Constant Prices, Change 2015 vs 2007
Source: Word Bank, July 2016
Per capita GDP grew in many places, but median income did not. Why the disconnect? We see the issue as widening inequality, which is why there is so much concern about the “1%”. Statistics on the share of income taken by the richest show that inequality has been rising from the early 1980s. It’s an old adage that it is easier to share gains than losses: when everyone’s income was rising, the difference between the richest and the rest seemed a price worth paying.
Share of Income Taken by Top 1%, 1955-2009
Source: World Income Database, July 2016
Across the developed world, people are discontented because the old post War consensus has been broken. We are no longer all getting richer. And worse, we have a situation where a certain segment (the elites, the one percent, etc.) have gotten richer, while many others have gotten poorer. With consumer debt at elevated levels in many places, and the cost of entry into the middle classes – a college degree – both costing more and offering less, we should not be surprised that the stratification in society is resulting in fractures.
Why We Were Rich
To understand our current predicament, we need to first understand where we came from. Growing up in the post war period in the developed world was like winning the lottery: you were a member of the global 1% by accident of birth. The reason the developed world was so well off is that it had learned the secret of manufacturing, and it was where all the capital (in terms of machines that made things) had been deployed.
Back in the 1950s and 1960s, the developed world exported manufactured products and services, while the developing world (including China) exported raw materials. This relationship was very good for workers in rich economies, as they were the bottleneck in world economic production. The producers of raw materials – say Brazil and China for iron ore, and the Middle East and Nigeria for oil – were poor, and the makers of cars were rich.
The chart below shows the share of world GDP taken up by the developed world (the US, Japan, UK, France and Germany); as can be seen, it peaked in 1950, and remained at an elevated level until about 2000.
Composition of World GDP by Country, 1700-2010
Source: Infogram, July 2016
This began to change with the emergence of the tiger economies in the late 1980s and 1990s: Taiwan, South Korea, Singapore and Hong Kong. Entrepreneurs in these countries realised that they had something that the old world did not – plentiful, cheap, labour – and that buying capital goods from Germany or Japan enabled them to compete on the world stage.
Where these small countries led, China and others are now following. China – which just 20 years ago was an exporter of coal, oil and various other commodities – is now a manufacturing powerhouse and commodity importer. The developed world’s core competence, turning raw materials into manufactured products, was taken away from them.
The Three Pillars of Discontent
The symptoms then are clear: the traditional growth driver of the developed world is behind it, and we suffer from stagnant GDP and rising inequality. But the cause of the ultimate disease is more complicated than just China learned to manufacture things. Indeed, we see three long-term drivers behind the developed world’s malaise: demographics, commodities and globalisation.
Demographics. The post Second World War period was known as the “Baby Boom”. Fertility rates were high, allowing a large number of people to enter the workforce two decades later. The effects of the baby boom were compounded in much of the developed world by female emancipation (again bringing people into the workforce) and the rise of contraceptives (which lowered birth rates, and – again – allowed much higher female labour participation rates). There was an added boost: the Second World War meant that in many countries there was a relatively small number of retired people.
In sum, the economies of the developed world – from 1945 to about 1995 – had a growing number of people available to work, and only a relatively small number of non-working people who needed to be supported. In other words, the dependency ratio was low.
Changing dependency ratios have a much greater impact on economic growth than is commonly realised. The purpose of China’s one child policy was to lower the population growth rate. The effect was to dramatically lower the dependency ratio as women no-longer needed to stay home to look after large families. This meant tens, or even hundreds, of millions of Chinese women entered the workforce, allowing new export industries to grow up. (The end of large families in China also forced households to increase their savings rates: in a one child world, there is no mass of children to look after you in your old age. A rising savings rate provided the fuel for China’ modernisation.)
Over the last 20 years the demographic picture for the developed world has turned increasing bleak. In 1990, there were between four and six working aged adults in the developed world for every retiree. As the chart below shows, by 2020, Japan will be at around two, while Western European countries and the US cluster around the four level.
Workers per Retiree, 1950-2050E
Source: Econdata US, July 2016
Having every potential worker support half a retiree (as will be the case in most of the developed world by 2030) is even more serious than it appears. For retirees – and especially older ones – typically absorb more resources than workers. Not only do they need pensions, but they also need help to cook, and clean themselves. Most expensively of all, that mass of retirees need health care; using numbers for the United States, we see that while a 20 year old costs $1,448 in annual health care, an 85 year old costs $17,071.
This issue can be seen by looking at the UK government accounts. For a long period, the proportion of government spending on pensions and healthcare averaged around 34% of total spending. In the last five years, as the population aged, this began to grow and it is now more than 38%. In a world where nominal GDP growth is under 2%, having a portion of the budget growing at least 4% a year is clearly unsustainable.
UK Government Spending on Health and Pensions, £bn, 2005-2016
Note: Years are UK tax years to end March
Source: Office of National Statistics, July 2016
In the developed world, there is little awareness that the issue has dragged on disposable incomes in the last 20 years, and will continue to do so in the future. The solution – implemented but unremarked – of increasing immigration levels from countries with higher birth rates looks set to grind to a halt, as many see the immigrants themselves as the cause of their diminished incomes, rather than the longevity of their parents.
Commodities. It seems like a long-time ago, but 2000 to 2015 was a commodity “super-cycle”, with China’s boom coinciding with the end of two decades of underinvestment by producers. The results were spectacular. From their 1990s lows, iron ore rose more than 16x, oil 12x, coal 8x, and copper and gold more than 7x.
Selected Commodity Price Moves, 1993-2013
Note: all values indexed to 1993 = 100
Source: Bloomberg, Indexmundi, July 2016
The developed world countries that have had the most difficult experiences – Europe, the US, and Japan – are all commodity importers. Despite its massive mineral wealth, the US was the world’s largest importer of oil, and imports substantial quantities of other basic materials. Europe and Japan are even bigger importers: both need oil, coal, gas, iron ore, copper and the like.
This matters because rising commodity prices act like a tax on the economy. If the price of basic commodities has increased, then either less must be used, or more of the rest of the country’s output must be diverted abroad to pay for them. And because commodity prices tend to have a relatively high degree of correlation, during commodity price upswings, GDP must be pulled down by the increased cost of imports. At its simplest, this is an accounting relationship: GDP is calculated by adding spending, investment and net exports; therefore, raising the price of importing commodities causes net exports to fall, lowering GDP.
We have created a simple model to see how much just the oil impact was on the GDP of developed countries. Our calculations were based on looking at the amount spent on imports of oil in 2000, and comparing that to 2014. (This is because the BP Statistical Review of World Energy allows us to easily calculate import costs at country level. Getting data on natural gas, coal, copper, iron ore, wheat, soy beans, zinc, aluminium, etc. is much harder.) As a result, it perhaps captures only 20-30% of the impact of rising commodity price. Furthermore, we also need to recognise – and do not attempt to capture the fact that the cost of importing other products – like chemicals, cars or processed steel – will rise to include the commodities used to make them.
Cost of Importing Oil and GDP Impact, 2000 vs 2014, US$m
Source: BP Statistical Review of World Energy 2015, World Bank, July 2016
Even though this analysis understates the size of the impact, we can see that rising commodity prices dragged sharply on economic growth. But the problems don’t end there. Higher prices of oil, natural gas and coal fall most heavily on the poorest in society and therefore raise income inequality. To quantify this, according to the Office of National Statistics in the UK, the poorest fifth of households spend 11% of their income on energy against just 3% for the richest fifth.
But there is good news. Unlike with demographics, where low birth-rates and increased life expectancy will weigh on disposable income for decades to come, the commodity price boom is now behind us. China’s growth model is changing away from fixed asset investment, reducing its appetite for all kinds of commodities. Simultaneously, the mining and energy booms are bringing substantial new supplies to market.
It seems quite likely that, just as the 2000 to 2015 period was like the 1970s for commodity importers, that the next 20 years might be like the 1980s and 1990s, with low commodity prices proving a long term crutch for many.
Globalisation. While the term ‘globalisation’ is relatively new, the process is not. Modern transport, containerisation, and the mobility of capital have meant that work has long moved to where it is cheapest to perform it. Taking a longer-term view, we can trace this process all the way back to the East India Company, but the beginning of this acceleration came more than 40 years ago with textiles. T-shirts were no longer made in the US, and a Mexican industry flourished, which was then undercut by Colombia, and which is now being outcompeted by Bangladesh.
What textiles started (easy to make, and transport, with low rates of depreciation), moved to other manufactured goods, and is now moving to services. Historically safe jobs – accountant, lawyer, computer programmer – can likely now be done by someone at lower cost in a different country. Technology is enabling us to all to get outsourced.
In the long-run, we will all earn what our skills command on the world stage. Globalisation – and the technology that enables its next iteration – is merely speeding the process up. That means the price of filling in a US tax return, doing UK conveyancing, or translating a document with be set in Chittagong, not Cheltenham or Chicago.
Such an outcome sounds disastrous for workers in the developed world. But it is worth remembering that the process is naturally self-balancing. As the chart below shows, wage rates in China have been rising rapidly in recent years: roughly trebling since 2006.
China Average Yearly Wages, Yuan, 2006-2015
Source: Trading Economics, July 2016
This trebling has taken place in the context of a relatively fixed exchange rate. Unless the productivity of Chinese workers has trebled in the decade (it hasn’t), then the extent of the great labour arbitrage between China and the West has diminished greatly. We might call this process The Great Rebalancing. In the old days, your life outcome depended primarily on where you were born. As more and more people live in developed countries, your life outcome will depend more and more on your skills and your effort.
But What of Australia and Canada?
The two developed countries to buck the trend
Two large modern economies have bucked the trend of falling median wages over the last 20 years: Australia and Canada. If we are correct in our diagnosis of the economic problems of the developed world, we need to explain why these countries have done so much better than peers in Europe, the US or Japan.
While the Canadian government only publishes household median income data with its census (every five years), Australia provides more detail. The chart below shows that – unlike the US, the UK or Japan – median household incomes have grown substantially. Why is this?
Australia, Real Median Household Income
Source: Australian Bureau of Statistics, July 2016
The first thing to note about Canada and Australia – other than their status as ex-British colonies and members of the Commonwealth – is that they are both significant resource exporters. While we think of them as modern economies, they score relatively poorly on indices of economic complexity. Canada, for example, comes in 23rd in the world, lagging not just the obvious (the US, the UK and Japan), but also the Czech Republic, Slovakia and Mexico. Australia scores even worse: its economy comes in at number 56, behind Greece, Turkey and India.
Economic Complexity Index, 2014
Source: MIT Atlas, July 2016
Both these countries score poorly because neither is a meaningful exporter of services, and both have relatively undeveloped manufacturing bases. (The exception is Canada’s Ontario, which is highly integrated into the US automobile supply chain.) The chart below shows the nature of Australia and Canada’s exports.
Canada and Australia Physical Exports, 2014
Source: MIT Atlas, July 2016
As we discussed above, the period from 2000 to 2015 saw the prices of oil, natural gas, coal, iron ore, and most other major commodities rise sharply. For large resource exporters this manifested itself in a two-fold boom. Firstly, export revenues rose sharply as a simple function of price. Secondly, high commodity prices led to rising capital investment, increasing the fixed capital formation portion of GDP.
Canada and Australia also benefitted more than most developed nations from globalisation. As mentioned above, their economies contained relatively few industries that found themselves outcompeted by China or India. (While China has exported coal and oil in the past, it is now an importer.) The relatively small manufacturing and services economies also cushioned them. By contrast, because these countries were already substantial importers of manufactured goods and services, they benefitted directly from the lower prices that came from globalisation.
Canada and Australia also went a different path as far as demographics. Booming economies sucked in relatively young migrant workers, which meant the ratio of workers to retirees did not deteriorate to the same extent as elsewhere. In 2015, Canada and Australia had two of the best ratios of retirees to workers in the developed world.
Workers to Retirees Ratio, 2015
Source: World Bank, July 2016
The success of Canada and Australia, then, is a consequence of the same trends that held back the economies in the rest of the developed world. Might this change going forward? Our view is that commodity prices are likely to remain subdued for an extended period of time, the consequence of China’s growth model moving away from gross capital formation, and substantial investment in new sources of supply.
Tax The Rich?
One of the biggest drivers of inequality has been changes to tax codes across the developed world. The trends have been near universal: rising VAT rates, and falling corporate and capital gains tax rates. The tables below show how VAT rates and corporation tax rates have changed over the past two decades for a selection of countries.
VAT Rates (%), 2015 vs 1995, Selected Countries
(a) USA is California, state sales tax only
Source: OECD Tax Database, Public Policy Institute of California (California Cities and the Local Sales Tax 1999), California State Board of Equalisation (Historical Tax Rates in California Cities & Counties)
Corporation Tax Rates (%), 2015 vs 1995, Selected Countries
Source: OECD Tax Database, July 2016
Increasing VAT (or, in the case of the US sales tax) rates increases the tax burden on the poorest in society. This is because VAT is a tax on consumption, and the proportion of your income that is consumed rather than saved correlates to your income strata: the poorest do not save, and only consume; the richest spend a smaller portion of their income and save the rest. While some governments have attempted to ameliorate the effects by lower (or zero) rating essentials such as fuel or food, increased VAT rates still fall disproportionately on the poor.
Falling corporation tax rates disproportionately benefit the richest. The owners of capital benefit from lower corporate tax rates. Those outside the top 5% have only negligible stakes in companies, and therefore see no benefit.
These were not the only tax changes: in many countries, capital gains tax rates were cut sharply. Just over a decade ago, taxpayers in the UK paid their marginal income tax rate on capital gains. Now, they pay just 18%.
Changes to the structure of taxation did not happen with the purpose of raising inequality. On the contrary, governments like VAT for a number of reasons: it is hard to evade, cheap to collect, and raising it tends to result in a higher savings rate. Similarly, the corporation tax rate was cut because it was relatively easy to evade, and because countries found themselves competing to attract foreign investment. (Ireland is the best example here: having one of the lowest corporation tax rates in the world attracted a large drug manufacturing industry as well as large factories from Intel and Apple.)
Taxation is always a vexing subject: everyone feels the burden should best fall elsewhere. Nevertheless, over the last two decades, we have seen taxes on the wealthiest in society fall, while they have risen on the poorest. At a time when people on median income – or worse – are feeling squeezed, we think this is unsustainable.
Money for Old Rope
The other recent driver of income inequality is Quantitive Easing. This modern refashioning of money printing was originally conceived to counteract the “zero bound” of monetary policy and therefore prevent excessive balance sheet contraction.
Easy money, compressed yields, and an assurance from central banks that monetary policy would remain loose for a sustained period of time did not have exactly the desired effect. Consumers in most countries, instead of taking the savings from their lower mortgage payments and increasing their spending, chose to reduce their debts.
Cheap money was supposed to stimulate spending and investment. However, as many consumers and businesses were so indebted going into the Global Financial Crisis, and because capacity utilisation at most firms was low, few wished to take advantage of central bank largesse.
Instead what sprung up was an arbitrage: real assets’ yields were well above the cost of funding. Cheap debt could be locked in for long periods, generating a substantial carry trade. In the US, which was early on the Quantitive Easing bandwagon, and where corporates were not over-indebted at the beginning of the crisis, corporates borrowed heavily to buy back stock. (Company managements are incentivised to raise the share price; buybacks on borrowed money was the inevitable conclusion in a low growth world.) Historically, some of a company’s profit would be returned to shareholders (through dividends and buybacks), while another chunk was used for future investment. In the QE world, as the chart below shows, companies consistently returned more to shareholders than they made in profit.
US, Buybacks and dividends as a percentage of net income
Note: Aggregate number for 3,297 publicly traded non-financial companies analyzed by Reuters
Source: Thomson Reuters data, regulatory filings
Just as with the tax rate changes, the impact of QE has been to raise inequality. Swelling asset prices, and increased profits – the consequences of cheap money – have benefitted the wealthiest in society disproportionately.
Old Wine, New Bottles
The new populists share a common diagnosis of how the world might be improved: an end to globalisation and free trade. Some – like Podemos or SYRIZA – come to this conclusion from the Left, while others come from the Right. Nevertheless, the common strand is a belief that free trade is a zero sum game, with winners and losers.
We have heard this song before of course. Between the First and Second World Wars, following the US passing of The Smoot-Hawley Tariff Act of 1930, a wave of protectionist measures were passed around the wold. This did not end well: world trade collapsed, and economies – that had been recovering – deteriorated further. The raising of tariff barriers around the world was one of the ultimate causes of the Second World War; something recognised in the creation of the General Agreement on Tariffs and Trade in 1947, which went on to become the World Trade Organisation in 1995.
World Trade 1929-1933, as % of World GDP
Source: League of Nations’ World Economic Survey 1932-33
It is true that the benefits of free trade appear very unequal: to an unemployed steel worker in Sunderland, the 1% in his country have gotten wealthier, as have the people of China and other emerging markets, while he has found himself without a job. The problem is that the proposed alternatives – of erecting tariff barriers – make the problem worse.
Raising tariff barriers on – say – imported steel to maintain jobs in Redcar or Port Talbot won’t save those jobs. Or, if it temporarily does, it will do so at the expense of the steel consumers of the UK – car makers and the like.
But let us imagine this issue could be solved (and that we could avoid retaliatory tariffs from those affected by our actions): who would be the purchaser of manufactured products from us if we attempted to protect our industries? We would be making a conscious decision to produce goods at above world market prices. And we need our exports: because without exports of goods and services, we cannot afford the natural gas and oil and the like we need.
As we discussed in Why We Were Rich, above, the developed world used to have the monopoly on manufacturing goods. It no longer does. Attempting to protect industries that are no longer competitive will not help them, it will merely unbalance economies further. Recognising this is painful. Not recognising it is worse.
The German Example
Lest this piece appear overly negative, there is an example of a country in the developed world which has managed to reduce inequality and grow its economy: Germany. Just 26 years ago, the formerly Communist Democratic Republic of Germany was subsumed into the Federal Republic of Germany.
The process was painful. Eastern Germany lacked modern industry, which – when combined with an inappropriate exchange rate – ensured that the post-unification period was marked by persistently high unemployment. Massive capital spending, much of it on construction in Berlin, drove German government debt up, and economic growth stagnated. Germany, at the turn of the millennium, was the sick man of Europe.
Yet now, a little more than a quarter century later, the situation is radically different. Brandenburg, the heart of the former Democratic Republic of Germany, had an unemployment rate of just 5.7% at the end of 2015 – and will have surely dropped since. Indeed, while unemployment in the five Lander that makes up the former East Germany is higher than in the West, it averages less than 7%.
This success is not simply a consequence of lavish government spending and public sector jobs. Instead, it is the consequence of a sensible tax and subsidy system, that encouraged firms to setup production in the East. This stands in stark contrast to the UK, where it is jobs in the wealthy South East and London which are subsidised through In Work and Housing Benefits.
Of course, we can produce a long-list of the strengths of the German economy which have made the transformation of the East possible: its family owned smaller companies (the Mittelstand), a banking system that prioritises lending to industry over credit cards, and an education and apprenticeship system tailored to producing people with the skills industry needs. Such advantages cannot be copied wholesale by those seeking to copy Germany. Nevertheless, there should be lessons here: regional development policies can reduce inequality, and improve outcomes.
Of course, there have been naysayers in Germany: in particular, there are those in the West who resent that their taxes are being spent so lavishly in the East. However, we believe this is the lesser of two evils: the German growth machines rumbles on, while others have stuttered and stalled.
In his magisterial history of the seventeenth century, Global Crisis, Geoffrey Parker explains how an exogenous shock – in that case the little ice age – resulted in a series of uprisings across the globe. The people, instead of realising the climate was to blame for falling crop yields (and therefore poverty and death), instead fixed their eyes up on the elites, and the existing social structure. The result was a century of revolutions, revolts, uprisings and wars.
While we would hesitate to put the current uprisings on the same scale as the English Civil War, or the Thirty Years War in Germany, we do believe there is a lesson to be learned: revolts occur when people feel they have no stake in the existing economic order and believe – rightly or wrongly – that they have nothing to lose by its overthrow.
There are examples of how developed countries can reduce income inequality, and can raise incomes in a globalising world. We can also be confident that economics is self-balancing, and that a large portion of the rebalancing between developed and developing world is now behind us. We are also likely – as happened in the 1980s and 1990s – to have the benefit of low commodity prices for a sustained period of time.
The new populists, peddling their simple solutions to complex problems, have not learned the lesson of the 1930s. Putting up trade barriers will not make the discontented of the developed world richer, but will merely worsen their lot. The risk of populist protectionism is not the impact today, but what follows its inevitable failure.
We take comfort in the fact that there are solutions to the problems of the developed world. There are policies that rebalance economies, and reduce income inequality. And although the new populists have risen almost everywhere, they have struggled to get beyond 28-30% in the polls in most places. The establishment has the opportunity to make economies work and reduce income inequality; they would be wise to do so now rather than be forced into it by a modern day revolt.
 The Lifetime Distribution of Health Care Costs, Berhanu Alemayehu and Kenneth E Warner, 2004
 Office of National Statistics, July 2016
 Oil, Copper, Gold, from Bloomberg; Iron Ore, Coal from Indexmundi, all accessed July 2016
 Household Energy Spending in the UK, 2002-2012, Office of National Statistics
 Institute for Fiscal Studies, Capital Gains Tax Rates, July 2016
 Eurostat, July 2016
 Global Crisis: War, Climate Change and Catastrophe in the Seventeenth Century by Geoffrey Parker, 2013
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