Rising economic nationalism

I read a very good piece on the psychology of economic nationalism by SocGen ‚s Dylan Grice earlier today. Because of some relevant thoughts from a reader regarding austerity, I wanted to pass on my thoughts on what he wrote in the context of the present economic situation.

This is going to be more a ‚political economy’ post than an economics or financial one. I take an extremely negative view on economic nationalism; and it would probably take too long to explain why here. But I will lay out the arguments as neutrally as I can so you can see what is happening.

Here’s what Grice wrote that I found insightful (hat tip Scott):

Many smaller eurozone countries have seen extreme political parties now either on the fringes of – or set to enter – coalition governments (e.g. the Netherlands, Austria and Finland). But the trend is growing. A recent article in ‚The Economist’ reported that a Catalonian politician, Xavier Garcia Albiol who is running for mayor in Badalona, just north of Barcelona, is gaining local support and national notoriety for his hard-line stance. He told the newspaper, „Wen people stop me in the street, 80% of the time it is to do with immigration or crime.”

Let’s see how this plays out in the laboratory. Grice writes:

[‚In-group bias’ researcher Henri Tajfel’s] most famous experiment demonstrates how easy it is to create real divisions within groups where none previously existed and how those divisions can soon lead to discriminating behavior. Bristol schoolboys from the same year in the same school were given sheets of paper with dots on them and asked to guess how many dots were on each sheet. The boys were told the test was intended to assess their visual abilities and that they’d be split into groups according to performance. In fact, the schoolboys were split randomly.

Tajfel then asked each schoolboy to independently allocate rewards to other schoolboys. But the other schoolboys were to remain anonymous, and the allocator was told only which group the other schoolboy belonged to. Famously, Tajifel discovered that the vast majority of subjects allocated significantly more reward to their in-group, at the expense of the out-group. His theory that discrimination against outsiders was to do with hardwired systematic processing errors rather than a few rogue personality types was vindicated.

When times are tough, people start looking for someone to blame. This is a universal truth. And usually it is not the In-group which gets the blame but out-groups like minorities, immigrants and foreigners. The case against immigration in the U.S. during the Great Depression is instructive:

When the United States last experienced an economic downturn greater than the present day depression, immigrants were often seen as a problem more than a solution because of high unemployment. As a result, Herbert Hoover authorised the Mexican Repatriation Program, which was the removal – by force if necessary – of both American Citizens of Mexican descent and Mexican immigrants from American soil…

Many of the repatriations took place via immigration raids. Wikipedia describes one raid period in Los Angeles in which INS officials questioned several thousand people over a three-week period. The result in terms of numbers of residents repatriated is unclear, but the effect in terms of intimidation on the wider Mexican immigrant community is clear. While the population of American residents of Mexican descent increased overall, an estimated 500,000 Mexicans voluntarily or involuntarily emigrated from the US back to Mexico during the Mexican Repatriation. Of this number, about 35,000 were deported.

–Mexican Repatriation: The Great Depression and Immigration Policy

In Arizona, in particular, illegal immigration is a big issue. Even Hispanics are divided over illegal immigrationissues. This is why you will hear Barack Obama, a liberal President talking tough on immigration issues. He understands that this is what people want to hear in hard economic times.

In a bid to remake the enforcement of federal immigration laws, the Obama administration is deporting record numbers of illegal immigrants and auditing hundreds of businesses that blithely hire undocumented workers.

The Immigration and Customs Enforcement agency expects to deport about 400,000 people this fiscal year, nearly 10 percent above the Bush administration’s 2008 total and 25 percent more than were deported in 2007. The pace of company audits has roughly quadrupled since President George W. Bush’s final year in office.

The effort is part of President Obama’s larger project „to make our national laws actually work,” as he put it in a speech this month at American University. Partly designed to entice Republicans to support comprehensive immigration reform, the mission is proving difficult and politically perilous.

Obama is drawing flak from those who contend the administration is weak on border security and from those who are disappointed he has not done more to fulfill his campaign promise to help the country’s estimated 11 million illegal residents. Trying to thread a needle, the president contends enforcement — including the deployment of fresh troops to the Mexico border — is a necessary but insufficient solution.

–Deportation of illegal immigrants increases under Obama administration – Washington Post, Jul 2010

As Grice noted, the situation in Europe is similar. The fact is, with unemployment high in most countries, foreigners are seen as a problem right across Europe.

There is a connection between extremism and economic downturns, as recent research demonstrates. Usually this takes the form of right extremism and nationalism rather than left extremism and socialism.

[H]igher per capita GDP growth is significantly negatively linked to the support for extreme political positions. While estimates vary between specifications, we find that roughly a one percentage point decline in growth translates into a one percentage point higher vote share of right-wing or nationalist parties. Moreover, we find that the amount of income inequality in a country affects the role that growth plays. Highly unequal countries display a lower growth effect than more equal countries. For countries with a more equal distribution of income, a one percentage point drop in the growth rate may increase the vote share of far right parties by up to two percentage points.

Our results therefore make clear that countries should not expect right-wing parties to get majorities unless growth declines quite as much as in the 1920s. Nevertheless, even with a less significant fall in economic growth rates, a rise in support for extreme parties is likely to change political outcomes – for example through their impact on incumbent parties’ political platforms.

Our more recent research on the vote shares of other groups of political parties points out that smaller growth rates mostly benefit right wing and nationalist parties – and not so much the communist parties. One explanation for this asymmetry may be that voters perceive right wing parties as generating more individual income uncertainty.

—The OECD’s growth prospects and political extremism

All of this documented evidence suggests that depression equals extremism. Economic downturns increase economic nationalism. And this has consequences in terms of economic policy.

Now, I mentioned the pro-Austerity view that people like Hugh Hendry have promoted in a recent post on Austerity in the UK. He calls for allowing the deleveraging to proceed apace. For example, many Americans point to 1921 as a positive example of how cutting back could move the ball forward quickly.

I see this as very risky. As I said at the height of the panic:

in practice, these measures would result in huge job loses, would induce further deleveraging and asset price declines, would deplete capital from an already fragile global banking system, and would lead to a probable depression of unimaginable severity. It is in such a bleak environment that dangerous despots and dictators like Hitler and Mussolini rose to power, taking advantage of the natural human need for ‚strong’ leader in a time of chaos and uncertainty. Could we expect any different today?

–Confessions of an Austrian economist

Paul Krugman also correctly points out that 1921 was an inflation-fighting recession, not a deflation-fighting one. So the macro environment was entirely different. The potential for an extreme deflationary or inflationary spiral was much less. Weimar Germany or Mussolini’s Italy are the correct analogues from 1921, ironically, one reason to resist Krugman’s calls for protectionism.

So, with the debt ceiling debates in the U.S. as backdrop, here’s what I see happening in the U.S.:

• Deficit spending on this scale is politically unacceptable and will come to an end as soon as the economy shows any signs of life (say 2 to 3% growth for one year). Therefore, at the first sign of economic strength, the Federal Government will raise taxes and/or cut spending. The result will be a deep recession with higher unemployment and lower stock prices.
• Meanwhile, all countries which issue the vast majority of debt in their own currency (U.S, Eurozone, U.K., Switzerland, Japan) will inflate. They will print as much money as they can reasonably get away with. While the economy is in an upswing, this will create a false boom, predicated on asset price increases. This will be a huge bonus for hard assets like gold, platinum or silver. However, when the prop of government spending is taken away, the global economy will relapse into recession.
• As a result there will be a Scylla and Charybdis of inflationary and deflationary forces, which will force the hands of central bankers in adding and withdrawing liquidity. Add in the likely volatility in government spending and taxation and you have the makings of a depression shaped like a series of W’s consisting of short and uneven business cycles. The secular force is the D-process and the deleveraging, so I expect deflation to be the resulting secular trend more than inflation.
• Needless to say, this kind of volatility will induce a wave of populist sentiment, leading to an unpredictable and violent geopolitical climate and the likelihood of more muscular forms of government.
• From an investing standpoint, consider this a secular bear market for stocks then. Play the rallies, but be cognizant that the secular trend for the time being is down. The Japanese example which we are now tracking is a best case scenario.

This is a verbatim copy of the sequence I wrote about in October 2009 when I said the recession is over but the depression has just begun. If you have a convincing case that’s more uplifting, I would like to hear it.

In Europe, the same is happening. Dylan Grice explains it well:

So “in-group bias” can cause wrong ideas to persist longer than they should. But persistence isn’t actually the problem. Any distribution has extremities at any point in time and there will always be some people with bizarre opinions about why one out-group or another is the cause of the world’s wrongs. The problem is when such thinking gains traction …

And this is why I’m worried about where the euro is going. Most experimental evidence clearly shows that while in-group bias is common, we do a good job at suppressing the distorted perceptions and prejudices it creates. Social norms, empathy and the adoption of more rational value systems all help to mitigate our tendency to discriminate against out-groups. However, on a personal level that suppression requires an ongoing supply of what is essentially a highly scarce resource: mental energy. And in a fascinating literature review of recent work into the psychology of prejudice by two academics at the University of Kansas a detailed picture emerges of how mental stress and emotional fatigue increase our susceptibility to “in-group bias”. Thus, the rise of aggressive nationalism throughout the world in the 1920s and 1930s and the consequent breakdown of global trade all occurred under conditions of extreme economic distress.

I believe what we are seeing is the beginning of the eurozone’s credit crisis, not the end. The historic and psychological evidence clearly links economic dislocation with the scapegoating of out-groups and, of course, the eurozone edifice stands increasingly lonely and tall as a lightning rod for the latter. I believe the likelihood is that over the course of the next decade or so, the trend will be towards greater fiscal problems and greater economic problems. I believe these problems will increase the temperature of debates about whose fault it all is, and that as the conclusion to these debates becomes more polarized they will play into the hands of nationalist, anti-immigrant and increasingly, anti-euro sentiment.

Again, I do appreciate a well-argued case that this is not what is likely to happen. But unless we see a multi-year recovery economy in which the nagging debt and default issues are entirely removed, economic nationalism will return with a vengeance. And that means political conflict in which the potential for armed responses is high.