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Global macro & geopolitics from a small economy perspective

On changing the rules of the game

David Skilling
27 October 2017

Strong political institutions have been central to the success of small economies, from Singapore to Switzerland and the Nordics. These institutions remain deeply embedded. A new Dutch government has just been formed after six months of negotiation, but the country functioned well in the interim – and GDP growth accelerated. And in New Zealand, a new coalition government was sworn in this week: although the new Labour government will make policy changes, these will be shaped by a well-developed set of political institutions (including on fiscal policy).

Political institutions are also important for large economies, but here there are more grounds for concern. Spanish institutions are under real pressure with respect to Catalonia, for example. And the Brexit negotiations are revealing weaknesses in the UK’s institutions. Over a year on from the vote, there is little clarity from the UK on its preferred exit arrangement (as well as ongoing Cabinet infighting). In the EU, the sense of existential crisis has lifted and EU economies are growing again. But the EU is still wrestling with different member preferences on issues from immigration and fiscal policy, to the desirability of deeper integration.

On the other side of the Atlantic, US political institutions are under pressure from an erratic President with a casual disregard for the truth and little interest in governing. The checks and balances in the US have stopped some of the wilder policies (and people), but there is much that can be done by executive order, and norms are shifting. The Republican Congress seems more interested in securing tax cuts than in responding to the President’s actions and words. And Senators – like Mr Flake this week – seem more inclined to speak out when they are stepping down. Yes, the US is resilient – but this undermining of institutions will do real harm.

As many have remarked this week, the contrast between a distracted, inward-looking US and the assertive, confident China on display at the 19th Party Congress is striking. Although the Chinese model of governance is not as strong as it is presented, and there are many structural challenges, China has a plan.

These institutional developments make it more challenging to deal with these large economies: from difficulties concluding FTAs with the EU, to figuring out whether agreements with the US will be honoured, and the ‘weaponisation’ of trade by China. And increasingly, domestic political pressures are impacting on large country approaches to international institutions.

Although international institutions – from the UN to the IMF and WTO – are imperfect, they have supported several decades of peace and prosperity. But to the extent that the Trump Administration has a strategic approach to the world, it is best called the ‘withdrawal doctrine’ as Richard Haass tweeted recently. From the Paris Accord to UNESCO to the TPP, President Trump has a record of withdrawing from international agreements and institutions. And NAFTA and the Iran deal are both at risk. In Geneva, the US is stopping the appointment of WTO appellate judges to hear trade disputes: one of the core functions at the WTO may grind to a halt. For the moment at least, the US has moved to short-term transactional diplomacy and away from multilateral institutions.

Others, from Japan to the EU, are stepping up their efforts to support multilateral institutions. But as international relations theory (and historical experience) shows, it is challenging to provide global public goods in a multi-polar world, particularly when interests vary significantly. Chinese cheerleading for globalisation, for example, should be interpreted cautiously. Although the statements of support are welcome, China’s support for an open international system is deeply asymmetric, reflecting its mercantilist preferences.

Such problems need not lead to economic (or military) conflict, but the efficiency and credibility of the system is at stake. And key aspects of the international economic system rest on confidence in the behaviour of the US. As just one example, take the reserve currency system.

The US is the dominant reserve currency issuer; not because of fiat but because the USD is widely accepted and liquid – and so preferred by the market. The USD is on one side of 88% of all foreign exchange trades, and IMF data shows than the USD accounts for 64% of central bank reserves. The euro is in a distant second place, involved in 31% of foreign exchange trades and accounting for just 20% of reserves. And the RMB is not freely convertible; it accounts for 1% of official reserves, and is less widely transacted than the Swiss franc in foreign exchange markets. There has been relatively little change in these numbers over the past decade, but it is striking that the commitment of the US to the international economic system is increasingly being discussed.

Relative to the past few decades, there is an unusually high level of uncertainty about the strength of domestic and international political institutions. Some of these effects are covered over by a recovering global economy, and markets do not seem concerned about structural institutional risks. But this is no reason for complacency. The weakening of economic and political institutions may only become apparent in times of crisis or stress. History shows that periods of regime change, like the early 1970s, can be bumpy. For small countries that are deeply exposed to these developments, now is a time to invest in building resilience to external shocks and to further strengthen domestic institutions.

twitter: @dskilling
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