Free trade does not make the whole country better off in the shortrun. And it never was supposed to.

The Brexit effect: Individual company relationships will trump formal trading agreements

Below is an interview with a fictitious reporter from the Flemington Times about Britain voting to leave the EU known as BREXIT. My responses are quite general and I have attempted to stick to what I know and feel qualified to write about — economics. The talking heads in the news are ready with projections and percentages, two years into the future; I have sensibly refrained from any subjective prognostication along those lines. - Professor Farrokh Langdana.

Flemington Times: Prof. Langdana, so are you worried?

Farrokh Langdana (FL): First, Welcome to the Powerhouse. And Worry? What? Me worry?  (This is actually a joke, but most of you are too young for this. This line was the "signature phrase" made by one "Alfred E. Neuman" whose face was the cover boy for Mad Magazine. See:

Flemington Times: Seriously, now, professor. Can you ever be serious?

FL: OK seriously. Let’s start at the beginning. The EU as we know it now, was originally never meant to be an economic union, or some piece de resistance of economic policy. It began with France and Germany taking an oath to never go to war again.

After two world wars in twenty years and with entire towns denuded of young men—to this day, many small towns in France have never recovered from the horrendous loss in life—the plan was to "marry" key industries so that war would be impossible. Following WW2, the French and Germans began by merging their coal sectors, then iron and steel, and then eventually the free trade bloc began to develop. 

The monetary Union (the Eurozone) was independent of the EU and was an even greater afterthought and was prompted really by events of August 1971, when Nixon took the US dollar off the Gold Standard, and then by the high inflation of the Stagflation era of the 1970s.

Flemington Times:  The Brits were always reluctant, right? The old 1957 Times of London Headline: "Fog in Channel. Continent Cut-Off" comes to mind.  They never really saw themselves as "continental" Europeans, did they?

FL: No they did not, and yes, Britain was indeed dragged kicking and screaming into the economic union—this was a free trade bloc that would eliminate trade distortions and promote free trade within the zone and make the whole bloc a powerful trading entity. One very significant cornerstone of the EU was the Mutual Recognition Pact.

A large number of trade distortions known as NTBs (non-tariff barriers) such as artificial and lengthy certification procedures for imports, and bogus domestic standards to keep imports out, were a huge problem. The mutual recognition pact by which a product deemed acceptable by one country had to be allowed to be sold in every country with the EU, was a big move towards unleashing the benefits of free trade.

Flemington Times: So then what went wrong?

FL: First, two fundamental shifts took place. The Wall in Germany came down in 1989. Suddenly Germany went from being "manageable West Germany” to going back to its original size with the largest population in Europe and becoming the predominant economic power in the EU. 

Second, the Soviet Union’s brooding presence had served as a sort of cementing influence for the countries within the Eurozone as the EU countries huddled together for protection. With the dissolution of the Soviet Union in 1991, this bonding influence weakened.

Both these events cannot be understated, and both served to weaken the bonds and the cement holding the whole EU thing together. 

Flemington Times: But now, Brexit? Explain?

FL: The Wall Street Journal said it best (WSJ, 6/25, “A Peasant Revolt Upends Britain’s Ruling Elite”, Quentin Letts).  What we had was indeed a Peasant’s Revolt, and this time, unlike 1381, the peasants won.   

If you read my last blog on Donald Trump and Angry Americans, much of the same argument applies. Free trade does not make the whole country better off in the short run. It never does in the short run and it never was supposed to.

The relatively abundant factors — highly educated white-collar workers and owners of capital in Britain and other developed countries — are supposed to be better off with free trade. On the other hand, the relatively scarce factors — the blue-collar workers — are indeed supposed to be worse off in the short run with free trade, as per David Ricardo, the father of free trade theory. And those scarce factors are the angry ones who have had enough.

That is your "peasants’ revolt." Apparently, the scarce factors showed up to vote in the UK referendum in huge numbers, while the less-than-stellar turnout of the "elite" made all the difference.

Flemington Times: But free trade, as per David Ricardo, explains how those "scarce factors" will eventually transition to the new high-tech industries thanks to free trade, and will eventually be better off. We went from agriculture in the US to manufacturing; Russ Roberts famously points out in The Choice how we went from over 80% of our workers being in agriculture in the US in the 19thcentury to under 10% by the end of the 20th., as they transitioned to "new" manufacturing jobs.

FL:  This is the problem. If you read my last blog, I explain why this has not happened this time. The new technologies — Twitter, Facebook, Uber, Biotech, Nano, Artificial Intelligence — have not been accompanied by large numbers of new jobs. 

Eventually in Europe, individual relationships will trump institutional trading agreements.
We need to wait for the fuss to die down and the panic to subside, Professor Farrok Langdana said. Illustration credit: Tommasourbin/iStock/Thinkstock.

In fact the attendant job creation of these new sectors has been paltry at best; Facebook has 1,700 workers with over 1 billion clients, for example. And if you factor-in the fact that a significant portion of what we had off shored should not have left home shores in the first place (see my blog on Angry Americans) then we have a large number of justifiably angry Americans, Brits, French and Germans, and the list goes on.  Throw on an unhealthy dollop of xenophobia and the refugee issue, and you now have a full-fledged uprising. 

Flemington Times:  But even though the British had 1,200 corporate CEOs and half of the chiefs of the FTSE 100 companies saying, "we must stay," there was no effect?

FL: My point exactly! The disenchanted workers did not want to hear from the elite! This was like pouring gasoline on a fire. They should have had the butcher and the baker telling them to stay, not the elite CEOs in their custom tailored Euro suits and their lavender ties and their expensive watches.

Gasoline on a fire!  Just to be clear—I was all for Britain "remaining" in the EU; this article attempts to explain the intensity, determination and frustration behind the "leave" sentiment and urges us in the United States to seriously examine the similar populist sentiments brewing here at home. 

Flemington Times: So how will this end?

FL:  We need to wait for the fuss to die down and the panic to subside. Make no mistake—there will be pain in the short run as long bond rates rise in the member-EU countries, thanks to the Fisher Effect anticipating future risk.

For us in the US now, the capital inflows pouring into our "safest cave" will keep our interest rates down and the dollar strong. Great for home-buyers but not so good for Boomer retirees hoping for interest income on their Treasurys.

But eventually in Europe, individual relationships will trump institutional trading agreements. If Company X in Country A (UK) is doing drug development with company Y in County B (Belgium), for example, and this has been a productive relationship, then both X and Y will find a way to keep doing so. 

If the pound has weakened by, say, K% after Brexit, then X and Y will both find a way to make it work so that X can keep being a customer to Y’s products. It will happen. 

Typically the heavy lifting is done by individual companies long before big trading agreements like the EU and NAFTA are established. In the US, much of the manufacturing activity had already been sent to the Maquiladora sector in Mexico long before NAFTA was proclaimed. The big trade agreements, in fact, mimic and lag real economic activity.  

Now we cannot dismiss the probability of EU governments hammering the Brits with punitive new NTBs (non-tarriff barriers) to keep them out. But I am confident that absent the formal agreements and massive punitive retaliation, businesses will still find a way to preserve their old trading relationships. 

If there is a new 50-foot wall that has sprung up, thanks to Brexit, then 51-foot ladders will be up in a heartbeat. Mercifully, individual relationships trump formal trading agreements.

Flemington Times: So you are not afraid, Professor Langdana?

FL:  Afraid?!  I am a product of The Rutgers EMBA Powerhouse. And I am American. We are never afraid. For More on the original Peasants’ Revolt of 1381:

P.S. This came in from Rutgers EMBA alumnus John Tintera who shared Professor Langdana's note above which was sent to EMBA alumni. 

I was in the UK last week, staying with an accomplished colleague who is in his 60s. He read your note on Brexit and had this to say:

"Well I largely agree with the professor. Clearly a good guy.

Many people I know voted to leave to take back their democratic rights and to shock the Euro Elite into making fundamental reforms to save the southern European countries. I believe the latter is about to happen! If it doesn't, the Euro zone will break up.

The UK elite completely ignored the blue collar workers and their massive concerns - in fact they said they weren't intelligent enough to cast their votes in this referenedum! Shocking but that is what happens when so called inteligensia in Islington get so out of touch. It was indeed a peasants revolt and I am proud to be a peasant!"

Farrokh Langdana is director of the Executive MBA Program and a professor of Finance and Economics.

Photo illustration credit: Egal/iStock/Thinkstock.

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