Davos 2018: The liberal international order is sick

Delegates need to consider what is to be done to save the model from wreckage

Martin Wolf

Last year, Donald Trump was a spectre haunting the World Economic Forum’s annual meeting, in Davos. This year, he may be there in the flesh. If so, it will be an uncomfortable encounter. He rejects the tenets of the liberal international order promoted by his country over seven decades. These values also animate the WEF. They are what make it something more than just a forum for world’s rich and powerful.

As Princeton’s John Ikenberry argues in a recent article, the “US and its partners built a multi-faceted and sprawling international order, organised around economic openness, multilateral institutions, security co-operation and democratic solidarity”. This system won the cold war. That victory, in turn, promoted a global shift towards democratic politics and free-market economics.

Today, however, the liberal international order is sick. As Freedom in the World 2018, published by Freedom House, a US state-funded non-profit organisation, states, “Democracy is in crisis”. For the 12th consecutive year, countries that suffered democratic setbacks outnumbered those that registered gains. States that a decade ago seemed promising success stories — such as Turkey and Hungary — are sliding into authoritarian rule.

Yet now, when potent authoritarian regimes challenge democracy, the US has withdrawn its moral support. Mr Trump even shows sympathy for autocrats abroad. Worse, argues Freedom House, he violates norms of democratic governance.

Under Mr Trump, the US also questions the fabric of international co-operation — security treaties, open markets, multilateral institutions and attempts to address such global challenges as climate change. It has, instead, proclaimed its intention to look after its own interests, even at the direct expense of longstanding allies. Relations are now to be transactional.

Nor is the underpinning of the world economy in better shape. The economy may be recovering, but no significant trade liberalisation has occurred since China’s accession to the World Trade Organization in 2001. Brexit will also prove to be an act of deglobalisation. Trade and capital flows have been growing no faster than world output. Hostility to immigration is rampant. China, a new superpower, even tightly controls the flow of ideas.

Those who believe in the symbiosis of democracy, a liberal world economy and global co-operation simply have to find all this more than a little scary.

So why has this happened? The answer consists of changes in the world and in the domestic condition of countries, especially that of the high-income democracies. Among global changes, the most important are the declining relevance of the west as a security community after the end of the cold war, together with its diminishing economic weight, especially in relation to China.

Many Americans feel they have both less reason and less ability to be generous to erstwhile partners. Among domestic changes, many in high-income countries feel that the liberal global order to which their countries have been committed has done little for them. It is generating, instead, the sense of lost opportunities, incomes and respect. It may have brought vast gains to the sorts of people who frequent Davos, but far less to everybody else. Especially, after the shock of the financial crisis, the tide does not seem to be rising and, if it is, it is certainly not lifting all boats.

As Mr Ikenberry summarises: “The crisis of the liberal order is a crisis of legitimacy and social purpose.” Mr Trump’s programme, which I label “pluto-populism”, is a recognisable result of all this. It tells its supporters that their interests will no longer be sacrificed: they will come first. The fact that the policies of the administration are unlikely to deliver any such benefits may be irrelevant. Not enough people are listening to those who argue this.

For those who believe a liberal international order rooted in democratic politics is ethically right and the best way to reconcile global co-operation with domestic legitimacy, this is depressing. Davos men and women have to consider what is to be done to save the global order from wreckage.

It would be possible merely to hope for the best. As the economy recovers, optimism may return. This should, in turn, assuage at least some of the discontent. But this is facile. The forces leading to divergent outcomes within our economies are powerful. It is far from evident that even financial fragility has been eliminated.Instead of complacency, we need to confront two fundamental questions.

The first is which is the more important if it comes to a hard choice: domestic political cohesion or international economic integration? At the margin, it has to be the first. Economic life demands political stability. The range of policies — fiscal, monetary and financial — must make the bulk of the population feel their interests count. Otherwise, democratic stability is in peril.

The second is where to focus efforts at global co-operation. The answer must be that managing the global commons and maintaining global stability comes first. While I would like to see further liberalisation of trade, it has to be done in the right way and is no longer a high priority. Still less pressing is opening borders further to free movement of people or even maintaining free flow of global capital. Politics are overwhelmingly national. The results of political choices must satisfy the people of each country.

Mr Trump is not the cure. But he is evidently a symptom. The liberal international order is crumbling, in part because it does not satisfy the people of our societies. Those who attend Davos need to recognise that. If they do not like Mr Trump’s answers — they should not — they need to advance better ones.

A Rogue Treasury Department Turns Toward the 1930s

The president shouldn’t allow an Obama appointee to guide housing finance policy toward disaster.

By Peter J. Wallison

First, the good news: A group of senators are working on a bill to repeal the government charters of Fannie Mae and Freddie Mac , according to a report last week in the trade publication American Banker. This would set the U.S. on a course toward a private system for financing mortgages. Now, the bad news: The Treasury Department wants to return to the regulated market that caused the financial crisis.

At first this might seem implausible. The aggressive deregulatory work of the Trump administration has stimulated the U.S. economy, but its Treasury Department is pushing for more extensive regulation of the housing-finance market. Among conservatives, there’s an emerging view that the Treasury Department is on a frolic all its own.

Photo: iStock/Getty Images 

Last week, the director of the Federal Housing Finance Agency, which regulates Fannie and Freddie, released a plan for housing-finance reform. The director is an Obama administration holdover, and it shows. His plan’s principal element is heightened government regulation, with all the elements that caused the 2008 financial crisis.

According to the plan, circulated in Washington but not formally released by the FHFA, Fannie and Freddie would be turned into privately owned utilities, with regulated rates that would assure a “fair return” to their shareholders. They would issue mortgage-backed securities covered by an explicit government guarantee. This would “attract and retain shareholders while also supporting broad liquidity in the single family and multifamily housing finance market with affordable mortgage rates.” The whole scenario comes straight out of the left’s fantasy world.

The FHFA also expressed concern that too much competition “could increase the potential for a race to the bottom in underwriting standards in pursuit of market share.” Its solution is again regulating the rate of return of the Fannie and Freddie successors, “which would limit incentives to unduly relax underwriting standards.” Ideas like this hark back to the New Deal.

The Roosevelt administration sought to prevent supposedly excessive competition on the theory that it would drive down prices, force companies out of business, and produce more unemployment.

Addressing another major Democratic priority, the FHFA’s plan called for government-backed affordable housing. The utility-like successors to Fannie and Freddie could have “a lower rate of return on purchases serving low-income and moderate-income borrowers.” This would ensure that “all taxpayers can share in the benefits of federal support for the housing finance market.” Remember that what taxpayers actually “shared” in 2008 was Fannie and Freddie’s losses of about $186 billion.

What caused those losses? Affordable-housing goals. A 1992 law required Fannie and Freddie to reduce their underwriting standards so they could meet quotas for low- and moderate-income mortgages. By 2008, on the eve of the financial crisis, half of all mortgages in the U.S. were subprime or otherwise risky. And 76% of those mortgages were on the books of government agencies, primarily Fannie and Freddie. The government had created the demand for these mortgages.

Treasury apparently has no problem with this. Last week Craig Phillips, counselor to Secretary Steven Mnuchin, said the department was “broadly supportive” of the FHFA’s plan. This is disturbing enough, but Treasury is also endorsing some of the details that are far afield of the administration’s deregulatory efforts. For example, last week American Banker quoted Mr. Phillips agreeing that the FHFA should use rate regulation to prevent a competitive race to the bottom: “The key is regulation. Whether there is one or five [guarantors], we cannot have weak regulation.” FDR must be smiling.

The trouble here is not merely that the Treasury is an outlier in what was supposed to be a deregulatory administration. It is also that the department’s current custodians appear to have learned nothing from the financial crisis, which was caused by precisely the policies they now support.

Before the affordable-housing goals were enacted in 1992, Fannie and Freddie would buy only prime mortgages. Although they competed with each other, there was no race to the bottom.

They began to reduce their underwriting standards, with tragic effect, after the affordable-housing goals came into force. The result was the largest housing bubble in American history, followed by a monumental crash in 2008. Another consequence, courtesy of Barney Frank, was the Dodd-Frank Act, which was based on the false idea that the crisis was caused by insufficient regulation of the financial system. President Trump has accurately called the act a “disaster.”

It over-regulated the rest of the financial system but left the insolvent Fannie and Freddie untouched, in the care of the FHFA as conservator.

Housing finance desperately needs reform, but Treasury is moving in the wrong direction—back to the 1930s. The headline on the American Banker story was “Treasury, FHFA see eye to eye on housing reform, top official says.” Who would have believed it a year ago?

Mr. Wallison is a senior fellow at the American Enterprise Institute. His most recent book is “Hidden In Plain Sight: What Caused the World’s Worst Financial Crisis and Why It Could Happen Again” (Encounter, 2015).

Why the US Can’t Afford a Trade War With the EU

By Antonia Colibasanu

When Donald Trump ran for president, he promised to protect U.S. industries from unfair trade practices. He focused on the steel industry, which he said suffers when other countries dump their steel products on the U.S. market. Now, the Trump administration is considering imposing new tariffs on steel imports, and while China is often the suggested target of such policies, another critical trading partner for the U.S. would also be affected: the European Union. The EU is the second-largest producer of steel in the world, accounting for 11 percent of global production. Increasing steel tariffs, therefore, could ignite a trade war with the EU – something that ultimately goes against U.S. interests.

The U.S. is the fifth-largest producer of steel (if you count the EU as a single entity), but since the 2008 crash, the sector has been beset by problems. It’s linked to many downstream industries such as automotive, construction, electronics and mechanical and electrical engineering that were hit hard by the crisis. Trump promised to protect the steel industry in several ways, including by applying Section 232 of the Trade Expansion Act of 1962, which allows the president to impose restrictions on imports for national security reasons. In April, he asked the Commerce Department to look into whether steel could qualify under this section, and earlier this month, the department announced it had completed its review. The White House has 90 days from Jan. 11 to act, or not act, on the report’s findings, which have not been released publicly.

Imposing restrictions on steel imports would have severe consequences for the EU. The European Steel Association considers the U.S. a key market, accounting for most European steel exports outside the EU. Steel has long been a strategically important industry in the EU, one that has fostered innovation, sparked economic growth and employed a lot of people. An increase in tariffs would mean fewer exports to the U.S. and a potential cut in production for European plants. It could also mean some European steel workers would lose their jobs, adding to the already high unemployment rates in some European states.

A worker ties a cable to a steel girder at a construction site in Washington, D.C., on April 3, 2015. NICHOLAS KAMM/AFP/Getty Images

Brussels would likely respond by increasing its own duties on U.S. imports. In theory, the EU could swiftly introduce additional tariffs on “certain imports” from the U.S. But in reality, it would take weeks because the European Commission needs to notify the World Trade Organization it is going to impose restrictions and establish the list of goods and services on which the measures will be applied.

To understand the potential implications of a trade conflict, we need to look at how dependent the U.S. and the EU are on trade with each other. In 2016, U.S. exports to the EU accounted for 18.7 percent of total U.S. exports, making the EU the top destination for U.S. goods and services. In the same year, EU exports to the U.S. accounted for 20.8 percent of total EU exports, making the U.S. the top destination for European goods and services. It is a fairly equal relationship, though exports are somewhat more important to the EU economy. In 2016, the exports-to-GDP ratio stood at 12.6 percent in the U.S. and 16.7 percent in the EU.

But when it comes to investment, the EU has more leverage over the U.S. than the U.S. has over the EU. The EU is the largest investor in the U.S, accounting for 60 percent of total foreign investment in 2016. Although the U.S. is also the largest investor in the EU, it only accounted for 40 percent of total foreign investment in 2016. In fact, since 2006, EU investment in the U.S. has exceeded U.S. investment in the EU. Both countries are roughly equally dependent on foreign investment. In 2016, total investment as a percent of GDP was 21 percent in the U.S. and 20 percent in the EU. In both places, roughly 20 percent of total investment comes from foreign sources, according to the World Bank.

Import barriers don’t just impede trade but also investment. Foreign companies that have operations and production facilities in either the EU or the U.S. depend on imports to run their businesses. A trade war could make it difficult for these companies to operate and hurt their bottom line.

Higher import tariffs imposed by the EU will also affect American exporters, including those in the manufacturing sector, a critical industry accounting for roughly 12 percent of U.S. GDP.

Eighty-four percent of U.S. exports to the EU are manufactured products. Of these, machinery and transport equipment account for more than 45 percent and chemical products account for 23 percent. These industries could suffer if the EU were forced to impose retaliatory measures in response to U.S. tariff hikes. In addition, rises in steel import tariffs would mean increased costs for sectors that are dependent on imported steel products. The automotive, construction, mechanical and electrical engineering sectors are all large consumers of steel products – some of which are only available from external suppliers.

Trump wouldn’t be the first president to raise duties on steel imports. In 2002, President George W. Bush increased tariffs to 30 percent. The EU responded with its own trade restrictions. (Back then, the trade relationship between the two was not as strong as it is today, and the EU’s share in total investment in the U.S. was lower.) The EU, along with China, Japan, South Korea, Norway, Switzerland, Brazil and New Zealand, brought the case to the World Trade Organization. It took 20 months, but the U.S. was forced to lift the additional tariffs. And during those 20 months, 26,000 U.S. jobs were lost only in steel-related industries.

Trump promised to put America first. But before he makes any moves to increase tariffs on imports, he will have to consider how this would affect U.S. businesses and, ultimately, jobs.

Since receiving the report from the Commerce Department, the Trump administration has imposed new tariffs only on imported solar panels and washing machines. The administration said China was the target of the measure, but the EU condemned the move as well.

Implementing more moves like this one could force the EU to respond, and that could hurt the U.S. economy.