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The Bull Market in Politics

There’s always a bull market somewhere. — Jim Cramer, TheStreet.com

February 2008

For most of the past twenty-five years the West generally, and the United States particularly, experienced a surprisingly apolitical interlude. The great perturbers of world war, cold war, sweeping social reform, and crippling resource constraints went largely absent. Only from the cramped viewpoint of the present could tussles over the NEA, Supreme Court justices, and spotted owls seem momentous. Politics receded. For investors, this meant that politics became a much less important variable in the grand calculus of interest rates, innovation, global integration, and so on. The recent past can therefore be conceived of as a sort of political bear market, one where the degree to which ordinary life — including economic activity — was mostly unaffected by politics. There have been many such bear markets, during which the economy and the lives of most citizens chug along rather nicely, or at very least, without substantial overt interference from the state. By contrast, during a bull market, political influence — over financial matters, public policy, decisions of war and peace — takes on great importance. After a placid quarter-century, many cannot bring themselves to believe that the future holds anything more than a continuation of the recent bear market in US politics. But tremendous structural changes to the world’s economy render impossible any such continuation: for the US, global integration and competition have reached a point where a significant political response is inevitable. The bear market is giving way to a powerful new bull market and for the first time in many years, US domestic politics will become a central concern for investors around the world. The background assumptions of the past three decades — that there will be no major changes in trade, immigration, and tax policy — have become unreliable. Portfolios that underweight the possibility of major policy shifts therefore risk significant underperformance as the US moves into an increasingly politicized future.
B u ll a nd B e a r M a rk e T S in Po li T iCS inter national B ull a n d B ea r Ma rkets in Politics

World history is littered with bull and bear markets in politics. The consequences for the polities and economies involved have been varied, though an historical review reveals that periods of heightened political ferment, while undoubtedly more interesting, prove less salubrious than more serene times. Recent bull markets in politics illustrate the general pattern. Perhaps the most important bull market of the past century was post-Tsarist Russia, which produced the first modern totalitarian state. From the rebellions following the Tsar’s defeat in the Russo-Japanese War to the Bolsheviks’ New Economic Policy in 1921, politics became central to the life of all Russians. To paraphrase Trotsky in another context, the average Russian might not have been interested in politics, but politics was interested in him. Equally catastrophic were the fascist bull markets in Europe of the 1920s-1940s, and the somewhat less dismal gyrations in the Middle East, Latin America, and Southeast Asia of the late 1940s-1960s.

This document is confidential and not for further circulation. This is not a solicitation or recommendation to buy, sell or hold securities. Certain statements contained herein may be forward-looking. Information contained herein is believed to be accurate and/or derived from sources that Clarium Capital Management LLC believes to be reliable; however, Clarium disclaims any and all liability as to the completeness or accuracy of the information contained herein and for any omissions of material facts. This document has not been filed with the Commodities Futures Trading Commission or any other regulatory body. Graphics contained herein are purely representational and do not reflect any hypothetical return from an investment in the depicted instruments. © 2008

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As a general matter, bull markets in politics coincide with major wars, the expansion of government, and the politicization of large parts of the economy, often to society’s detriment.1 As Robert Higgs documents in Crisis and Leviathan, advocates of statist intervention take advantage of economic downturns, wars, and other catastrophes to introduce reforms that may have little to do with the situation at hand, typically outlive the crises that provoked them, and produce correspondingly dismal results. But the case should not be overstated: not every bull market ends in disaster. The Putin era, in which the state reasserted itself over an economy looted during a period of instability and transition, is certainly a political bull market. For all his faults and singular dependence on an oil windfall, Putin moderated the chaos of the early post-Soviet era, to the general acclaim of the people. The jury is still largely out on Putin, but Medici Italy, Louis XIV’s France, and the Gladstone-Disraeli era are other examples of bull markets in politics that produced some, and occasionally significant, benefits for the populace and investing classes. And, as we shall see, Europe’s vigor over the past 40 years has been, in part, the product of a narrow bull market in economic policy (though one which has ironically produced 27 smaller bear markets as Brussels squashed economic nationalism). By contrast, bear markets in politics and the politicians who create them tend to be understudied, under-analyzed, and underrated; these markets are viewed as unimportant to national well-being. But while they may be less interesting fodder for the historian, they generally produce more congenial results. The outstanding recent example is Adenauerera Germany. Adenauer took politics out of the central place in German life — for instance, by removing the suffocating price controls that the Allies had carried over from Nazi government, and establishing a sound, apolitical currency. The resultant German Wirkschaftswunder (economic miracle) was in fact the predictable result of providing an industrious populace in an historically viable nation-state with a stable government and rule of law, and removing the suffocating hand of regulation. Adenauer’s famous 1957 election slogan, Keine Experimente (No Experiments), could serve as a motto for bear market politicians everywhere. Adenauer’s dedication to establishing a bear market in German politics should not be confused with inaction or lack of vision; the Chancellor was vigorous and brilliant in pursuit of his goal, at an age when most men would have long since been retired. But the bias of political scientists and historians is against political bear market politicians. Their programs seem dull and bourgeois, their slogans are rarely sexy, and their achievements lack grandiosity of vision — principally because, as these statesmen themselves admit, the successes they rack up have little to do with politics, except insofar as the politicians have been shoved out of the way. This is one reason that Mao Zedong’s grand experiments absorb more historical ink than Deng Xiaoping’s less colorful efforts. But it was Deng’s bear market that has made China a real competitor with the West, not Mao’s paroxysms of violence and dogma.
a m erica n B ull a n d B ea r Ma rkets in Politics

American politics has also produced bull and bear markets to roughly similar effects, though the American bull markets tend to produce somewhat less cataclysmic results than their recent European counterparts, while being somewhat longer-lived. As the US is about to enter its first bull market in a quarter century, an historical survey is instructive, with a focus on the under-studied bear markets.

1 So far, only one major war, the Korean War, is associated with a bear market in politics, though it remains to be seen whether the present war in Iraq will add to that short list.

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Bull markets in politics form the standard narrative of what we might call American court history: the Revolution and Federal period, the run-up to and fighting of the Civil War, the Progressive era and World War I, the Great Depression and entry into World War II, and the Sixties and Seventies. Bull market presidents tend to get the highest rankings from historians. Yet America’s prosperity has arguably been built during political bear markets. The entire Colonial period from the founding of British North America at Jamestown in 1607 to the Stamp Act of 1765, with a few sharp local exceptions, can be viewed as one long and generally successful bear market in politics, the legacy of brilliant compromises by Elizabeth I.2 The Colonial period may lack the drama of revolution, but it made the Revolution possible. Jumping ahead 150 years, the 1920s witnessed another bear market in politics, and one largely characterized by great national accomplishment. The engineer of this bear market was Warren Harding. If you want to know what a political bear market politician sounds like, consider Harding’s well-known call for a return to normalcy:
America’s present need is not heroics, but healing; not nostrums, but normalcy; not revolution, but restoration; not agitation, but adjustment; not surgery, but serenity; not the dramatic, but the dispassionate; not experiment, but equipoise; not submergence in internationality, but sustainment in triumphant nationality.

Substitute “China’s” for “America’s” and Deng Xiaoping in 1978 would have agreed with every word of it. Though Harding is commonly viewed as a disaster, his accomplishments belie the common conception. During his brief administration, Harding released political prisoners,3 negotiated the world’s first arms reduction treaty, cut taxes from their high wartime rates (the top rate fell from 73% to 43.5%, with capital gains at 12.5%), reduced unemployment and inflation drastically, cut spending dramatically, and established the Bureau of the Budget (now the Office of Management and Budget). The economy surged — real GNP rose 9% annualy in the two years after Harding took office — and when Harding died, he was among the most popular presidents in American history. Eventually, Harding was besmirched by those who took issue with his dismantling of Progressive reforms, and he is now better remembered for his philandering and the cupidity of his Cabinet than for his considerable accomplishments.4

2 Despite or perhaps because of the politically correct attention she gets for being a woman, Elizabeth I is still underrated as an important politician because she created a bear market in politics (at least by the colorful standards of her day). Elizabeth took over a society in which political murder was common and left a society in which it was much rarer. 3 Most notably, socialist labor leader Eugene V. Debs, imprisoned for protesting World War I. 4 Close students of history will remember that Harding also engaged in some seemingly bull market tactics on the immigration and taxation fronts. However, Harding’s efforts were merely a return to the status quo ante after an exceedingly turbulent period. On immigration, Harding’s reforms — passed with trivial opposition — built on earlier reforms designed to moderate the stupendous flow of immigrants from Europe. Following the Harding quota, formerly war-stoked immigration fell from a brief high of 1.2 million to 425,000 annually, but the latter level was roughly the same as that prevailing in the relatively peaceful period from 1880-1900. In the case of tariffs, the picture is more mixed. There is no question that the Fordney-McCumber Tariff of 1922, taken alone, seems like the act of a bull market politician. But in conjunction with the tariff, Harding reduced the recently innovated income tax, restoring traditional US tax policy and reducing taxes overall. In context, then, the net effect of Harding’s policies was to reduce the intrusion of politics into private life, which, of course, is the definition of a bear market politician.

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Dwight Eisenhower, another bear market politician, suffered a similar but less cruel judgment; he was long viewed as a faintly ridiculous caretaker. But his presidency coincided with peace in Korea, creation of the modern middle class, mass education of large segments of the American population, a sustained burst of prosperity and fertility, and an almost single-handed avoidance of a one-sided nuclear war with China. Whatever the received wisdom about Harding and Eisenhower, their accomplishments were real. The Eisenhower years effectively ended with the Democrats’ big win in the mid-term elections of 1958, which ushered in a new era of activist, idealist government (the New Frontier, the Great Society, the space program and the Vietnam War are, on this reading, all of a piece). Americans began to celebrate the federal government’s transformative potential — its capacity to end poverty and racism, and contain Communism — and politics became ever more important and remained for more than two decades marked by an unwinnable war, exploding social pathology, inflation, and relative economic decline. The reaction against the disappointment of Americans’ inflated hopes for the prospects of government can be seen in the election of Ronald Reagan, which ushered in (after an initial burst of important economic policies, principally tax cuts and deregulations) a political bear market that continued until quite recently. Indeed, one could see the administrations of George H.W. Bush and Bill Clinton as periods when Americans expected relatively little from the government, either at home or abroad. The outcome of such expectations — which helped elect George W. Bush, who famously promised a “humble” foreign policy — was sustained economic growth, balanced budgets, and a peacetime military. For many, 9/11 seemed to mark a return to a bull market in politics. The first major domestic attack in the United States since Pearl Harbor seemed to call for a reevaluation of ways of life and politics. In the words of Dick Cheney, after 9/11 “everything changed.” The extensive US military operations in the Middle East and re-ignition of Samuel Huntington’s thousand-year clash of civilizations with Islam, exacerbated perhaps by US elites’ silent unease over the deteriorating global energy outlook, certainly bear this sentiment out in a narrow foreign policy sense. But while Cheney and kindred global architects of US strategy may care about such things, the US political zeitgeist appears largely not to. The radical Islamist menace, however terrifying in the long run, has fizzled as a day-to-day threat in the consciousness of the US electorate. Whatever the forwardlooking worries of some policy elites may be, from the perspective of the present, AlQaeda has been badly hamstrung by coordinated efforts among the world’s intelligence agencies, the Taliban were easy routed, even if pockets of resistance remain, and even the direct economic effects of 9/11 were modest — a few hundred billion dollars at most, against a $13 trillion economy. Asked to choose the issue most important to deciding their vote in an exit poll, pivotal New Hampshire primary voters put terrorism fifth (the economy was first).5 And the war in Iraq, a byproduct of 9/11 and by no means popular, has simmered down considerably in electoral significance: Even before the surge strategy began, voters in the 2006 midterm elections ranked congressional corruption well ahead of Iraq in importance.6 And yet, a new bull market in politics is incipient. It comes not in reaction to terrorism, war, or any of the operatic generatives of history, but through the more prosaic vehicle of global economic competition. American industry and labor is challenged by China, India, Japan, and Europe, and the US is awakening to the implications. It is economics,

5 Behind the Clinton and McCain Comebacks . (last visited February 20, 2008). 6 Exit polls: Scandals hurt GOP more than war. (last visited February 20, 2008).

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not security or civil liberties, that is the key issue, even for Republicans, as the exit polling showed.7 And so investors must now account for not only a resurgence in the importance of politics, but a political bull market whose genesis and consequences are explicitly economic.
T he Glo Ba l Ch a l l en Ge Two ha m m er s, Two a nvils, a n d a m erica

The US finds itself wedged between sets of economic hammers and anvils. The hammers, the emerging economies of China and India, as well as others, are competing successfully for US markets and industries in mass manufactured goods and tradable services. The anvils, principally Japan and Western Europe, are strenuously defending their positions in advanced industry and luxury goods against US incursions. The challenge of the hammers is widely appreciated: less-sophisticated manufacturing in the US is being systematically stripped by China, while India’s boom in tradable services and offshoring is maturing into a viable threat. The results are reflected in GDP growth rates that far outstrip that of the US. What is much less well understood is that the anvils pose an almost equally severe challenge, even though their GDP growth is far less spectacular. While growing no faster than the US, Japan and Europe — through careful design — are holding onto entrenched industry positions: Japan and Germany in advanced manufacturing and (to oversimplify somewhat) non-Germanic Europe in luxury goods and advanced services. Europe and Japan’s achievements are occasionally mocked by jingoists as mere defensive victories, but these highly capitalized societies with slow-growing populations seem, upon present evidence, able to maintain their positions. Wedged between the hammers and anvils, and as yet without a meaningful response, America faces something that can be called the “Global Challenge.”8 By nature, the world-ranging transformations of the Global Challenge will unfold over decades. But investors will have to confront the political (and thus investable) consequences of the Global Challenge over a much more immediate timescale. China and India, despite the progress in some parts of their economies, are still in their early adolescence of their overall development. The United States will remain the world’s dominant economic polity for some time. But the political effects of the Global Challenge will begin as soon as there is a critical mass of public awareness that there is a Global Challenge. Indeed, the central argument of this essay is that this acceleration is happening right now. Matters will intensify as the full dimensions of that challenge are realized, long before the dangers actually play themselves out or are averted. The decisive moment need not await the final capitulation of the dollar or some other equally dramatic economic dislocation. Voters need not actually lose jobs or suffer real declines in living standards before reacting. An abrupt increase in anxiety over potential

7 The resurgence of John McCain is not to the contrary; his popularity, especially among moderate Republicans, derives significantly from his break with Bush on tax cuts and special interests, some of which are perceived by voters as responsible for the subprime mess. 8 The term “Global Challenge” derives from Jean-Jacques Servan-Schreiber’s Le Défi Américain (The American Challenge), an epochal 1967 work that outlined the competitive threat the US then posed to Europe, the effects of which will be discussed later in this essay.

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losses is enough to drive intense political change. Sometimes these reactions are constructive, as with enormous investment in education and technology post-Sputnik. Sometimes they are destructive, as in protectionist convulsions following the various panics of the 19th century. But if ordinary Americans perceive that their well-being is under immediate threat, they are likely to put immense demands on government to address them. The evidence (detailed in later sections) is mounting that Americans now feel this way about intense foreign competition, about the Global Challenge. Let us consider each challenger in turn: China, India, Japan, and Europe.
T h e Chin ese ha m m er: Mass Ma nu facturin g

China is long people, and short everything else. The Chinese challenge is based not on raw materials or technology but on cheap, compliant labor and, critically, on the container ship, which can efficiently transport its products to markets once the inviolable dominion of domestic producers (i.e., the US itself). Most notably, China has many workers willing to labor for very little. This is well known, though the true scope of the challenge is rarely appreciated. China is producing competent industrial workers on a vast scale. Of basic workers, those with education equivalent to the US 8th grade, China produces 17 million, about five times as many as the US; of more advanced workers, six times as many.9 Moreover, China has vast reservoirs of underutilized labor. Conservative estimates of Chinese surplus agricultural labor vary between about 150 — 200 million people, of which a substantial fraction can shift to factory work in relatively short order and an even larger fraction of which will eventually send their sons and daughters to factories in the cities.10 At some point, this aspect of the China challenge will moderate as the effects of the one-child policy strengthen and China’s reckless environmental policies (such as a lack of up-to-date scrubbers on coal plants) stunt the development of many of China’s children and force major reforms that raise production costs.11 But these events lie years in the future — meaning further decades of wage pressure on lesser-skilled American workers. Given the size of the labor pool, it is not surprising that Chinese workers command extremely low wages. But again, it is worth considering the precise scale of the problem. Even assuming a 100% revaluation of the renminbi — far beyond the implicit 28% demanded by Senator Schumer, or any other major figure who thinks currency revaluation will solve the problem — Chinese wages (even with further real wage increases) are unlikely to rise beyond a mere 20% of US wages. The West can never again compete with China in mass manufactured goods. A major revaluation is unlikely to provide even incremental relief. Until now, the Chinese attitude toward exports has been that they would take any manufacturing job to boost employment. As a matter of state policy, they were not picky. The likely Chinese response to a renminbi revaluation is to slough off the lowest value-added industries like apparel to even more desperately poor countries such as India, Pakistan, and Indonesia; keep those industries where China is collectively a price-setter; and focus growth on higher

9 China Statistics Yearbook at 789-90 (2007). 10 World Bank China Quarterly Update at 19 (September 2007). 11 “Pollution has made cancer China’s leading cause of death…. Ambient air pollution alone is blamed for hundreds of thousands of deaths each year. Nearly 500 million people lack access to safe drinking water…. Only 1% of the country’s 560 million city dwellers breathe air considered safe by the European Union.” Joseph Kahn & Jim Yardley, The New York Times at A1 (August 25, 2007).

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value-added products. But, in addition to fueling US inflation, this would just move the Chinese threat up the value chain, and threaten even more-sophisticated industries and more-valuable jobs in the US. In other words, far from alleviating pressure on the US, a renminbi revaluation is quite likely to make things worse. A generalized decline of the dollar against other currencies as well would be just as futile, and would have the unpleasant side effect of higher oil import costs. The second driver of the Chinese challenge — and one that will continue to strengthen — is the ability of the Chinese to ship mass produced goods to Western markets for very little. Currently, China ships most of its goods in containers loaded onto vessels which can accommodate up to 5,000 forty-foot containers. However, expansions of key canals and harbors will soon permit China and other exporters to utilize ships (the Malaccamax) that can carry almost 9,000 forty-foot containers. The rough doubling of cargo capacity means that unit shipping costs for these new vessels will be 15% lower than their predecessors. China’s push to develop its transportation infrastructure linking the interior to the coasts allows manufacturers to move plants away from the higher-wage coastline to significantly lower-wage destinations within the country without paying significant additional shipping costs. Advances in transportation infrastructure and shipping technology are therefore poised to make Chinese exports even more competitive. One way to visualize the Chinese hammer is to imagine a 10 lane causeway built across the Pacific from Shanghai to Los Angeles. It costs less than $3,000 to ship a container from Shanghai to Los Angeles. For that same $3,000, one can truck the same container about 1,750 miles, 70% of the distance from Hawaii to Los Angeles. All of coastal China is thus closer to the US in truck-equivalent miles than Hawaii, and moving closer. From the point of view of US manufacturers, the barriers of distance that have helped protect them from Chinese competition are crumbling.
Fig. 1 Shipping Advances Put Chinese Manufacturers Ever Closer To US Markets

Truck Equivalent Mileage Adjustment

Shipping Advancements Mileage Adjustment

Los Angeles

Shanghai

Shanghai

Shanghai

Honolulu

1475 1750 Current And Projected Truck-Equivalent Distances between LA and Shanghai

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T h e in dia n ha m m er: Mass Tradable Services

The blow to American competitiveness in services comes from India. Like China, India’s competitive advantage derives in part from its enormous population. Indeed, going forward, India, not China, will be the largest source of labor in the world: The 20 yearold age cohort now matches the size of China’s, and live births are 31% higher than in China. But the legacy of the Raj has left India with a singular advantage: a vast number of English-speaking workers. India has roughly 350 million Anglophones, about the combined populations of the US and Great Britain. While many have dismissed the Indian challenge, citing India’s abysmally low levels of educational attainment and socially immobilizing caste structure, India does produce more than 2.5 million college graduates per year — more than twice the number produced in the US. These graduates can compete at both the lower and middle ranks of the service spectrum. Another point less commonly appreciated is that India also poses a challenge to the US at the higher end of the service spectrum. Graduates of elite Indian technical schools who flock to America for training and opportunity frequently return home to found Indian services companies that directly compete with the US. India can offer upper middle class workers a lifestyle that is vastly less expensive and more culturally congenial than that of United States. Servants, for example, are available as they have not been in the US in living memory. And lower costs of living mean that Indian firms can pay significantly less for equivalent workers, buttressing India’s competitive advantage. India’s significance for the world is markedly less than China’s. But not so its significance to the Global Challenge facing America; that significance is more nearly equal. This is because India focuses on one of the few areas of remaining American predominance: tradable services conducted in English (i.e., the lingua mundi). At the lower end, it is the one country that really threatens many middle-class service jobs, such as call centers and technical support. As with Deng’s leadership in China, India’s competitive threat has increased dramatically since the 1991 reforms of Manmohan Singh inaugurated a bear market in Indian politics under the government of Narasimha Rao. One of the great competitive advantages of the US is that its political bear market politicians have had few emulators in the emerging world until recently, and the US has thus been a much more attractive destination for investment than elsewhere. But India’s bear market in politics is allowing it to become a competitor not only for middle class service sector jobs, but increasingly as a target for investment as well. In many ways, India is an emerging market version of the US (or, to a lesser extent, the UK): it has an uneven educational system, a chronic trade deficit, an inability to build incremental infrastructure (in the US, since the Robert Moses era ended about 1970 or so), a dysfunctional if democratic political system, and plenty of English-speaking service employees. It offers all that America does and in some ways more, but at a fraction of the price.
T h e Japa n ese a nvil: ad va n ced Ma nu facturin g

The most intriguing aspect of the Global Challenge is the least appreciated: competition from mature economies. Of these, Japan is the least-well understood, at least by outsiders. Japan threatens the US neither through cheap labor nor through literal economic outperformance. Rather, it threatens the US because its strategy for dealing with China

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— obsessive superiority in advanced manufacturing — deprives the US of some of its best options for response. Specifically, Japan has shown that it can successfully hold onto the more advantageous industries it already has, preventing the US from offsetting losses to China and India by expansion into these areas. And this is a rolling, not a static defense: as it has since becoming rich, Japan will defend its grasp upon the highest rungs of the global manufacturing economy by aggressively promoting the advanced industries of tomorrow. That Japan will not exhibit intimidating rates of GDP growth while doing this is irrelevant, although this is an important subtlety overlooked by the many who dismiss Japan as a stagnant also-ran. Japan, like Europe and the United States, but unlike China and India, is a mature economy growing relatively slowly at the top of a high plateau of per-capita GDP. But Japan’s developed-country growth rate is not a sign of sickness, let alone incipient decline. Japan is fully invested in state-of-the-art productive technologies and has already transitioned essentially all of its workforce out of pre-modern activities like peasant agriculture. That it cannot rack up easy growth, as China and India do, by simply moving a few hundred million people out of medieval production methods into factory life in no way diminishes the threat. Nevertheless, Japan is persistently dismissed because a popular barometer of economic health — the stock market — remains depressed. But when evaluating Japanese performance, it is essential to realize that the Japanese financial system is the most radically anomalous of all the world’s major capitalist financial systems. There is, for a start, the basic fact that Japanese finance emphasizes debt at the expense of equity, and ties up so much equity in keiretsu cross-shareholdings that a normal equity capital market, let alone an American-style market for corporate control, does not really exist. One consequence of this is that Japanese corporate performance is not reflected in Japanese stock market returns. Consequently, the mediocre returns of the Tokyo stock market do not mean the Japanese economy is performing badly. Japan’s exports and global market share in key industries, which continue to thrive, are a far clearer indicator. And indeed, Japan’s GDP growth since 2000 has been roughly in-line with the US and EU; the finance-bubble slump has finally ended.
Fig. 2 Japanese Growth Has Converged W ith That Of Other Advanced Economies
Source: IMF

5% 4% Real GDP Growth (Per Capita) 3% 2% 1% 0% -1% -2% -3% 1998 2000 2002 2004 2006 2008
Japan United States European Union

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Another fact lost among the stories of cabinet shuffles and a seemingly rudderless governing party is that Japan has a coherent economic policy for dealing with the rise of China. Japan has not been surprised by the rise of China. Indeed, Japan has to some extent engineered this rise by providing technology, capital, and above all the model of growth based on export-led manufacturing steered by a one-party state. That Japan is technically democratic and China is not matters less in this context than the basic fact of a tight ruling-elite consensus in favor of economic success at all costs, with the distracting social conflicts permitted in Europe and the United States subordinated to this priority. As Japan’s own economy has matured into a high-wage one, Japan has to some extent even welcomed the rise of China, if only because it cannot continue to concentrate its economy on the highest value-added sectors of the world economy, or the highest value-added stages of the productive process, without having some suitable place to shed the remainder. Most famously, the production of consumer electronics involves both crude physical assembly, which is today a low-value activity, and the production of key components, like chips and electro-optical components. Because Japanese firms dominate the industry as a whole, and thus have strategic control over the location of the various stages of the production process, Japan maintains a remarkable ability to skim the cream and remain the location of the highest value-added activities. Japan’s strategy has been not to produce substitutes for Chinese goods, but higher-value complements. This strategy is the essence of Japan’s response to China, the only part of the Global Challenge that seriously threatens Japan, given that it does not have major positions to lose in the industries threatened by India and Europe. Japan has grasped that while China has an overwhelming advantage in manufacturing industries where unskilled or semi-skilled labor is the primary cost of production, this is simply not the case for every industry. In many advanced manufacturing industries, direct labor is only 15-20% of production cost, with capital and indirect costs making up the rest. And China does not have privileged access to capital or technology: these inputs are not cheaper in China than anywhere else. Despite contrary mythology, manufacturing is not an innately primitive part of the economy, and Japanese companies have shown how it is, in fact, well-suited to building up formidably defensible positions based upon expensively accumulated proprietary knowledge and vast capital plant.12 Logically enough, Japan has systematically set out to acquire competitive advantage in capital and technology. Japan’s anomalous, debt-oriented financial system is geared to produce cheap debt financing, a fact reflected in Japan’s low cost of capital. Firms in the US have a weighted average cost of capital of 8%; in Japan, it is closer to 4%.13 At the same time, Japan’s educational systems defend its advantages in human capital by producing huge numbers of technically competent graduates to man the industries in which Japan specializes.
T h e eur opea n a nvil: lu x ur y G oods

Americans enamored of their own more free-market economy occasionally scoff at Europe, dismissing it as sclerotic, hamstrung by regulations and entrenched labor unions, and hence uncompetitive. As in the Japan example, however, self-serving depictions are betrayed by reality: over the past five years, Europe has grown strongly, exported vigorously, and enjoyed sharp gains on its bourses.

12 See Eamonn Fingleton’s In Praise of Hard Industries (1999) for further discussion. Another side-effect of Japan’s ruthless focus on suitable industries is the production of an unusually energy efficient economy, which will serve Japan well in the time of peak oil. 13 UBS and Goldman Sachs internal estimates.

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Fig. 3 European Bourses Have Performed Strongly

350 300 250 200 150 100 50 0 2002

DAX CAC 40 FTSE

October 9, 2002 = 100

DJIA

2003

2004

2005

2006

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The vision of European senility is clearly wrong; Europe remains a serious competitive threat. Like Japan, Europe has a strategy: to be sparing in the use of resources and low- cost labor and to focus on industries where firms are able to pay high hourly wages. As a result, Europe is well-positioned in advanced manufacturing (printing presses, heavy machinery, and so on) as well as luxury goods and services, from Brioni to Barclays. Some argue that China threatens European manufacturing, especially in non-Germanic Europe, and most intensely in Italy. However, Europe retains a uniquely appealing style, culture, and way-of-life that is aped but as yet unmatched by any other region of the world, including the US, and which has been successfully embedded in a range of products. Few would have thought even two years ago that the euro could soar or European industry do so well, outcomes that are a testament to Europe’s economic strategy and ineffable mystique. Europe’s strategy is, ironically, a direct result of the challenge that the US posed to Europe 40 years ago, which Le Défi Américain outlined in detail. Since then, Europe’s policy makers have relentlessly focused on enabling economies of scale to the exclusion of almost all else.14 The drive for scale goes far beyond the requirements of a minimalist common market. But much as they rankle local patriots, European harmonization directives make cold economic sense: they render the details of doing business in any one country largely identical to another, from using a single currency to employing a single accounting standard. The potency of the combination will only grow when the rapidly growing nations of Eastern Europe finally join up and the UK adopts the euro. Eurosceptics quibble that none of this performance is due to the actions of Brussels. In this view, the standardization occurring within the common market is simply a consequence of

14 W ith the half-exception of the EU’s large, ludicrous, and untouchable agriculture subsidies. But all developed nations, including the US and Japan, suffer from bizarre agricultural policies.

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market forces — after all, it is Intel and Microsoft that gave Europe a common IT standard, not some polyglot parliament. But even if the Eurosceptic critique is partly true, and Europe has succeeded despite the EU, not because of it, Europe has succeeded nonetheless. What matters for present purposes is that the US faces a vast and growing continental competitor with regulations no more heterogeneous than those of the 50 states. Transmitted through the magnifying conduit of the common market, European policy has developed several advantages, particularly with respect to the US. The first is a significant edge in energy use: European land-use favors cities rather than suburbs, compact cars rather than SUVs, and renewables rather than fossil fuels. As a result, Europe is roughly twice as energy efficient per unit of GDP as the US, and derives far less of its energy from depleting sources. In an era of peak oil, these advantages will allow Europe to invest and consume to a greater extent than the sprawling US, which will be forced to send otherwise investable dollars abroad to pay for oil — a problem that will only get worse as the dollar continues to fall. Second, the European social model confers a distinct advantage. The outperformance of European primary and secondary education is well known. But less appreciated is the role that generous social benefits play in increasing human capital. Because of these benefits, European labor does not migrate to new locations or industries during a recession, but stays in the same town. When the recession is over, the same person goes back to work at the same job. While the research remains limited on the relationship between investments in human capital and labor mobility, it seems likely that the European social model allows European companies to invest more intensely in each worker’s productivity. Investment in human capital is captured by those who pay for it, so as a result of its various labor advantages, European productivity has soared. On a per-hour basis (rather than the more commonly cited per-capita basis), French and German productivity rates exceed that of the US by some 30%. Europe works.
Fig. 4 European Productivity Exceeds That of US *GDP in US Dollars
Source: OECD

FRANCE

GERMANY

UNITED STATES

Labor Inputs

Maximum Weekly Hours Average Hours Worked Annually per Employed Person Labor Force Hours Worked Change 1990-2006

35 1554

48 1433

None 1715

-1.0%

-6.3%

+20.7%

Productivity

GDP Per Person Employed as % of US

124%

110%

100%

GDP Per Hour Worked as % of US

138%

131%

100%

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None of this is to argue that the US should adopt all of Europe’s practices. In part, the US’s competitive advantages lie elsewhere. However, Europe’s existing strengths will guarantee that over the next two decades this increasingly unified continent will remain a ferocious competitor to the US — particularly in the higher value-added goods and service industries where the US might hope to compete, given its inability to match China in mass manufacturing or India in tradable services.
T h e Global Challen ge

The US is cornered. That is not to say that the US lacks for world-class companies: for every GM, there are still several Apples, Boeings, and Intels. And the US remains the entrepreneurial leader. But there is a real question regarding whether or not such companies and entrepreneurialism create enough middle-class jobs. The political evidence suggests they do not. At the end of an unprecedentedly stable quarter-century of economic growth, intense political anxiety is producing a transformational shift in American political values.
T he n e w a x iS o f a M eriC a n Po li T iCS

In recent years, free trade and relatively open immigration have been settled parts of the bipartisan policy consensus — and thus, of little concern for investors. While the fortunes of exporters, importers, shippers, currencies, homebuilders, and various other aspects of the economy intertwine inextricably with trade and immigration policies, these policies have hardly mattered to investors as they have hardly changed. The calculus will soon differ: in the next few Congresses, the federal government will change either its trade or its immigration policy to an extent that will strike many observers as extreme and unpleasant. This will be one of the first momentous consequences of the nascent bull market in US politics. The moral content of changes in immigration and trade policy are, for the investor, of little moment. What matters is when and how policy will change, which in turn depends on how persuasive the arguments are for change — not to the investor, but to the electorate. Although it is uncertain whether free trade or relatively open immigration will give way, change in one these issues is inevitable. It became so on June 28, 2007 — the day American politics shifted on its axis. The old axis of American politics with regard to trade and immigration was simple because it broke along class lines. In one camp, there were the Hermès globalists: in favor of free trade and open immigration. In the other camp, there were the Wal-Mart nationalists: against both. The classic set piece of this axis was the NAFTA debate between Al Gore and Ross Perot in 1993 — the cool, Ivy-educated highbrow lecturing the Texas tubthumper.

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Fig. 5a The Old Axis of American Politics — Nationalists v. Globalists

Trade

+
LEFTISTS

+
GLOBALISTS

Immigration

-

NATIONALISTS

RIGHTISTS

Until June 27, 2007, the old axis appeared to be holding. Behind S. 1348, which proposed to grant legal status to 12 million illegal aliens, stood almost the entire American elite: the White House, the Democratic and Republican Congressional leaderships, the Fortune 500, the US Chamber of Commerce, the realtors (about which more later), the civil rights and ethnic lobbies, most major newspapers, the largest church organizations, the most prestigious opinion leaders, the great and the good. Less than 24 hours before the vote, fewer than 30 Senators were in opposition. The next day, because of an unprecedented Internet campaign, 53 Senators — 12 more than necessary — scuttled the bill. The old axis had broken. A bull market in US politics had begun. The new axis of American politics breaks not on class but partisan lines: instead of Globalists facing Nationalists in a contest whose outcome is foreordained in favor of the Globalists, there is a genuine fight between Leftists and Rightists, the outcome of which is uncertain. But as will become clear, the shift is driven by the Global Challenge.
Fig. 5b The New Axis of American Politics — Leftists v. Rightists

Trade

+
LEFTISTS

+
GLOBALISTS

Immigration

-

NATIONALISTS

RIGHTISTS

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To highlight the split, a review of the voting record is instructive. For immigration, a senator’s vote on the immigration amnesty bill, S. 1348, is definitive — with affirmative votes placing a senator decisively in favor of immigration and conversely. Since there is no equivalently epochal vote in the House, the grades given members of Congress by Americans for Better Immigration serve as guides: those who receive A’s and B’s are antiimmigration, those with C’s, D’s, and F’s are pro.15 For trade, a Representative’s vote on the Central American Free Trade Agreement (CAFTA), the most recent piece of major trade legislation, serves the same purpose. CAFTA passed narrowly in both the House and Senate. The partisan breakdown in the House was stunning. Virtually every Republican in the House voted for CAFTA; virtually every Democrat opposed it. The Senate breakdown was less striking, but still pronounced. In the Senate, Republicans voted 78% in favor, only 22% against. The Democrats voted 24% in favor, with 76% against. Combining the CAFTA vote with the ABI grade and the amnesty vote, each Representative and Senator can be assigned to a quadrant in a matrix. Although CAFTA was in an earlier Congress than the amnesty vote (hence freshmen are not counted below), the results are clear enough:
Fig. 5c The New Axis of American Politics — Trade v. Immigration

Trade

+
Republican

+
GLOBALISTS
1 145 House 8 8 Senate 26 15 House Republican Democrat

LEFTISTS
4 21 Senate

Immigration

Democrat

Senate Republican Democrat 6 8

House 24 14

Senate 29 2

House 136 3 Republican Democrat

-

NATIONALISTS

RIGHTISTS

What is clear is most Democrats are Leftists and most Republicans are Rightists, with few the reverse. The Globalist quadrant is small and shrinking. The underlying reason for this move is the impact of the Global Challenge. Both the explosion in effective foreign competition to American industries, and the ever-increasing numbers of would-be and actual immigrants to the US, place unparalleled stress on the American working and middle class. Anti-immigration and anti-free trade policies are each a coherent way to try to combat that stress.

15 Americans for Better Immigration takes the restrictionist side of the debate. But its grading system is widely acknowledged to be exhaustive and scrupulous even by its opponents.

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The emerging Democratic answer to the Global Challenge has an external and an internal component. The external component, as noted, is to shrink the relative exposure of the American economy to the global economy through restrictions on trade. (This is by definition what restrictions on trade do, whether the restrictions are beneficial or harmful.) The internal component is to reduce income inequality by increasing the progressivity of the American tax system. The emerging Republican answer to the Global Challenge is to reduce, by restricting immigration, the number of slices into which America’s economic pie is cut. Because GDP is a function of inputs that grow with population and inputs that don’t, less population growth implies, other things being equal, higher per-capita GDP. Less population growth reduces the need for jobs, capital, social services, housing, land, and raw materials. Interestingly, the wage effects of reducing immigration (which furnishes overwhelmingly low-wage earners) will produce similar reductions in income inequality, but without the Democrats’ tax increases. Trade restriction and immigration reduction are similar policies in many ways. Although the details are complex, both policies fundamentally work in very simple ways, attacking easily measured systemic aggregates. Both will have cascading effects through vast areas of the American economy and society. Both work by imposing costs, at least prima facie, on foreigners — who don’t vote. Both are supported by public opinion and opposed by elite opinion. Finally, both are wedge issues that each party will use to attack the other. And so both, in the end, represent viable ends to the old bear market in politics. The current recession is certain to neutralize, and quite likely to destroy outright, what is left of the old Hermès Globalist quadrant in politics, though remnants of intellectual and media support may persist for some time. When this happens, either free trade or mass immigration will collapse quickly. Let us consider the effects of each possibility.
ou TCoM e a: free T r a d e Co l l a P SeS

As noted, the emerging Democratic response to the Global Challenge is trade restriction. It is emerging, because no national Democrat as of yet repudiates free trade in toto. But the winds are blowing strongly in that direction, as the positions of the leading Democratic presidential candidates shows. At bottom, Senator Clinton, like her husband, is as thoroughgoing a Globalist as it is possible to be and still win major office. But she can’t simply defend free trade outright, as her husband did, with rhetoric about retraining workers for new jobs; times have changed. She must give serious sops to the anti-trade Left, as with her vote against CAFTA. She has called for a “timeout” on future free trade agreements, as if foreign trade were an unruly three-year-old. She is one of the cosponsors of Senator Schumer’s tariff on goods imported from China. Senator Obama also supports a major restrictionist shift in trade policy. He has gone so far as to state that current US trade policy makes American workers the losers in globalization. Like Clinton, he voted against CAFTA. He has also publicly stated that he would immediately reform NAFTA and trade relations with China if elected. What those reforms might entail is not entirely clear, but their general shape and extraordinary depth can be discerned from Obama’s statement that “people don’t want a cheaper T-shirt if they’re losing a job in the process.” Except in the very long-run, it does not matter whether or not trade restriction is wise policy. It is a sufficiently coherent answer that it could be attempted. The key reason it cannot be peremptorily dismissed is that current US trade practices are unsustainable, so

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something other than the present order of aggressively free trade would seem to be needed to replace them — be it Democratic restrictionism or something else. America’s trade and current account deficits have reached over 6% of GDP. The last time a developed country reached that level was Italy in 1920 (where deficits reached 8% just before Mussolini assumed dictatorship). It is simply impossible to continue this way indefinitely, buying goods and outsourcing services, while exporting very little and relying on foreign credit to finance it all. There are many different ways in which America’s current trading order could collapse. The best scenario would be an export-led boom, but this is highly unlikely, given that America’s declining competitiveness relative to foreign exporters is at the root of the whole scenario. As a simple accounting identity, America’s trade must balance in the long run, so there must either be further steep declines in the dollar that throttle imports and enhance exports, or a deep consumption recession that throttles imports, or legislated trade restrictions. But something has to give. For those who would dismiss the prospect of new trading restrictions as too unorthodox to be viable, recent rumblings in academia provide startling instruction. Unbeknownst to most in the financial community, academic unanimity on free trade is breaking down. The move was heralded by a 2004 article in the Journal of Economic Perspectives by Nobel Laureate Paul Samuelson, who is also the author of the top-selling economics textbook and thus tutor to the future. Samuelson held that free trade was not necessarily the best strategy for the rich countries such as the United States when faced with competition from poor countries such as China that have rapidly rising productivity. For the orthodox, this is a stunning development. As Princeton economics professor and New York Times columnist Paul Krugman observed regarding the Samuelson-led changes in academic views, “it’s hard to avoid the conclusion that growing US trade with third-world countries reduces the real wages of many and perhaps most workers in this country. And that reality makes the politics of trade very difficult.” Krugman added while he was not a protectionist,“those who are worried about trade have a point, and deserve some respect.”16 The subject of Samuelson’s work and Krugman’s respect is called New Trade Theory, and it gives academic legitimacy to attacks on free trade for the first time since the collapse of neo-mercantilism. New Trade Theory raises at least the possibility — it is too undeveloped as yet for even its exponents to claim it licenses the certainty — that protectionism could work. And the theory gives legitimacy to the core anti-trade argument noted by Krugman: that free trade reduces the real wages of Americans, especially low-income Americans. It does not matter for present purposes whether or not New Trade Theory is true, or whether it generates worthwhile policy recommendations. What matters is that the theory is increasingly respectable among policy elites. It is no longer possible to summarily dismiss arguments against free trade on the grounds of quackery. At heart, New Trade Theory attacks the jugular vein of free trade — David Ricardo’s famous theory of comparative advantage. The attack was anticipated by Michael Porter, University Professor at Harvard Business School, as early as 1990. Porter wrote of Ricardo:

16 Paul Krugman, “Trouble with Trade,” The New York Times Editorial Page (December 28, 2007).

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The standard theory assumes that there are no economies of scale, that technologies everywhere are identical, that products are undifferentiated, and that the pool of national factors is fixed. The theory also assumes that factors, such as skilled labor and capital, do not move among nations. All these assumptions bear little relation, in most industries, to actual competition.17

While these critiques have been known for some time, they have at last been properly mathematized, and have therefore begun to penetrate the high church of academic economics.The most important work of New Trade Theory is the still somewhat obscure Global Trade and Conflicting National Interests by William Baumol and Ralph Gomory.18 They contend that in the presence of economies of scale and scope, the free market will produce not just one most-efficient equilibrium distribution of tradable goods industries among nations, but multiple possible equilibria, some more efficient and others less so. These equilibria are determined by accidents of industrial history, and free trade will not necessarily assign any given nation the equilibrium most advantageous to itself. It is therefore at least theoretically possible that state intervention could improve an outcome for a country, a conclusion that should give conventional free-traders pause. New Trade Theory makes other, complementary critiques. Ricardo’s theory assumes no factor mobility. But, as Harvard professors Stephen Marglin and Dani Rodrik have noted, factors are mobile, and increasingly so under modern conditions of acquired, not innate, factor advantages.19 Another critique is that Ricardo implicitly assumes that the time discount on consumption is the same among the populations of trading nations.20 But this does not appear to be the case: Chinese households have a ferocious cash savings rate; American, a negative rate.This opens the possibility that free trade is merely the most efficient way to indulge a consumption binge that reduces long-term wealth. It is not necessary to list all the critiques of New Trade Theory to make the key point: the old-school Ricardian consensus that free trade is always and everywhere the best policy will bleed credibility for many years to come. Freshman titters about the unrealistic assumptions of orthodox economics have been transformed into professional critique. New Trade Theory doesn’t require the US to repudiate free trade; it clearly indicates that there are many policies that are worse than free trade, even if there could be some that are better. New Trade Theory has not yet offered clear recommendations. When New Trade Theory does develop such recommendations, they could easily be derailed or rendered harmful by the politics by which they are implemented. However, such nuances are likely to be lost on the new Democratic opponents of free trade. For them, the essential point is that a critical mass of professional economists now say that some attacks on free trade are acceptable, with the nuance of the word “some” being lost over time. Moreover, the critique that New Trade Theory thinkers tend to be Leftists will help rather than hurt its credibility among Democrats.

17 Michael Porter, The Competitive Advantage of Nations at 12 (1990). 18 To reemphasize for naturally suspicious readers: New Trade Theory was not developed by industry or union hacks. For example, both Gomory and Baumol were professors at Princeton, in mathematics and economics respectively, and Baumol is a former head of the American Economics Association. They are from the same establishments that gave us free trade orthodoxy to begin with. 19 See, e.g., Dani Rodrik, “Why Do More Open Economies Have Bigger Governments?”, Journal of Political Economy, vol. 106, no. 5 (1998). 20 See Ian Fletcher, “A Neoclassical Hole in Neoclassical Free Trade,” Post-Autistic Economics Review, August 2004.

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Changes in trade policy, when and if they come, will be much larger than expected, with large macroeconomic effects. Incremental reform changes nothing, and therefore has no constituency; only large policy changes can satisfy political imperatives. As examples of large policy changes, the US could withdraw from the WTO, NAFTA, and other trade agreements, long a core demand of left-wing Democrats. The federal government could set up a real national trade bureaucracy, with meaningful control over domestic industries and labor markets. Or the US could impose a major tariff on China. To elaborate the last example, there are simply no votes for a small tariff on China, say, an increase of 5%. The major blocs either support no tariff or a large tariff, as with the 28% tax proposed by Senator Schumer. While those opposed to free trade have confined themselves to small gestures such as beating up on economic flyweights like Chile, these are just warm-up rounds. Almost any conceptual case against free trade with Chile can be applied against free trade with Japan, China, India, and Europe. There is a final and novel corollary to trade reform, which is a rise in taxation. US corporate tax rates are among the highest in the world.21 The directly competitive response is to lower corporate taxes (the approach advocated by McCain), but the erection of trade barriers reduces competition and so alleviates pressure toward lower tax rates. It should therefore come as no surprise that both Clinton and Obama favor corporate tax reforms that will increase the aggregate levels of taxation.
ou TCoM e B: iM MiGr aT io n Co l l a P SeS

As noted, the emerging Republican answer to the Global Challenge is to reduce the number of slices into which America’s economic pie is cut, by restricting immigration. Less immigration will shrink the pie somewhat, but will shrink the number of slices even more. And there are a great many slices that can be eliminated: each year one million legal immigrants and half a million illegal aliens join a pool of 26 million legal and 12 million illegal immigrants. While critiques of free trade come mainly from the Left, critiques of relatively open immigration come mainly from the Right. Popular resistance to immigration is often dismissed as irrational, much as criticisms of free trade are waved off on similar grounds, but there are at least four solid reasons why immigration has become a major issue. First and most importantly, mass immigration drives down wages, especially for the most vulnerable, through the simple mechanism of supply and demand. However, unlike the price of almost everything else, higher labor prices should be the goal of national policy, and the temptation to adjust the supply of labor in an attempt to boost prices may prove irresistible. As an expression of this theory, consider the arguments of the restrictionist Center for Immigration Studies: “For the 23% of natives employed in [low-skilled] occupations (about 25 million workers), a 1% increase in the immigrant composition of their occupation reduces wages by .8%. Since these occupations are 15% immigrant, this suggests that immigration may reduce the wages of the average native in a low-skilled occupation by perhaps 12%.”22

21 In this, and in the relative importance of trade to the economy and living standards (as through the provision of cheap goods), the current situation differs rather substantially from prior eras of trade tension. 22 Testimony of Steven Camarota Before The Subcommittee of Immigration, Border Security and Claims (October 30, 2003).

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Second, the current mix of immigrants does not, in general, seem well matched to America’s economic needs in era of Global Challenge. The supply of low-skill jobs in manufacturing and tradable services will continue to remain stagnant or will decline in the face of Chinese and Indian competition.Yet these are the jobs for which the majority of recent immigrants to the US, legal and illegal, are qualified.23 Third, lower-skilled immigrants are also major net consumers of public resources, notably taxes and infrastructure. Robert Rector of the Heritage Foundation (admittedly partisan — but it is partisans who make policy) has estimated the fiscal deficit of immigrant households lacking a high-school degree at about $20,000 per household: such households pay $10,573 in taxes, but consume $30,160 in government services.24 And this does not count the indirect fiscal effect in reducing the wages of native-born lower skilled households. Compared to other developed countries, the US has rapid population growth fueled largely by immigrants and their children. This contributes to overcrowding of public infrastructure such as roads and schools, urban sprawl, and incremental energy use in an era of constrained energy supply. It therefore comes as no surprise that many middle-class Americans, while gaining directly from employment of low-skill immigrant labor, also bear costs which they perceive as outweighing the benefits. Fourth, immigration is perceived as contributing to national security risk. Anxiety over national security fueled by terrorism continues to drive Americans to seek control over US borders, which are poorly secured. Such sentiment has not declined appreciably in the six years since 9/11 and border security remains a hot issue among presidential candidates. Of course, important benefits also accrue from mass immigration. Immigration increases aggregate GDP, through the obvious means of increasing the population of producers and consumers. Certain industries (such as agriculture) rely on a steady stream of lowwage workers. As noted, many native-born Americans benefit directly from reduced prices, especially of domestic services performed for lower wages, thanks to the downward pressure generated by an expanding labor supply. Further, high-skill immigrants bring with them education and expertise from which the US economy benefits and which it did not have to underwrite. Finally, Harvard economist George Borjas estimates that the social group which benefits most from mass immigration is the investor class — whose political influence far outweighs its numbers.25 It is not for us to resolve here whether reducing immigration is the best long-term public policy. The analysis above suggests that immigration cuts can quickly deliver certain benefits to the quality of life of middle-class Americans, and redistribute wealth downward without increasing taxes — two goals that will become increasingly urgent in the upcoming economic squeeze. Immigration reform will remain a popular position among millions of Americans, and as the effects of the Global Challenge drive a political bull market, the appeal of immigration restriction will only intensify among Rightists even as trade restriction sentiment intensifies on the Left.

23 Current immigration reform efforts are thus novel: Whatever cases could be advanced legitimately against the influx of Industrial Era immigrants, they were not dramatically ill-suited to America’s competitive labor needs. Moreover, in prior eras of higher fertility, restrictions on immigration had significantly less impact on composite growth, the implications of which will be taken up shortly. 24 Robert Rector, The Fiscal Cost of Low-Skill Immigrants to the U.S. Population, The Heritage Foundation. (May, 22, 2007). 25 George Borjas, Heaven’s Door: Immigration Policy and the American Economy at 91 (1999).

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To assess the likelihood of immigration reform, consider the political benefits accruing to its Republican sponsors. In the most cynical calculus, cutting immigration improves the Republicans’ relative position, as immigrants vote Democratic by about two-to-one. Less cynically, reduced immigration will help preserve the Republicans’ cherished middleclass society over the near term, if only because immigrants are overwhelmingly unskilled, lower-class laborers. Finally, Republicans need to say something concrete about a number of issues to which they have so far had only tired, lame responses: 1) jobs and benefits, especially health care, 2) the environment, and 3) public infrastructure such as roads and schools. Reduced immigration is a viable response to all of them — and one that harms relatively few people who may vote in US elections. As with trade, the likely changes in immigration policy are large and would have deep macroeconomic effects. The restrictionist agenda is drastic, notwithstanding the fact that it can be achieved through discrete, moderate steps such as verifying eligibility to work, building a border fence, and getting rid of the visa lottery. Each of these measures can be proposed, advocated, voted for, and implemented independently, which makes each restriction easier for the public to swallow. The net result of a Rightist success would have far reaching consequences. The departure of illegal immigrants would increase dramatically, even as inflows shrivel. Added to that the normal emigration of US citizens and resident aliens, the result is stunning: net immigration would be negative for the first time since the Great Depression. Immigration accounts for half of US population growth in the short-run (and more than all of it in the long-run, a seeming paradox that is possible if other sources are negative).26 Without immigration, demand for new US housing construction would be cut roughly in half. Moreover, the residual demand going forward would be disproportionately for multi-family, empty-nester, and senior housing. The bottom would fall out of demand for new single-family homes in a way that would make the current slump (and its side-effects) seem mild and transient. Hence, the realtors’ lobby’s fervent support for maintaining the immigration status quo. And, the US would begin a transition to an older, slower growing population more closely resembling Europe, with all that that implies. As already intimated, if they come, reductions in immigration will come on a much vaster scale than commonly believed, because the realities of immigration reform will not be satisfied by incremental reform. The policy logic for cuts in immigration apply at any non-zero level of immigration; whether the influx is one million or half a million per year, preventing the immigration of another quarter million immigrants produces similar effects. Moreover, because restrictionist sentiment is a reaction both to the flow and the stock of foreign-born (now 38 million), restrictions will remain popular even if net immigration is extremely low. Finally, as the economy deteriorates under the pressure of the Global Challenge, restrictionist sentiment mounts. The immigration reform movement arose during a period of stable growth with only minor recessions; a deep recession will provide much more receptive conditions for restrictionists. The trend can be seen in part through the growth of Numbers USA, a leading restrictionist group:

26 All of this is by design. Somewhat unexpectedly, the modern immigration reform movement is an environmental movement growing out of the conservation movement of the Sixties and Seventies and funded, until recently, mainly by environmental donors. Thus, hardwired in its DNA is a focus on numbers. It is only very recently that immigration reform has become a key Republican answer to the Global Challenge.

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Fig. 6 Restrictionist Sentiment Is Reflected In The Explosive Growth Of NumbersUSA Source: NumbersUSA

700 600 500 Members (thousands) 400 300 200 100 0 1999

Membership

2002

2005

2008

Thus, if the dam of the legal immigration orthodoxy breaks, it will happen suddenly — not over decades, but in quarters or years. In many ways, immigration is a simpler policy issue than trade. The means to reduce legal immigration could not be more straightforward: issue fewer or no visas. And there are only four major steps required to stop illegal immigration, most of which are within sight of being implemented: make workplace verification of eligibility mandatory (the proposed SAVE Act); build a physical fence along the southern border; fully implement the system to track the comings and goings of foreigners to the US (the US Visit system); and increase deportations by increasing cooperation with local law enforcement (the proposed CLEAR Act). It is true that the means to reduce illegal immigration are costly and considerably harder to implement than cuts in legal immigration. These are each multi-billion dollar programs. But all of them are well within the capacity of the US government. For example, a border fence is considerably less difficult to construct than a stealth bomber. And the measures are popular with the public.
So w ill i T B e T r a d e o r iM MiGr aT io n ?

The bear market in US politics is dying. The Global Challenge posed by China, India, Japan, and Europe demands a response. So far, none has been forthcoming, a state of affairs made possible by high and unsustainable levels of foreign investment. Until recently, this flow of cheap capital was justified in part by the illusion that the US is a faster-growing economy than its anvil competitors, Europe and Japan. But as we have seen, comparative “outperformance” has been fueled not by rapid productivity gains, but by the crude driver of more basic inputs: population growth (which depends on high rates of immigration) and associated lower labor costs, higher energy consumption, and other factors such as

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extensive imports of low-cost goods traded by the “hammer” competitors. As these inputs are curtailed by political will and geologic realities, the US economy will appear far less dynamic. Both the flow of cheap capital and top-line GDP growth will slow. And these forces can feed on each other, as slowing growth makes it more difficult to attract cheap capital and higher capital costs in turn put the brakes on growth. The outlook for the US generally is therefore poor and growing worse; the impulse toward a bull market to address that problem has become irresistible. So, as the political bull market arrives, how will the US respond? Will worried Americans be more willing to regulate the flow of goods or the flow of labor? For investors, the triumph of either or both policies has profound implications. It is easy to see the path to immigration restriction, for the argument is well-developed and straightforward. Immigration restrictions are popular and enjoy some support across party lines, and political scaffolding is already in place in the form of the Congressional Immigration Reform Caucus. The coming recession will only intensify the visceral appeal of the restrictionist argument. However, the Republicans are in retreat, compromising their ability to push major legislation. By contrast, trade restriction is neither as simple nor as well-developed as immigration reform. Trade policy is simple only if Ricardo is right. If Ricardo is wrong, as New Trade Theory would have it, then trade theory is much more complex. In a world where everything can be traded, the economics of trade are the economics of everything — a problem of almost infinite complexity. And New Trade Theory is in its infancy, so no serious student of New Trade Theory yet claims to know what is the right answer for America, or for any other nation. The only thing that can be said with near-certainty is that New Trade Theory will not ride to the rescue of the US T-shirt industry. This uncertainty deprives anti-trade politicians of the ammunition needed to win most political fights. However, unlike immigration reform, trade restriction is sponsored by a party that is likely to control both the legislature and the executive in 2009. Having few credible answers to the Global Challenge and constituents hostile to free trade, the Democrats will aggressively promote restrictions on trade. And trade restrictions, which are the functional equivalent of a tax increase on America’s overseas trade partners, will give cover to Democrats to maintain or increase domestic corporate taxes. That the Democrats would obtain control as the economy marks its first full year of recession only increases the likelihood of these responses. If free trade falls, there are many cross-currents. It seems unlikely that the yuan peg can survive the emergence of serious US trade restrictions, and in the immediate aftermath of the peg break, the yuan and yen will soar, with the euro tagging along for the ride. After that break, the dollar is likely to strengthen considerably as tariffs are an alternative policy tool to currency devaluation while, paradoxically, inflation spreads throughout the system as the dollar price of goods in the US rises. If immigration is throttled back and free trade preserved, housing and house prices will be gutted. Most home builders will go bankrupt. An immigration-driven housing degringolade will bring deflation, both in the form of outright disinflation in owneroccupied rent equivalency and also in alternative measures of inflation that capture the true costs of housing. In this scenario, bonds rally, and the dollar should rise as demand for goods wanes.

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The prognosis for Mexico and Central America is not good in either scenario. Each region depends heavily on free trade (enabled by NAFTA and CAFTA), as well as remittances sent home by immigrants, which for Mexico is its single largest source of foreign revenue, even greater than oil sales. The scale of the problem is amply demonstrated through the almost obsessive focus of Latin American policymakers on prodding the US to keep its borders open to people and goods. Coupled with a generally slowing US economy, the outlook is not good for this group. One US sector which should successfully weather the Global Challenge and the political bull market it engenders is defense. Bull markets tend to be good for defense spending, and defense (including aerospace) is the one major sector in which the US enjoys advantages in skilled labor, technology, and trade pathways that are world-beating. Following Reagan’s first term, it became the custom of the investment community to monitor major elections, make minor tweaks to portfolios to account for shifts in the political wind, and then ignore politics until the next cycle. It will be tempting to continue this practice, for it is simple and has been successful for many years. But the temptation should be resisted. After a long quiescence, politics is about to resume its central role in economic life. We will take up the further extraordinary implications of this shift in Part II of this essay.

roBer T Son Morrow Principal Clarium Capit al Management llC