The compensation hypothesis holds that public support for free trade can be maintained if a compensation mechanism exists that shifts some of the benefits of free trade towards those that initially lose out. Free trade benefits a country as a whole in most cases as the production possibilities frontier moves outwards but income distribution will be shaped by the relative scarcities of capital and labour to name just two factors. The benefits of free trade are mainly in lower prices which benefit society as a whole, whereas the negatives hit partial sectors of the economy. Yet these partial sectors can make use of the political process and forestall free trade causing society as a whole to lose out. We all benefit from lower prices for electronic appliances but workers at factories that have to shut down due to competition from places like Indonesia will hardly rejoice in that fact. Whilst saving a few hundred dollars on a new TV purchase their paycheck providing them with stable income every month disappears. They will understandably clamour for some way of compensation unless they find a new job quickly. Failing that, they will demand for their sector to be protected from cheap imports. Politicians can overcome this issue by establishing means to compensate the losers and diminish their power to hold off an expansion in free trade. Studies have shown that higher unemployment benefits are linked with a higher free-trade inclination. The same applies as well to higher government spending.

It was during and after the Great Depression in the United States that the fundamental role of the state as a stabilizer of the economic system was proposed and widely accepted. Even closed economic systems are thought not be inherently stable and thus require a strong state to deal with downturns. The welfare state is but one expression of this fundamental belief which also results in many of the regulatory functions the state takes on, such as supervision of the financial system. Yet Globalization undermines the capacity of the state to act boldly and causes more uncertainty and negative effects in partial sectors of the economy even though it acts as a force for good when looking at the whole picture. As weak industries fall by the wayside of liberalized trade and workers become unemployed, the state sees its function in buffering their loss and offers help via its welfare system. However it is precisely this welfare system that causes the structural shift that is needed not to occur.

Now add in cuts in welfare spending due to austerity and you can see why I am open to the suggestion of an upcoming trade-war.


Being a German with foreign parents I have had the opportunity to get somewhat of an insider’s and outsider’s perspective. A year I wrote that there was no way we’d bailout Greece or risk inflation because the problem itself was simply too large and that in knowing that politicians wouldn’t even be so daft as to consider it. Well, we haven’t printed because that’s been a German taboo so far, but bailouts had been a taboo once as well. You have to understand that the current leadership and many Germans value the integrity of Europe beyond anything, they would even sacrifice their own country for it. Talking with Germans I don’t get think they understand the concept of ‘national interest’ in the same way Americans or Chinese do. To the decision-makers ‘national interest’ is tied up with Europe. One of the leading magazines, Der Spiegel, recently had an article why Spain’s government dynamics were supposedly better than Germany’s. In what other country would people basically turn against their country to support another one in the name of regional integration? If you look around you can see that the groundwork is being laid to hammer into German’s minds that a) it’s a liquidity crisis and if only the ECB intervened all would be fine and b) that printing money doesn’t equal Weimar. Merkel has been saying for weeks the same thing: ‘if the Euro fails, Europe will fail’. They’d rather print and find excuses for it rather than see the Euro collapse.

It now comes to this, German inflation-angst versus war-guilt and the sheer will to keep the Euro and thus Europe intact. My money is on the will to keep the Euro intact. Yes there’s a way to keep Europe and the EU working without the Euro but try telling that a German…

There’s two caveats though. One is that markets move faster than the Germans are willing to let the ECB print. Secondly, Germans don’t seem to understand that reforms, even if succesful, take time and market’s won’t wait long enough. It is simply absurd to claim that things will be in the markets once reforms are pushed through. Far from it, reforms take time and austerity is going to bite into growth initially. My prediction thus, Germans will let go of their Weimar-induced inflation-angst and let the ECB print to keep yields at a punishment level of around 6%. Obviously this won’t be much of a help without guaranteed future transfer payment because the competitiveness gap within the Euro is simply too big at this moment, the necessary deflation which is needed in Southern economies can’t occur due to the high debt stock. But that’s a problem for another day.

We live in a world where increasingly one global price exists for commodities, natural resources and other factors of production. Due to trade liberalization and the influx of more than two billion workers (from China to India to Vietnam) the labour force is not shielded from this development. Income inequality between countries has fallen whilst income inequality within countries has risen. The reasons for this are simple; most (manufacturing) work can be done after learning a relatively simple set of instructions and even typical middle-class jobs require just a few years of training. On the other hand, those with a skill-set that is in demand and hard to acquire see their purchasing power rise as they can leverage their wages over goods whose price has been commoditized.

Labour Structure

After World War II it was relatively easy to get a decent-paying job in manufacturing right after high-school, investors mostly stayed within their national boundaries. When people complain that manufacturing jobs are transferred overseas because labour is cheaper there, they forget that it is only because they were born in a Western country that they could even think of demanding multiples of a foreign-labour wage. Both provide the same labour and there’s not a huge productivity difference, why then is it expected that the company compensates one much higher simply for carrying the right passport?

The vast majority of Western workers would see their purchasing power fall dramatically were they to provide the same labour outside their home country. That ranges from blue-collar workers to waitresses to clerks. When people talk about a lack of demand in the U.S. they fail to acknowledge that demand is nothing else but purchasing power and there is no fundamental reason why an American worker at McDonalds should demand higher purchasing power than a Chinese university graduate. There is simply no way that any system where this is the case can be upheld for long. There may be some premium for living in the ‘right’ country but certainly not as high as it is today. The labour structure and wage demands in the U.S. however do not reflect this.

Looking at the labour structure in Asian countries this issue becomes clearer. The Asian system provides two main benefits: one is the lower level of taxation of the economy and labour which increases competiveness vis-à-vis Western rivals and secondly, and less transparently, by lowering the cost of essentials such as food, the wage level of export-industries can be lower without a corresponding loss in standard of living as the cost of living is reduced thanks to the structure of labour. Otherwise unemployed workers compete in low-skill areas and drive down the price of going out, having dinner outside or simply having a good time by enjoying the vast amount of human services.

Yes, these workers constitute an underclass in society. Due to our philosophical and moral inheritage we feel bad about people toiling for hours on end receiving little compensation in return. That underclass benefits from a generous welfare system in the West where transfer payments routinely exceed developing-world wages. According to numbers by BoostUp, one in three American students isn’t graduating from high school. If you have a look at the figures from states such as California you will struggle to comprehend the sheer scale of the issue. In the past decade these people could finance consumption via several measures such as landing a factory job even after dropping out of high-school or using credit and home-equity withdrawals. All those options are gone and there is no conceivable way how these people can demand a wage which is going to be a meaningful. GDP and consumption can only be high if the underlying human capital is strong. But with huge parts of the workforce deteriorating or not substantially more productive than foreign competitors how is consumption ever supposed to pick up?

For investors in the stock-market this isn’t necessarily bad news as companies have a diversified revenue stream and will see their income from emerging nations pick up. It is all about finding the right mix, between companies who have a huge upside thanks to exposure in countries where purchasing power grows and companies whose revenue stream will be impaired due stalling income from their main markets. The Chinese market is surprising in that it allows foreign companies a large market share in non-sensitive areas. American brands are everywhere, a stark contrast to South Korea or Japan. India and Brazil will be similarly open for business.

Cursory Glance at the Budget

Incidentally, this is also why any budget deal that may or not be struck this week will hold out for long. International competition also applies to countries

In Asian societies people that are at the bottom of the social ladder have the corresponding mindset that they don’t deserve hand-outs from society, never mind transfer payments as large as in a Western state. In contrast, they do what little they can to move society forward. Our societies have made the choice to carry weaker people on the back of stronger ones. It is more and more difficult for governments to justify social spending when other governments use their tax money to expand infrastructure and become ruthlessly more competitive. The power to tax its citizens is ultimately what stands behind any government’s promise to honor its obligations.

Markets flush with liquidity, a deleveraging environment and occasional flights to safety will continue to hold the price of Treasuries high for a certain amount of time which is why a case for buying Treasuries and selling them at an opportune time exists. The case for buy & hold on the other hand is on very shaky fundamentals.