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.