It was Shakespeare – not William, but rather Stephan, the Britishhead of research firm YouGov – who first coined the drawbridgephrase in 1995 as a reference to the threat of isolationism:
"We are either ‘drawbridge up’ or ‘drawbridge down’. Are you someone whofeels your life is being encroached upon by criminals, gypsies, spongers,asylum-seekers, Brussels bureaucrats? Do you think the bad things will allgo away if we lock the doors? Or do you think it’s a big beautiful worldout there, full of good people, if only we could all open our arms andembrace each other?"
PIMCO has focused on the threat of deglobalization since 2009 as part ofour New Normal and later New Neutral secular outlooks. Since the greatfinancial crisis, this threat has been manifest in the form of stagnantglobal trade volumes and a dramatic shrinkage in the stock of cross-borderfinancial assets.
The popular backlash against the resulting subpar economic outcomes isgiving rise to “drawbridge capitalism,” a form of economic nationalism thatseeks to reclaim the spoils of globalization. This goes beyond, potentiallyfar beyond, mere skepticism of the fruits of globalization. With the UK’svote to leave the European Union and the U.S. election of Donald Trump aspresident, a political economy mix normally confined to emerging marketshas come mainstream. Inevitably, the rise of drawbridge capitalism willmake the world more insecure and potentially less stable.
No matter the perceived villain, the trend toward drawbridge policiesreflects a nationalistic desire to regain control of borders, regulationand economic policy, and by extension to reap the benefits of sharing less.Local firms are protected at the expense of foreign firms; immigrationcontrols aim to shield domestic workers; and companies are incentivized toinvest domestically. Fiscal policy is loosened to support theseinitiatives. If the retreat from globalization has been relatively passiveto date, drawbridge capitalism actively accelerates the withdrawal.
The market consequences of this acceleration are likely to be a moreexplicit link between geopolitical and commercial relationships; the returnof pronounced currency volatility; and greater tension at all levelsbetween China, the world’s largest producer, and the U.S., the largestconsumer.
America's shifting global role
The U.S. is at the epicenter of drawbridge capitalism. A retreat from itsvoluntary international commitments now looks inevitable. Future “securityrental arrangements” should entail a more explicit link between commercialbenefits and the provision of security services.
Still, U.S. demobilization from its global responsibilities will likelyhappen gradually in favor of a new foreign policy revolving aroundcounterterrorism strategy and protection of borders. This should have theimmediate effect of forcing traditional beneficiaries, namely those inEurope and Asia, to spend more on security. Within Europe, it wouldreinforce an evacuation at the national level from the political centertoward the extremes. In Asia, to the extent that China can expand itsregional political influence, the rest of the region is likely to becomemore financially linked to China. At the same time, the goal of fightingradical Islam will work in favor of improving U.S. relations with Russia.
U.S. retrenchment will also tend to leave a void in areas where the U.S.has acted as a guarantor of stability. How these voids are filled isarguably a more consequential concern than whether the U.S. Treasury namesChina a currency manipulator. Tensions around North Korea and Taiwan arelikely to pose early tests for the Trump administration, raising thepolitical risk premium on Asian assets.
Renegotiating trade agreements is central to President Trump’s reshoringpriorities. One of his first acts as president has been to withdraw fromthe Trans-Pacific Partnership trade agreement with Asia. Even if thethreats to China and Mexico tend more toward nationalist bark than populistbite, markets are prone to react first and ask questions later.
The Mexican peso’s depreciation to levels not seen (in real terms) sincethe 1994 Tequila Crisis is a case in point. The North American Free TradeAgreement (NAFTA) is not likely to be scrapped altogether. Mexican-sourcedgoods are simply too important of an input to U.S. value chains. But thepopular reaction to Trump’s policies increases the chances of a leftistvictory in the 2018 Mexican presidential election. Threats and rhetoric cancarry lasting costs to stability.
The rise of drawbridge capitalism has broad global ramifications.
- Drawbridge capitalist policies are generally harmful to potentialgrowth over time at the expense of temporarily higher growth outcomes.Lower taxes, higher spending on infrastructure, reduced offshoring andtrade protectionism all play in favor of higher inflation and bond yieldsas a secular theme. Just as the market has dragged the Federal Reservetoward lower terminal rates, it will now push the Federal Open MarketCommittee in the opposite direction.
- The dollar risks a repeat of mid-1980s-style volatility . Drawbridge capitalism’s arrival in the U.S. at a latestage in the business cycle is likely to exacerbate the dollar’s interestrate advantage. The dollar’s gains should be particularly pronouncedvis-à-vis the Japanese yen (owing to the Bank of Japan’s yield cap) andother low-yielding Asian currencies that are most sensitive to globaltrade.
- The U.S. version of drawbridge capitalism is likely to lead to renewedvolatility in foreign exchange markets.The Trump administration believes that most trade agreements have beendisadvantageous to the U.S., and that many key trading partners haveengaged in mercantilistic currency policies. U.S. efforts to forceappreciation of currencies benefiting from large trade surpluses and torenegotiate trade accords are likely to backfire as capital outflows fromtargeted countries override trade considerations.
- Chinese currency stability, or lack thereof, will remain an importantbellwether for the way and the extent to which U.S. policy stimulus istransmitted to the rest of the world.Pronounced Chinese currency depreciation, likely stemming from a need tosupport domestic growth and financial system stability, would impart alarge deflationary shock to the rest of the world.
- Outside the U.S., the relative economic winners should be Europe(largely owing to the favorable combination of negative real rates and acheap exchange rate buffeting Germany)and commodity producers that benefit from temporarily stronger growth.The Swiss franc should be viewed as a better proxy than the euro for therelative strength of the German economy, given that European Central Bank(ECB) policy normalization will remain constrained by periphery weakness.
- Combining experience from the 1980s and 1990s, the dollar’s overshootis likely to end at a point when China is no longer willing or able tosustain capital outflows and depreciation pressure.The end will more likely be a U.S. recession stemming from a slump inChinese and emerging markets growth than any Plaza-like exchange ratecoordination. A materially weaker yuan would imply pronounced weakness inLatin American and Asian currencies, as well as the Australian dollar(AUD), while being supportive of the yen and the euro. But until then,America’s recourse to drawbridge capitalist policies should be supportiveof commodity currencies including the Brazilian real and the Russian ruble.
- The U.S. Congress should be a check on the threat of tradeprotectionism in its most pernicious sense.But markets will nonetheless demand some risk premium from those deemed tobe in the cross hairs (Mexico, China, Korea), and vice versa for thosedeemed to be safer (Russia). Discerning where to lean against suchrepricings will require analysis that goes beyond direct trade effects toimplications for monetary policy and political stability.
- Drawbridge capitalist policies are likely to be contagious.Within developed economies, this will matter most for Europe. Extremistparties are likely to be the net winners in the Netherlands, France,Germany and, if elections are held, in Italy. As part of coalitiongovernments, they will not go immediately to extremes, but they will serveto exacerbate the divide between creditor and debtor countries. Suchoutcomes work against a pragmatic deal on Brexit and will tend to imposegreater political constraints on the ECB. In emerging markets, voters’reactions to U.S. retrenchment will work against reforms and fiscalconsolidation.
Despite its reflationary promises, the proliferation of drawbridgecapitalism creates a financial bias for safety, borne of a stronger dollar,greater geopolitical and trade uncertainties and rising pressure on China.The unconditional lowering of drawbridges over the past 30 years drove asurge in cross-border capital flows predicated on diversification benefits.Trade agreements helped spawn the convergence to low and less volatileinterest rates globally. What follows under drawbridge capitalist policiescan prompt sharp retrenchment in cross-border capital flows, particularlyfrom emerging markets. Rising trade and geopolitical uncertainties mark anatural convergence between deglobalization and economic nationalism.
Gene Frieda is a PIMCO global strategist based in London.