It was Shakespeare – not William, but rather Stephan, the British head of research firm YouGov – who first coined the drawbridge phrase in 1995 as a reference to the threat of isolationism:
"We are either ‘drawbridge up’ or ‘drawbridge down’. Are you someone who feels your life is being encroached upon by criminals, gypsies, spongers, asylum-seekers, Brussels bureaucrats? Do you think the bad things will all go away if we lock the doors? Or do you think it’s a big beautiful world out there, full of good people, if only we could all open our arms and embrace each other?"
PIMCO has focused on the threat of deglobalization since 2009 as part of our New Normal and later New Neutral secular outlooks. Since the great financial crisis, this threat has been manifest in the form of stagnant global trade volumes and a dramatic shrinkage in the stock of cross-border financial assets.
The popular backlash against the resulting subpar economic outcomes is giving rise to “drawbridge capitalism,” a form of economic nationalism that seeks to reclaim the spoils of globalization. This goes beyond, potentially far beyond, mere skepticism of the fruits of globalization. With the UK’s vote to leave the European Union and the U.S. election of Donald Trump as president, a political economy mix normally confined to emerging markets has come mainstream. Inevitably, the rise of drawbridge capitalism will make the world more insecure and potentially less stable.
No matter the perceived villain, the trend toward drawbridge policies reflects a nationalistic desire to regain control of borders, regulation and economic policy, and by extension to reap the benefits of sharing less. Local firms are protected at the expense of foreign firms; immigration controls aim to shield domestic workers; and companies are incentivized to invest domestically. Fiscal policy is loosened to support these initiatives. If the retreat from globalization has been relatively passive to date, drawbridge capitalism actively accelerates the withdrawal.
The market consequences of this acceleration are likely to be a more explicit link between geopolitical and commercial relationships; the return of pronounced currency volatility; and greater tension at all levels between China, the world’s largest producer, and the U.S., the largest consumer.
America's shifting global role
The U.S. is at the epicenter of drawbridge capitalism. A retreat from its voluntary international commitments now looks inevitable. Future “security rental arrangements” should entail a more explicit link between commercial benefits and the provision of security services.
Still, U.S. demobilization from its global responsibilities will likely happen gradually in favor of a new foreign policy revolving around counterterrorism strategy and protection of borders. This should have the immediate effect of forcing traditional beneficiaries, namely those in Europe and Asia, to spend more on security. Within Europe, it would reinforce an evacuation at the national level from the political center toward the extremes. In Asia, to the extent that China can expand its regional political influence, the rest of the region is likely to become more financially linked to China. At the same time, the goal of fighting radical 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 is arguably a more consequential concern than whether the U.S. Treasury names China a currency manipulator. Tensions around North Korea and Taiwan are likely to pose early tests for the Trump administration, raising the political risk premium on Asian assets.
Renegotiating trade agreements is central to President Trump’s reshoring priorities. One of his first acts as president has been to withdraw from the Trans-Pacific Partnership trade agreement with Asia. Even if the threats to China and Mexico tend more toward nationalist bark than populist bite, markets are prone to react first and ask questions later.
The Mexican peso’s depreciation to levels not seen (in real terms) since the 1994 Tequila Crisis is a case in point. The North American Free Trade Agreement (NAFTA) is not likely to be scrapped altogether. Mexican-sourced goods are simply too important of an input to U.S. value chains. But the popular reaction to Trump’s policies increases the chances of a leftist victory in the 2018 Mexican presidential election. Threats and rhetoric can carry lasting costs to stability.
The rise of drawbridge capitalism has broad global ramifications.
- Drawbridge capitalist policies are generally harmful to potential growth over time at the expense of temporarily higher growth outcomes. Lower taxes, higher spending on infrastructure, reduced offshoring and trade protectionism all play in favor of higher inflation and bond yields as a secular theme. Just as the market has dragged the Federal Reserve toward lower terminal rates, it will now push the Federal Open Market Committee in the opposite direction.
- The dollar risks a repeat of mid-1980s-style volatility . Drawbridge capitalism’s arrival in the U.S. at a late stage in the business cycle is likely to exacerbate the dollar’s interest rate advantage. The dollar’s gains should be particularly pronounced vis-à-vis the Japanese yen (owing to the Bank of Japan’s yield cap) and other low-yielding Asian currencies that are most sensitive to global trade.
- The U.S. version of drawbridge capitalism is likely to lead to renewed volatility in foreign exchange markets. The Trump administration believes that most trade agreements have been disadvantageous to the U.S., and that many key trading partners have engaged in mercantilistic currency policies. U.S. efforts to force appreciation of currencies benefiting from large trade surpluses and to renegotiate trade accords are likely to backfire as capital outflows from targeted countries override trade considerations.
- Chinese currency stability, or lack thereof, will remain an important bellwether for the way and the extent to which U.S. policy stimulus is transmitted to the rest of the world. Pronounced Chinese currency depreciation, likely stemming from a need to support domestic growth and financial system stability, would impart a large 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 a cheap 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 the relative 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 overshoot is likely to end at a point when China is no longer willing or able to sustain capital outflows and depreciation pressure. The end will more likely be a U.S. recession stemming from a slump in Chinese and emerging markets growth than any Plaza-like exchange rate coordination. A materially weaker yuan would imply pronounced weakness in Latin 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 supportive of commodity currencies including the Brazilian real and the Russian ruble.
- The U.S. Congress should be a check on the threat of trade protectionism in its most pernicious sense. But markets will nonetheless demand some risk premium from those deemed to be in the cross hairs (Mexico, China, Korea), and vice versa for those deemed to be safer (Russia). Discerning where to lean against such repricings will require analysis that goes beyond direct trade effects to implications for monetary policy and political stability.
- Drawbridge capitalist policies are likely to be contagious. Within developed economies, this will matter most for Europe. Extremist parties are likely to be the net winners in the Netherlands, France, Germany and, if elections are held, in Italy. As part of coalition governments, they will not go immediately to extremes, but they will serve to exacerbate the divide between creditor and debtor countries. Such outcomes work against a pragmatic deal on Brexit and will tend to impose greater political constraints on the ECB. In emerging markets, voters’ reactions to U.S. retrenchment will work against reforms and fiscal consolidation.
Despite its reflationary promises, the proliferation of drawbridge capitalism 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 a surge in cross-border capital flows predicated on diversification benefits. Trade agreements helped spawn the convergence to low and less volatile interest rates globally. What follows under drawbridge capitalist policies can prompt sharp retrenchment in cross-border capital flows, particularly from emerging markets. Rising trade and geopolitical uncertainties mark a natural convergence between deglobalization and economic nationalism.
Gene Frieda is a PIMCO global strategist based in London.