Recent electoral events in Europe and the US have revealed a new wave of populism.

Recent electoral events in Europe and the US have revealed a new wave of populism, with voters seizing the opportunity to demand radical change after a decade of austerity and stuttering global growth.

In the UK, the Leave campaign rallied hard against the so-called political elite which it said had consistently ignored voters on key issues including inequality and immigration. On the other side of the Atlantic, Donald Trump’s campaign mirrored this approach and offered voters an alternative vision of how America could be run, promising faster job creation and tighter immigration controls.

Whether or not one agrees with the recent election outcomes, many voters have demonstrated that they are no longer satisfied with the current holders of power. But is populism the answer?

Historic phases of populism

Historic populist leadership has tended to follow four key phases (1) that start well but always end badly.

The first phase entails increased government borrowing and spending (fiscal expansion), while inflation is kept in check by price controls. This provides a boost to growth, employment, wages and voter confidence.

During the second phase, these positive factors start to decline as governments reach the limits of what they can borrow without causing unintended and unhelpful economic side effects. In order to sustain wage levels, the government devalues the currency (e.g. by selling the local currency and buying foreign currencies). This makes imports more expensive and combines with the increased supply of money being injected into the economy through government spending to increase inflation. For the time being, wages are able to increase at the same speed as inflation.

(1) “The Macroeconomics of Populism,” Dornbusch and Edwards, January 1991.

By stage three, there is a rapid deterioration of fortunes as unexpectedly high inflation sets in and government spending declines after reaching unsustainable levels. Falling government spending leads to rising unemployment, meanwhile wages fall. The fourth stage is one of deep recession compounded by severe political instability and worsening income for the middle classes and low-skilled jobs.

How could populism affect the US economy and financial markets?

The economic and political structures in the US are robust and transparent. While we anticipate a significant level of fiscal intervention set against an uncertain backdrop, we expect some degree of restraint to be exercised.

Populism at work in the US

Possible positives
  1. A tighter labour market could boost real incomes among middle-class households.
  2. Consumption could increase.
  3. Faster progress could be made in reducing debt burdens.
Possible negatives
  1. Rising barriers to trade and immigration would raise labour costs, lowering profit margins in the process.
  2. Large multi-nationals will be particularly affected given their dependence on overseas markets.

Source: Lloyds Banking Group, November 2016

Also, Donald Trump’s desire for a tighter labour market could help to boost real incomes (i.e. increase how much a salary can buy) among middle class households. This, in turn, could increase consumption and the reduction of debts.

But there are potential challenges. By increasing barriers to trade and immigration, labour costs could increase while company profits could fall. Large multinationals would be hardest hit given their dependence on overseas trade.

The momentum of populism could gain sway elsewhere. By the end of 2017 there could be new political leadership in Holland, France and Germany. The theme of uncertainty continues unabated.

What about globalisation?

As we have seen this year, populism can include a large dose of separatism: the UK has voted to separate itself from the EU, and Donald Trump has pledged to restrict trade between the US and elsewhere (notably China). The danger of such moves is that they could undermine economic growth across what, through globalisation, have become extremely interconnected and interdependent national economies and cultures.

A modest retreat from globalisation would not irrevocably harm global growth, but a full-blown trade war certainly would. One of the biggest “known unknowns” here is how much of Donald Trump’s campaign rhetoric will translate into actual policy.

Mr. Trump has already appointed two women to his cabinet, which is no small matter bearing in mind some of the President-elect’s past choices of word and deed. What makes these appointments more significant is that both of these women have been openly critical of Mr. Trump.

If these appointments prove to be examples of Mr. Trump “reaching out for guidance and help” from those who did not support him, then the entirely Republican leadership of the presidency, the Senate and the House of Representatives might be subject to moderation that could curtail populist excess to some degree. We shall have to wait and see.

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