Category Archive: Analysis

1. The Political Economy of Brazilian Inflation

   August 8, 2024 6:53 pm Comments Off on The Political Economy of Brazilian Inflation

   Over the past two decades, Brazil has seen two great swings in its distribution of real national income. In the years between 2004 and 2014, the wage share increased progressively. This phenomenon faced severe political resistance. The momentous events of 2015—the impeachment of President Dilma Rousseff and the swearing in of Michel Temer—reflected this resistance and coincided with a reversal in the trend. For the next seven years, wages’ share of national income fell continuously until 2022. The year 2023 marked a possible new inflection point. While the long decline in the wage share finally reversed, however, the return of wage growth has coincided with a resurgence of unhappiness in business and financial circles urging more austere macroeconomic policies, including the central bank’s interest-rate policy. 

   The theory used by the Central Bank to justify its interest rate setting is the “New Consensus” macroeconomic model (NMC). Since 1999, the National Monetary Council—comprised of the Minister of Finance; the Minister of Planning, Development and Management; and the Governor of the Banco Central do Brasil (BCB)—has determined a central inflation target. The instrument for achieving this target is the BCB’s interest-rate policy. The NMC’s model assumes that inflation grows (or drops) as the result of demand shocks—when actual output is above (or below) potential output—and that “supply shocks,” including external shocks, average out to zero in the long run. Accordingly, the BCB sets the basic interest rate to manipulate aggregate demand and make output equal to potential. The New Consensus model also assumes that, in the long run, such monetary policies are neutral in respect to both the distribution of income and the trend of potential output; it manages inflation by matching short-term aggregate spending to the trend of long-run growth, which are given by supply-side factors.¹
   

   Figure 1: Inflation and target

   

   Historically, between 1999 and 2023 (figure 1), the BCB’s inflation targeting system has been relatively successful on its own terms. Inflation surpassed the target ceiling only in the years immediately following its implementation, between 2001 and 2003, and then specifically in a few individual years: 2015, 2021 and 2022. 

   This success regarding inflation control, however, did not occur through the transmission channel the New Consensus model assumes. Figure 2 illustrates that the behavior of Brazil’s unemployment rate under the current inflation-targeting. The years in which inflation was higher and above the target limit are exactly the same years in which the unemployment rate was also higher—rising prices coincided with the cooling, not the heating, of the Brazilian economy. Moreover, periods with low unemployment rates correspond to stable inflation rates within the target range. Since the adoption of its inflation-targeting regime, therefore, Brazil has seen inflation that is not systematically associated with labor shortages. 

   Figure 2: Unemployment rate (%)²

   

   How can the success of Brazil’s inflation-targeting policy therefore be explained? If the relationship between aggregate demand dynamics and inflation are the opposite of what the “New Consensus” expects, then there must be an alternative explanation for the political economy of Brazilian inflation—the relationship between the government’s macroeconomic policies, inflation, and the distribution of income across the institutions mediating between the two. Instead of the “New Consensus” model’s assumption that policy transmits to inflation through the real interest rate’s effects on aggregate demand, there is a more appropriate framework for explaining the success of Brazilian inflation targeting. This is the idea that trend inflation isn’t demand-pull, but cost-push, and results from distributive conflicts. This “cost-push” and “distributive conflict” framework for understanding inflation has important implications, for it also explains the consequences of inflation targeting on the distribution of income and the political processes that influence macroeconomic policy. 

   Production costs and distributive conflict

   Contrary to the insights of the “New Consensus” model, approaching inflation as a cost-side phenomenon is also compatible with explaining the trend of long-run growth as driven by effective demand. According to this view, the level of effective demand determines much more than current output. It also determines the economy’s productive capacity—potential output and this explains, in general, the fact that there is a relative abundance of labor in relation to the capital stock that comprises that capacity. The stock of capital adjusts itself through investment according to the trend of effective demand.³ In light of this, the idea that the trend of inflation is due only to current excess demand deserves to be questioned. After all, a demand-pull inflation would only occur when the level of effective demand—aggregate monetary expenditures measured at supply prices—were above the full-employment level of output. This situation would reflect a shortage of productive resources and would be temporary since inflation itself would diminish aggregate spending in real terms to a level compatible with production at full capacity. 

   Brazilian inflation in the past two decades, however, occurred when production was below potential and persisted over time. Instead of reflecting a shortage of productive resources and having a tendency of being only temporary, cost-push inflation and distributive conflict occur before the economy reaches a situation of scarcity. That is, these models show how it is possible for nominal wages to increase before the economy fully employs the labor force. Inflation can persist, permanently, in this scenario, reflecting the distributive incompatibility of rival claims over the existing output, below potential. In general, however, distributive conflict results in inflation and not in acceleration of inflation.⁴

   Wage bargaining is a fundamental form of distributive conflict. Even if the economy isn’t anywhere near reaching full-employment, persistently low (or high) unemployment rates can strengthen (or weaken) labor’s bargaining power, subject, of course, to the broader political and institutional context—the labor laws, trade union organization and leadership, social insurance protections, etc., that influence the bargaining process. A wage-induced inflation process arising from worker’s bargaining power in an economy that is abundant in labor, even if influenced by a higher level of activity in the labor market, reflects a phenomenon of cost and distributive conflict, not one of demand. 

   Besides labor costs, the increase in production costs is also greatly influenced by government-regulated prices of certain goods and services, as well as by the prices of tradable goods (final and intermediate goods that a country exports and imports) set in global markets and converted by the nominal exchange rate into local currency prices.⁵ These two sources of inflationary pressure can intensify the distributive incompatibility of claims by impacting real wages and profit margins. Under this approach, the cost-push inflation related to tradables and administered prices, as well as the one induced by wages, are not neutral from the distributive point of view. 

   Monetary policy transmission channels

   Although the Banco Central do Brasil has been relatively successful in keeping Brazil’s inflation close to target under its “New Consensus” inflation-targeting system, there are three main reasons why higher interest rates don’t lead to a systematic control of inflation through the aggregate-demand channel. First, there are a series of institutional factors that impact the regularity of the relationship between the real basic interest rate and consumer credit for durable goods and residential investments, such as spreads of state-owned banks, payroll loans, and housing policies, in addition to household debts. Second, changes in the interest rate can produce shifts in the exchange rate and impact demand in the opposite direction: currency devaluation resulting from an interest rate reduction can suppress real wages and consumption more than it expands demand through an increase in net exports. Third, variations in nominal wages seem to respond very little to the deviation of the unemployment rate from its trend. Only sustained unemployment rates, high or low, seem to have persistent effects through the demand channel over wage trends. 

   Factors related to production costs, on the other hand, are systematically related to the BCB’s interest rate policy. The main transmission channel between interest rates and production costs is the effect on the nominal exchange rate. A nominal interest rate higher than the international interest rate (plus sovereign spread) leads to a positive interest differential, which is usually associated with a trend of local currency appreciation. This happens because a positive (negative) interest rate differential tends to impact the inflow (outflow) of short-term capital flows which, in addition to other elements of the balance of payments, are central to determining the nominal exchange rates. Besides that, with the exchange rate’s “adaptive” or endogenous expectations, floating exchange rate regimes can favor speculation and instability. Consequently, a change in the nominal exchange rate usually alters the expected exchange rate in the same direction, intensifying the exchange rate appreciation or depreciation process.⁶ 

   In Brazil’s case, the nominal exchange rate plays a fundamental part in determining the inflation rate. First because it directly influences tradable goods’ prices. Note that the exchange rate not only impacts the price of intermediate and final goods Brazil imports but also those that the country exports: exporters don’t sell their products in the domestic market at a different price than the one set for the international markets. Second, tradable prices are inputs into the indexes used for government-administered prices, such as the IGP—a price index that regulates the adjustments of a series of rental agreements and of the government-led price management process. Both factors impact the cost of production of all other economic sectors; the exchange rate significantly affects Brazil’s internal price dynamics. Whether the BCB achieves its target therefore depends to a high degree on prices in global trade markets (in dollars) and the exchange rate, which in turn determine prices that cascade throughout the national economy. In other words, the transmission channel from the interest rate to the exchange rate reveals a lot about how inflation is actually controlled (or not). The years in which inflation didn’t reach the target range are very much related to great currency devaluation episodes.⁷ 

   The determinants of Brazil’s inflationary dynamic under Inflation-targeting

   Through an empirical analysis of Brazil’s inflationary dynamic under inflation-targeting and its results regarding income distribution from 1999 to 2014, we can differentiate these variables’ behavior in two moments.⁸ The first one encompasses the years between 1999 and 2003, marking the implementation of New Consensus inflation targeting during Fernando Henrique Caardoso’s administration (1999–2002) and the first year of Luís Inácio Lula da Silva’s inaugural term in office (2003–2006). The second moment regards the period between 2004 and 2014, a timeframe that includes the seven following years of Lula’s first two terms (2003–2006 and 2007–2010) and the four years of Dilma Roussef’s initial term in office (2011–2014).

   Immediately after the Cardoso administration’s adoption of central bank inflation targeting, between 1999 and 2003, the inflationary target was widely unfulfilled (figure 1). This resulted from (i) pressure from the imported inflation, which was caused by a currency devaluation process in a context of external instability; and (ii) high inflation of managed prices (figure 4). Overall, nominal wages’ growth rate was kept below inflation, leading to real wage losses and to a decrease of the wage share (see figure 6).

   It is worth noting that in this international instability context, the interest rate differential—measured by the difference between the basic domestic rate and the basic international rate (the last one measured by the Fed’s basic rate added by the sovereign spread estimated by the EMBI)—decreased significantly (figure 3). Indeed, this differential became negative in 2002, once the great rise in sovereign spread wasn’t compensated by a sufficiently large increase in the domestic interest rate. 

   Figure 3: Nominal interest rate differential

   

   The currency devaluation process, therefore, was largely influenced by the interest rate differential operating at the time. Figure 4 illustrates the imported inflation’s behavior, that is, the price’s variation in dollars in addition to the nominal exchange rate variation, as well as the behavior of the inflation regarding regulated prices.⁹ It is evident that both indicators have contributed for inflation to not reach the target in the 1999 and 2003 period. 

   Figure 4: “Imported” inflation and regulated prices inflation (annual aggregate)

   

   Between 2004 and 2014 the inflation target was met every year. Success, however, didn’t result from interest-rate control of demand. This period was also marked by a continuous decline in the unemployment rate as the product of a heated economy (figure 2). Rather, inflation was kept low by an improvement of the Brazilian international trade and finance situation—from a progressively better-managed balance of payments. Two factors allowed for Brazil to reduce its domestic interest rate whilst maintaining a high interest differential and accumulating reserves. Resulting from the commodities’ price rise and the increase in export volumes, there was Brazil’s trade balance enhancement. Financial accounts also improved, since there was an increase in international liquidity in the context of the US Fed’s low interest rate and the consequent compression in sovereign spreads. 

   These movements occurred in concomitance to a currency valuation process which, despite the commodities’ price rise in dollars (US$), was translated into a lower imported inflation in reais (RS) compatible with the inflation target. Additionally, the regulated prices inflation was lower, as a consequence emerging partially from the currency valuation itself (and its effects over the IGP index) but also from changes in the pricing rules of these goods and services promoted by the government and by state enterprises (see figure 4).¹⁰

   Wages, nonetheless, had a distinct behavior between 2004 and 2014 when compared to the years from 1999 to 2003. The most recent period was marked by what we call the “undesired revolution” in Brazil’s labor market.¹¹ This decade allowed for the strengthening of workers’ bargaining power for a series of reasons, such as (i) the policy of wages’ real increase and the broadening of social policies coverage; and (ii) the structurally lower unemployment rate, resulting from higher economic medium growth rates, broad job creation in the service sector, and minor expansions of the labor force due to demographic reasons. Consequently, between 2004 and 2014, the wages’ inflation was above the inflation rate itself (figure 5) and there was a real increase in wages (higher than productivity).¹² The distributive result of such a phenomenon is observable on the share of wages’ increase in the national income functional distribution during that period (figure 6).

   Figure 5: Wages inflation and prices inflation (as accumulated in 12 months)

   

   Figure 6: Share of wages in the national income¹³

   

   What comes after the “undesired revolution”? 

   The events from 2015 onwards can be understood from this same analytical framework. Even though inflation was within the target during 2004 and 2014, the distributive conflict was aggravated by the “undesired revolution,” gradually creating political consensus regarding the need to change Brazil’s economic policy. 

   This takes us back to the work of Michal Kalecki. During the Great Depression, World War II, and the spread of macroeconomic thinking and policy across the post-war world, Kalecki drew attention to the possibility that an expansionary economic policy capable of generating a long-lasting and low unemployment rate, and consequently strengthening worker’s bargaining power, could be reversed in the face of a growing opposition from a ruling class of employers and owners.¹⁴ Such an opposition would occur both due to political aspects (e.g. a loss of “factory discipline”) and economical aspects of full employment (e.g. decreasing profit margins and increasing wage shares of income).¹⁵ He pointed out that such a ruling class would act to convince the government to change the direction of economic policy, slowing growth down and increasing unemployment rates. 

   The first year of Dilma Roussef’s second term as president (2015–2016) saw this political economy dynamic at work. It was marked by a profound political instability and by the narrow win in the 2014 presidential elections. In the beginning of 2015, the government drastically altered the direction of economic policy and promoted a strong contraction of demand through many different instruments.¹⁶ This change was carried out in the context of accelerated reduction in state-owned enterprises’ investments as a response to the allegations of the Lava Jato Operation. The transformation simultaneously included a strong fiscal adjustment, contraction of public credit, interest rate hikes, exchange rate depreciation, and the increase of administered prices. 

   If such economic measures were greatly contractionary, causing the GDP to fall sharply and the unemployment rate to rise significantly, they were also inflationary policies. In 2015, the inflation rate was above the target cap, which is explained by the increase in both imported inflation and regulated prices’ inflation. In the following year, the inflation rate decreased again as the currency depreciation and administered prices’ effects were fading. Still, unemployment was kept at a high rate, putting a stop to the process of real wage growth and creating an ideal environment for the implementation of reforms destined to reduce labor and social rights in order to permanently curb workers’ bargaining power. In effect, from 2015, especially after Dilma’s impeachment and Michel Temer’s inauguration (2016–2018), followed by Jair Bolsonaro’s victory in the presidential elections (2019–2022), Brazil adopted a series of austerity measures, putting an end to real wage growth, rolling back social policies, enforcing labor and pension reforms, and implementing a public spending cap.

   In the face of a sharp reduction in workers’ bargaining power, nominal wages started to grow below inflation between the years of 2016 and 2019 (figure 5). As a result, the wages’ share in the functional income distribution decreased continuously in this period (figure 6). The inflation rate also considerably decreased as a consequence of the low nominal wages’ growth as well as of the lack of robust pressures of imported inflation and administered goods-and-services’ prices. Once again, Brazil met its inflation target. 

   The Covid-19 pandemic magnified this redistributive tendency. On the one hand, the 2020 recession expanded the unemployment rate even further. On the other hand, there was a strong increase in both imported inflation and regulated prices’ inflation, resulting from a sharp currency depreciation in addition to high dollar prices on tradable goods and services (mainly those related to energy costs). The latter reflected a high global inflation consequent to logistical problems in global value chains and the war in Ukraine’s effects on global commodities markets.

   Besides echoing a global movement of emerging countries’ currency devaluation, it is worth noting that the strong exchange rate devaluation between 2020 and 2021 was deepened by the BCB’s policy of determining the country’s interest rate. Figure 3 exhibits how the BCB fixed its basic interest rate below international rates set in the US in this period, as it did in 2002. This led to a process of nominal exchange rate devaluation.¹⁷ 

   From the beginning of 2022, the turn in BC’s interest policy that resulted in a process of basic rate’s increase seems to have contributed to the control of the imported inflation by a reversion in the currency devaluation movement. Additionally, a deflation in managed prices resulted from the adoption of a punctual public policy of price control – most notably the control over gas prices implemented in the last year of Jair Bolsonaro’s term, 2022, which was also marked by his defeat in the presidential elections against Lula – whose term started in the following January (2023–2026). 

   Brazil’s inflation rate was once again within the target range in 2023, a result that seems to be much more related to those cost elements than to factors regarding aggregate demand. Despite the cycle of increases in nominal interest rates by the BCB, employment expanded continuously in 2022 and 2023. Among other reasons, this occurred because of a more expansionary fiscal policy. Despite the unemployment rate’s drop, wage increases only partially offset losses due to inflation, leaving a gap to absorb wage pressure and avoid higher inflation levels. The distributive result of this movement was an increased wage share in the national income during the 2020–2022 period—as figure 6 shows.

   Brazil’s disguised incomes policy 

   The analysis of Brazilian inflation behavior under the targeting regime, based on the cost-push inflation approach and on the distributive conflict perspective, allows us to identify three central elements to the country’s recent macropolicy. The first one regards the 2004–2014 distributive conflict intensification and its positive effects over real wages, resulting in a permanently higher but stable inflation rate, although not in acceleration of inflation. Coupled with strong control measures over imported and government-regulated prices inflation, this phenomenon was responsible for the inflation rate to stay within the target range throughout the period, even if in some of the years it was above the target center. The second one is that even when the distributive conflict was appeased and the real wages growth was not observable, the inflationary targeting was still highly dependent on imported inflation. The third element, as it has become clear, is that the inflationary process isn’t neutral in distributive terms, not only because it depends on the nominal wages’ behavior and on the workers’ bargaining power, but also because it greatly depends on the exchange rate, the behavior of tradables’ dollar prices, and on the administered prices readjustment policy. All of these variables influence the functional income distribution. 

   Austerity policies go beyond changing the basic interest rate by the Central Bank, and they must be understood through this context. Ultimately, to curb the wage inflation process by sustaining a high unemployment rate as a measure for reducing worker power is to execute much more of a disguised income policy than a neutral or technical price control policy. Abba Lerner, an historic economist and advocate for the distinction between cost-push inflation and demand-pull inflation, not only criticized policies that aimed at maintaining a high unemployment rate in order to reduce the cost inflation and the distributive conflict, but also offered an alternative to the austerity measures: to link income policies directed at controlling cost-push inflation with demand expansion and full-employment promotion policies, thus avoiding waste in productive resources.¹⁸  

   As seen, if the distributive conflict intensification leads to a permanently higher inflation rate, but not to an accelerating inflation, income policies that soften this conflict can be a progressive alternative to austerity measures. Taking Brazil’s structural and institutional aspects into account, a possible income policy would be expanding the provision of public goods and services and lowering managed prices. This would raise real wages and prevent the negotiations from occurring only regarding nominal wages bargaining. Over time, it also would be important to avoid abrupt fluctuations on regulated goods and services’ inflation, as well as on the nominal exchange rate and, consequently, on the imported inflation. The exchange rate fluctuation management imposes limits to lowering the domestic nominal income rate, specially when the basic nominal income rate set by the Fed still finds itself in high levels and without any clear perspective of being reduced. 

   Considering its recent sharp drop, to recover the wages’ share in the functional income distribution will certainly require efforts in the direction presented above.¹⁹ After the unique growth of the wages share in 2023, the minimum-wage real readjustment policy that has been readopted and the lower unemployment rate represent the conditions necessary for the steady recovery of the wage share. On the other hand, even the brief reversal of the distributive trend is generating discontent among business and financial circles, already calling for an end to it. In line with the interests of these same circles, the zero-deficit fiscal policy and the recent reduction of the inflation target will certainly constitute additional obstacles to a sustained recovery of the wage share of income. 

2. Democratic Defense

   5:23 am Comments Off on Democratic Defense

   Much ink has been spilled on the erosion of democracy in India, but the country’s most recent elections demonstrate such erosion has not gone unchecked. During the last decade, Indians across sectors of society have repeatedly stood up to a repressive state in an effort to defend democracy. In this pivotal year, during which at least 4 billion people will be casting their vote in some form of election, the actions of ordinary Indians have much to show the world about how democracies may yet survive authoritarian onslaughts. 

   Indians voted in a seven-phase election over the spring and summer of 2024 to elect members of the Lok Sabha, the lower house of parliament. Led by Prime Minister Narendra Modi, the ruling Bharatiya Janata Party (BJP) was widely projected by a series of exit polls to win an overwhelming majority in the elections and return to power for a third term with a crushing majority. The results, declared on June 4, shocked the government and its supporters. The BJP was stripped of its parliamentary majority. Although it managed to form the government, it only did so in coalition with other parties. 

   The results culminated a decade of discontent. From student protests against the government’s growing authoritarianism to collective action that supplied oxygen masks to those in need during the devastating pandemic, and entertainers poking fun at the majoritarian obsession with protecting Hindus in a country where they are an overwhelming majority, opposition to the BJP has been widespread and diverse. The election results affirmed that, while Narendra Modi remains widely popular, Indian voters sought to rein in the excessive authoritarianism he tended to practice and project. 

   A breakdown of the election results suggests that a simple economic narrative is inadequate in explaining voters’ reversal. Though Modi’s government did exacerbate already worsening inequalities, some of the hardest hit regions maintained support for his party, while some of the country’s wealthiest withdrew it. This, however, does not mean that Modi’s decline is entirely separable from India’s political economy. A long-term view of India’s post-independence governments illuminates the delicate balance of economic interests that have long underpinned its democratic institutions—a balance which the Modi government’s authoritarian measures have attempted to undermine. While rising inequality alone may not explain the results, the repression that underlies India’s present economic model just may. 

   Unpacking the vote

   The BJP’s electoral reversal appears puzzling to observers impressed by the rates of India’s economic growth. A tempting response to this puzzle is to argue, correctly, that the benefits of economic growth have not been evenly shared across Indians. Indeed, the evidence that inequalities of wealth and income have both increased in India is impossible to ignore. Moreover, the government is perceived to be favorable to rich industrialists: Modi is often personally identified as close to India’s richest industrialists, the Adanis and the Ambanis. These ties were repeatedly raised by opposition politician Rahul Gandhi, scion of the Nehru-Gandhi family and leader of the Congress party. In rallies held as far apart as Konbir (Jharkhand), Khargone (Madhya Pradesh), Nagarkurnool (Telangana), Pune (Maharashtra), and Delhi, Gandhi urged his audiences to question the close links between the Modi-led government and rentier segments of big business. Opposition politicians repeatedly raised the growing compact between state and big business and the resultant concentration of political and economic power during the election campaign. This set of explanations would prime us to believe that the BJP’s electoral reversal could be explained as a class war. 

   Indeed, the Uttar Pradesh (UP) vote suggests a gradual politicization of inequality. The richer west and far western regions returned a majority of National Democratic Alliance (NDA) legislators—the BJP-led right-wing coalition. The middling east and central regions were a mixed bag, with both coalitions matched evenly. The poorer south and south-central were harshest on NDA and were swept by the Indian National Developmental Inclusive Alliance (INDIA), the Congress-led opposition coalition. Here, agricultural distress played a pivotal role. It was in Kheri, one of these constituencies, that a BJP legislator mowed down protesting farmers a few years ago and was shown the door. Prosperous urban constituencies—Varanasi, Lucknow, Kanpur—went entirely to BJP, suggesting the vote’s class dimension. Rural and semi-rural UP went largely to INDIA, suggesting the resonance of its campaign which spoke to material struggles. 

   However, a nationwide analysis of the election results defy such a generalized economic explanation. Poor people in UP voted against the BJP to much greater extent than they did in neighboring Bihar which shares similar economic difficulties and social hierarchies. Some of India’s poorest districts in Odisha voted for the BJP despite the economic inequalities fomented under its watch. Voting patterns in affluent constituencies further undermine this narrative. The BJP expectedly swept Delhi where its claims to economic growth resonated with voters. But it was washed out in Mumbai, the financial capital where many beneficiaries of the economic growth touted by Modi live.

   Findings of the well-respected Lok Niti exit poll suggests that almost an equal proportion of the richest and poorest quintiles in their sample voted for the Congress Party, suggesting that class polarization might not be as salient in shaping the electoral results as the electoral rhetoric might suggest. 

   Democracy in India

   While a simple economic narrative doesn’t quite hold, a qualitative look at transformations in Indian political economy may shed more light on present circumstances. India was always an unlikely democracy: for decades, it defied the conventional wisdom that development is a prerequisite for democratic transition. Upon independence in 1947, few people expected the impoverished country to survive. It had just emerged from a blood-soaked religious partition that left at least one million dead and rendered ten million people refugees. Hindu nationalists called for a whole-scale expulsion of Muslims so that the partition could be full and final, a call that ceased only when Mahatma Gandhi was assassinated by a radical Hindu. 500-odd princely States dotted the Indian Union, threatening to tear under its territorial integrity: these were eventually incorporated within the Union with the promise of a privy purse, a lifelong payment to compensate them for the loss of their reigns. Indians obtained universal adult suffrage soon after obtaining independence and adopted a republican constitution in 1950, a full fifteen years before then-superpowers such as the US lifted literacy and tax qualifications for voting.

   Independent India’s first Prime Minister, Jawaharlal Nehru, buttressed its democracy through a coalition of dominant proprietary classes that included big business, landlords, and professional groups including, most importantly, the bureaucracy.¹ Big businesses were guaranteed large doses of public investment, including subsidies for inputs. Landlords were allowed enormous sway in the countryside and succeeded in extracting a major fiscal concession from the government: agricultural income was hereafter exempt from taxation. Professional groups—including lawyers and bureaucrats but also doctors, teachers, and other salaried personnel—were assured subsidies for higher education, an elaborate welfare system, and cheap food grains via the public distribution system. 

   Built into this coalition was a system of checks and balances. Big businesses were subject to stringent regulations on who could set up industries, where they could locate their factories and how much they could produce in them. Landlords were stripped of the revenue-collecting authority they enjoyed in colonial times and were fed the fearful rhetoric of land reforms, which led many of them to sell their surplus lands to rich farmers who soon became masters of the countryside. Despite their social privileges, professional groups were too disparate to form a coherent class fraction and enjoyed neither the economic clout of the big businessmen nor the political clout of the landlord-rich farmer. 

   Against all predictions, India emerged—warts and all—as the world’s largest democracy. As the dominant coalition sought an upper hand in gaining political and economic power, they often aligned with one or the other constituents to marginalize the third. The Congress Party’s leftward lurch under Indira Gandhi’s first Prime Ministerial tenure (1966–77) facilitated an alliance between emboldened professional groups and rich farmers, who demanded governmental support to keep agriculture profitable. Gandhi’s government nationalized banks as well as the production and distribution of coal and copper, abolished privy purses promised to the princes, and terminated monopolies and other practices that restricted trade. Big businesses were kept firmly in check by an alliance of bureaucratic and agricultural elites.

   This alliance prompted a wave of demands from below: members of the so-called lower castes claimed greater representation in jobs and employment while peasants, sharecroppers, and landless laborers demanded a redistribution of land in the countryside. In response, successive governments through the 1980s drew up a plethora of welfare schemes and affirmative action programs. These measures in turn provoked an “elite revolt” as big businesses sought to assert their economic and political power.² The gradual liberalization of India’s economy during the 1990s assuage their economic worries somewhat, even as political power leached away from the once-dominant Congress Party toward regional, leftist, and anti-caste parties that ruled the country in coalition with one another. 

   The extent and depth of these political struggles testify to how some of the poorest people on the planet have sought to construct and sustain democracy against enormous odds. Free and fair elections were held as scheduled. India’s states, many of which are larger than several European countries, were asserting their voice in national politics and shaping it toward a truly inclusive polity. The national parliament and provincial legislative assemblies had become more and more representative of the country’s diverse population.

   Inclusive growth

   The collapse of the Congress Party as India’s dominant political formation heralded an era of coalition politics that gradually liberalized the economy but also enabled hitherto marginalized groups a share in political power. For example, UP, where entrenched caste hierarchies had weathered Hindu, Turko-Mughal, and British rule in succession, came to be governed by political parties led by politicians stigmatized as “low caste” or “untouchable.” As caste hierarchies were shaken up by political parties committed to social equality, India’s economy went from a feeble “Hindu rate of growth” to a productivity surge that delivered decades of strong growth beginning in the 1990s.³ The average annual growth in GDP went from 5.9 percent in the decade between 1990–2000 to 8 percent in the decade between 2000–2010.⁴ Increased growth rates persisted irrespective of whether the coalition governments were led by the Congress (1991–96 and 2004–14), BJP (1998–2004) or other parties (1996–8). 

   Between 1999 and 2012, unemployment declined across both rural and urban regions and among both men and women. The proportion of the population in regular employment increased from 16 percent to 20 percent and those in casual employment dropped from 24 percent to 29 percent.⁵ At the same time, the growth of social protections, such as the Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA), contributed to poverty reduction. Though precise estimates vary, most scholars of poverty in India concur that poverty in the country significantly declined,⁶ with one influential study suggesting that the plethora of social welfare schemes may well have pulled 271 million people out of poverty.⁷

   A large new middle class of mixed caste composition emerged. As a percentage of the population, the middle class increased from 29 percent in 1999 to over 50 percent in 2012.⁸ Using a per capita expenditure method which defines the middle class as earning between US$2 and US$10 per day, other scholars estimate that the size of the middle class in India more than doubled from 290 million people in 1999 to 604 million in 2012.⁹ This expansion was not limited to urban India, as the middle class increased from 20 percent to 41 percent of the population between 1999 and 2012 in rural areas. Notably, while the expansion of the middle class occurred across all social groups, it was most prominent among the caste groups stigmatized as lower caste. These groups, while considered ritually inferior to the self-styled upper castes, regarded themselves superior to the groups historically oppressed as untouchables: in 1999–2000, 24 percent of these households (officially known as Other Backward Class, OBC) could be enumerated as middle class, a figure that crossed 50 percent in 2012.

   Reducing poverty was one thing; containing inequality was another. Disproportionate gains were made by the wealthiest. Wealth shares owned by the top 1 percent in India rapidly increased since 2010, when they owned 40 percent of the country’s total wealth, to 58 percent in 2016.¹⁰ Growing inequality was witnessed within states and within the most important social grouping of caste. The income gap between the poorest and the richest states increased, and urban inequality increased for all the fifteen major states during the 1990s.¹¹

   Successive Indian governments tried to ensure that economic liberalization would not undermine political stability.¹² Governments prioritized manufacturing and information technology (IT) sectors precisely because they were least likely to generate opposition. The state also invited foreign direct investments in finance and insurance, although nationalized institutions remained widespread, thus minimizing their exposure to global trends. The government also invited private sector participation in the mining and mineral sector, but the state retained the power to allocate licenses. The agricultural sector was almost entirely exempt from liberalization as governments feared social turbulence in the countryside. This partial liberalization suggested a tenuous alliance between bureaucrats and big business in a desperate bid to salvage the political and economic power of the dominant proprietary classes. 

   The partial nature of economic liberalization also saved India from the worst effects of the Global Financial Crisis that ravaged the west (refer to the Index of Economic Freedom chart below). The extensive network of nationalized banks, coupled with the Reserve Bank of India’s heavy regulations, protected the banking sector from turmoil. When the effects did begin to show (due to decline in FDI, remittances, and earnings from exports), they were relatively minimal thanks to India’s limited reliance on the global economy. The Indian government responded with an extensive fiscal stimulus over and above the budgetary provisions for increased expenditures that had already been announced earlier in the year. Given that 2009 was an election year, the Congress-led United Progressive Alliance (UPA) coalition government did not want to take any chances. The stimulus packages paid off and the UPA government was re-elected to power. 

   Index of Economic Freedom: India and the United States, 1996–2004

   

   But economic growth began to slow down in 2010. It fell from 8.5 percent to 5.2 percent in one year, increasing slightly to 6.3 percent by 2013.¹³ This slowdown resulted from the model of economic growth pursued by the UPA government as it prioritized investments in minerals and mining, telecommunications, and construction and real estate—sectors from which politicians and bureaucrats could extract rents through corruption. Indeed, the proportion of billionaire wealth originating in these sectors grew rapidly compared to other, more competitive sectors such as agriculture, manufacturing, and IT.¹⁴ The professional groups splintered as the rapidly expanding salaried middle class, as well as civil society activists and influential members of the judiciary, protested the corruption of the bureaucrats and politicians. Big businesses also fractured between the rentier segments mentioned above and the competitive groups. The countryside was aflame as far-left Maoist Naxalites contested the extractive political economy that exploited mineral resources in areas inhabited mostly by Adivasi citizens commonly derided as “primitive.” 

   As the government’s inability to control these agitations became evident, investors lost confidence. Government seemed paralyzed. Decision-making ground to a halt and voters grew anxious. A Carnegie Endowment report found that economic growth was the foremost issue that worried voters in 2014.  

   The advent of Narendra Modi

   Narendra Modi emerged as a solution to voters’ worries. Unlike the Congress Party, which emphasized poverty reduction, the BJP led by Modi offered the prospects of inclusive development: “Sabka saath, sabka vikas,” Modi thundered in Hindi to emphasize his commitment to sustain economic growth, increase jobs, and ensure that everyone benefitted. His promises sutured the alliance between big business and professional groups by assuring expanded infrastructure, encouragement to manufacturing, and creation of salaried jobs—even as it neglected the agricultural sector. He also made much of his own “low caste” origins. These were infused by his commitment to Hindu nationalism, a century-old idea that Hindu ideals (ought to) provide the bedrock of politics in the country. The stage had been set in an interview to Reuters, when he was pointedly asked if he was a Hindu nationalist, Modi glibly replied: “Well, I am a Hindu and I am a nationalist, so—yes—I am a Hindu nationalist.”¹⁵

   In power, the BJP at first appeared to have succeeded where the Congress-led UPA failed in stemming the economic slowdown. Modi’s arrival to Delhi on a private jet owned by Adani, one of India’s leading businessman with investments in industry and infrastructure, was a sign of things to come. Since then, growth rates have eclipsed those of the waning UPA years, supported by government efforts to tame environmental laws and regulations in order to facilitate extractive industries, investments in real estate, and construction of infrastructure projects, as well as dilute labor laws. Both these measures assure big business of their ability to profit and serve to attract investment. In 2016, the government demonetized high-denomination currency notes, rendering worthless over 85 percent of all cash circulating in the economy: even as the country’s laboring poor struggled to use the now-illegal currency notes they held, the digital infrastructure that was put in place saw a surge in the profits made by new fintech startups such as Paytm, PayU India, and Ezetap. 

   These profits were not distributed equally. Manufacturing has remained stagnant, jobs are fewer to come by, and unemployment has increased. In 2020, the government quickly, and without broader consultation, passed three laws that promised to liberalize agriculture, thereby weakening state oversight over farming and dismantling the elaborate protections that guaranteed farmers a minimum support price to guard against fluctuations in the market and prevent the takeover of agricultural land by corporate entities. 

   Like its predecessor, the BJP continued to pursue a growth model that favored rentier segments of big business such as infrastructure, telecommunications, and construction and real estate. But it deviated from earlier governments in two key respects. First, the BJP’s cultural policies have actively fomented religious polarization to attract Hindu voters across caste and region. It has shied away from reining in vigilantes who have taken it upon themselves to protect cows, sacred to many Hindus: such vigilante action has resulted in lynchings, beatings and killings of individuals suspected of killing cows and eating beef. An overwhelming majority of the victims of these lynchings have been Muslim. More recently, the government introduced the Citizenship Amendment Act (CAA), a religious filter to India’s citizenship laws, further entrenching the marginalization of Muslims. Calls for expelling Muslims to Pakistan have been resurrected, threatening India’s complex social fabric. 

   Secondly, the Modi government has invoked colonial-era sedition laws against individuals whose activities are deemed against the interests of the state. To be clear, the UPA government was on the side of the rentier magnates against Adivasi communities in what has been dubbed “India’s dirty war,” and it cautiously initiated the liberalization of agriculture. But the Modi-led government has been more extreme in unleashing the full force of India’s security apparatus, using alleged plots to assassinate the Prime Minister as an excuse to clamp down on resistance. Civil society activists are frequently criminalized as “urban Naxals” and dissenting farmers branded as secessionists, anti-nationals, and terrorists. 

   These heavy-handed efforts at delegitimizing dissent have disrupted the carefully cultivated checks and balances between the dominant proprietary classes that had been the mainstay of Indian democracy since Independence. While attempting to draw voters through a Hindu First ideology, these efforts have not stymied rising inequality. India overtook its former colonial power, Britain, as the world’s fifth largest economy in 2021. Top 1 percent incomes are now at an all-time high, surpassing colonial-era inequalities, bolstered by Modi’s authoritarian tendencies. 

   Defending Indian democracy

   Such inequalities—and the underlying authoritarianism—have not gone unchallenged. The past decade has witnessed a series of social movements against the Modi government, attesting to the breadth of opposition from different sectors of society that have resurrected checks on the central government’s power. In 2016, India was rocked by chilling images of seven laborers of Dalit backgrounds, stigmatized as “untouchables,” being lynched by cow protection vigilantes. The video of lynchings sparked unprecedented protests from Dalits in Gujarat, and over 1,500 Dalits traveled to the Una to dump cow carcasses in front of the district office. These protests, which forced Gujarat’s chief minister to resign, demonstrated the force of working-class mobilization.

   The 2019 protests against the CAA were perhaps the largest in the BJP’s tenure. Beyond the well-documented sit-in at Shaheen Bagh, at the south-eastern edge of Delhi, people protested the divisive legislation across the country. Many of the protestors came from middle class backgrounds, suggesting a growing discontent within this social group against the social polarization wrought by the BJP’s policies. 

   The farmers’ protests of 2020 forced Modi to retreat on legislation that promised to reform India’s ailing agricultural sector by allowing big business to intervene and invest in land. Angered by the speed with which the laws were pushed through the Lok Sabha, farmers across social classes (rich and poor, landed and landless, upper caste and lower caste) converged on Delhi to protest through the bitter winter of 2020 to 2021. Hindu and Muslim farmers across western UP found common cause. The national strike called on September 27, 2021 paralyzed Punjab and parts of western UP and received extensive support in the southern states of Andhra Pradesh, Tamil Nadu, and Kerala. With the repeal of the acts, the farmers’ decisive victory demonstrated their resurgence as a social bloc that refused to be relegated to the political margins. 

   The spectrum of movements that challenged the ruling party contributed to the electoral reversal witnessed in 2024, in which voters in many formerly BJP-voting States rejected Modi’s vision. The BJP lost forty-four rural constituencies while the Congress gained seventy-seven of these, reflecting discontent in the countryside: the Congress won seventy of 147 semi-urban constituencies, reflecting a hunger for change in these rapidly transforming spaces. Of 131 constituencies “reserved” for Dalits and Adivasis under India’s affirmative action programs, the BJP won fifty-five, down from seventy-seven in the previous elections.  

   There is little doubt that India’s democratic achievements since Independence, far from perfect, have eroded after 2014. Indeed, the 2024 elections have been widely billed as the among the most unfair and unfree elections in India’s postcolonial history. The ruling party cornered most of the political finance. The mainstream media crawled when asked to bend, seeking to create an atmosphere favorable to the government. Barely three months before the elections were to commence, the government hurriedly consecrated a temple dedicated to the Hindu deity Ram in the northern town of Ayodhya in UP. Built on a site where a 450-plus-year mosque had been torn down by Hindutva activists mobilized by the BJP and its associate bodies in 1992, Ayodhya’s Ram temple was meant to symbolize the advent of a Hindu Renaissance. Modi himself presided over the consecration ceremony, thus actively personifying his government’s Hindu First ideology. The ceremony was broadcast live across the world as a means of projecting India’s revival as a civilisational state. When the elections commenced, the ruling party and its allies, billed as the NDA, appeared to be easily able to crush the opposition. 

   But the election results revealed the hollowness of these performances. The temple construction left behind a trail of destruction, evicting almost 5,000 households and businesses without commensurate compensation. The Faizabad constituency, Ayodhya’s electoral home, saw the BJP’s candidate lose definitively to the opposition candidate. Along with thirty-five of the UP’s eighty constituencies, Faizabad’s residents chose the Samajwadi Party (literally: Socialist Party), known for taking a hard line against the movement to build the Ram Temple. 

   The BJP’s electoral prospects were further dimmed by the widespread perception, fanned by its own politicians, that if the party secured a two-thirds majority, it would amend the Indian constitution—code for dismantling affirmative actions for historically oppressed communities. In response, the Constitution and its democratic guarantees quickly emerged as the talking point for voters across the State. Building on the state’s vernacular socialist tradition, opposition allies assured audiences that a caste census would be conducted and resources distributed accordingly. “Jiski jitni sankhyabhari, utni uski hissedari,” a phrase popularized by the widely-respected social justice activist Kanshiram, was revived. Modi tried communalizing this claim to fair distribution by suggesting that the opposition would confiscate properties owned by Hindus and distribute these to Muslims. The vitriol backfired as people in UP, as elsewhere, tuned in ever more to the opposition manifesto. 

   India’s democratic decline appears to have slowed down. Although it has neither been arrested nor reversed, the election results have compelled the BJP to rely on coalition partners for their political survival. Economic inequalities may not be resolved, and they may even deepen in the years to come. Nonetheless, the recent results point to the limitations not only of the unequally distributed benefits of economic growth but of the authoritarian politics underpinning Modi’s economic model.  

3. Mansfield is Open for Business

   July 18, 2024 5:34 pm Comments Off on Mansfield is Open for Business

   In 2017, the town of Mansfield pointed the way for the Conservative Party. The Conservative candidate defeated a longstanding Labour incumbent who had tried, among other things, to sue the Mansfield Town FC supporters’ association. Amid the density of local experience it was easy to dismiss the loss as a fluke result for an unpopular candidate, but the same was happening in Middlesbrough South and East Cleveland, in Stoke-on-Trent South and in Walsall. This reflected not just local issues or Brexit per se, but a longer-term secular decline in Labour support among voters in areas with declining manufacturing employment, which progressives soon dubbed Labour’s “Mansfield problem.” For locals, the drift was palpable. Left commentators were initially optimistic that Mansfield could be regained at the next elections, propelled by an impressive Momentum mobilization for a sympathetic local candidate. But the public image of Jeremy Corbyn proved to be increasingly repellent to many local voters. Speaking to people in Mansfield in the Corbyn years, it was not uncommon to hear them wish him dead. In 2019, Labour got trounced here, winning 31 percent of the vote to the Conservatives’ whopping 64 percent.

   Keir Starmer’s party regained Mansfield in last week’s elections, having expelled many local leftists from the party. The party, it is being said, has remedied the causes of the stinging defeat of 2019 and won back the voters it lost in this traditional Labour bulwark. Or has it? Labour added only 870 votes to its 2019 Mansfield total, out of more than 40,000 cast. Turnout was down to a paltry 55.8 percent of registered voters, with many 2019 Conservatives staying home or deserting the Tories for Reform. As patterns like these brought Labour victories up and down the country, scholars rushed to read up on the Gallagher Index, the formal measure to indicate the disproportionality of an electoral system. Political scientist Dr. Heinz Brandenburg calculates that with Labour’s enormous landslide on a 34 percent vote share, this measure has reached a height unparallelled in UK political history. Coupled with an unprecedentedly fragmented party system, a decline in political trust, and Labour Party membership down by almost a third from its 2019 peak, Labour’s position looks more precarious than its Parliamentary landslide might suggest.

   The disproportionality of the result makes Labour’s targeting effort no less impressive, nor its electoral strategy any less successful. But the narrowness of its base suggests that holding on to power will be a challenge. Thus far Labour has offered neither significant redistribution nor any soaring rhetoric to unify its coalition, fearing that a more polarizing, ambitious politics might galvanize the other side more than their own—Corbyn’s 2019 reception in Mansfield being a case in point. Instead, it relied on public anger and disillusionment with fourteen failed years of Conservative rule to bind together its coalition. That bond will slacken over time as attention turns to what Labour will do in power. Insofar as there is a larger narrative on offer, it lies in Starmer’s case for an active state in the national interest and his return to the language of class identity, if not the language of class conflict. The now-Chancellor Rachel Reeves has also affirmed her commitment to a political economy anchored around “security” and “resilience”—what she is calling “securonomics”—to be achieved through new entreaties from state to market. In doing so, the new government hopes to “unlock growth,” in Starmer’s words, to achieve rising living standards without large-scale redistribution in an economy defined by stagnation and inequality. 

   These scrupulously focus-grouped messages fall some way short of a Gramscian project to rearticulate common sense. But with its hands now on the reins of state power, Labour has access to new opportunities to shore up its coalition. Moreover, the party has an incentive to match that public appetite for change. From the Left, the success of the Greens and the independent candidates risks the further erosion of two of Labour’s core voting blocs if Labour fails to deliver substantive change in government: a downwardly mobile graduate class, heavily concentrated in urban seats, and working-class Muslim voters, for whom the genocide in Gaza crystalized a growing disillusionment with the party. Meanwhile Reform, Nigel Farage’s reactionary revolt, now sits in second place in eighty-nine Labour-held seats. Although Reform draws few Labour switchers, a misinterpretation of the result would threaten to pull the government’s agenda in a very different direction. Against this backdrop, the best route to holding together and growing Labour’s 2024 coalition in 2029 is by wielding the power of the state to drive up quality of life, rather than waiting for the market to deliver.

   Labour’s framework

   One week before the election, Reeves laid out Labour’s program in a speech delivered at the Rolls Royce factory near Derby. The program rested on three pillars: stability, investment, and reform. Juxtaposed against “Tory instability” and “Tory chaos,” “Labour stability” would provide business with “certainty,” a prerequisite for “the lifeblood of economic growth…business investment.” “Reform” applied not to corporate behavior but to workforce training and construction planning, “to ease the burden of bureaucracy and red tape on British businesses.” Reeves pledged not to increase corporation tax for the duration of the next Parliament, summarizing Labour’s program with a syllogism: “If we can bring business back to Labour, then I know we can bring business back to Britain.” Four days after the election, she repeated the message from the Treasury’s offices at Whitehall, in rooms ceremonially opened by Alan Greenspan in 2002. She addressed the business world directly: “to investors and businesses who have spent fourteen years doubting whether Britain is a safe place to invest, then let me tell you…Britain has a stable government, a government that respects business, wants to partner with business, and is open for business.”

   This three-legged framework to drive change reflects a shift in the logic of British economic statecraft, albeit one that remains incomplete and contradictory. At its core it is about the state attempting to govern fixed investment—the composition of capital and infrastructure stocks that shape the supply side of the economy—to deliver on the government’s overarching missions: higher growth, rapid decarbonisation and rebuilding economic resilience. The National Wealth Fund announcement is an early indication of that shift, reflecting a recognition that industrial decarbonisation and its benefits are best delivered with supportive public investment and new institutions to guide the process. Yet this recognition of the necessity of a more active state to address Britain’s deep-rooted problems is undercut by Labour’s signaled reliance on private investment and ownership as the primary instruments of social and economic transformation.

   This reliance partly reflects ideological commitments to entreprenurialism over the postwar Labour goals of planning and socialism. But it also underscores political concerns that a more ambitious fiscal agenda will frighten key Labour constituencies: owner-occupiers sensitive to fluctuating interest rates, certain fractions of the business community, and financially squeezed households that might be skeptical of tax hikes and higher borrowing. There is, however, a tension. Starmer achieved his electoral advantage over Corbyn by broadening the geographic scope of his coalition, recapturing the ex-industrial constituencies of the midlands and north. Symbolic losses in Labour heartlands such as Mansfield, Walsall, and Stoke have been reversed, while ex-industrial swing seats like Corby and Newark have turned red once more. These places are familiar with the results of market-led renewal, as beautiful civic buildings are left to rot while shared spaces are paved over for business parks full of bad employers and newbuild housing that locals can’t afford. It is unrealistic to expect the private sector to rebuild the public realm in these marginalized areas; a lack of direct state action risks deepening political alienation. Interviewing local citizens, as one of us did recently, many express a sense that their representatives do not care: “I’ve always felt that they [politicians] were a very unsafe bunch, a very self-interested bunch,” one former steel worker said. “They only look after themselves. [That’s] number one. Number two they look after their family. Number three, they might or might not look after their constituents. Number four, they look after the country, if they have to.” His wife nodded. “We are way down the list.”

   Winning again, strategists say, depends on delivery, delivery, delivery. But delivery how, by whom and in whose interest? Take the question of childcare: the Labour Party has matched the Conservative pledge to expand free hours for working families in England, bringing it closer to universal childcare than ever before. Delivering policies like these will make a tremendous difference to people’s everyday lives. The new government has taken no position, however, on who provides state-funded childcare and has thus far declined to impose limits on the extractive practices and dubious financial constructions that characterize the private equity-backed part of the sector. Doing so might trigger market exits, hampering the roll-out of provision and necessitating greater state involvement. But the government’s queasiness over these possible reactions to regulation or public enterprise leaves the door open to profiteers. While smaller providers are struggling to meet rising costs, private equity firms are hoovering up childcare settings and loading them with debt. 

   Similar dilemmas arise in other flagship policy areas. Will Labour’s housebuilding strategy involve state action to guarantee affordability or limit itself to handouts to the property developers? Will Great British Energy—the name of Labour’s new public energy company—offer genuine public ownership and operation of clean power or become a mere vehicle for enlarging private profits? A division of labor between state and capital wherein the state largely abstains from undertaking direct public investment and long-term ownership leaves it scrambling to induce private investment through public subsidy, debt guarantees on private financing, and other “derisking” mechanisms. 

   Alternatives

   Labour’s response to these economic questions is shaped by a public mood of political cynicism. As the transformative projects of Corbynism and Brexit lose their grip on politics at large, a rising tide of political engagement recedes again, with large swathes of the public left alienated and mistrustful. Many citizens are disinclined to put their faith in another political project. Faced with a public wary of big promises but eager to see change, Labour will receive offers of assistance from private finance giants like BlackRock, Macquarie and Fremman Capital. The UK history of private finance initiatives for public provision suggests that this will be more expensive and less effective, while carrying all the same political uncertainties about the reality of delivery. As it sets out to rebuild the UK, the new government will nevertheless be tempted by this Faustian bargain, which allows it to temporarily avoid the spiky politics of tax rises and greater public borrowing at the cost of turning the country into a giant infrastructure asset.

   Renewal will require a fuller break with the primacy of market rule. Market coordination — premised on private control of investment, private ownership of capital and infrastructure, and decision-making driven by the profit imperative — is ill-equipped to deliver the quality and quantity of investment needed to renew the public realm and revitalize Britain’s fraying infrastructure. Nor is it likely to distribute the gains of potential growth equitably across time or space. Among other things, an active state could revitalize ex-industrial town centers by taking over abandoned and underused sites and redeveloping them into hubs for learning and leisure, including childcare provision, cultural centers and technical and vocational education. This requires, however, that the state increases not only public investment, taking chances where the market will not, but also the level of ongoing expenditure on operations that may earn no return at all—it requires growing a public sector insulated from profit motives and funded by redistribution. Only by challenging the institutions and practices of market coordination can Labour revitalize its reconquered heartlands and restore the promise of politics as a collective project of demands and decision-making.

   An agenda that builds out the institutions of public coordination must be complemented by a fiscal politics capable of slaying the ghosts of the Truss debacle. The legacy is double-edged: her catastrophic if short-lived mismanagement of the British economy was a decisive blow to perceptions of competent Conservative economic management, yet if the lesson learned is that borrowing at scale is a forbidden fruit then her premiership will prove harmful to progressives in the long run. Truss induced an economic shock by her assault on institutions like the Treasury, the Bank of England and the Office for Budget Responsibility combined with an unstrategic, inegalitarian and poorly signposted borrowing surge, which exposed hidden frailties within the pension system. By contrast, investors have already signaled Labour could borrow more to invest without UK bond market backlash. With Britain’s disastrously weak investment performance relative to the OECD at the heart of its economic divergence, Labour would be wise to take advantage, cashing in on the greater latitude their stress on stability has earned them by borrowing to increase investment.

   At the same time, Labour must be prepared for shocks. The world is still reeling from the turbulence unleashed over the last few years by an intensifying ecological crisis, sharpening geopolitical tension and macro-financial fragility—shocks that are likely to become increasingly frequent. Many of us have experienced the sinking feeling at the supermarket self-checkout when you scan the contents of your trolley only to find your weekly shop has increased in price again. At the most abstract level this reflects the inflexibility and limitations of the transatlantic macroeconomic policy framework for governing the economy. In response to highly specific price shocks, the conventional macroeconomic wisdom is capable only of restraining demand and inducing stagnation and recession, in turn preventing the larger production and consumption nexus from processing those shocks without severe side-effects. 

   Addressing what Britons used to deride as the Conservative’s “stop-go” economy demands a more granular and concrete understanding of the structure of the British system of public and private enterprise. As Isabella Weber and others have argued, the response must be for governments to develop targeted macroeconomic and macro-financial stabilization policies, from price coordination of strategically significant sectors and green credit guidance to sectoral windfall taxes or building out commodity stockpiles. This is undoubtedly a difficult political and technical task. But failure to move beyond macroeconomic orthodoxy will mean Britain is likely to remain, like much of the North Atlantic world, trapped in the toxic combination of stagnation and inequality that has been the hallmark of the past decade.

   The alternative of status-quo politics with a dash of government-by-BlackRock is not just bad economics but also politically dangerous. It will alienate not just committed progressives but also “left-behind traditionalists.” In pubs, socials and community venues in the ex-industrial seats Labour regained, talk about politics often revolves around the alleged corruption of politicians. In places like Mansfield, respect for hard work and entrepreneurship often co-exists with the sense that the economy is rigged and that partnerships with the private sector are little more than handouts which prove that politicians will only ever look after their friends and business allies. When the government is forced to step in to protect over-leveraged childcare chains from collapse, when energy bills rise despite public investment and when the rentiers come to collect their due, these mistrustful voters will read this as proof that the new government has been lining the pockets of its mates. This may be a fragmented and contradictory consciousness, but people know a racket when they see one.

   Major and imminent policy choices will indicate whether the government is ready for a more robust break with the past—or whether the turn toward renewal in Mansfield will remain nascent and half-formed. The first question regards what Labour has called its “new deal for working people.” Will it be more than a tweak at the margins of UK employment law? Workers in the distribution centers around Mansfield would materially benefit from fair pay agreements in the warehousing sector, but Labour, the party named for workers, has already moderated its ambitions in this policy area. Whether the amended plans can provide the foundations for a less unequal labor market and business sector remains to be seen, as does the future of the two-child limit on public benefits for families. Failure to abolish this regressive and punitive welfare cap is planning to increase child poverty. 

   The second is the National Wealth Fund and GB Energy, and other institutions tasked with driving decarbonization of industry and power. Will these be based on genuine and substantive forms of public coordination, ownership and investment or amount to trivial and ineffective derisking ventures? Concretely, these should be adequately capitalized, able to raise debt and empowered to take on the coordination role that has been sorely lacking. Yesterday’s announcement in the King’s Speech that Great British Energy will “own, manage and operate clean power projects” marks a promising start, but the limited capitalization will prove an enduring issue. 

   And finally, there is the question of housing. Having recognized that rapidly expanding the UK’s housing stock is a precondition for solving a nest of interconnected problems, the party must decide how to meet this objective. Are planning deregulation and private for-profit developers its principal instruments, or will it robustly commit to direct public provision of housing and strengthening protective regulation? Formulating the right answers to these questions will be critical to ending the housing crisis. In doing so, Labour can begin to build out a coherent economic and political strategy for ambitious public investment, strategic public ownership, and public coordination as central tools to ending Britain’s downward drift.

   In the ex-industrial heartlands, the belief that hard work merits public rewards has never left. But this moral lodestar has proven incongruous with business-first regeneration, which has yielded poor jobs and little security, while town centers decline and provision disappears amid emaciated public budgets. In subtle and unsubtle ways, the reliance on private investment and the kind of economy it creates conveys to people that their work and their lives are not valued. Starmer’s welcome promises to restore a sense of public service, to commit to national renewal and to value working-class citizens is fundamentally incompatible with the economic model his policies implicitly rely on. One or the other will break. If Labour is to win another term and deliver on its commitment to national renewal, it is vital that it be the latter. 

4. Why So High?

   July 17, 2024 8:00 pm Comments Off on Why So High?

   Since day one, Lula’s third administration has been marked by multiple clashes with Roberto Campos Neto, president of the Brazilian Central Bank. The disagreement is over the benchmark interest rate in Brazil. Lula has repeatedly urged Campos Neto to lower rates, which he argues is necessary to stimulate the economy and reduce unemployment. Higher public revenues from the resulting growth would, in turn, help fund policies aimed at reducing inequality—a key commitment of his campaign. Campos Neto, for his part, has been hostile to the idea, arguing that lowering rates would fuel inflation and undermine the credibility and autonomy of the Central Bank. Throughout the majority of Lula’s first year in year—until August 2023—the interest rate remained at 13.75 percent. Since then, bowing to pressure from both political and market forces, the policy rate was reduced to 10.5 percent, a still outstandingly high figure. Forecasters anticipate the rate to be cut to 10.25 percent by the end of this year, but no further. The inflation target is 3 percent. Should this target be met, the resultant real interest rate would be 7.25 percent—the second highest real interest rate in the world.

   These clashes between Lula and Campos Neto illustrate the complex and controversial nature of interest rate setting in Brazil, a country historically beset by high inflation and unsustained growth. Interest rates are the key instrument of central bank-driven monetary policy, affecting the availability and cost of credit, the exchange rate, the level of investment, consumption, output, and, ultimately, the population’s welfare. Low interest rates are generally considered conducive to economic growth and development, as they encourage borrowing and spending, reduce the debt servicing burden, and open the space for fiscal policy. Low interest rates, however, may also entail risks, such as increasing inflationary pressures and creating asset bubbles.¹

   The Central Bank’s resistance to low interest rates stems from two complementary sources. First, the Brazilian fiscal-monetary system entails a unique institutional setup, where the basic interest rate used by the Central Bank as their monetary policy instrument is the same rate that remunerates approximately 43 percent of the national debt, which consists of no-coupon short-term bonds. Because of this, when the Central Bank carries out overnight operations involving federal treasury bonds in the public securities market its interest rate targets must include a rate of return that investors consider adequate to enable the Treasury to roll over its debt. Discretionary monetary policy in Brazil, therefore, has immediate effects on fiscal policy: how much the treasury pays when its bills mature, and the cost of issuing new debt, rises and falls directly with the monetary policy rate. The risk premium on the Treasury’s debt, in turn, sets a lower threshold on monetary policy, preventing the Central Bank from reducing its policy rate beyond a certain point the Treasury considers necessary for its lenders. 

   The second source of the Central Bank’s maintenance of high interest rates is tied up with the fact that domestic prices in Brazil respond only minimally to interest rate changes. In order for the Bank to have any impact at all on prices, it needs to hike interest rates to an extraordinary degree. If the transmission channels for monetary policy worked better in Brazil, monetary policy wouldn’t need to be so extreme. Making these improvements so that interest rates can come down would require fundamental institutional reform. But the latter is little discussed today, even as fights over monetary policy repeatedly feature on the front pages of newspapers.

   Treasury bonds as the liquidity management tool

   The Brazilian Central Bank works under an inflation-targeting regime, and the policy rate is the primary tool used to achieve this target. If inflation is expected to rise above acceptable levels, the Central Bank increases the interest rate to steer inflation back to the target. Conversely, if the rate of inflation is deemed appropriate, the Central Bank works to maintain it. This means that, regardless of the source of inflation, the Central Bank will hike interest rates to reduce economic activity, increase unemployment, and decrease workers’ bargaining power. Understanding the mechanisms for determining interest rates is somewhat more complex and requires a short detour via repurchase agreements, the market for short-term lending. 

   Repurchase agreements are financial transactions where a financial institution sells (or buys) securities with the commitment to repurchase (or resell) them at a future date, prior to or equal to the maturity date of those securities. These operations are carried out between two or more financial institutions, between a financial institution and the Central Bank, or between an institution and an individual or legal entity. The securities used can be public or private, with public securities being the most common in this type of operation due to their lower risk and liquidity. In the case of repurchase agreements involving Brazilian public securities, the operations are carried out in the Special Settlement and Custody System (Selic), a clearing system managed by the Central Bank that provides immediate transfers of securities and funds—all operations are settled with their real-time values. The Central Bank Monetary Policy Committee (COPOM) meets every 45 days to set its policy rate target. In open market operations, the Central Bank acts in the Selic system to both manage liquidity in the economy and ensure that the average interest rate on public securities aligns with its policy rate target.² The federal funds rate is called the Selic rate because of this system.

   The Selic system consolidated in 1979, amid a period of high inflation. At the end of the 1980s and well into 1990s, Brazil grappled with soaring inflation rates, peaking at over 80 percent per month in 1990. To continue public financing without dollarization, the Treasury began issuing a new instrument, Letras Financeiras do Tesouro (LFT), or Treasury Financing Notes. LFTs are no-coupon bonds whose yield to maturity equals the interest accumulated by the Selic rate.(These instruments are therefore known as “post-fixed” securities in Brazil.)³ In high inflation times, short-term LFTs often served as a store of value: “post-fixation” to the Selic rate granted both adjustments to inflation and liquidity assurance by the Central Bank. When price stabilization was finally achieved with the Plano Real in 1994, the Treasury continued issuing LFTs. The peculiarity of this arrangement has persisted into the twenty-first century⁴ and shaped the country’s unconventional fiscal-monetary system.⁵

   Today, approximately 43 percent of the Brazilian public debt consists of LFTs and repurchase agreements, both indexed to the Selic rate. In essence, since the short-term interest rate used by the Central Bank to regulate liquidity is also the interest rate the Treasury pays on a greater share of its debt, an increase in the policy rate means a rise, too, in the value of public debt. The Central Bank directly determines the interest rate for both bank excess reserves in open market operations and the majority of public debt securities. This not only interferes with the short-term financing needs of the National Treasury, but also renders it almost impossible to extend the maturity profile of public debt. Since a significant part of the public debt pays the same interest rate as the cost of overnight lending, market participants overwhelmingly prefer short-term, post-fixed interest rate investments. Furthermore, this practice limits the potential for the Selic rate to come down adequately; since it remunerates public bonds, it must necessarily cover the risk premium associated with the National Treasury.

   This is a primary reason for Brazil’s soaring interest rate, and it has another economic consequence. While rising interest rates in other countries reduce liquidity, aggregate demand, investment, and consumption, in Brazil, by contrast, higher interest rates augment financial wealth. This is due, in large part, to the fact that the value of Selic-indexed public debt will increase directly with the overnight interest rate, and such bonds are mainly held by commercial banks as reserves: raising the rate increases their liquidity. 

   Ultimately, Brazil has fallen into the trap of elevated interest rates in capital markets that discourage long-term investment, as its national Treasury must constantly roll over a great portion of its debt in short-term markets at a policy rate set high enough to achieve both low inflation and capital inflow.

   The roots of inefficient monetary policy in Brazil

   With such a large gap between domestic and international interest rates, one might assume that the result would be an over-appreciation of the currency, a sharp contraction in aggregate demand and, consequently, very low inflation levels, or even deflation. This, however, has not occurred. In emerging economies, monetary policy transmission channels are limited by a series of constraints, reflecting a nation’s economic, political, and social characteristics. In Brazil, these channels are outstandingly ineffective. 

   One relevant reason is that credit market segmentation—the high proportion of directed credit in the total credit available—significantly reduces the ability of monetary policy to influence aggregate demand and, consequently, inflation. Often subsidized by the government, directed credit does not respond to variations in the basic interest rate, limiting the effectiveness of the credit channel.

   Another significant factor is the truncated term structure of interest rates. Variations in the basic interest rate do not effectively translate into variations in Brazil’s long-term rates. This limits the impact of monetary policy on long-term consumption and investment, as economic agents do not perceive changes in long-term financing conditions. 

   Many prices are also rigid. In many emerging economies, a significant portion of prices—such as energy tariffs, transportation, and fuel—is managed by the government. In Brazil, these prices do not respond directly to monetary policy, limiting the effectiveness of the Selic rate in controlling inflation. Moreover, price-adjustment contracts based on past inflation for rent or wages, a common instrument to protect real incomes, potentially create inflationary inertia that distorts monetary policy effects. Finally, the country’s huge informal sector does not respond predictably to policy rates.

   The broader economic structure, too, plays a crucial role. The heavy dependence on primary sectors such as agriculture and mining increases the Brazilian economy’s vulnerability to variations in international commodity prices and other external shocks that import inflation and affect foreign capital flows. High exposure of prices to global economic conditions and exchange rate volatility leaves little space for domestic monetary policy. 

   Lastly, the large share of Treasury Financial Notes (LFTs) in the total public debt composition is a key contributing factor to the obstruction of monetary policy transmission mechanisms, particularly the so-called wealth effect. The wealth effect outlines how changes in interest rates can impact the market value of assets and, consequently, consumption. When interest rates rise in most markets, the value of bonds and other financial assets tends to fall, shrinking the perceived wealth of individuals, which potentially scales down consumption and leads to inflation reduction as a result of limited aggregate demand growth. This could be the case of Brazil if its public debt was issued mainly in the form, more familiar to the advanced economies, of fixed-income instruments known in Brazil as “pre-fixed” securities. However, LFTs are no-coupon bonds whose yield varies directly with the Central Bank’s policy rate. This means the way values and yields behave in Brazil is the inverse of most debt markets. Since a large component of financial assets in Brazil is immune to changes in the policy rate, the asset value transmission channel turns out to be unproductive.

   A way out?

   How can Brazil overcome its pathology of chronically high interest rates? One possible solution is to separate the functions of the Selic rate itself, so that it is no longer required to operate both as the Central Bank’s main policy instrument and the main capitalization rate for the public debt. This would entail separating the money market from the treasury bonds market. If this were to occur, the Central Bank’s basic rates could be used to remunerate reserves without directly carrying the risk premium from the government debt. This would allow the Central Bank to lower its policy rate without directly affecting either the market for public debt or the volume of bank reserves. Lower interbank lending rates, in turn, lower other lending rates for households and businesses, encouraging more productive and innovative investments in the real economy.

   Separating the dual functions of the Selic rate, however, would first require changing the Selic market’s structure and operation. Currently, the Selic rate is determined by the supply and demand of overnight loans between banks through repurchase agreements operations, which are collateralized by treasury bonds. Changing the Selic would entail (i) drastically reducing repurchase agreements backed by LFT treasury bonds as the tool to regulate liquidity; and (ii) replacing the Selic rate as an index that remunerates part of public debt by another index not directly associated with the Central Bank’s policy rate. This is a difficult task because Selic’s benchmark role means any alternative mechanism for public debt must start by paying above the Selic rate. Such an adjustment may only be feasible in the context of low interest rates worldwide, allowing a reduction in the Selic rate. A sudden fall in the Selic that is not connected to a fall in global rates could cause the value of public debt (and bank reserves) to decrease—creating a risk of financial panic. But in a situation in which Selic is already low, investments in alternative assets could be stimulated, and space for an alternative market for public debt opened, creating an opportunity for change. Yet lowering the Selic rate is itself difficult, according to the Treasury, as finding a borrower for its debt issues usually demands an attractive interest rate. 

   In a 2005 essay on Brazil’s monetary regime, Yoshiaki Nakano argued that a “deficit zero” fiscal policy is an essential prerequisite to achieving lower interest rates, as reform of public debt management depends on the credibility of financial markets.⁶ But the way in which public debt stability should be achieved is a matter of political dispute, and different strategies can lead to opposing results. An austere fiscal policy, for example, might inadvertently produce perverse macroeconomic outcomes and even foster social and economic instability. If the government engages in strong public expenditure cuts to guarantee zero deficit or a primary surplus, it can negatively impact demand and output growth. This approach risks triggering social turmoil and might even increase the government’s risk premium, thereby increasing the cost of the debt instead of reducing it. In addition, the stability of public debt is only important, for this matter, if it effectively lowers the interest rates on public bonds, thus shifting the investment dynamics by increasing the demand for riskier assets and bonds. Stability purchased at the price of economic stagnation is likely inherently destabilizing. But even if a low Selic rate could be achieved, a strong and broad political coalition would be required to support the institutional reform. This may not be so easy, given the levels of political polarization and fragmentation in Brazil. 

   Lowering the interest rate in Brazil is technically achievable but will require a fundamental challenge to the status quo. This means creating a new, stable coalition among the beneficiaries of lower interest rates capable of pressuring the government to set this reform as a priority in its agenda and supporting it throughout the process. If this is not a simple or quick task, it may be an opportunity for Lula to build upon his claim to lower interest rates and push for structural changes that avoid similar constraints in the future. 

5. Strategic Interdependence

   July 11, 2024 9:30 am Comments Off on Strategic Interdependence

   On October 7, 2022, the US Department of Commerce’s Bureau of Industry and Security (BIS) released the implementing rules to support Joe Biden’s export controls policy against China. In continuity with Donald Trump’s “America First” Strategy, Biden imposed restrictions on the purchase, license acquisition, and exports to China of advanced computing chips, supercomputers, and high-powered semiconductors—all in the name of national security.¹ A year later, the BIS further tightened the restrictions to ensure no advanced manufacturing equipment ends up in Chinese fabrication facilities. The impact was compounded through international partners like Japan and the Netherlands, who were prohibited from selling semiconductor manufacturing equipment like lithographic machines. 

   The US’s export controls policy is part of a wider strategy to regain control over the global semiconductor industry. With the CHIPS act of 2022, Biden signed $39 billion in grants and loans for semiconductor manufacturing into law. Emphasis has been on developing US leadership in semiconductor R&D, including a projected increase of 203 percent in wafer fab capacity by 2032 and marked improvement in critical technological frontiers such as leading edge fabrication, DRAM memory and analog chips, and advanced packaging. 

   This reverses the decades-long trend of globalization of chip-making, in which design and manufacturing were divorced from each other in an effort to promote efficiency, lowering costs of fabrication, and seeking more profits in a low return, high risk sector.²

   In response, China has poured $1.7 billion in subsidies towards domestic chip companies in 2022 to achieve self-sufficiency, undertaken massive state-led investments through the National Integrated Circuit Industry Investment Fund, and announced a plan to build technological infrastructure critical bottlenecks like wafer fabrication and lithographic machines. China has also imposed retaliatory trade measures in 2023, such as a licensing system for critical raw materials like gallium and germanium needed for chip-making.

   The slew of export restrictions between the US and China is an important sign of the raging high tech warfare that underpins the new logic of industrial policy in the post-neoliberal global order. Industrial strategy has been implemented in the name of an economic war in which only a few countries are able to compete. 

   But even in the face of these escalating tensions, our global economy remains the site of overwhelming interdependence. A brief look at supply chains within the semiconductor industry readily demonstrates that decoupling may not be as easy as policymakers make it appear. 

   Figure 1: Major Industrial Policy Initiatives on Semiconductor Industry, 2020–Present

   

   China in the chip wars

   Chris Miller’s book, Chips War, demonstrates that the US’s hegemonic victory in the Cold War depended on its technological prowess in the semiconductor industry. Semiconductors—chips as tiny as sub-10 nanometres—are ubiquitous inputs across our supply chain, ranging from washing machines and computers to advanced technologies in new clean energy and missile and defense systems. The quest for producing smaller chips at maximum efficiency created a highly decentralized supply chain, whereby US firms sought to reduce costs by separating chip design from wafer fabrication manufacturing and subsequently differentiating assembly and packaging.³ This process of decentralization enabled the US to outcompete the former USSR in the arms race and overcome Japan’s challenge to US economic hegemony. 

   Cost reduction in chip manufacturing coincided with rising costs in fabrication and in design, compelling firms to specialize in very niche tasks, some of which have become indispensable.⁴ For example, Taiwan’s TSMC built their competitive advantage in pure play foundry, which meant that chip design became completely divorced from fabrication. South Korea’s Samsung, by contrast, specialized in memory chips while chip design remained under the hands of American companies, thanks to the development of electronic design automation (EDA) tools.

   The US’s control over global chip production poses a significant obstacle to Chinese development. China entered the supply chains of semiconductors amid stiff competition, with East Asian economies already well ahead in wafer fabrication capacity and the European Union (EU) and Japan on a race to regain their competitive edge in chip design and equipment manufacturing. Prior to US-China competition, Chinese companies took advantage of openings in the assembly and packaging, and then gradually transitioned into upstream segments (see Figure 1). Between 1978 and 1999, China focused its industrial policy on leveraging the large domestic market to encourage private investments in chip-making, encouraging joint ventures and acquiring assets to close the technological gap between China and the US, Europe, and Japan. China has therefore long viewed the semiconductors supply chain as pivotal for its progress in industrial development. 

   Figure 2: Leading Companies in the Semiconductors Chip Design and Manufacturing Segments of Supply Chain

   

   The US’ current containment strategy against China has been successful precisely because of the sheer structural power of American firms in the lucrative upstream segments of the supply chain. As long as China depends on American companies for EDA tools and IP design, any shift in US government policy aimed at curbing access to advanced Chinese chip-making tools is likely to slow down China’s rise in the hi-tech ladder. 

   Since 2018, China has sought to balance against this power by expanding its own manufacturing capabilities. In line with its self-sufficiency principle, in early 2023, the government designated five key firms— Huawei, SMIC, YTMC, and toolmakers Naura and AMEC—to gain privileged access to government R&D. As a result, Huawei made significant R&D headway in critical segments, such as deep ultraviolet and extreme ultraviolet lithography systems. This fabrication equipment is vital for Chinese lithography companies given their technological lag compared to industry leaders Dutch ASML and Japanese Nikon and Canon.

   The reality of co-dependence

   Despite rising tensions between the great powers, the reality remains one of significant co-dependence. As the 2023 US-China Economic and Security Review Commission opined, the United States is heavily reliant on Chinese production of key minerals, both for sourcing directly from China and indirectly through the predominance of Chinese gallium (53 percent share) and germanium (54 percent) in global supply chains (see Table 1). This, in turn, makes the Chinese export control policy imposed on critical minerals effective in ensuring the resilience of supply chains for advanced manufacturing. Without a diversified supply chain, quid pro quo bargaining between the US and China and more measured restrictions are likely to continue in order to ensure that global supply chains are not entirely disrupted.  

   Table 1: Critical Minerals the United States Primarily Sourced from China, 2022

   Critical Mineral	China’s Share of US Imports	Major Uses
   Antimony	63%	Flame retardant; antimonial lead and ammunition
   Arsenic	57%	Herbicide and insecticide; wood pressure treatment; semiconductors for solar cells, space research and telecommunications
   Barite	38%	Oil and natural gas drilling; radiation shields at nuclear plants and for x-ray
   Bismuth	65%	Metal additive for cast iron and pope fittings; pharmaceuticals; semiconductor manufacturing
   Gallium	53%	Manufacturing of semiconductor wafers
   Germanium	54%	Semiconductor manufacturing; solar cells; fiberoptics; LED
   Graphite	33%	Batteries; brake linings; lubricants; steel-making
   Rare earths elements (compounds and metals)	74%	Magnets; catalysts; metallurgical; battery alloys
   Tantalum	24%	Alloys for gas turbines used in aerospace and oil and gas industries; automotive and consumer electronics
   Tungsten	29%	Cutting and wear-resistant applications in construction, metal-work, mining, and oil and gas drilling; specialty steel alloys; electrical components
   Yttrium	94%	Catalysts, electronics, lasers, metallurgy; jet engine coatings, sensors, bearings, and seals

   A second point is more obvious: China remains a huge market for intermediate and end-user products. Chinese consumer power remains an important aspect for any long-term business strategy for Western firms. Dutch and Japanese companies’ resistance to their governments’ respective exports control policies demonstrates the power of the Chinese market. Access to this consumer base is equally important for firms as geopolitical objectives are to their national governments.  

   In the highly lucrative battery supply chain, which links the critical minerals sector to electric vehicles, China has secured its position as a major producer (see Figure 3). China’s industrial policy built economic linkages between mining and the productive economy. This reflects the manufacturing prowess of China and the likely future of industrial competition between China and the West.

   Figure 3: China and the Global Supply Chain Linking Critical Raw Materials and EV Cars

   

   We are unlikely to return to the pre-COVID economy, in which American capital alone shapes the fate of global economic growth and prosperity. Regardless of who wins in the US presidential election in November, the cross-party consensus demonstrates strong preferences towards containing China’s economic ambitions, and with it, military expansion. Yet, despite the turbulence in US-China relations, the goal of decoupling is unlikely to happen soon. Instead, achieving supply chain resilience necessitates seeking new ways of cooperation in the face of proliferating barriers. 

6. Terms of Investment

   7:22 am Comments Off on Terms of Investment

   More than one-in-seven units in the American rental housing market have substantial quality issues, according to the Government Accountability Office. These range from cracked walls and the presence of rodents to a lack of essential components such as heating equipment or hot and cold running water. Of those rental units lacking essential components, nearly 80 percent are rented by lower-income households.

   Climate change is compounding these trends, making it even harder to find a safe place to live. About 40 percent of the country’s 44 million rental housing units are located in areas facing immediate risk from climate change, expecting at least moderate costs thanks to the changing environment. Meanwhile, residential energy use is responsible for roughly one fifth of greenhouse gas emissions nationally.

   Now two years old, the federal Inflation Reduction Act (IRA) sets the stage for billions of federal dollars to flow toward home energy upgrades through home energy rebates, grants, and tax credits. Most of the funds for residential properties—$9 billion over ten years—take the form of rebates that flow to the property owner of a building as a tax write-off or reimbursement once they have invested in specific types of energy efficiency, electrification, and/or clean energy improvements. These rebates are for households earning less than 150 percent of Area Median Income and are capped at $14,000 per unit, which likely will not cover the full cost of comprehensive upgrades in many jurisdictions. The IRA also includes more than $2 billion to accelerate residential decarbonization through national nonprofits as part of the Greenhouse Gas Reduction Fund program, which aims to catalyze further private investment in residential decarbonization. Additional programs allowing public entities to receive tax credits for clean energy projects also apply to some specific housing contexts. 

   Notably, the IRA’s housing funds are limited to energy. When proposed in April 2021, the package that eventually became the Bipartisan Infrastructure Act originally included $213 billion to “produce, preserve, and retrofit more than two million affordable and sustainable places to live.” By November, after the infrastructure spending peeled off and the Build Back Better legislation passed the House of Representatives, there remained $170 billion for federal programs to expand construction, bring down rental costs, and provide holistic repairs (this legislation failed to pass the Senate). Today, as states prepare to disseminate $9 billion in public funds for insulation and decarbonization, there are few safeguards in place to prevent landlords from using publicly-funded repairs as an opportunity to displace long-term, low-income tenants.

   The US rental market and the IRA

   In the US rental market, the quality of housing is largely left in the hands of landlords. The trends in multifamily housing management show that owners increasingly contract these responsibilities out to management companies. From 2012 to 2021, the share of the country’s rental units in multifamily properties where landlords outsourced management rose from 12 to 20 percent, according to the US Department of Housing and Urban Development’s Rental Finance Housing Survey. In the six years from 2015 to 2021, the share of all rental units with outsourced management rose from 23.7 to 29.2 percent. The quality of rental-housing maintenance, moreover, has been in long-term decline. Between 2011 and 2021, according to the HUD’s American Housing Survey, the share of rental housing units with neither a manager nor owner living on sight has increased from 41 percent to 51 percent.

   

   In a tight housing market where business firms own the vast majority of large apartment buildings, owners have the market power and incentive to keep rents high, defer maintenance, and reduce the habitability of rental housing. Improvements to habitability or clean energy upgrades that do take place are often conditional on raising costs for tenants, regardless of whether that requires replacing them with different people. Yet while improvements are often conditional on price increases, rising rents do not guarantee improvements. While the share of units with habitability issues has remained constant between 2001 and 2017, the share of renter households who pay more than 30 percent of their monthly income in rent rose from 42 to 48 percent in the same period. In 2022, that fraction rose to above half of all renters—an all time high.

   The IRA is designed to pull in further public and private dollars into the decarbonization industry—including home renovations and retrofits. Though the funds it appropriates for homes pale in comparison to the need for general repairs—Harvard’s JCHS estimates the costs for home repairs alone in the nation’s rental housing stock at $51.5 billion—these green energy dollars nevertheless have the possibility of drawing forth real spending where many other kinds of tax write-offs elicit only paper commitments.

   In the US, housing policy distinctively subsidizes homeownership. Most notably in the form of the Mortgage Interest Tax Deduction, federal policy benefits owners much more than tenants. Climate policy is no different. In public or cooperative housing models, the government or cooperative serves as the landlord or property manager, and therefore has more direct influence over the fate of property conditions. In much of the private market, by contrast—which is where the vast majority of tenants find housing—the federal government sees its role as less direct. Tenants in many multifamily properties have no direct method of contracting for services; many do not know who owns the real estate. The IRA’s focus on incentives and credits for landlords maintains this property relationship.

   The fact that about one in three housing units are occupied by tenants raises questions about the effects such climate tax incentives will have on owners of rental property. The Biden Administration has emphasized the importance of channeling these funds to “disadvantaged communities,” maintaining that about 40 percent of funds should go toward low-income households, 10 percent of which should go toward multi-family households. However, the facts of ownership leave open a stubborn question: will landlord spending on climate retrofits—a condition for receiving public funds—alter existing financial terms between tenants and landlords?

   One of the key challenges is that clean energy investments in private housing run up against the “split incentive” problem. Rebates exist for landlords to install clean energy sources. But if landlords themselves don’t live in the property or pay the utility bills, there is equal incentive to do nothing, since the credits require landlords to undertake investments and commit managerial overhead. The fact that the IRA’s clean energy rebate amounts often will not cover the full cost of the upgrade adds to this, leaving landlords with fewer incentives to dip into their revenue to cover the remainder of the upgrade.

   The underlying condition of disinvestment and depreciation in the American rental housing market layers on new challenges to decarbonization. While in some cases, IRA funds can include core repairs like window and door replacements to improve insulation, the IRA does little to provide resources for the estimated $51.5 billion in underlying repair needs in the rental housing stock. Strapping a heat pump to a building filled with mold will not deliver the material health and climate improvements that tenants need to live safely. In states like New York, clean energy dollars cannot flow to buildings unless they are already up to code.

   Health improvements and clean energy investments must occur side by side, and it will be up to local and state governments to braid IRA funding with local regulations and public dollars to achieve more holistic home repairs. 

   But the real challenge for this prospect is multifamily housing, where conflict between landlords and tenants is increasingly organized into the business model. According to the AHS, the share of all rental units that exist in properties with five units or more increased from 27 percent in 2011 to 38 percent in 2021. Tenant requests for repairs in such contexts are often met with retaliation from landlords. Even if a tenant wants to see clean energy upgrades and is motivated to ask their landlords to take advantage of IRA rebates, knowing who your landlord is can be a challenge where “customer relations” are handled by third-party, web-based services and owners are insulated not only from liability but from the possibility of communicating with their tenants.

   Terms of investment

   The conflicts over tenancy and landlord obligations for habitable housing point to a second set of risks for renters. When habitability or clean energy improvements do take place, they are often accompanied by rent hikes or no-fault eviction notices—terminating a lease and detaining possession of a property through no fault of the tenant—to increase the revenue a landlord can make from any given unit.

   A patchwork of limited federal, state, and local tenant protections already leave tenants vulnerable to rent hikes and displacement regardless of whether owners make commitments offset by IRA credits. For private market rental housing in the US, there are no federal rent regulations or eviction protection policies. The federal government has long chosen to punt the question of tenant protections to state and local governments. Local governments have themselves put straightjackets on municipal authorities: about thirty states preempt local jurisdictions from adopting rent controls, and only seven states have “good cause” eviction protections to ensure renters are not evicted for no reason.

   This status quo renders the prospect of widespread landlord spending on green upgrades into an obvious opportunity to raise rents, potentially causing more harm to the low-income renters that these investments are aimed at supporting. New solar panels or triple-pane windows increase the value of the property and attract higher-paying tenants. As with any business investment, such costs require higher revenues if profit margins are to be sustained. As researchers at Strategic Actions for a Just Economy have documented, such property upgrades can lead to “renovictions”—when a tenant is evicted following renovations—that are highly disruptive to tenants’ lives. In most places, tenants are not covered by any anti-rent gouging or rent control protections, making this chain of events legal and common.

   In an effort to limit this issue, the Department of Energy did condition IRA home rebate funding on a small set of tenant protections. Landlords who receive rebate funds for energy upgrades in low-income housing cannot evict tenants or increase rents as a result of the upgrades for two years following the rebate. This guidance serves as an acknowledgement from the federal government that tenant protections are needed, and goes beyond what many other federal programs have offered in regards to tenant safeguards. The protections, however, expire two years after upgrades take place. This short two-year window comes with almost no enforcement requirements or funding, leaving organized tenants and tenant advocates afraid that little will be done to keep tenants housed. Unless states build upon these rules and create strong enforcement plans, these tenant protections will likely be too limited to challenge the status quo of derisking landlords’ investments without tenant safeguards in place.

   Toward new horizons for green investments and tenant power

   Across the country, tenants are building the power and organizations to chart a new path forward for multifamily housing. At the most grassroots level, tenant organizers are taking conditions and clean energy demands into their own hands. The Los Angeles Tenants Union (LATU) launched “repair and deduct” campaigns, where tenants make their own repairs and deduct the costs from the rent. The LATU has also forced landlords into signing contracts outlining specific repairs that will be completed, using rent strikes as a tactic to bring the landlord to the table. In Kansas City, KC Tenants successfully organized tenants to confront a negligent landlord over repairing the heat at a property that was home to primarily Burmese refugees and Mexican immigrants. Beyond the objective of winning much-needed improvements, these actions advance the project of building political power for tenants. Tenant organizing creates formidable social and electoral blocs in localities to contest the status quo, whether through pressure campaigns on landlords or on public authorities.

   In the legislative arena, campaigns aimed at regulating the private market and creating a more fair tenant-landlord relationship are also gaining steam. Such state and local campaigns are essential policies to guardrail IRA implementation. There has been a resurgence in campaigns for rent regulations, with serious campaigns in at least fifteen states just this last year alone. Good cause eviction protections are also gaining momentum. This year, Colorado, which is slated to receive over $140 million in IRA home rebate funding, passed a good cause eviction bill through the legislature, and several more states are considering this legislation in real time.

   Such state and local campaigns also begin to assemble the political materials for national coalitions incorporating the tenant interest. The tenant-led Tenant Union Federation is one such initiative pushing for the Federal Housing Finance Agency to condition federally-backed loans on a set of tenant protections and rent regulations, which could cover up to one in four rental apartments in the country. These important campaigns would provide urgent protections to keep people housed, and could enable green investments to flow to renters without displacement.

   These efforts will help safeguard tenants from displacement and build tenant power. For many of these tenant organizing projects, the north star guides even further, all the way to green social housing. Permanently affordable, resident-controlled housing that exists outside of the speculative market can provide climate resilience and drive decarbonization. Social housing efforts currently underway are not focused solely on new housing construction, which only accounts for 3.5 million units in the last twelve years, but also on a commitment to improving the current living conditions of millions of working-class tenants. Labor unions were key players in building the social housing of the late twentieth century, and unions representing teachers, healthcare workers, and trades sectors are joining with tenant advocates to make a renewed push for social housing in the face of high costs and limited supply. In New York, for example, the Carpenter’s Union and the United Federation of Teachers have joined the fight for green social housing. In Los Angeles, UNITE-HERE, UTLA, and the LA/OC Building Trades Council joined together to win a new tax on high-dollar real estate sales raising $900 billion a year for the city’s housing department, including funds for rehabilitation.

   By focusing on the tenant and climate crises under one policy proposal, new political alliances can help realize a just transition for workers and tenants.

   This year, the Connecticut Tenants Union organized and won the first collectively bargained lease in the state, a victory against Ocean Management, one of New Haven’s largest landlords. The lease mandates routine maintenance and prohibits costs from being passed to tenants through rent hikes. Now, tenants at this seventy-unit building are trying to buy their property and turn their community into a democratically governed cooperative. They want community space, permanently affordable units for families with kids, and solar panels on the roofs. They want to generate enough clean electricity to feed it back to their surrounding community, including to the school next door.

   It is precisely because home upgrade efforts can increase the value of a property, which in turn allow the owners to increase the rents they can charge, that conflict is inherent in this area of climate change mitigation policy. Continued disinvestment is the cost for continued occupancy; displacement the condition for investment. There are few laws to limit this pattern. Climate policies that aim to reach frontline communities must contend with this, and ensure its approach fosters—rather than harms—tenant stability. Without supplementary reforms to address the imbalanced power dynamic and misaligned incentives between landlords and tenants, the IRA will fall short of enabling climate resilience for tenants. The path toward decarbonizing the US rental housing stock lies in the prioritization of tenants as protagonists in the just transition and a stronger commitment in policy and implementation to decarbonization without displacement.

7. The View From Nairobi-Washington

   July 4, 2024 9:49 pm Comments Off on The View From Nairobi-Washington

   On June 25, crowning a dramatic, nationwide tax revolt, demonstrators in Nairobi stormed Kenya’s parliament buildings. President William Ruto’s new finance bill, introduced in Parliament in May, sought to increase levies on everything from bread and money transfers to sanitary items and cellular data. In response, the “Gen-Z” generation that has been criticized for not being politically active took it upon themselves to organize on TikTok and mobilize in the streets.

   The public mood was souring even before the social explosion. Last year, Kenyans reported the second highest share of people struggling to eat globally, and the highest share of people fearing political unrest that would lead to violence. Public services have deteriorated rapidly with hospitals virtually empty, running out of essential medicines, and doctors striking for pay and better funded facilities. Since mid-2021, Kenya has spent twice as much on interest payments as on health. Joblessness is rising.

   Kenya is not alone in its crisis. The majority of the world’s governments have undertaken austerity policies, under either direct IMF pressure or the indirect discipline of other creditors. Last spring, we warned that such moves would cause societies to boil. According to the World Bank, three in five low-income countries are now at risk of, or are already in, debt distress. No less than twenty-one sub-saharan African countries are in an IMF program. Eighteen countries defaulted between 2021 and 2023, but balance sheet calamities rarely get the attention of the international media—until social crises, dramatic protests, and violent repression break through.

   

   The cure to debt distress is not regressive taxation. On June 13, Budget Day in Kenya, protestors disrupted parliament in an effort to halt the new bill. “We cannot continue to be ruled like this; by sick people. By mad people. Liars and thieves and criminals,” said the activist Julius Kamau. 

   As the protests gained momentum, Ruto’s government responded violently, deploying the military to protect the parliament. The military shot live rounds, killing 39 people and injuring hundreds, according to the Kenya National Human Rights Commission. After initially blaming the violence on “criminals” who had “hijacked” the protests, and facing a snowballing legitimacy crisis, Ruto gave in to protestors’ demands and withdrew the finance bill. (And this week, Ruto’s response has continued: to allay corruption concerns, he dissolved forty-seven state agencies and cut budgets for foreign junkets.)

   Legitimacy matters to Ruto because he portrays himself as an anti-establishment figure, criticising previous Kenyan government “dynasties” for excessive borrowing, and using subsidies to pander to ethnic groups while delivering poor public services. Hence the sense of betrayal from Ruto’s base of countless unemployed and underemployed young voters in the so-called “Hustler movement,” who have, writes the political scientist Ken Opalo, developed “unprecedented levels of public interest in the minutiae of economic policymaking over the last two years.”

   As with many other countries in 2024, Kenya’s predicament can be traced to the unjust financial architecture, Covid-era shocks to the credit, food, and energy markets, interest rate hikes by Western central banks, and climate-fueled disasters. (In the last four years, the country has been hit by devastating drought, floods, and even locust swarms.) None of these are within the control of the Kenyan government—which is not to say that poor governance and corruption has not contributed to the crisis.

   At the Summit for a New Global Financing Pact in Paris last summer, President Ruto had bluntly told assembled heads of states that a new financial architecture must be created so that “governance and power is not in the hands of a few.” Ruto’s diplomatic efforts were frenetic over the course of the following year. Despite making sixty-two visits to thirty-eight countries, he was nonetheless unsuccessful in getting concessional finance or debt relief. The international financial system remains extractive, with money gushing out of poor countries into the coffers of the wealthiest. To a large extent, it was this fact that laid the ground for Ruto’s austerity.

   

   Ruto’s attempts to solve the crisis

   Since becoming president in September 2022, Ruto has achieved something few leaders of poor countries have managed. He has been granted an audience with G7 heads of state, feted on a US state visit, and received airtime in the elite international media for something other than war, corruption, and crisis.

   Like Barbados’s Prime Minister Mia Mottley in her Bridgetown Agenda, Ruto has been  advocating for financial justice, climate action, and strategic agency for poor nations. His calls for global tax reforms led to the formation of a French-Kenyan-Barbadian taskforce that is exploring all options. The “Nairobi–Washington Vision,” released as part of Ruto’s state visit to Washington in May, sets out an agenda for international financial institutions to create coordinated packages of support so that “high ambition countries don’t have to choose between servicing their debts and making necessary investments in their futures.”

   

   Through all this, Kenya has been under acute liquidity pressure. Lenders had for some time been anticipating how Kenya would repay the principal of a ten-year, $2 billion eurobond that matured in June. With the Kenyan shilling under pressure, the country scrambled to retire the bond early, using proceeds of a $1.2 billion World Bank facility and issuing a new $1.5 billion bond—essentially punting these repayments to a future date.

   But the immediate driver of Kenya’s austerity program is its need for several hundred million dollars on top of the almost $4 billion already extended to it by the IMF. In return, the IMF is demanding that Kenya repay its debts. This will mean selling state assets and state-owned companies. In October last year, the Kenyan Treasury was empowered through a change of legislation to sell state-owned enterprises without seeking approval from Parliament. Eleven state-owned enterprises have already been privatized and stakes have been sold in another thirty-five public firms through the Nairobi securities exchange. Those on the auctioneer’s block included the public national oil corporation (NOCK), pipeline company (KPC), machining company (NMC), vehicle manufacturing company (KVM), seed company (KSC), rice milling companies (MRM and WKRM), milk company (NKCC), and the textile company (REAL).

   Could Kenya default?

   Now that increasing revenues from taxes has been taken off the table, cuts to government spending will be even harsher. Debtor countries are forced to make terrible choices between debt payments and food provision, energy and social services. They often prioritize debt payments so as not to risk the ire of creditors, and to retain the existentially important ability to raise US dollar-denominated debt from global bond markets.

   The IMF just last week included Kenya in a list of sub-Saharan African countries that had issued bonds for the first time since the Covid pandemic, “signalling investor confidence that those countries can repay their debts.” But as the African Sovereign Debt Justice Network noted earlier this year, it is a perversity to see these bond issuances as a sign of a country’s healthy position in the global financial system, while ignoring the exorbitant interest rates demanded by bond investors. Kenya’s new bond issued in March has an interest rate of 10.375 percent—vastly higher than the 6.875 percent ten-year bond that it helped to replace.

   Repaying debts at all costs or simply defaulting are not, however, the only options available to countries in Kenya’s situation. Brad Setser noted that markets were expecting a restructuring of Kenya’s debt—that is, negotiating an adjustment to the terms of repayment. Sovereign bonds are governed under New York State law and debt justice campaigns have advocated for legislation to bring private creditors to the bargaining table.

   Kenyan officials were seeking some form of debt relief in talks with IMF and World Bank counterparts at last year’s Spring Meetings. The IMF, critical to pursuing any restructuring, has urged the Kenyan government to stay the course with austerity measures. “The authorities should be resolute in their actions to help keep confidence anchored,” it says of a plan to cut the debt-to-GDP ratio to 55 percent by 2029 (it has recently hovered around the mid to high 60 percent level).

   Few countries pursuing strict debt reduction goals have escaped social and political upheaval. A Brookings Institute paper by Janice C. Eberly, Barry Eichengreen, et al identified Jamaica as one of the very few countries to steadily and dramatically cut its sovereign debt to GDP ratio without domestic turmoil. Key to its success was the consultation between sectors: “democratic corporatism” and its “social partnerships” between civil society, unions, and so on, that were developed over decades following the horrifically violent 1979 elections. Achieving this kind of coordination is slow work, and the paper’s authors propose that being a small country helps: only Ireland, Iceland, and Barbados have had similar success. Kenya, on the other hand, is home to fifty-six million inhabitants and is the economic, logistical, and financial hub for all of East Africa. There is no instruction manual for reducing its sovereign debt.

   A Nairobi-Washington vision?

   When the protests in Nairobi were met with deadly force, there was a sense of awkwardness for the Biden administration, which had just days before designated Kenya a “major non-NATO ally”—the first in Sub-Saharan Africa—a relationship expressed in the deployment of 400 Kenyan troops to “restore peace” in Haiti and stepped up joint operations against Al-Shabaab insurgents in Somalia.

   

   Ruto’s Washington visit last month advanced green “technological cooperation” with the US. The idea is for the US to facilitate investments in Kenya’s green growth agenda—data centers, geothermal electricity, electric two wheelers, green fertilizers—that Ruto launched as a “African Green Investment Initiative” at COP28 with $4.5 billion from UAE. The West, as we anticipated, has effectively outsourced funding of the energy transition to Gulf Kingdoms that are flush with oil cash, having already left an increasing portion of development funding up to China and private capital in the decade or so prior.

   The Emiratis want to turn Kenya into the center of technological innovation on the continent. The US and UAE have together gotten Microsoft and UAE-based tech firm G42 to invest $1 billion in a geothermal-powered AI data center campus in the Great Rift Valley. Kenya is thus a beneficiary of the US-China chips war: To make the deal happen, the Biden administration approved Microsoft-G42 use of cutting edge NVIDIA AI chips in exchange for G42 agreeing to cut ties with Chinese companies like Huawei.

   It is good for Southern elites to win such technology investments. But while the New Washington Consensus delivers full employment and trillions in deficit-financed welfarism and public investments in the North, the Nairobi-Washington vision for which Ruto is a stand-in is insufficient for fostering prosperity across the South—where debt-stressed countries with soaring joblessness are imposing class war austerity and privatization, amid Western intransigence in delivering touted financial architecture reforms.

8. Trade and the Manufacturing Share

   June 28, 2024 2:19 pm Comments Off on Trade and the Manufacturing Share

   One of the concerns in American policy circles in recent years has been the long-term impact of foreign trade and industrial policies on the health and strength of American manufacturing. The Trump and Biden administrations tried to address this weakness when the former, in 2018 and 2019, put into place tariffs on hundreds of billions of dollars of Chinese imports, and the latter announced in May of this year that it was raising tariffs on other goods. It is clear that whoever wins the election in November, this attention to trade among US policymakers will only continue, and indeed is spreading throughout the world.

   But as long as the US continues to play its role of global consumer of last resort—as long as it continues to run trade deficits large enough to absorb up to half of the trade surpluses of the rest of the world—we are unlikely to see a revival of US manufacturing overall. That’s because when it comes to trade imbalances and the strength of manufacturing, the global pattern is pretty clear: while manufacturing comprises 16 percent of global production (GDP), according to the most recent World Bank data, it comprises a much lower share of GDP for advanced economies that run persistent trade deficits, and a much higher share for those that run persistent surpluses.

   Among advanced economies that in recent years have run persistent trade deficits, for example, manufacturing comprises 11 percent of US and Spanish GDP, 10 percent of France’s, 9 percent of Canada’s, and 8 percent of the UK’s. Among those that run persistent surpluses, it is 18 percent of German and Swiss GDP, 21 percent of Singapore’s, 26 percent of South Korea’s, and 34 percent of Taiwan’s.¹

   The graph below shows the relationship between the manufacturing share of GDP and the current account deficit for the ten largest advanced economies during three different years—2000, 2010, and 2020.² As the graph shows, advanced economies with current account surpluses mostly have manufacturing shares of GDP that are above the global average, and advanced economies with current account deficits mostly have manufacturing shares of GDP that are below the global average. On average, the manufacturing share of GDP is 3.4 percentage points above the global average for surplus economies and 3.5 percentage points below the global average for deficit economies.

   

   Japan’s history is especially instructive in this respect. In the 1980s and early 1990s, when Japan ran the world’s largest trade surpluses, the manufacturing share of its GDP averaged between 25 and 27 percent, among the highest of any advanced economy. With the end of the Japanese asset bubble in the early 1990s, its trade surplus began to decline, and as it declined, so did the role manufacturing played in Japan’s overall GDP, until in the past two to three years, at a time when it has been running trade deficits, manufacturing has comprised just 19 percent of its GDP.

   Why does manufacturing play a markedly more important role in surplus economies than in deficit economies? The relationship isn’t just coincidence. While economists often assume that the strength of the manufacturing sector in any country has more to do with intrinsic drivers of comparative advantage than with trade imbalances and other external factors—and often argue that the declining share of manufacturing in the US economy represents a natural evolution among advanced economies—in fact the circumstances that lead to trade imbalances also affect the ability of that country’s manufacturing sectors to compete globally.

   This is because what matters is whether success in exports is driven by rising productivity or by suppressed labor costs. In the former—i.e. in economies with highly efficient manufacturing—rising productivity drives rising wages, so that the more productive workers are, the more they get paid. This allows them to consume in line with what they produce, which also means that the country imports as much as it exports. Successful manufacturing exporters with balanced trade are economies that export a specific set of products, enjoy comparative production advantage, and use the revenues generated by those exports to pay for imports in those areas of manufacturing in which they do not enjoy comparative production advantage. This is the classic role trade is meant to play.

   But this is not the case in economies that run persistent surpluses. Surplus economies tend to export a much wider set of manufacturing products, and they import less than they export largely because domestic demand is insufficient to convert export revenues into an equivalent amount of imports. A trade surplus, in other words, simply means that domestic demand is too weak to allow the economy to absorb the equivalent of what it produces. 

   And it is almost always too weak because of the low share workers in these economies—compared to their counterparts in deficit countries—directly and indirectly retain of what they produce. This is why these economies must run surpluses to sustain employment and growth: their citizens cannot consume in line with what they produce.

   Successful exporters with balanced trade are very different from successful exporters with persistent trade surpluses. In the latter case, the policies that prevent wages from keeping up with the productivity of workers explain both their global competitiveness and their weak domestic demand. But what economists often fail to realize is that the policies that prevent wages from keeping up with the productivity of workers don’t just affect the surplus economy that implements them. They have the obverse effect on the economies of their trade partners. 

   Consider, for example, a country that devalues its currency to make its exports more competitive on global markets. Undervalued currencies affect the domestic distribution of income by penalizing net importers within a country (by raising the cost of imports) while benefiting net exporters (by raising their sales and profits). This redistribution of income within the economy acts as a transfer in which net importers are effectively forced to subsidize net exporters.

   Because all households are net importers, and net exporters are mainly producers of tradable goods, undervaluing the currency effectively forces households to subsidize producers. In that case, manufacturers become globally more competitive while households become less able to consume. This is what it means to say that the export competitiveness of producers in such an economy is simply the obverse of weak domestic demand.

   But the impact doesn’t stop there. The opposite happens with its trade partner. If one country’s currency is undervalued, by definition the currency of its trade partner must be overvalued. In that case its trade partner has the obverse transfer, and so its manufacturers are forced to subsidize its household consumers. This mirror reaction of one economy to a trade policy in another economy is the automatic consequence of the need for trade to balance globally, and for global investment to balance global savings. If one country forces its household consumers to subsidize its manufacturers to the point where it must run trade surpluses, those manufactures must subsidize household consumers in another country.

   This reaction occurs with any form of trade and industrial policy, and not just with currency devaluation. A wide variety of mechanisms create this dynamic—including direct subsidies to manufacturers, fragile workers’ rights, managed credit, weak social safety nets, and even overspending on business infrastructure—but they all work in broadly the same ways. They effect income transfers that force consumers to subsidize production in the economy that implements the measures, and force producers to subsidize consumption among their trade partners.³

   In that case, it can be no surprise that the former must run trade surpluses to balance their weak domestic demand, and their trade partners must run deficits to balance excess demand—in other words, “excess” demand relative to weaker domestic production of tradable goods. That much is easy to understand.

   But this dynamic also explains why manufacturing must comprise a higher share of GDP in the surplus economies than in the deficit economies, and consumption a lower share. To remain globally competitive in a hyperglobalized world in which communication and transportation costs are extremely low, global manufacturers have little choice but to migrate to jurisdictions where their operations are most heavily subsidized—to where workers are paid the lowest wages relative to their productivity.

   There is no mystery, in other words, as to why advanced economies with persistent surpluses are also economies in which manufacturing plays a larger role in the economy, and why advanced economies with persistent deficits are those in which manufacturing plays a smaller role. In either case, global manufacturing is simply migrating to where the subsidies are greater, while consumption must migrate in the opposite direction.

   And as long as the former continue running surpluses and the latter continue running deficits, distortions in the role of manufacturing in their economies are likely to continue. This has an important implication for countries like the US that are concerned about reviving their manufacturing sectors. It means that they must not only implement trade and industrial policies that support specific sectors of their economies. They must also exit from the trade-deficit dynamic of producing fewer manufactured products (and other tradable goods) than they consume.

   There are broadly three ways a persistent deficit economy like the US can respond to its trade and manufacturing imbalances. One way is if Washington decides to do nothing, implementing neither trade nor industrial policies to counter policies implemented abroad. This refusal to impose countervailing measures doesn’t mean that the US economy is absolved from government intervention in the economy. It will continue anyway to be affected by industrial policy, but this policy will be designed abroad—in Beijing, Berlin, Tokyo, Seoul, Moscow, Riyadh, Tehran and other centers whose policies cause their economies to run persistent trade surpluses. In that case American “industrial policy” will effectively be the obverse of whatever policies its more aggressively mercantilist trade partners choose for themselves.

   The second way the US can respond is if Washington chooses to implement its own countervailing industrial policies in order to protect and expand strategically important sectors of the economy. In that case, while the US can encourage specific manufacturing sectors, its continued trade deficits—a required condition as long as the US persists in absorbing the excess savings of its trade partners—mean that the overall US manufacturing sector will prolong its long-term weakness. Strategically important sectors of the economy may do well, in other words, but only at the expense of the rest of US manufacturing.

   Finally, Washington can choose to opt out of its accommodating role in absorbing global trade and capital imbalances. This will allow it to protect American manufacturing in general, but not just in strategically important sectors in which other countries have already obtained a comparative advantage—like China with electric vehicles, solar panels, and batteries. The most likely way the US might opt out of its outsized role in absorbing global imbalances would be by imposing across-the-board tariffs on US imports or—more effectively—by restraining unfettered access to US financial markets.

   The latter would involve some form of capital controls that restrict the ability of foreigners to dump excess savings into the US economy. Capital controls come in many varieties and are quite widely used around the world to prevent overvalued currencies, speculative money flows and disruptions in local credit markets. In the US they were used as recently as the early 1980s.⁴ The net impact of limiting access to claims on US assets is that countries who repressed domestic demand in order to subsidize their manufacturing industries would not be able to externalize the cost of those subsidies by acquiring US assets to balance their trade surpluses.

   The recent tariffs imposed by the Trump and Biden administrations have set off a great deal of discussion about trade and industrial policies, but bilateral tariffs cannot address fundamental trade imbalances. While these tariffs may strengthen manufacturing sectors that the US considers strategically important, they will not result in an overall revival of American manufacturing. As long as the US is willing to run the persistent deficits needed to absorb global excess savings, it must accept the continued erosion of its share of global manufacturing. To revive US manufacturing requires much deeper structural changes that either eliminate persistent trade imbalances in the global economy, perhaps through new global trade agreements, or that unilaterally revoke the US role in absorbing them.

9. Battery Supremacy

   June 27, 2024 6:40 pm Comments Off on Battery Supremacy

   In the Summer of 2022, Viktor Orbán sparked international outrage by lamenting that countries where Europeans and non-Europeans mingle were “no longer nations.” Amid the uproar, a dramatic pronouncement in the same speech largely escaped notice: Orbán declared his ambitions to make Hungary a “superpower” in electric vehicle (EV) battery production, with the world’s third-largest manufacturing capacity.

   The scale of the economic undertaking was staggering. Orbán aimed for a dominant position in a key value chain, trailing only China and the United States and competing with Germany. The ambition far exceeded the size of the Hungarian economy, which is roughly equivalent to the Munich metropolitan area. And the rhetoric was backed with action: by luring South Korean and Chinese gigafactories with generous incentives, Hungary developed an EV battery manufacturing capacity of 87 GWh per year, reaching 4th place in the global battery race.

   Orbán’s program baffled many Hungarian economists, who questioned the decision to  bet so heavily on a single, technologically volatile industry in the absence of sufficient energy, water, and labor force to support production at this scale. The strategy conjured memories of the forced industrialization of the Soviet-era, and pipe dreams to turn resource-poor Hungary into “the land of iron and steel.” 

   The new industry also came with devastating ecological costs: battery gigafactories have brought a relentless flow of news headlines about environmental damages, including toxic chemicals found in groundwater. This sparked public outrage in communities near existing and planned production sites. Following the announcement of Chinese battery giant CATL’s gigafactory in the Debrecen area, a public hearing on the factory’s environmental permits descended into chaos and fistfights. The regime crushed dissent—scrapping mandatory public hearings by decree, blocking referendums and data requests, and harassing and intimidating protesters.

   Yet, the Hungarian strategy garnered support from an unlikely source: Brussels. Battery production is central to the European Union’s new industrial policy paradigm. Despite Orbán’s open political conflict with European institutions, EU Commission Vice President Maroš Šefčovič lauded Hungary as a “pioneer” and a “champion” of decarbonization objectives and strategic autonomy.

   In its desperate attempt to catch up with China, the EU has reduced scrutiny over member countries’ industrial policy aims. This will have long term implications. While Hungary’s powerful EV battery sector may appear to advance EU objectives, it generates profound ecological damage and increased geopolitical risk. Orbán seeks leverage control over a key value chain as a political weapon.

   The EU’s EV push

   The European Commission has long set its sights on EV battery technology. The sector occupies a central position in the EU’s revitalized industrial policy drive. In 2017, the European Battery Alliance was formed to coordinate stakeholders and facilitate the construction of 20–25 gigafactories in Europe. At that time, automakers were hesitant to invest in their own capacity for battery production, citing market uncertainty and funding constraints. The Commission intervened with a Strategic Action Plan on Batteries in 2019, asserting the industry as “a strategic value chain, where the EU must step up investment.”

   Since then, several developments have propelled the sector forward. In 2020, the EU Green Deal mandated bloc-wide climate neutrality by 2050. To that end, the union banned the sale of polluting vehicles beginning in 2035. Importantly, the EU significantly relaxed its prohibition of state aid—prior to November of 2021, governments were largely prevented from subsidizing domestic companies in order to ensure a level playing field within the common market. Together, these initiatives have encouraged generous subsidies for gigafactory projects across the continent.

   Re-shoring battery production is not the most expedient path to decarbonization. China, Japan, and Korea together hold over 90 percent of market share in batteries and have a sizable cost-advantage due to energy price differentials. The EU nonetheless wants to move away from import-reliance and justifies its pivot on three grounds: climate neutrality, strategic autonomy, and the protection of Europe’s automotive industry.

   EU officials argue that battery cells produced elsewhere may lack the EU’s environmental standards. They also highlight heightened supply chain disruptions that may risk import supply. By localizing production, the EU aims to lessen vulnerabilities amid geopolitical tensions and trade uncertainties. Increasingly conscious of the possibility for “weaponized interdependence,” EU officials are wary of opportunities for nontransparent, nondemocratic regimes to exploit trade dependencies for coercive purposes, a concern intensified by Russia’s leveraging of energy. If China were to invade Taiwan, prompting Europe to reply with economic sanctions, severing trade ties with China would be extremely costly.

   Finally, Europe’s automotive industry is the backbone of its manufacturing employment. The industry has already suffered setbacks given the progressive phase-out of the internal combustion engine. Since the Biden administration’s Inflation Reduction Act showered green (and not so green) industries with subsidies, fears that the continent will see its industrial base diminish have become more widespread.

   Assessing alignment

   The Hungarian battery industry undermines two of these stated aims. Because the EU leaves monitoring and enforcement of its climate standards to member states, they can easily disobey. In fact, investors were drawn to Hungary by explicit promises of relaxed regulations, including streamlined permit procedures and exemptions from mandatory environmental impact assessments. The manufacturing of EV batteries is extremely energy-intensive. An energy-poor country, relying heavily on Russian natural gas imports and lagging behind on renewables, has neither the resources nor the network infrastructure to sustain the industry. Water usage in the face of frequent droughts is also causing anxieties—the estimated daily water demand of Samsung’s factory in Göd is equivalent to a city of 120,000 people. Many of these production segments are low value-added, highly water- and energy-consuming, involve hazardous toxic chemicals, and localizing them may adversely impact other environmental goals.¹

   Hungary’s EV battery push also deviates from the EU emphasis on strategic autonomy. Though inviting Chinese companies like CATL to build battery factories in Hungary does offer a closer supplier, it offers little protection in the face of a serious geopolitical fallout. Orbán is unlikely to expropriate factories, as are the Germans who have recently demonstrated their reluctance to seize Russian assets.

   Strategic autonomy is further undermined by the Orbán regime’s vehement opposition to loosening ties with Russia or China. The administration has been obstructing sanctions (calling them “pointless exhibitionism”) and remains steadfast in sourcing Russian natural gas. Hungary has welcomed billions in Chinese investment (often financed by opaque Chinese loans) and even invited Chinese police to patrol the streets of Budapest.

   Ironically, in its attempt to reduce dependence on nondemocratic external partners, the EU might find itself reproducing such a reliance within its own borders. Hungary’s centrality in a key value chain could enable Orbán to shield his autocratic regime from EU-level censure and ensure the flow of EU funds to his networks. It is a concerning political exposure, given Orbán’s demonstrated propensity for open blackmail—and exactly the type of risk that the EU’s pursuit of strategic autonomy aimed to counteract.

   The primary incentive driving the EU’s support for Orbán, then, appears to be the protection of the European carmakers and industrial base. It is unclear, however, why the EV industry has been singled out as the continent’s jobs engine. If taxpayer resources are used to create jobs and prop up industries, ensuring high domestic value-added and the ability of local firms to join the value chain should be guiding principles. This was the traditional aim of industrial policy: to move up the value chain. Hungary’s EV battery industry, by contrast, generates three-shift assembly line jobs in foreign-owned battery factories—a far cry from high quality jobs creation.

   With Chinese firms’ dominance in the entire EV industry (and other green technologies), embracing Chinese FDI may be inevitable. In fact, it is no longer accurate to speak of a battery race—it is a landslide victory for China. If Europe wants to catch-up, low value-added manufacturing could arguably pave the way for further development. Welcoming market-leading firms like CATL can foster dynamic production networks: joint ventures with local partners, technology transfer, and eventual upgrading or leapfrogging.

   But there are reasons to doubt this optimistic scenario in the Hungarian case. Upgrading would require upskilling—and decades of defunding in Hungary’s education sector severely constrains these prospects. Leapfrogging failed to materialize in the case of Western-European (mainly German) FDI, and it appears more challenging with Chinese or Korean investors, known for tightly guarding technology and R&D. What further sours the economic calculus is the fact that the state foots a significant bill, covering on average 15 percent of the investment value in subsidies and additional sums in infrastructure development.

   Hungary’s bid for battery supremacy is political, not economic. Throughout the past fourteen years, Viktor Orbán has learned that catering to the German automotive industry can protect his regime from EU censure. Hungary transitioned into an autocracy, marked by an increasing crackdown on civil rights and widespread corruption, yet German FDI kept flowing. The alignment of interests between Orbán and German industry has contributed to the “EU’s authoritarian equilibrium,” in which the German conservative CDU/CSU parties cooperate with Orbán in exchange for favors to their key industry.

   In 2022, the EU shifted to a more proactive stance against democratic backsliding. As a historic first, it utilized financial sanctions: the bloc suspended €34.1 billion in development funds, citing breaches of the rule of law. In this openly contentious relationship, Orbán surely sees the value in controlling a choke-point for German car-makers. While national borders often lose economic significance in value chain geography, a critical production segment clustered under Hungarian jurisdiction can hold political relevance. This opens the door to weaponizing the value chain, for instance, by obstructing battery cells’ export permits or applying other punitive administrative measures.

   Searching for alternatives

   Hungary is not the only EU country pursuing an industrial policy focused on battery production. Battery factories are rapidly being rolled out across the Union, although not at uniform speed. Over the next six years, the bloc is poised to meet its motor vehicle production demands with domestically manufactured batteries, achieving a total capacity of 1,319 GWh per year.

   The largest economies, Germany, France, and Italy have announced gigafactory projects, aiming to supply battery cells sufficient for about 150 percent of their current production volumes (importantly, these are maximum capacity numbers, factories can always produce less). Ownership profiles of these planned investments vary greatly, however (Figure 2).

   Figure 1. Planned battery cell production capacities by 2030 in GWh (maximum capacities) ‒ compared to demand estimates

   

   Figure 2. Ownership patterns of planned battery gigafactories, GWh of capacity

   

   In the German case, where by far the largest capacity is needed, domestic firms contribute to a smaller extent than in France or Italy. Over a third of Germany’s capacity is set to be produced by China’s CATL, the same firm that has ignited strong local political pushback in Hungary.

   EU officials typically highlight that battery production is a rapidly growing market, with an estimated annual value of up to €250 billion by 2025. If EU countries are to appropriately seize market share, domestic value added will be key.

   Value creation is distributed unevenly in global value chains: it is highest in pre-production (R&D, design) and post-production (marketing, sales), but lowest in assembly work. Therefore, rather than batteries “Made in Europe,” the aim for growth should be batteries “Invented in Europe.” These technologies evolve in fast and nonlinear ways, so European ownership and control of these firms should be at the heart of growth strategies. Luring Chinese assembly lines into Europe is unlikely to do the trick.

   Swedish battery production offers a useful point of comparison. The country’s 2020 battery strategy was created in an inclusive process that involved stakeholders from industry, local governments, and academics. So far, gigafactories in Sweden produce 60 GWh of capacity per year, and an additional two are planned to add another 100 GWh by 2025. Outstripping even the Hungarian capacity/demand ratio of 600 percent, this will amount to a capacity/demand ratio of 700 percent. Unlike the Hungarian case, which involves no domestic companies, the Swedish strategy is built around Swedish-owned battery giant Northvolt, and its joint venture with Volvo. This ensures that higher value-added activities like R&D happen locally, promising a much stronger growth engine. Dóra Győrffy’s analysis highlights that, while Hungary notably lacks all important production factors, particularly energy and water, Sweden’s strategy is strengthened by local access to raw materials and, crucially, a robust renewable energy sector. The cold climate in Sweden reduces the need for extensive cooling in battery production, leading to lower water usage. In contrast to Central and Eastern Europe’s race-to-the-bottom to attract investment, the Nordic Battery Belt is a collaborative project of Sweden, Norway, and Finland.

   The Swedish case demonstrates that under the right conditions, the EU-based battery value chain can indeed fulfill the desired aims—it can provide a viable growth impetus through a “national champion” firm like Northvolt, its environmental footprint can be mitigated if renewables are used to cover the production’s energy needs, and an EU-based firm can contribute to strategic autonomy.

   Lessons for Europe and beyond

   The Hungarian case raises concerns about the EU’s new “geopolitical” industrial policy, which seems blind to the leverage risks posed by an autocratic member state. In the bloc’s so-called friendshoring efforts, it should more carefully assess who its friends really are.

   Furthermore, if the EU is serious about its environmental pledges, it ought to strengthen its monitoring and enforcement capacities. There are stringent and progressive regulations in place, but enforcement remains weak. Strengthening it might entail the creation of a new EU Environment Authority or better corporate due diligence frameworks to sanction environmental and labor rights violations.

   A common European subsidy scheme would also be preferable to relaxing state rules. Competitive EU subsidy wars harm the public as well as fiscally weak and small member states. In Hungary’s case, the added insight is that an autocratic regime can more successfully play the race-to-the-bottom by squeezing the public sector to reorient funds, or lifting environmental or labor protection standards without facing political accountability.

   The academic literature often links the effectiveness of industrial policy to state capacity while overlooking the role of democratic oversight. This case highlights that without transparent and inclusive processes, industrial policies risk being derailed. It is essential that various stakeholders, like environmental NGOs, local governments, academics, trade unions, and journalists have a seat at the table.

   Finally, as the EU and member states pour fiscal resources into the EV industry, a critical question arises: is there a comparable commitment to fundamentally transforming mobility towards more sustainable, less car-dependent models? A truly sustainable approach would aim not just for more electric cars but for fewer cars overall. Moreover, higher levels of infrastructure development and maintenance may be more effective engines for job creation in the long run.

10. Driving Capital

    June 20, 2024 9:06 am Comments Off on Driving Capital

    Since President Biden signed the Inflation Reduction Act (IRA) into law in August 2022, the Mexican auto assembly and parts industries have been booming. Tesla and the Chinese state-owned carmaker Jetour announced the construction of new factories for electric vehicles (EVs) and gasoline cars, spurring investments down the supply chain. Tesla’s glass supplier AGP Group plans to open a factory accompanying Tesla’s in Santa Catarina, Nuevo León. In August 2023, Metalsa, a chassis manufacturer for Toyota, opened its second factory in Guanajuato. Tatiana Clouthier, Mexico’s former Secretary of the Economy, stated approvingly that the IRA “doesn’t discriminate against [Mexico’s] automotive industry,” echoing widespread optimism about the IRA as a massive investment in the Mexican auto industry that will generate jobs.¹

    By tightly linking the car manufacturing sector with the mining sector and climate strategy, the US law has major socioeconomic and political implications across borders. EVs, the digital economy, and the energy transition require nickel, copper, cobalt, and most importantly, lithium—all of which are now listed as “critical minerals” by the Mexican, Canadian, and US governments. The reception of the IRA in Mexico stands in stark contrast to criticisms from European nations, whose automakers are largely excluded from EV tax credits that require mineral and/or battery components to be sourced and processed in the US or in a country, such as Mexico, member to a US trade partnership. 

    The IRA arrives three years after the United States-Mexico-Canada Agreement (USMCA), joining a composite of policies that have transformed Mexico’s longstanding auto industry into an electric car manufacturing hub. To qualify for the IRA’s Clean Vehicle Credit, a vehicle must have undergone final assembly in North America, defined as the United States, Puerto Rico, Canada, and Mexico. This “regional value content” requirement for producers seeking to sell into the new US tax-subsidized consumer market reinforces the USMCA’s “rules of origin” standards for goods to qualify for the trade agreements tariff exemptions.

    Financial incentives for employers to geographically reorganize production also carry the promise of empowering Mexico’s workforce to bargain for higher wages, benefits, and participation in the economic life of their country. Two recent examples of this struggle between workers and producers in the auto industry, however, demonstrate the limitations the USMCA places on workers and government officials in Mexico and the United States who might otherwise attempt to make good on this continental promise. Parts makers VU Manufacturing and Unique Fabricating, both Michigan-headquartered companies, have responded to workers requests for collective bargaining through the USMCA provisions with capital flight—choosing to not comply with the labor provisions found in both the 2019 Mexican Labor Code and in what is seen as a historic agreement between Mexico and the United States. Whether the IRA will benefit Mexican workforces employed in the regional supply chains of car production remains an open question. 

    Labor and free trade

    Prompted by critiques of free trade during the Trump administration, the renegotiation of NAFTA in 2017 provided an opportunity to include labor in the main body of the agreement.² The resultant USCMA devotes multiple chapters to assuaging fears over the loss of US manufacturing jobs to Mexican workers. Voiced by both the protectionist right and the labor left, this concern thus invites a variety of solutions. In a set of recommendations for the renegotiation, the AFL-CIO argued that wages for Mexican auto workers should be high enough to grant them and their families a decent standard of living—access to food, water, housing, education, health care, clothing, transportation, and the ability to save for retirement and emergencies. Chapter 4 of the final agreement, “Rules of Origins,” reflects this concern, requiring “40-45 percent of auto content be made by workers earning at least $16 per hour.” 

    In addition to wage increases, the US’s largest labor federation recommended strengthening unionization, workplace democracy, and collective bargaining rights. Instead of pulling back trade, as more conservative protectionist rhetoric often recommends, these standards would level the playing field among North American auto workers. Thus, the final USMCA includes diverse mechanisms related to labor rights in Mexico. Chapter 23 “Labor” and Annex-23 A “Worker Representation in Collective Bargaining in Mexico” outline rights at the workplace and are in line with ILO Declaration on Fundamental Principles and Rights at Work. Annex 31-A, “Facility-Specific Rapid Response Labor Mechanism” (RRLM), which applies to Mexico and the US, allows workers to file petitions when their labor rights and freedom of association are denied; failing to comply with the UMSCA’s labor provisions can result in the suspension of preferential tariff treatment, imposition of penalties, and the prevention of the entry of products or services produced by the company.³ Since the enactment of the USMCA in July 2020, the RRLM has been deployed eighteen times.⁴

    The USMCA also established the Interagency Labor Committee (ILC) to enforce labor obligations, with an Independent Mexico Labor Expert Board to monitor and evaluate Mexico’s labor reforms. Together, these measures aim to uphold basic labor rights and raise wages in Mexico, correcting for asymmetries in labor’s power along the North American auto supply chain. Heralding this combination of high-road employment and international trade, the US Department of Labor’s Bureau of International Labor Affairs described the USMCA as having  “the strongest and most-far reaching labor provisions of any trade agreement.”

    Mexico’s labor model

    Prior to NAFTA, domestic industrial policy in Mexico largely shaped investment into the automotive sector. Considered capital and labor intensive, car production was central in industrializing the country and forming its industrial workforce during the era of import-substitution-industrialization (ISI, 1940-1970s). The government’s heavy intervention in economic development relied upon and strengthened a corporatist labor model that sought to empower industrial unionized workforces under the state’s main union, the Confederation of Mexican Workers (Confederación de Trabajadores de México, or the CTM).⁵ This model morphed into governing labor relations authoritatively and repressively benefiting the state and companies.

    Workers’ labor conditions and wages were determined by “employer protection contracts,” which are labor agreements that seek to protect investments over workforces’ interests. These contracts, which are endorsed by the government, are signed by employers and unions affiliated mainly to the CTM yet without the rank and file knowledge on the terms of the agreement. Employer protection contracts are a significant barrier to freedom of association and collective bargaining, creating a tight relationship between employers, unelected unions, and state officials to maintain optimal investment conditions. For decades, autoworkers—along with workers employed in other industrial sectors—have fought against the CTM and unions affiliated to this labor confederation. Thus, by extension, they have challenged the state and companies with the goal of improving labor conditions, workplace democracy, and worker representation. 

    In 2018, under the slogan of “The Fourth Transformation,” President Andrés Manuel López Obrador (2018-2024) began a series of structural reforms to Mexico’s economic model. On May 1, 2019—International Workers’ Day—López Obrador signed into law what could be considered the most significant reform’s to Mexico’s labor relations, terminating the existing model that created and perpetuated the “employer protection contracts.” The reforms to Mexico’s Federal Labor Code stipulated, among other changes, wage increases, the freedom to engage in collective bargaining, the freedom of association, and respect to unions. Between 2018 and 2024, the minimum wage increased by 110 percent, giving Mexico the sixth highest minimum wage in Latin America. The 2019 labor reforms were preceded by Mexico’s 2019 ratification of the Convention on Freedom of Association and Protection of the Right to Organize (Convention 98) of the International Labour Organization (ILO). The US has yet to ratify ILO Convention 98, while Canada ratified it in 2017. This was the domestic political context within Mexico when the country entered into negotiations with the Trump administration over reopening NAFTA and writing the terms of the new USMCA. 

    The 2019 reforms offer greater protections around collective bargaining than the USMCA—particularly on the all-important question of the right to strike. Mexico’s Labor Code article 387 stipulates that if the employer refuses to enter into collective bargaining, the workers can exercise that right. Under NAFTA, the right to strike was reduced to “mere consultation and left out of any enforcement mechanism [as] trade policy trumped labor policy.”⁶ Under the UMSCA, the right to strike appears as a footnote in section 23.3: Labor Rights instead of the main legal binding body of Chapter 23. 

    Since 2020, labor legislation in Mexico has been determined primarily by two legal bodies: the USMCA’s chapter 23, Annex-23 A of the USMCA, and Mexico’s 2019 labor law. While these may appear aligned, the contradictions between the goals of raising labor standards and of increasing international trade and investments become clear when considering the kinds of enforcement mechanisms the USMCA, like NAFTA, includes and for whom. 

    Capital flight

    At both VU Manufacturing in Piedras Negras, Coahuila and Unique Fabricating in Santiago de Queretáro, Queretáro, factories shut down operations in Mexico after they were ordered to comply with basic labor rights under the USMCA and Mexico’s Labor Code.

    VU Manufacturing produces plastic and vinyl interior automotive pieces with its headquarters in Troy, Michigan. Workers in the VU Mexico factory filed two complaints under the RRLM. The first complaint, concerning freedom of association, was successful, leading to the election of an independent union, La Liga. The second complaint alleged that VU refused to engage in contract bargaining. Mexico and the US declared the complaint valid, giving VU six months to implement a “course of remediation.” Instead, the VU shut down its Mexico factory and blacklisted VU labor leaders. The US Department of Labor investigation, which began in January 2023, was closed in October 2023.  Deputy Undersecretary of International Affairs Thea Lee responded to the factory closure by insisting, “We knew employers would not choose compliance in every instance.” The US Trade Representative Katherine Tai urged the Mexican government to “seek remedies for the affected workers and strategies to prevent retaliation against former VU workers at other facilities.”

    A similar scenario played out at Unique Fabricating, a plastics, foam, and rubber manufacturer headquartered in Michigan. After filing two complaints with the Labor Court in Queretaro, with no response, the democratically elected union Transformacion Sindical (TS) filed a complaint with the RRLM. Preliminary investigations confirmed the TS complaints, and the Queretaro Labor Court ruled in favor of TS. In April 2023, the Mexican and the US government announced the successful completion of the labor complaint filed under the RRLM. Unique Fabricating agreed to respect workers’ freedom of association and to comply with the 2019 Labor Code legal obligations. But in November 2023, the company announced bankruptcy and shut down its factories in Mexico, the US, and Canada. The Office of the US Trade Representative declined to conduct an investigation. The result was the same: workers lost their jobs, the state was forced to find “remedies,” and companies headquartered in the US faced little to no consequences.

    These cases shed light on the challenges in implementing the UMSCA’s labor provisions. The UMSCA lacks legal tools to enjoin corporations from defying their obligations to workers or the public good. Compare this absence with legally binding regulations that protect corporations’ investments, such as the investor-state dispute settlement (ISDS) enshrined in Chapter 14 and Chapter 31 of the USMCA, or NAFTA Chapter 11, used to sue the governments of Mexico, Canada, and the US. The ISDS enables corporations to receive monetary awards from the state if investments or even future profit are put in jeopardy by projects that benefit the common good—including for public health benefits, environmental protections, or the affordability of services such as electricity. According to Scott Sinclair, the ISDS empowers corporations to use a private justice system “to challenge vital and legitimate public policy measures.” The ISDS forces governments to either repeal laws and regulations for the public good, or pay “damages” to corporations with public money.⁷

    Under NAFTA, Mexico and Canada have paid millions of dollars to corporations in monetary damages plus legal fees, while the US has never lost a case. The USMCA was modified to significantly limit the ISDS for the US and Canada, but the mechanism can still be pursued in Mexico. Under the USMCA, the US and Canada have initiated two trade disputes against Mexico: the first is over Mexico’s energy reform, which gives preference to Mexico’s state-owned company over the distribution of electricity; the second concerns Mexico’s ban on genetically modified corn imported from the US. The cases suggest that like NAFTA, the UMSCA’s main goal is to continue facilitating investments regardless of their social and environmental consequences.

    VU Manufacturing and Unique Fabricating exemplify how multinationals respond with capital flight when investments in Mexico are threatened by labor provisions found in the UMSCA and Mexico’s labor code. There are no mechanisms similar to the investor-state dispute settlement (ISDS) found in Chapter 14 and Chapter 31 of the USMCA, or NAFTA Chapter 11, to hold corporations accountable in the sites where their subsidiaries are located and to the workforces in such locations. That US multinationals closed down operations in Mexico with such ease, and the US government was unwilling to intervene, suggests that the UMSCA is a mechanism to protect the investments of US corporations. 

    These cases also demonstrate how US-based corporations—and by extension the US government—transfer the costs and responsibilities of their subsidiaries to the Mexican and Canadian governments. In addition to compensating corporations through the ISDS mechanism, the Mexican and Canadian states must make up for the loss of employer-based benefits through severance payments, unemployment benefits, and clean-up expenses once a subsidiary shuts down.⁸ This builds on over five decades in which corporations have transferred the costs of social reproduction to Mexican households and the Mexican government, a result of labor flexibilization, tax breaks, and refusal to pay severance. VU Manufacturing, for instance, continues to owe workers unpaid wages and severance pay, but with the closure of the Mexican subsidiary, the company will face no penalty. 

    While the US government has distanced itself from the case of VU Manufacturing, under the USMCA, it continues to serve as the watchdog of Mexican workers’ labor rights in the automotive sector. This disjuncture illuminates a fundamental aspect of the agreement. While celebrated as the first free trade agreement committed to stronger labor rights, the USMCA firmly entrenches corporate power while eliding the 2019 Mexican labor laws. For Mexican workers employed in the supply chain of car production, so long as US-based corporations face little accountability for retaliation and capital flight, achieving labor rights and improved conditions approximating those of autoworkers in the United States will continue to be an uphill battle. With the US taking on the role of enforcer, effective reform requires accountability mechanisms to be built into the existing structure of the UMSCA. 

    Labor struggles

    In the US, while the IRA is tied to labor standards and prevailing wage rates in some sectors, the automotive sector remains outside these specifications. Although car companies have received generous incentives to manufacture EVs, Shawn Fain, president of the United Auto Workers (UAW), has pointed out that the incentives do not guarantee workers’ wages and labor conditions. Mexican workers face a similar dilemma, with the USMCA prioritizing mechanisms to protect investments over legal obligations toward workforces. 

    The IRA’s incentives could lead to different outcomes in Mexico. The EV tax credit could strengthen Mexico’s supply chain of car production, but the incentives to car manufacturers in the US could also result in the “reshoring” of the supply chain. The lack of USMCA regulatory mechanisms to prevent capital flight make the latter option more probable. If confronted by labor complaints in the future, more US multinationals may shut down their operations in Mexico. VU Manufacturing and Unique Fabricating have a set dangerous precedent for Mexican workers: under the USMCA and US labor enforcement, US-based corporations can respond to labor protections by shutting down their subsidiaries. 

    To serve workers across borders, as the USMCA claims to do, the trade agreement must penalize corporations when their subsidiaries fail to meet international labor standards. But such solutions seem far-fetched in a reality in which free trade agreements are investment agreements, the results of negotiations between states to primarily benefit corporations and their shareholders, with the consequence of constraining domestic policy space. Following the recent election of Mexico’s next president, Claudia Sheinbaum, the planned review of the USMCA in 2026 could prove crucial for limiting multinationals’ ability to evade labor compliance. But in the absence of mechanisms to hold US-based corporations accountable for labor violations, the IRA is likely to speed up the race to the bottom.