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Populist economic policy - what does it mean for the global economy?
What are the typical signs of populist economic policies and how will they affect us in the long run?

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A populist economic policy aims to offer citizens a life beyond their current means. The costs of this short-term increase in prosperity are inflicted on future generations. They will have to pay public and foreign debt, and bear long-term losses in growth due to a lack of technological progress and structural change. This article describes what macroeconomic consequences can be expected if large industrial nations such as the US pursue this path in their economic policy.

 

Hallmarks of a populist economic policy

 

There is as yet no general definition for the concept of “populist economic policy”.  In my opinion, such an economic policy is characterized by the following features:

 

  • A populist economic policy aims to grant citizens a live here and now beyond their means. It promises quick and oversimplified solutions to economic and political problems, ignoring medium and long term costs. Necessary reforms are not made so as to not threaten the popularity of the government.
  • The costs for such short term welfare spikes are being pushed onto the population of tomorrow as they are the ones who will have to clear government debts and foreign debt. They will also have to deal with long term growth reductions due to missed technological advances and structural change.
  • Different economic factions are therefore portrayed in two opposing larger groups. These are on the one hand the domestic population, whose welfare and jobs are being threatened in the current economic system and opposed to them a small group of profiteers (elites in politics and the economy as well as foreign countries and foreigners in general)

 

Some of the most important instruments of this economic policy are: tax cuts and permanent credit-financed increases in government spending, high import restrictions in conjunction with subsidies for exporting companies, massive interventions in the price system through subsidies, minimum and maximum prices, as well as indebtedness of the entire national economy abroad.

 

Previous experience with populist economic policy

 

Latin American countries in particular (Peru, Chile, Brazil, Argentina, Mexico and Nicaragua) had experience with a populist economic policy in the 1970s and 1980s.  Rüdiger Dornbusch and Sebastian Edwards studied these countries and published the results in 1991 in the ground breaking book “The Macroeconomics of Populism in Latin America”. They identified four phases of economic development:

 

  1. Tax reductions and increased government spending strengthen growth and employment in the short term, but also increase public debt. High domestic demand cannot be met by domestic production, so loan-financed imports increase. This leads to a current account deficit and foreign debt.
  2. Increases in demand lead to price rises. A widening current account deficit causes depreciation of the domestic currency, making imports from abroad more expensive. Higher inflation leads to wage increases (wage-price spiral). State subsidies alleviate the losses in purchasing power caused by growing inflation. Government deficit and foreign debt increase. Protectionist measures are taken to reduce imports.
  3. State efforts to curb inflation and depreciation of the domestic currency fail. The current account deficit and foreign and national debt grow. Real wages fall because wage increases are no longer able to compensate for inflation. Capital flight leads to a drop in investment. Production and employment drop, and gross domestic product shrinks. The growing lack of foreign exchange and declining credit rating restrict capacity to import, resulting in supply shortages for the population.
  4. Hyperinflation and growing debt ultimately lead to a massive economic slump and the voting out or overthrow of the government. In order to kick-start economic activities, financial support from abroad – e.g. through the International Monetary Fund – is necessary.

 

Current trends of a populist economic policy

 

At present, there are a number of right-wing populist parties in Europe whose economic policy goals and/or measures that have already been adopted can be viewed as elements of a populist economic policy:

 

  • Austria: the “Freedom Party of Austria” (FPÖ) called for an increase in pensions, unemployment benefits and the minimum wage in the 2013 election campaign.
  • Poland: the national conservative Polish party “Law and Justice” (Prawo i Sprawiedliwość, PiS) has undertaken numerous social policy measures, such as the introduction of child allowance and a minimum wage, since taking power in autumn 2015. In addition, it plans to lower the pension age, introduce tax relief for low-income earners and initiate a state housing construction program. The resulting revenue shortfalls and higher public earnings will lead to a government deficit.
  • France: in the election campaign, Marine Le Pen, among others, promised greater protection for French companies from foreign competition. The “Front National” program calls for a three-percent special tax on imported goods and services. The government revenue thus generated is intended to finance a bonus for low-income earners and pensioners.
  • USA: US President Trump’s election campaign program included targeted tax relief and state infrastructure measures, as well as demands for higher import taxes and export subsidies for US companies.

 

The implications for the global economy are not clear. Previous experience with a populist economic policy is limited to small economies with only a relatively low level of economic development. Therefore, these countries did not have a major impact on the global economy as a whole.

 

If large, highly developed industrial nations like the US were to apply a populist economic policy, this would have a different impact on global economic development. The basic cause-and-effect relationships are likely to be as described. Some consequences would be less serious than in the Latin American situation. In other areas, however, the global impact could be far more substantial.

 

Similar macroeconomic effects

 

The combination of government spending increases and tax reductions would also lead to an increase in government debt and a widening of the current account deficit in developed industrial nations. In the short term, the growth impetus triggered by fiscal policy would cause an increase in production and employment. The prospect of an economic upturn would motivate foreign investors to invest their money in the country with the populist economic policy. The result would be higher demand for the country’s currency, which would therefore appreciate. At some point, however, the government’s capacity to accrue new debt would reach its limits. The by then necessary tax increases and reductions in government spending would weaken demand for goods. This would lead to a slackening of production and employment, which could turn into a recession.

 

Less serious macroeconomic effects

 

The Latin American experience with a populist economic policy is characterized by hyperinflation as well as growing national and foreign debt, which finally end in national bankruptcy. There is no danger of national bankruptcy in the US or Europe at least in the short term, because developed industrial nations have a much higher credit rating than less developed countries.

 

I also do not see the risk of hyperinflation. In the Latin American countries, inflation was accelerated by the depreciation of the domestic currencies; when international investors lose confidence in the currency of a country, they part with that currency. If the central bank of the country concerned has no reserves of gold and foreign exchange, it is not in a position to stabilize the price of its currency by buying its own currency on foreign exchange markets. Large industrial nations, on the other hand, usually have sufficient gold and foreign exchange reserves, which they can use to shore up their own currency.

 

More serious macroeconomic effects

 

If economic heavyweights like the US take protectionist measures, this may trigger retaliatory measures by other countries, resulting in a global trade war. A global race-to-the-bottom regarding devaluation could arise: the devaluation of its own currency is a fast-acting instrument to improve the international competitiveness of domestic businesses. If, for example, the US central bank were to ‘flood’ the international foreign exchange markets with a rapidly increasing supply of dollars, this would lead to depreciation of the dollar. If many central banks were to pursue this monetary policy strategy, there would be excess liquidity globally. This would increase the risk of speculative bubbles forming on capital markets, which would burst sooner or later. The consequences would be a real economic crash – similar to that following the bursting of the real estate bubble in the USA and the associated Lehman bankruptcy.

 

Outlook

 

As a result, economic development that leads to a populist economic policy (as defined here) in large industrial nations entails considerable risk for global economic development. The negative effects on production and employment in the global economy are likely to go far beyond the extent that we know from previous Latin American experiments with a populist economy.