The Independent Market Observer

The Ties Between Politics and Economics

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Sep 16, 2014 2:02:17 PM

and tagged Europe, Politics and the Economy

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For many, the study of economics goes back to the eighteenth-century urtext, The Wealth of Nations, by Scottish economist and philosopher Adam Smith. Notably, Smith and his contemporaries did not study economics, but political economy. At the time, there was no notion that economic behavior could be analyzed separately from its context, the political environment. The different governmental structures made the impact of government on human behavior absolutely impossible to separate—the ties between politics and economics were inextricable. To put it another way, it would be like considering the health of the brain while ignoring that of the heart.

The separation of politics and economics

Over the past 50 years, governmental structures have grown larger, even as nations have remained the same. I wrote the other day that the euro is a political construct rather than an economic one, and parallels can be drawn with the European Union, which is driven by a need to separate governmental decisions from the underlying nations. Nations—insofar as they represent groups of people with common histories, languages, and institutions—can be proxied as voters. Just as the euro was designed to separate the currency from national economies, the EU was designed to separate the government of Europe from the nation state, which is to say from the voters.

U.S. history offers other good examples of this. The Civil War represented our American solution to the conflict between the states and the central governments. I see the reemergence of regional tensions, shown in the confrontation between blue and red states over the past five years or so, as our version of the current drama playing out in Scotland and elsewhere in Europe.

In short, we have seen the reemergence of the local in many ways. Scotland is just the most recent, and potentially the most shattering.

As investors, we have to try to stay one step ahead of how things change. I believe that, over the past couple of decades, we have seen the triumph of economics over political economy. The “end of history,” to borrow Fukuyama’s phrase, meant the end of the nation state, and the triumph of rational, economic man. In that environment, stocks have soared, and wars have, by and large, been unthinkable, certainly on a large scale. Technocratic experts purported to run the economy, and the world, on a rational basis.

Strengthened ties

The political drama in Scotland indicates that this separation of politics and economics is not going to hold true in the future, if indeed it really ever was. Economically, there is no case for Scotland’s independence. But that doesn’t matter. Politics may well trump economics because emotions drive the vote.

In 1914, war was unthinkable. A popular book of the time argued that war was impossible, given the economic and political ties that existed among European countries. Interestingly, Europe at that time was the most integrated that it had ever been and the most integrated it would ever be until, well, now.

What this means for investors

I don’t live in Europe, and I’m no expert on the region. I do know, though, that if the union of England and Scotland can break up, any other union—including the EU—is much more fragile than is popularly supposed or is being priced into current markets. Anyone investing on economics alone should consider whether the world is moving back to a time when politics is at least the equal of economics—and very often acts as the trump card.

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