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Monday, August 12, 2019

China’s Existential Dilemma

By Roy C. Smith

The US-China trade dispute should have been resolved a year ago, enabling both countries to get on with their growth agendas and avoid a lot of unnecessary market disruption and investment uncertainty.

Early negotiating sessions suggested that China would yield to some US demands and increase agricultural purchases to avoid any new tariffs. But Mr. Trump apparently wanted more and negotiations slid off into the political arena where both Trump and Xi Jinping risk losing face for crumbling before an adversary, which made things worse.  Now both sides are in territory in which blows may have to be struck and the time until an agreement is achieved has been delayed further. Even if the blows are more symbolic than forceful, their effect will be on slowing the growth rates in both countries and several others.

China’s official growth rate was 6.2% in the second quarter of 2019, the lowest in 27 years, and is predicted to slow further even without the trade dispute. According to local economists, China’s true growth rate is probably well less than 6% and many indicators show the turmoil over tariffs and the slowing of long-term foreign direct investment will bring it down further.

That will put pressure on China to address political dissatisfaction throughout the country that has already begun to develop over future job growth, opportunity for upward mobility, and the adequacy of pensions and health care services for an aging population.  For years China watchers have said that a minimum growth rate had to be achieved for the people to continue to allow the Chinese Communist Party to rule without elections. That assumed rate used to be around 8%. Xi Jinping knew this when he came to office, and he acted quickly to consolidate his personal power, and then to distract attention from growth to pride in China’s long history, rising global influence and power, as seen in its South China Sea activity and in expensive demonstration projects like the “Road and Belt” initiative. But the decline in growth has led to bankruptcies, increased layoffs, unemployment and public protests and demonstrations. So far, these protests have not been very disruptive, but In January 2019, Xi warned fellow party members of the rising dangers of public dissent.

Dissent has now broken out in Hongkong, where for ten consecutive weeks, more than 2 million protesters have taken to the streets and violence erupted on several occasions. The resistance is to increased grasp by China of local political power. Hongkong is much more than a returned autonomous colonial territory – it is a vital business center for the country (affecting  about 25% of China’s GDP) and key to the financial markets of Southeast Asia. Bottling up Hongkong with political and maybe military strife could be disastrous to the Chinese economy, and could include a capital flight (which may already have begun) that China would be unable to prevent without draconian measures, which could precipitate a financial crisis such as occurred in Japan 1989 and ended that country’s ambitions to being an economic superpower.

Financial crises are like avalanches, you never know in advance where they are coming from or when.  A large part of China’s securities and bank credit market activity is presently provided by non-Chinese investors that can change their minds in a flash. China is now sitting on a record level of debt (300% debt to GDP), about 60% of which is not federal, but of more unsteady corporate and municipal entities.  Declining economic conditions have caused defaults to rise, credit ratings to fall and access to credit to be constrained.  Avalanches in credit instruments begin under circumstances like theses, then accelerate and broaden to include all securities, pushing  market values well below their true value, and, because of mark-to-market accounting, requiring massive loss taking (and bailouts) within the financial system. This happened in New York in 2008, in the Euro-era in 2010. +In both cases, the velocity of market movements greatly exceeded governments ability to halt them.

China can survive a financial crash, though at great cost to the economy. But economic distress can open the doors to political risk that protests such as are occurring now in Hongkong could spread to nearby Guangzhou, Shenzhen and even to Shanghai, autonomous industrial cities in the South, distant from Beijing, where millions of migrant workers with few economic rights would be subject to a sudden increase in layoffs and economic difficulty unassisted by social safety nets.  

This could be an existential moment for Mr. Xi and his Communist Party colleagues in Beijing. It could get out of hand and require violent repression to settle, which  like Tiananmen Square in 1989, was deemed the only way to save party rule.

These circumstances give Mr. Trump the advantages in negotiating with China that he has claimed from the beginning (“We can win a trade war...”).  He may be prepared to face a Chinese existential crisis, though it would not be in the US’ interest to have one. Mr. Xi , on the other hand, may believe that Mr. Trump cannot sustain a trade war with China through an election year, and China can wait him out. Maybe, but Trump is unpredictable, changeable and seemingly very confident in his political base to support him in the election.  This could end up in a very dangerous game of "chicken." with disproportionate consequences. China would be well advised to find a way to settle the trade issues soon, even at some loss of face, to slow the growth decline but, more important, to preserve political stability. This should be obvious, but all politics are domestic in the end, making some obvious things hard to do.

Americans need to remember that the US struggled for more than 20 years to manage trade disputes with Japan, a country we wanted as an ally but many Americans believed exploited US benevolence. Then we spent another 20 years dealing with China’s rise as the next Japan. But China is not a democracy, and though it has said it has opened its markets to link with the capitalist system, it has joined the capitalist system only in part, while preserving Deng Xiaoping’s notions of “socialism with Chinese characteristics,” or capitalism with exceptions.

The Chinese characteristics, however, are seen by Mr. Trump, and many others, to include many anti-competitive measures prohibited by the World Trade Organization, such as providing large subsidies to state-owned enterprises that make up a large portion of the Chinese economy. Trump sees these as exploitative, Xi sees them as essential to keep large, unprofitable state companies from collapsing.

These issues are difficult but not unresolvable. To resolve them, both sides will have to swallow stuff they don’t want -- but  can be renegotiated in the future. That's what politicians in capitalist countries do,  Failing to do so will bring back some Cold War intransigence that we would be better off to avoid.

Wednesday, July 24, 2019

Why Americans Don’t Trust Economics Anymore.

By Roy C. Smith

For as long as we can remember, Republicans and Democrats have been divided by their economic policies. Republicans have been the party of low taxes, fiscal discipline, and champions of the private sector as the country’s growth engine.  Democrats have been supporters of Keynesian economic theory that says when things slow down, its OK to promote growth by government spending programs and subsidies that require substantial additional borrowing, even if that leads to unbalanced budgets, increased inflation and a weaker dollar.

These may be the party’s basic economic platforms, but in reality, they are ignored. That’s because politics and other things invariably get in the way. As Dick Cheney once said “principle is okay up to a certain point, but principle doesn't do any good if you lose.”  So, when Mr. Trump wins an election, the Republicans have a tax cut, even though the economy had already returned to a low unemployment growth mode and could only be inflated by further stimulation, which would raise inflation and interest rates, and threaten future growth. If Republicans weren’t worried about this, why should Democrats? Everybody likes a tax cut.

Anyway, all the bad things didn’t happen, at least not right away. Though the US was running a big fiscal deficit (4% of GDP), and total government debt held by the public reached 78% of GDP in 2018 (a post-war record), with prospects following the 2017 tax cut of the ratio exceeding 100% within ten years, no one seemed to care very much. The debt, after all, was repayable in dollars and we could always print more of them, like Japan has done for years (its debt to GDP ratio is 236%). This is a key argument of the Modern Monetary Theory now being promoted by some Democratic presidential candidates as an explanation for how their platform of new social programs will be paid for.

Nor were markets very bothered by the debt. The low prices of consumer goods resulting from the US trade deficit with China and other countries, kept inflation down and generated sizeable financial flows into the US that funded new capital investments and boosted bond prices that kept long-term interest rates relatively low. Stock prices rose too, to new records during the first two Trump years (despite two high-volatility setbacks). Because US international trade has risen to represent 27% of its total GDP, trade affected the economy significantly by slowing the rate at which the direct effects of deficit spending might otherwise have occurred.

So, when Congressional negotiators announced agreement yesterday on a budget bill that would increase the deficit by $32 billion over ten years, the markets only shrugged.

Should they be more concerned?

Well, maybe not. The markets are about expected outcomes over time, and these are indeed determined by underlying theory, but also by other stuff, especially politics and markets forces. When Ronald Reagan’s deficit financed tax bill passed in 1981, economic growth shot up to average 4.3% from 1982-1990, and unemployment fell from 11% to 5.6%. Debt to GDP, which was only 32% in 1980 left room for leverage so the ratio rose to 54% in 1990, helping to kill the boom. When George H.W. Bush, Reagan’s successor, ran for reelection in 1992, the economy was in recession and the deficit had ballooned from 2.7% to 4.7% of GDP, and growth slowed from 1990-1992 to 1.7%. When Bush, ignored Dick Cheney’s other great economic pronouncement (“Reagan proved deficits don’t matter”) and went back on his promise of “no new taxes,” many in his party deserted him for Ross Perot and he lost the election to Bill Clinton, whose economic policy was to reduce the deficit ratio further (to 33%) so bond market rates could go down even more (“everyone wants a lower cost mortgage”) and the economy improved to average 4.5% growth from 1997 to 2000 and the deficit turned to surplus, the first one in 28 years,.

But, when the deficit chickens fly away, it is just a matter of time before they come home to roost.  We end up paying for the benefits of the deficits at a later time, in one way or another – in a financial crisis, a recession, inflation, high unemployment, or a meaningful change in voter perceptions about economics.

The slow-moving, but powerful give-and-take between economic theory, politics and markets one day requires a price for today’s neglect of the deficits. Most likely it will be in the form of lower GDP growth, which the Federal Reserve is now forecasting to fall to 1.9% for 2020 from its cyclical peak of 3.1% (in 1Q 2019, but it  dropped to 2.1% in Q2), back towards the average US GDP growth since 2000 of 2.0%. And, Trumpian uncertainties, well known to the markets today, could make things worse.

It may not, however, because other things such as a brilliant trade deal, that could change the game. But if it does, the system will adjust over time. Even at 20% interest rates, US debt was refinanced in financial markets after the Volcker Shock in 1979. Political sympathies for unchecked deficits may change and markets will discount future stock prices for lower growth or other concerns. Market power is now enormous, with more than $300 trillion in market capitalization of all tradeable stocks and bonds in world markets. And, other factors, unknown to us now, may also affect long-term outcomes.  But even then, fear of deficits, won’t last for long, and deficits will come back in style.  



Wednesday, July 3, 2019

She's the One

By Roy C. Smith

Yesterday, the European Parliament nominated Christine Lagarde, 63, Managing Director of the International Monetary Fund (IMF) to replace Mario Draghi as President of the European Central Bank (ECB) at the expiration of his 8-year term. Lagarde is a former French Minister of Finance under Nicholas Sarkozy, who took over at the IMF also in 2011, after the global financial crisis of 2008-2009 had spread to threaten European financial markets and economic stability.

The financial crisis had profound effects in Europe. It was only through the painstaking efforts of Germany and France, the IMF and the ECB over about 2 years that the subsequent “European sovereign debt” crisis of 2010 could be resolved. The resolution involved the Euro-Area (countries using the euro) establishing voluntarily a $1 trillion fund to make direct loans to the troubled countries (on the condition of strict reforms to be approved and enforced by the IMF), and later, for the ECB to break historical precedent by (1) extending large loans to euro area banks to restore financial stability (“the ECB will do whatever it takes…”) and (2) to support euro-area government bonds in secondary markets, in a form of “quantitative easing” to encourage recovery. Between these two efforts, the ECB’s contribution, which involved employing several trillions of euros in market interventions to provide liquidity, was by far the more important in ending the crisis.

But the sovereign debt crisis clearly revealed some major flaws in the euro system. It was not a typical federal system that could impose fiscal policy and enforce standards on the members, nor did important members of the system want it to be so if that would mean extending a mutual guarantee of member country debts. Indeed, the German constitution prohibited participation in such guarantees and a seminal case was brought to the German Constitutional Court to decide what, if anything, Germany could do to assist other countries in the debt crisis. (It could participate in case-by-case relief but only if these were approved by the Bundestag.)

However, much was learned in the slow process of discovery of what was possible. There was much give-and-take, and many ideas were proposed by the European Commission (the EU’s executive authority) that were not taken up, including jointly-backed Eurobonds, a Banking Union with common deposit insurance for euro-area banks, a European Monetary Fund to act like the IMF for euro members, and a financial transaction tax to help pay for such reforms. On the other hand, a step was approved in 2011 to require members to limit their budget deficits and debt-to-GDP ratios, and the temporary European financial stability fund that assisted Greece, Ireland, Portugal and Cyprus, was renamed the European Stability Mechanism and made permanent. 

Most important, however, was the agreement of the euro-area countries to authorize new and substantial interventionist and regulatory powers for the European Central Bank, which gave credibility to the euro-area’s willingness to do what was necessary to end future crises. This important shift in the role of the ECB came about with the appointment of the former Bank of Italy head, Mario Draghi, 71, an activist former head of the G20’s Financial Stability Board, to replace Jean Claude Trichet, a traditionalist former head of the Banque de France. Draghi knew that the considerable resources of the ECB would be necessary to regain the confidence of financial markets in the euro system, but he had carefully to gain the support of the various European heads of state (and the US Treasury and Federal Reserve) to do so.

The Sovereign Debt Crisis, however, made it clear that the EU was a two-tiered economic system, with some members (the euro-area) operating according to one set of rules (which became much more restrictive during the crisis), and the non-euro members working under different rules that were mainly related to trade and the four freedoms of the Single Market Act. Several of these latter countries, especially some from Eastern Europe that were able to enjoy growth rates higher than those of the euro-area as a result, were not eager to see more powers accrue to EU institutions.

Of course, all this made Draghi very controversial.  Many in Europe (especially in Germany), believed he had usurped and applied powers never intended under the Maastricht Treaty. He used massive ECB resources to intervene in markets that some thought ought to have been left free, and had directed that new European controls and regulations be applied to large banks that had previously only had to contend with more lenient and forgiving national rules.

By 2012 it was clear that the EU had evolved into a “confederation” (a voluntary association of states for a common but limited purpose) and the euro-area into something more than that but still far less than a federalized fiscal union, i.e., a centrally administered tax and spending regime that absorbs most of the sovereign economic powers of its member countries. Most of the EU members are protective of their sovereign powers, and their voters are reluctant to give them up, so increasing the federal function of the EU is a tall order. But, as the Sovereign Debt Crisis revealed, tall orders can be less tall in extremis.

In a confederation there are no fiscal powers so economic management hangs on monetary powers delegated in this case to the ECB, making it the most important institution in the EU.

Christine Lagarde is the best possible choice to replace Draghi. She worked with Draghi for eight years on these and related problems and was one of the insiders in addressing the Sovereign debt crisis. She is known in Europe as a skillful politician (abilities needed in the job) who is respected by all of Europe’s heads of state and financial officials. She is the former head of the world’s largest international law firm, Chicago-based Baker McKenzie, speaks several languages and is a former member of the French national swimming team.

She has no experience in central banking but this is of no importance – the ECB has an outstanding professional staff of economists and bankers upon whom she can rely, just as she did at the IMF. What the EU wants is someone able to get the most out of its most important institution.  Europe’s future is very unclear, with populism, Brexit and member country discipline all creating new financial challenges for the EU. Lagarde is the one for the job.
So, addio e grazie Mario, and bienvenue, Christine, et bonne chance.

Tuesday, May 14, 2019

Will FinTech Companies Disintermediate the Banks?

By Roy C. Smith

Regulation following the Financial Crisis of 2008 has tied the global banking industry in knots, especially the European portion of it.  Increased capital requirements (relative to risk-adjusted assets), decreased leverage, requirements for liquidity, stress tests and fears of litigation for products or trades that go wrong -- along with serious damage to reputations -- have forced most large banks into subdued “regulated public utility” business models, from different from the opportunistic, trading oriented, integrated capital markets/commercial banking model that all adopted after the repeal of Glass-Steagall in 1999.

So, the financial services industry is now vulnerable to attacks from outside the industry, especially from those aiming to use modern technology in various ways to secure competitive advantage.

A new financial industry – Financial Technology (“FinTech”) – has already risen to challenge the old by offering new ways to use modern software and Internet technology on a (much cheaper) non-banking regulatory base to disintermediate traditional financial products (mortgages, personal loans and deposits, trading, asset management, and transaction processing). And they have been quite successful so far by reducing the cost of and access to financial products to tech-savvy retail users. Quicken Loans is now the country’s second largest mortgage provider; in 2017 five of the top ten mortgage providers were non-banks that accounted for $114 billion of mortgages. Lending Tree is the leader in the non-bank digital lending market place, providing $41 billion of personal and commercial loan originations in 2017, and a variety of “robo-advisers” accumulated $181 billion of advisory assets under management. In addition to these sectors, FinTech activity also is spreading to insurance, payment processing, and blockchain management. All of these sectors have been growing much faster than their banking industry peers, but because of the vast size of the global financial services industry, their cumulative market shares remain small. Risks associated with FinTech activities, so far, have been minimal - exposures are diversified over large numbers of relatively small separate accounts.

In February 2019, Forbes published its fourth top-fifty FinTech list. The top five firms on this list had combined (estimated) market value of $50 billion. Some have already gone public, others are “unicorns” (financed by private equity funds) waiting their turns.

FinTech firms compete on the basis of accessibility, price, convenience and the ability to gather customer attention in fresh and innovative ways. Accounts can be opened and deposits made in no time. Loans can be obtained without guarantees or collateral after filing out an on-line form for an algorithm to process. Costs of trading and execution are competitive with on-line brokers. But, so far, these low-overhead entities are not subject to banking and securities regulation, nor are they entitled to Federal Deposit Insurance.

FinTechs do not have large balance sheets, and so must sell off the loan/deposit packages they generate, either to FNMA (for qualifying mortgages), or to banks, the institutional or securitization markets. This, however, exposes FinTech firms to wholesale rates set by the interbank markets (to which FinTechs do not have access unless they have a partnership with a bank). In other words, after a certain amount of grabbing of low-hanging fruit, the FinTechs don’t add much economic value to the markets they hope to serve, especially to larger customers. They do hope to operate on a small business friendly basis, and at a lower cost because of lower overhead and regulatory costs.

FinTech risks can involve faulty algorithms that don’t keep up with quickly shifting changes in the consumer credit market, liquidity squeezes when mark-to-market accounting requires write offs just when assets need to be sold and new investors are scarce. Further, large retail banks will fight back – Goldman Sachs and Citigroup have announced major digital banking initiatives.

FinTech investors will do well to remember the tech revolution of the 1970s when approximately 100 PC hardware manufactures competed to dominate this new industry. Investment banks clamored to underwrite new issues of securities issued by companies with no profits.  Only a handful of these companies have survived. The early days of the Internet provided a similar scene of B-to-B and B-to-C innovation that also left only a few firms on the field after the “tech wreck” of 2000-2002. Those that disappeared either went bankrupt went bankrupt when roll-over and working capital finance dried up suddenly (many did), or were successful in quickly selling their firms to larger competitors like Microsoft that used high-priced stock to acquire technology they didn’t have.  There have always been profits to be made in technology revolutions, but big losses too.

Tech revolutions often start with attacks on stogy industries that need restructuring and renewal, and can raise capital because their undertakings are the newest new thing. The various financial service industries are now in the cross-hairs. The established financial services firms, particularly the banks, are also trying to adjust their business models to utilize technology to lower costs and make things work better. Some banks will make successful business model transitions, but many won’t and will be broken up and restarted by new investors supporting FinTech applications. Some of these may be large non-financial, tech heavy corporations like Walmart, Amazon or Apple  

But in the end, all finance involves other people’s money and requires regulation. Non-banking entrepreneurial ventures are not the same once they are captured by the regulators. Competition too is different in markets willing to take risks for small gains. The list of large non-banking firms that failed in taking over investment banks and brokers in order to turn them around is very large and includes such companies as General Electric, Prudential Insurance, Sears Roebuck, and American Express.

Still, Fin Tech firms have been able to attract start-up capital readily, some from private equity firms that intend to provide funds for promising companies to grow as fast as they can without worrying about profits, then selling to another financial service company or going public, much like Tesla, Lyft and Uber have done. But when bubbles burst, profits are hard to find. Uber’s stock is down 18% since its IPO, Lyft’s is down 33%, and early FinTech darling, Lending Club, is down 86%.

FinTech is here to stay, but not all the FinTech companies are.  The financial services industry needs the know-how, the energy and the new product innovation that FinTech represents, but a lot of it will come from tech engineers hired by the banks, such as Goldman Sachs at which computer engineers now represent a quarter of the firm’s total headcount.

Monday, May 6, 2019

Bridging The Public Pension Fund - Infrastructure Gap

By Clive Lipshitz and Ingo Walter

During the State of the Union address, President Trump issued a renewed call for an infrastructure bill. Two days later, the House Committee on Transportation and Infrastructure held its first hearing of the new Congress to address the state of U.S. infrastructure. Confronting the nation’s infrastructure gap is one of the rare bipartisan issues in Washington today. It is a priority for the American public and for elected officials at the federal, state, and local level, all of which make it a likely legislative focus for both the 116th Congress and the Administration.

That U.S. infrastructure needs improvement is not news. Any discussion about closing the $2 trillion 10-year investment gap quickly zeros-in on funding – revenue streams in the form of dedicated taxes or user fees – and financing solutions. While there are perfectly suitable public finance tools, a large pool of untapped available capital resides in the retirement funds of public sector workers. In a new, detailed study of the $4.3 trillion U.S. public pension system, we’ve investigated the infrastructure investments undertaken by the largest public pension systems in the country. Our findings suggest now might be the perfect time to match pension capital with infrastructure investment needs, creating winners on both ends of the financial chain.

Infrastructure assets have features that are appealing to pension investors. They are long-duration and offer some degree of inflation protection. They are not correlated with the other asset classes so they offer much-needed diversification. Best of all, they generate steady cash flows to meet the needs of current retirees. These are among the reasons pension funds have cited when establishing programs to invest in infrastructure, and our analysis bears out most of these benefits. Still, infrastructure investment programs in big American public pension funds are relatively recent and they remain small – averaging less than 1% of fund assets.

Implicit in public pensions’ investment objectives is to accumulate cash flow-generating assets and hold them for a long time. Yet when pension funds invest in infrastructure, they typically invest in private equity-type funds that often have first-rate expertise but seek capital gains, not current income. And the funds usually buy infrastructure assets from other private owners. These investments have generated strong returns in the form of capital gains, benefitting substantially from rising valuations. Infrastructure assets now trade at multiples well in excess of those in other investment classes such as real estate and private equity. But these investments don’t generate much in the way of the cash-flows pension funds need to support current retirees. Bottom line: Insufficient investment in infrastructure as an asset class, using the wrong investment vehicles, and for the wrong purpose. There are better solutions.

To explore ways in which pension capital might evolve into a financing solution for U.S. public infrastructure, we might look to models that have been successful in other countries.

In Australia, asset recycling is a financing tool that has been used successfully to “repurpose” infrastructure capital. Public sector agencies sell long-term concession rights on existing infrastructure to investors (including pension funds) and use the proceeds to finance development of new infrastructure. The public sector retains ownership of the legacy assets, receives cash proceeds to develop new infrastructure, and avoids burdening its public finances with more debt. Private investors get a stream of proven cash flows from existing infrastructure over a fixed period of time. The federal government often provides an incentive in the form of a top-up of the proceeds from the concession sale.

True, institutional investors like pension funds are wary of investing in ground-up development -- they are properly concerned about cost overruns, delays, and unpredictability of revenue streams. But pension systems are uniquely positioned as informed and influential players in regional and local economies. Just one example: The Quebec pension fund, CDPQ, developed and operates Montreal’s light-rail system and was able to assemble the financial and technical resources and muster the political support to pull it off.

Among the other ways to deal with infrastructure project risk is partnering pension capital with the knowhow of EPC (engineering, procurement, construction) firms, which have extensive experience in designing and delivering new projects. Dutch pension funds, for example, have invested alongside engineering firms in new road construction projects.

Of course, using pension capital on public works requires strong governance to avoid white elephants, waste, and bloated costs. The presence of private capital can provide necessary transparency and discipline. And there is an argument for investing pension capital locally. If done right, it can generate economic development, which in turn leads to more jobs and more tax revenues – ultimately favorable to sustainable pension finance. Additionally, when pension funds invest directly in infrastructure, they don’t introduce the political risk of transferring “crown jewels” to private investors.

Most important is to put in place mechanisms that will allow for an improved flow of investable U.S. infrastructure assets. When that becomes evident to pension fund administrators, they will become more comfortable expanding their allocations to this attractive asset class – perhaps to the 5-10% levels that are common in Canada. This will provide hundreds of billions of dollars in incremental financing which will go a long way to reducing our infrastructure gap.

Clive Lipshitz is managing partner of Tradewind Interstate Advisors. Ingo Walter is Professor Emeritus of Finance at NYU’s Stern School of Business. Their study “Bridging Public Pension Funds and Infrastructure Development" has been released in the spring and is available on SSRN.

Tuesday, March 12, 2019

Is the Economic System Really Hollowed Out?

By Roy C. Smith

Every so often the world economic system has to adjust to major “shocks” that threaten it. Normally, these come about every other decade, but we have had three such shocks since 2000: (1) two major, highly destabilizing financial crises (2000-2002) and (2007-2009), (2) an outbreak of terrorist bombings and a huge wave of unwanted migration into Europe from Syria and North Africa, and (3) the many effects on labor markets of the US and EU of outsourcing of manufacturing activities to China. One result of all this has been the growing perception in the US and Europe that the working-and-middle class populations have been “hollowed out” by economic shifts that have increased income inequality and forced nearly half the population in the developed world into economic anxiety and uncertainly.

The aggregate effects of these changes have brought about a rise in populism, anti-globalization, a disregard for the so-called governing elite and an appetite for authoritarian solutions. These factors have generated unexpected changes in governments in the US, the UK, Germany, France, Italy, Spain, and other several other European countries. Indeed, the question seems to be: will these changes in established support for globalized free-market economic policies be enough to set the system back to what it had been in the 1950s, when market economics were not a high priority?

Cumulatively, these political manifestations are the signs of serious resistance to the idea that economic performance can be optimized by participation in the global, open-market capitalist system that was cobbled together after WWII and produced 80-years of peace and prosperity. More recently, and for the first time, such economic participation expanded into Emerging Market Countries though “globalization,” and was encouraged and sustained by a general belief that the “new” system for economic development worked far better than the old.

President Trump, however, says he disagrees. He says he is an economic “nationalist,” and the “globalists” have sacrificed US interests in building an international trade and economic system that has mainly benefited other countries.  Globalists, however, point out that the system he decries was in fact responsible for the extraordinary recovery and enormous prosperity in the post WWII world, greatly reduced world poverty and fostered democracies in replacement of authoritarian states. Bill Emmott, a former editor of The Economist, observed in a 2017 book that we have entered a “battle to save the world’s most successful political idea.” The idea being “liberalism,” or “liberal democracy,” (liberal in the British context of “liberty” being reflected in free-markets and open societies, not in the US sense of far-left politics), and he claims it is under assault. Several other books by well-known, establishment figures have described the rise of authoritarianism and the weakening of democracies and also believe a battle has begun; others have focused on the erosion of the well-being of the working-and-middle-classes in the US and Europe where the conflict is vigorously being waged with active support from both the political left and right.

Is all this right? Or, is there another narrative that simply gets less attention?

The alternative version of the story asserts that the economic division between the classes is serious but overstated. The shocks have been very powerful and have taken almost two decades to be accommodated, but the system has adapted, as it has done before, and is well-into turning around. Financial stability has been restored. Terrorism and migration are more manageable than they were, China’s threat to the world economy is in decline (and under negotiation) and now is much less than it was. And, there are signs that we have reached the end of the hollowing out period, with record low unemployment, rising wages, and some policy measures taken (or proposed) to improve the economic security of the lower half of the population?

Indeed, at the millennium (before the shocks), Americans were able to celebrate the greatest twenty-year period of wealth creation the world had ever known.  This was largely provided by a fourteen-fold increase in the Dow Jones average from 1982-1999, an annual compound growth rate of 16% for 17-years, in which 48% of US households participated (according to the Federal Reserve) through pension funds, mutual funds and investments in homes that appreciated with the stock market. Wealth creation was coming from many directions: entrepreneurs, corporate restructuring, increased global trade, mergers and other forms of deal-making and investing. New telecom, pharmaceutical and internet industries were developing, innovation and competition challenged market leaders, and polls indicated that the public was not envious or resentful of the rich, but instead appreciated that their children could be rich too.

 “Household net worth” (the value of all household financial and non-financial assets, less mortgages, personal debt and credit cards, after inflation, living expenses, tuitions and taxes) increased 8% annually for twenty years, more than twice the rate of the real economy. In the US, the median household net worth was $96.700 in 2001, it declined due to the shocks to $63,900 in 2013, but has since growth by 53% to $97,300 in 2019.

The source of the wealth creation was the private sector that employed 85% of the US workforce and had had the benefit of the liberal economic policies of the Regan-Thatcher era, carried on by their successors and emulated in developing countries and post-Communist Europe. Since 1980, China, India, the former Soviet Bloc and many emerging countries adopted the liberal economic model in one way or another, enabling more than 50% of the world’s population to prosper from it by the end of the twentieth century. The so-called “BRIC” countries (Brazil, Russia, India, China) emerged as major beneficiaries of the idea, and began to attract large amounts of foreign direct and portfolio investment.  The stock market capitalization of emerging market countries as a whole rose from $186 billion in 1980 to $18.3 trillion in 2007, nearly a ten-fold increase. Liberalism worked, and was now ascendant, broadly accepted and entrenched.  But serious vulnerabilities would soon become apparent, and the “shocks” would soon challenge the liberal economic system to its roots.

The hollowing out condition may be overstated, but there is more than a little data to support it.

In 1970, manufacturing industries employed 27% of the US workforce in well-paying jobs with health and pension benefits, often under union contracts. During the nearly 50-year period, since then, US manufacturers experienced low-cost competition from Japan, South Korea, Taiwan, and China, moved domestic production overseas, and invested heavily in automation and supply-chain management. The US is still the world’s second largest manufacturing country, employing 12 million workers in 2013, but now only 8.8% of the workforce. From 1998-2013, 5.7 million manufacturing jobs were “lost.” Some of the job loss was the result of automation and improved factory engineering, but a 32% drop in manufacturing jobs over 15 years was hard to ignore, especially in the rust-belt sectors of the economy where the relative impact on jobs, community life and families was more intense. 

China joined the World Trade Organization in 2001, when its global trade surplus was $360 billion. In 2006 the surplus peaked at $761 billion, and since then has declined 26% to $560 billion in 2017.  But, China’s trade surplus with the US reached $276 billion in 2017, a record high, when exports to the US totaled $2.9 trillion. The US is China’s second largest trading partner behind the EU – China had a trade surplus with the EU of $176 billion in 2017.

Calculating net job losses from trade with China is very inexact in a competitive economic system with lots of “creative destruction.” China’s trade surplus, is shrinking under its own weight. Its local manufacturing costs are rising, labor has become scarce, and, particularly under the Trump administration, it is encountering stronger resistance to its trade policies, barriers to entry, subsidies and other practices prohibited by WTO rules. US importers are beginning to source supply chains from countries other than China. The perception of the public, however, is that imports from China have been a major contributor to the job losses of the working-and-middle classes of the US, and the EU.

Manufacturing jobs with pension and health benefits were hard to replace with part-time, or freelance, jobs provided by the new “gig” employment universe. Wages became stagnant. A recent Pew Research study reported that US inflation-adjusted wages had no more purchasing power in 2017 than they had in 1978. By hollowing out, many observers have noted, “good” jobs have been replaced by lower valued ones, and the Great Recession and slow-down (2009-2016) have made full time employment more unstable and uncertain.

Making it all worse, the 2008 mortgage crisis shock resulted in 5.5 million home foreclosures, most among the working-and-middle classes reflecting their income decline. The share of federal income taxes paid by the lower half of US income-earners dropped to 2.8% in 2015, from 7.1% in 1988, as income inequality increased in the US. Many in the lower income half have minimal (or no) health insurance. Health care ranked as the most important issue to Americans by a nearly two-to-one margin in the 2018 midterm elections in the US, according to exit polls published by CNN. Also, for the lower income group, the costs of college education (the escape route for their children) have been rising faster than their incomes.

Despite the bull market in stocks since 2009, nearly two decades of stock market underperformance (the S&P 500 total return index, adjusted for inflation, rose less than 3% from 2000-2018, as compared to 13% for the 1980s and 1990s) has left corporate, union and state and municipal pension and retirement funds significantly underfunded. According to Vanguard, the median balance in 401k income retirement funds for those in the 65+ age group in 2017 was a mere $69,000. The great American middle class was far less financially secure in 2016 than it was before 2000.

In 2017, researchers with the Gallup-Sharecare Well-Being Index surveyed American adults about their perceptions of their financial, social and general well-being and reported the worst results in the 10-year history of the survey. Another 2017 Gallup poll surveying American between the ages of 18-29, showed only 45% approved of capitalism, a 12-point decline in young adults' positive views of economic liberalism in just the past two years and a marked shift since 2010, when 68 percent viewed it positively. Still, these approval rates tend to fluctuate over time. The young want both equality and efficiency.

Several observers of the deteriorating conditions for working-and-middle class Americans have pointed to other consequences as well: a lower college completion rate, a sharp fall in the US birth rate as marriages are delayed, reduced religious activity and participation in social organizations. So, a large segment of US society, perhaps as much as half of it, believes it has been steadily falling behind the other half. And, as should happen in a vibrant democracy, this perception of diminishing status has shown up in voting booths. Mr. Trump’s solid “base” continues to number about 43% of the electorate, but it may be larger than that. There are many former Democrats from the working class, and active or retired business executives who respond favorably to his illiberal approach to running the government.

No other candidate from either party has anything like a base of support of this Trumpian size, but his support is offset by a vigorous anti-Trump effort that recovered control of the House of Representatives, thus blocking any far-right populist legislative efforts and leaving Mr. Trump dependent on uncertain Executive Orders to govern the country. Democrats will be unable to legislate anything of their own, of course, and will largely spend their time blocking Republican efforts and investigating Mr. Trump. Even with successful trade negotiations with China and the EU (a “maybe” outcome at best), and the (fading) effects of the 2017 tax cuts, the Trump administration is unlikely to be able to add much growth to the US economy over the next two years, as reflected by the Fed’s recent growth forecasts for 2019 (2.3%) and 2020 (2.0%) as compared to 3.0% in 2018.

If these forecasts prove to be true, providing a significant reversal of economic impetus, then Mr. Trump will be in trouble by 2020.  His ability to alter economic policies so as to change back to a growth mode will be seen to be very limited. And, at some point in the next year or two Mr. Trump will have to confront debt-ceiling issues as US federal debt outstanding as a percentage of GDP reaches levels not seen since WWII.

Those who voted for Mr. Trump in 2016 did so knowing he had little experience in government and, at best, he would “shake things up.” This he has done with a series of confrontations with trade partners and important allies, that will take years to benefit the working class, if they ever do

Meanwhile, Democrats and their counterparts in Europe are trying to attract this cohort of voters with (essentially) unfinanceable public give-way programs that both conservatives and moderates dislike.

The net result of this uncompleted struggle between extremists seems to be that no one is in charge, and the economic system that Bill Emmott praised is largely adrift.

So, it’s time for moderates on both sides of the Atlantic to appear and apply some forceful common sense to the otherwise dysfunctional political/economic situation we have drifted into. The moderates, particularly from the business, academic, and political establishment should be able to see their way to support some affordable policy issues that will help rebuild the working-and-middle classes – e.g., allowing minimum wage increases, providing health care insurance no worse than Obamacare, developing effective job retraining and vocational education programs, among many other ideas that have been proposed. The moderates are essential to find solutions to these problems that can attract majority support, which the extreme liberals and conservatives presently dominating the political arena do not.

This is essentially what happened in the 1890s-1910s when “muckrakers” checked the power of Guilded-Age capitalists with much-resisted anti-trust legislation; in the early 1900s with equally resisted laws affecting the rights and activities of labor unions; in the 1930s with New Deal financial regulation, deposit insurance and social security; and in the 1960s with Great Society legislation (social security enhancement and Medicare for the elderly). Though most of these laws were introduced by Democratic administrations they passed with bi-partisan support.

Capitalists know that capitalism can only succeed in a democracy with the consent of the people, and that consent may be hard to maintain with half the population feeling left out. But maybe half of that half are sorting themselves out, and need to be heard from too. Probably what you would hear from them is “no one is entitled to a free ride, but there are times when sensible government actions can and should make things work better.” A consensus around such a policy position might begin to change to hollowed out perception.  Changing perceptions helps a lot in rebuilding growth.  

Friday, January 11, 2019

It’s Been a Messy 20-years, but the Euro has Been Successful Enough

by Roy C. Smith

The euro and its companion institution, the European Central Bank (ECB), are products of the Maastricht Treaty of 1992, approved by the 18 EU member countries at the time, with three “opting out” of adopting the new currency. On Jan. 1, 1999, the euro was introduced as an “accounting currency” (with notes and coins arriving three years later). On the same day, Credit Lyonnaise, the largest French Bank run by the former head of the Treasury, announced in full page adds all over the world that it was already, and prepared to remain, the largest bank to the euro community.  The 1999 Nobel Prize in Economics was awarded later in the year to Canadian Robert Mundell (the only well-known North American economist to support the euro – Milton Friedman gave it no more than ten years in which to collapse).  Credit Lyonnaise did collapse in 2003 as a result of too much over-eager lending and too many overpriced acquisitions.

So, right from the beginning it was a mixture of wishful thinking, fanfare, and fundamental misconceptions. It didn’t follow monetary traditions, or economic theory, and the political justification for joining varied widely among member countries. But, it happened.

Its chief sponsors were German Chancellor, Helmut Kohl, and French President Francoise Mitterrand. For them this was the natural follow on the Single Market Act (1986) that would bind EU countries together economically to make another war between them impossible. But the binds were imperfect because the EU was unwilling to shed national sovereignty to the extent necessary to for a real economic “union” (like the US). The Treaty provided for “monetary union” (currency, interest rates) but no “fiscal union” (taxation and budgetary powers), and expressly rejected the notion that countries could be called upon to assist other member countries. So, the linkages of the EU were never destined to be more than those of a “confederation of states” (e.g., similar to the loosely bound, ineffectual united states that preceded the signing of the US Constitution in 1797). 

But among the wishful thinkers were those who saw a different future for Europe. They saw a base of free-market democracies expanding to form a more competitive, energetic private sector and making the association available to all or many of the 29 countries of the USSR and the Soviet Bloc that were forming anew after the collapse of the Soviet Union in 1991.  They also saw that the rule making and enforcement powers of the EU Commissions, and of the new ECB, would begin to force all the member states to converge into less interfering and subsidizing economic bodies that would have to compete with each other for workers and investment capital, which under the Single Market Act, could move wherever in the EU they wanted. The more of this, the healthier the system they were trying to create would become.

In the first decade of its existence, the euro faced a number of painful shocks – two financial crisis that affected the real economy significantly; Islamic terrorist attacks after 9/11 that opened a floodgate of trouble - the Arab Spring, ISIS, several civil wars, great instability and massive illegal migration to Europe from the Middle East; and a “hollowing out” of European manufacturing jobs due to Chinese and other imports. But despite these shocks, the interest rates on all member country government bonds were very close to the rates charged on German bonds for a decade, despite substantial credit differences between them.  The market believed that despite no obligation to assist each other, the euro countries would do just that if necessary. This proved to be true in 2010 when the EuroArea (EA) bailed out Greece, Portugal, Ireland and Cyprus after the banking crises in these countries overwhelmed them. Further, abundant market liquidity was supplied by the ECB during the crisis as necessary to resolve it. All of this was done with the reluctant, step-by-step approval of the northern EA countries, ever fearful that their southern neighbors would suck them dry. Indeed, all of the recipient countries, despite stormy political changes, agreed to tough conditions that they have followed (more or less) and have made reasonable recoveries since.

Indeed, the sovereign debt crisis frequently raised the question as to whether Greece (GREXIT) or Germany (GERXIT) would be better off outside the euro than in it. By leaving, Greece would consign itself to being a developing country again, would have to devalue its new currency from the euro, but still bear the burden of the euro-denominated debt it undertook from the EA. The cost of imports (Greece imports much of its food, clothing, energy and manufactured goods) would rise, but its export businesses are largely confined to tourism and agriculture and would lag behind.

If Germany were to leave, its currency would revalue, making exports more expensive and as Europe’s largest exporter, especially within the EA, it would cause a significant slowdown in Germany’s growth rate. Germany’s departure would very likely bring an end to the euro, which would have a variety of unwanted consequences, including perhaps, also bringing an end to the EU.

Arguably it should be easier to leave the EU than the euro, which has additional complications. The UK’s experience in attempting to leave the EU however, has shown how difficult and potentially harmful to its economy leaving the EU would be.

Meanwhile, the euro ticks along, being widely accepted by 340 million EA citizens, and by global financial markets. It is the only alternative to the US dollar, it is the second most traded currency in foreign exchange markets and the second largest reserve currency with 1.2 trillion outstanding at the end of 2018.

The euro was never designed to be perfect. Just adequate to hold what union there is together. So far, so good.