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Friday, October 20, 2017

Black Monday Recalled

By Roy C. Smith

October 19th is the thirtieth anniversary of “Black Monday,” the great US equities market crash in which the Dow Jones dropped 22.6 %, the largest single day decline then or since, and instantly spread to other markets in the world’s first massive liquidity event .

The event was sparked by the usual suspects – an overvalued five-year bull market (the S&P 500 index was up 44% on the year at its peak in August), some near-the-top volatility, and an early morning panic in Hong Kong that passed through Europe and hit NY like a hurricane.

When it did, it forced aggressive margin calls, revealed structural weakness in US trading systems, and sank the then new computer-based, automatic “program trading” and “index arbitrage” schemes.

The speed at which the crash developed created problems of its own. Price information was hard to get; many NYSE stocks (for which markets were made by “specialists” on the trading floor) failed to open on time, and closing prices from the day before quickly became meaningless. Program trading that required the purchase of futures contracts and simultaneous selling of shares in the cash markets quickly became disorderly and unbalanced, and further accelerated price declines, overwhelming whatever opportunistic buying there was. All this accompanied “defensive” (i.e., panic) selling by traditional institutional investors.

This crash spread instantly to other markets around the world. Global linkages and technology improvements had made this possible, but the consequences were severe. All markets with more-or-less modern trading platforms were affected, and most suffered plunges worse than in the US. Markets were down 27% in the UK, 31% in Spain, 46% in Hong Kong and, surprisingly, down 60% in far off New Zealand. Coping with shocks requires a large and well developed institutional base of investors with liquid reserves, which were scarce. This kind of global market contamination is now baked-in to our global financial system, and has occurred on several other occasions, most notably in 2008.

The crash also halted two related dynamic actvities that had developed during the 1980s, a global mergers and acquisitions boom, and a series of very large privatization sales of stock in nationalized companies by the UK government of Margaret Thatcher.

I was meeting with Sir Patrick Sheehy, CEO of BAT Industries, whom I was advising on a prospective $13 billion takeover offer for Farmers Insurance, a California company whose management and regulators would probably resist the deal. We were devising a price range for the yet unannounced deal and plotting our initial moves. I was nervous about the market that had been turbulent all the prior week. So, I got up periodically to check the office “Quotron” machine (a sort of electronic ticker tape) that was located outside my office. It was clear by early afternoon that all hell was breaking loose, and our merger experts advised me that we should postpone the deal until market conditions improved. This was because we would need the support of M&A arbitrageurs and other institutional investors to buy up stock on the contested deal’s announcement to show support for it. But the arbitrageurs were badly hurt by losses in their existing positions, so they had little room for new ones. My clients were disappointed, and left in a bit of a huff, ending our hopes for completing one of the largest deals of the year that we had been working on for months. (The transaction was completed in the next year).

At the same time, Goldman Sachs was in the middle of leading an underwriting of the US tranche of a $12.2 billion privatization sale of British Petroleum shares. This deal was truly enormous by 1987 standards. It was being conduicted under UK underwriting rules in which a price/per share was fixed at the announcement of the offering, which was followed by a two-week “subscription” period for investors to take up the shares. Any shortfall was left to the underwriters, which in the UK already had been placed with institutional investor sub-underwriters.  But, the crash occurred in the middle of the subscription period, and dropped the market price of BP shares to 224p., about 25% below the subscription price of 330p., which meant that no one would subscribe for the shares and they would all be left with the underwriters. The four US underwriters, under US rules, could not close on stock sales until the end of the subscription period, so they took a loss of about $250 million on this one deal alone, enough to threaten the viability of some of the firms.

There were a lot of other losses that day too, from trading positions and cancelled deals, which was frightening to everyone on Wall Street, but especially so to the partners of Goldman Sachs, a New York partnership with unlimited personal liability of partners, with all their money tied up in the firm.
So, it is understandable that October 19, 1987 was and is still very memorable to me. At the end of the year I retired as the senior international partner of the firm to join New York University as a finance professor, something that had been in the works before the crash.

After the crash, the market recovered quickly and by the end of December closed 2%  above where it had begun in January. (Overseas equity markets, however, recovered much more slowly). The government appoint a commission to consider causes, etc. and some reforms were put in place.  The “Roaring Eighties” did not end, however, until late December in 1989, when there was a mini-crash and a recession began. The merger boom died out then too, after the junk bond market that had financed a large part of it collapsed with the failure of Drexel Burnham, its principal advocate.

As bad as the 1987 crisis was, however, the event did not trigger any significant form of government intervention. The Federal Reserve said it would do its job to provide liquidity to banks wanting to lend to security firms on good collateral, but not much else. The exchanges stayed open, losses were absorbed, wounds licked and business went on. The market’s quick recovery eased the pain considerably.

Indeed, in the case of the massive BP stock offering, the US underwriters did what they could to persuade the UK government to postpone the deal because of force majeure; they had help in this from some sympathetic government officials worried about systemic failure, but Mrs. Thatcher said Absolutely Not! – contracts must be honored in free markets – and the deal went on despite the massive losses. If it had been pulled, then the value of underwriting contracts (especially under the UK system) may have been subject to question.

Thirty years later, we operate in markets that are ten times larger (in today’s dollars) than in 1987. Today’s US equity markets have a market capitalization of $27 trillion; but all the world’s stock, equities and tradable bank loans, according to McKinsey, are valued at over $300 trillion. Liquidity panics and global linkages continue to present a serious systemic risk to the system, as was demonstrated in 2008. New measures to contain such risks have been adopted, but are untested.

Not much is predictable about the future, but another financial crisis probably is.

Roy C. Smith, an Emeritus professor at New York University,  was a partner of Goldman Sachs in 1987.

From: Financial News, Oct 19, 2017

Monday, October 9, 2017

Will Trump Take Half a Loaf on Taxes?

By Roy C. Smith

The Trump $1.5 trillion tax plan is really two-bills-in-one. A good one and a bad one.

The first is a legitimate effort at long overdue reform of the method and effect of collecting taxes from businesses. It would repeal a long out-of-date system of taxing income wherever earned around the world, after deducting local taxes paid, but allowing tax payments to be deferred until the income was brought back into the US. In a time of global business integration and competition, the present system is inefficient because (a) it applies a 35% tax rate to all income, the highest tax rate of any large, developed country, (b) but that tax rate is reduced by the deferment provisions to an average effect rate of about 26%, which happens to be the average corporate rate for OECD countries, (c) however, only a few hundred large global corporations get the benefit of deferral, so the vast majority of America’s 5.5 million corporations pay an exceptionally high rate, which clearly impedes their growth and development.  A rate cut to 25% for smaller and midsized businesses would benefit them a lot.  

By the way, the argument that the cash reflecting the deferred taxes, some $2.5 trillion or so, is “trapped” outside the country and cannot be used to fund domestic investment is phony. Corporations can and do lend money between subsidiaries, or borrow from banks with the deferred cash as collateral.

Two solid reasons for adopting these Trump corporate tax reforms are that it harmonizes the US tax system with those of our global competitors and levels the playing field. And, it will add sufficiently to after-tax cash flows from all `businesses and raise their returns-on-equity to enable more economic growth, a major objective of the Trump plan.

Another reform element of the Trump plan is the abolishment of the estate tax on inherited wealth. This tax is now only paid on wealth greater than $5.45 million ($10.9 million for married couples), but it is then taxed at the rate of 40%. Abolishing the tax would be a huge benefit for the very rich (just 0.2% of taxpayers), which, of course, attracts a lot of political heat. Yes, the heirs of Mr. Trump and much of his cabinet would prosper greatly from such a change, but the numbers are not big on a national scale, as the estate tax represents less than 1% of annual tax revenues. The estate tax was installed in 1916 and has endured since, largely because of the argument that without such a tax a permanent class of enriched “nobility” would emerge that would weaken our democracy. The counter argument to this was the America is the land of opportunity in which wealth could be created from very little, but an estate tax confiscated the fruit of such efforts – constitutionally protected private property on which federal, state and local income and property taxes had already been paid. The present estate tax law, enacted in 2016, is a trade-off between these points of view. There is not much appetite to bring estate taxes up again so soon after the last effort to reform it and eliminating, and, in any case, it won’t affect the economy much

The rest of the Trump tax plan is essentially bad because it will increase the fiscal deficit and probably won’t create much growth. It is a hodgepodge of business and personal tax cuts designed to satisfy traditional republican demands for lower taxes to stimulate growth. Mr. Mnunchin says the plan will pay for itself by increased tax revenues from added growth. Despite the popularity of the “Laffer Curve” that predicted such an outcome from the Reagan era tax cuts, it didn’t happen then and very few economists believe it will this time.

About 47% of tax filers don’t pay federal income taxes, so they won’t be affected.  Analyses to date suggest that the tax cuts for middle income people will be offset by the loss of deductions that leave the average taxpayer about where he or she was. Lower rates on higher income people won’t matter that much, as most wealthy Americans pay much lower effective tax rates than the 39.6% maximum because of allowable deductions and so much of their income is from capital gains that are taxed at 22.8%. Reducing the maximum rate to 35% won’t result in much additional consumption on which incremental growth depends.  The rich don’t spend their tax savings, but instead invest it in (already high-priced) securities. But at very low unemployment (4.2%) and inflation (1.5%), the odds are that whatever new spending there may be from the tax cuts will end up increasing wage inflation more than growth.

One feature of the Trump plan, however, could make a big, if unintended, difference. This is the provision that would allow corporations or individuals to utilize “pass-through” vehicles (limited liability corporations or partnerships) to benefit from a maximum rate of 25%. Pass through vehicles are entities that don’t pay taxes but pass income (and losses) on to shareholders to pay (or deduct) at individual rates. A small business owner can often lower taxes considerably by passing through, but some of the biggest users of these entities are hedge fund and private equity investors and real estate operators like Mr. Trump. If the 25% rate were adopted for pass-throughs, these types of investors would be major beneficiaries along with many wealthy lawyers, doctors, and others who would set up their own entities to channel income to get lower rates. But if the corporate rate is to be lowered to 25%, this provision really is unnecessary.

Certainly, the Trump tax plan has its share of political problems. To get passed, it will have to be presented to the Senate as a “budget reconciliation” measure that can be approved by a simple majority of 51 votes. For this to happen, the Senate must first pass a budget resolution based on the Trump budget submitted earlier this year (the House passed such a resolution last week). According to the bi-partisan Tax Policy Center, the budget will produce a deficit of $2.4 trillion over 10-years, or $240 billion per year (1.2% of today’s GDP, to be added to the existing fiscal deficit of 3.1%). This deficit will then have to be financed by additional government borrowings, which may upset the deficit hawks among Republicans (they have been quiet so far), the future debt ceiling bill that will have to be passed to accommodate it, and raise serious questions as to whether the $2.4 trillion estimate, or the Treasury’s of net deficit reduction is reliable.  The Treasury forecast is based on “dynamic scoring” which assumes incremental tax revenues from a 3%+ annual growth that it says the tax plan will generate. In the past, dynamic scoring forecasts have been very inaccurate -- the amount of derived growth has been less than promised, and the deficits have been greater. Continually missing these forecasts partly explains why the US government’s debt to GDP ratio (107%) has grown to be the highest since WWII. This has been very worrying to many finance experts, debt rating agencies and those fearful of a debasing of the currency, and it should put some serious loyalty stresses on Republican senators who properly understand these issues.

The tax plan is unlikely to attract any support from Democrats, who are in lock-step that the whole thing is a give-away to the rich. It might get through the Republicans, but it will be tough on those Congressmen running for reelection in high-tax states that would lose the deductibility of state and local income and property taxes. The loss of this deduction is one of the last surviving means (after abandonment of the “border tax”) to gather new revenues to pay for the other cuts and increased defense spending.

The best outcome might be for Congress to pass only the good bill, the corporate tax reforms, and let the rest (like health care repeal) go for another time. Doing this could add to growth without growing the deficit. Middle class tax cuts may have been promised, but what would be delivered won’t be that much. Pass-throughs and an aggressive program of accelerated depreciation create distortions and unintended economic consequences that are more trouble than they are worth. Even the rich are resigned to paying some form of estate tax, so its repeal won’t really be missed.

Doing this, of course, would be an example of a half a loaf being better than none, something our present all-or-nothing Congress has been unable to accept as a working principle of governance.

Friday, September 15, 2017

The Troubled Future of Global Banks, Revisited

by Roy C. Smith

In different articles last year, Brad Hintz and I argued that the world’s largest capital market banks faced a troubled future, burdened chiefly by vastly increased regulatory requirements, heavy litigation costs, pressure on margins, and changes in the trading markets.  These burdens resulted in lowered returns on equity, and higher costs of equity capital, such that the net economic valued added (EVA) of these firms was negative and had been for several years.  Our conclusion was that the banks would have to substantially restructure their business models to regain economic viability. The data we used to form our opinion has been consistent since 2009, but the most recent set was as of Dec. 30, 2015. 

Since then, many things have happened. After the election of Donald Trump as President of the US the S&P 500 stock index rose 17.5%, As they continually surpassed record levels, stock markets hummed with speculation about improved economic growth rates, a strong dollar, and a sizeable reduction in US financial and other regulation.  The banking sector was to be a major beneficiary of these positive expectations.

Seven of the top ten capital market banks’ stock prices have gained more than 20% since January 1, 2017, though three (Barclays, Deutsche Bank, and Credit Suisse) posted declines of 20% or more.  The average price-to-book ratio for the top ten banks in Dec. 2015 was 0.75, at the end of the second quarter of 2017 it was 0.99; in 2015, the average EVA (the spread between the banks’ returns on equity and their cost of equity capital) was -8.90%; now it is -2.16%. Though five of the ten banks were in positive EVA territory, two, Deutsche Bank and Credit Suisse posted EVAs of -10.3% and -13.4%, respectively).

Banks have benefitted (in their EVA calculations) from the lowering of their average “beta” (a volatility measure used to calculate cost of equity capital under the Capital Asset Pricing Method) from 1.72 to 1.38. Lowered betas are a direct result of reduction in the risk levels of the banks, which was the main purpose of the increased regulation.

Average returns on equity also improved from 5.36% to 6.64%. Most of this appears to be due to cost cutting, asset sales, and reengineering products and trading platforms. Revenues for the top banks were up 4% for the first two quarters of 2017, but still down 13% from five years ago.

Overall, these data indicate things are getting better for most of the banks. And, the enormous storm of litigation from financial crisis misdeeds that weakened returns and book values for the last several years has apparently run its course. US banks have also done better on the stress tests and been permitted large increases in dividend payouts and stock repurchases.

However, expectations for an economic boost by reforming taxes, infrastructure spending and deregulation have diminished significantly – Republicans are divided and Mr. Trump seems helpless to do much about it. Whatever does happen will be less impactful, and later in arriving, than was thought six months ago. Deregulation is limited to executive orders not requiring Congressional approval, and this, too, has amounted to less than expected. The SEC produced a report in August that said it was unable to tell whether the Volcker rule limiting proprietary trading was effective or not, suggesting it might not be changed. Earlier, a Treasury Department report required by an earlier executive order only recommended five regulatory reforms of the most general nature. When and how these might be produced and become effective is unknown. The Financial Choice Act, meant to neutralize the Dodd Frank Wall Street Reform and Consumer Protection Act, was passed by the House of Representatives in June, but has little chance for passage by the Senate this year. Still, most observers believe that something will happen in the next year or two to soften Dodd Frank, but probably not anything very meaningful to capital market banks.

Dodd Frank is vast and very expensive to comply with, but it is not the chief source of the capital market banks’ regulatory burden.  These come from Basel III (a minimum bank capital adequacy agreement) and the new form of qualitative stress tests that central banks now impose on their global systemically important banks. Most of these measures were adopted by the G-20 group of countries with strong US support.

Basel III effectively doubled the capital adequacy requirement while halving leverage and requiring capital buffers to insure adequate liquidity in a time of crisis. This made trading inventories expensive when trading volumes were soft and margins were under competitive pressure as they still are. Basel III constraints seriously limited the operating field-of-play available to banks.

The stress tests were designed to be impossible to “game,” and the consequences for not meeting them were potentially so severe (in terms of limiting payment of dividends and stock buybacks) that none of the banks tried to do so.  However, the rules of the stress tests change without notice, so the banks’ operating areas were limited further.  Even so, some banks (JP Morgan, Goldman Sachs, and Wells Fargo) , have adapted and been able to generate minimally satisfactory EVAs under this regime (JP Morgan’s is +3.2%, modest but acceptable), but others (Credit Suisse, Deutsche Bank, Barclays, and Citigroup) continue to be unable to do so, despite years of tinkering with their balance sheets and business models.

One thing that hasn’t changed since Dec. 30, 2015 is the unwillingness of the struggling banks to break themselves up. That is, into investment banks or commercial banks in order to specialize in trading and fee businesses, or deposit taking and lending, two very dissimilar businesses.

We presented a case for such breakups last year – when many banks were trading well below book value – as a way of recovering shareholder value. None followed our advice, and now that some banks have seen major increases in their share prices, it is unlikely they will be interested in doing so now. But half of the industry is still in big trouble, still trading below book and earning far less that it costs their investors to hold their stock.

So, despite some signs to the contrary, nothing really has changed, or is likely to soon.  But our original argument still seems valid, so there is still a good argument for breaking up at least some of the worst performing banks.  Institutional and activist investors ought to encourage them to do so.

Published Sept. 13, 2017 in Financial News

Friday, August 25, 2017

Is Brexit another Dunkirk?

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By Roy C. Smith

The stunning events depicted in the movie Dunkirk, one of the summer’s top sellers, was short on context so possibly not everyone understood that it was Britain’s worst military defeat in its long history, however heroic the effort to recover the soldiers from the French beaches on which they had been suddenly pushed by the German army in 1940. The British were unprepared for the war, despite plenty of evidence that one was coming.

Brexit is another effort by Britain to pull its troops out of Europe, despite plenty of evidence that it could trigger an economic disaster for the UK and probably the rest of Europe. The UK and the EU are mutually bound together in important (if troublesome) ways; breaking this link is a political failure by the Conservative government of David Cameron that threatens to strand Britain on the beaches again.

Brexit was the outcome of a public referendum last year on whether to remain in or to exit the European Union. Turnout was 33 million (72% of the electorate), with 51.9% voting to leave. Conservative politicians (including Donald Trump) acclaimed the result as creating new opportunities for Britain to separate itself from an expensive, low-performing economic club they would be better off without. Most observers believe that the voters (and Mr. Trump) had little understanding of what was really at stake.

Some of the troubling effects of Brexit are just starting to come into focus: About 50% of the UK’s $700 billion two-way trade in goods and services will be subject to new tariffs, Northern Ireland’s politically and economically essential open border with Ireland will be closed, and the City of London (Britain’s – and Europe’s - financial center which exports more than $20 billion to the EU) will be weakened and some of its functions and personnel will be forced to relocate within the EU. Britain, which has received nearly half of all EU foreign direct investment to date, will attract much less of it in the future.

The EU has insisted that before negotiations on “transitional” and “final” relations between the UK and EU can be started, the UK must agree to a “divorce” settlement in which the UK pays it share of all outstanding EU liabilities, which some have estimated to be as much as $100 billion. Further, the already weakened Pound, which has dropped 17% relative to the Euro since the vote, will likely slump further.

Britons will no longer have free access to, or employment opportunities in the 27 remaining member countries of the EU where 1 million Britons now work, and EU residents of the UK will leave, as many have already begun to do. Indeed, Brexit will deprive Britain of a modest but necessary immigration of willing workers from other EU countries, many of them skilled, which the UK needs to maintain its labor force and growth rate. The birth rate in the UK is 1.8, higher than many EU counties but still well less than the natural population replenishment rate of 2.1. It is true that open immigration was one of the more controversial things that UK voters disliked about EU membership, but most voters did not understand that the annual net immigration, though having risen slowly since 1993 to 248,000 persons in 2016, is only 0.4% of the UK’s population of 65 million. 

Britain’s departure will weaken the rest of the EU. The UK is the EU’s second largest trade partner (just behind the US), generating a net trade surplus for the EU of $135 billion. The UK, fortified by its long traditions of liberal economic policies, was always the free market champion of the EU, without which Europe may slide back to becoming the over-regulated, under-performing “Eurosclerotic” economy it was before 1986 when, with help from Margaret Thatcher, it adopted the Single Market Act that made the EU into the world’s largest free trade zone of 500 million people and a GDP today of $16.5 trillion. The Single Market Act (1987) was followed a few years later by the Maastricht Treaty (1992) that created the ultimate in unification, a common currency and monetary policy, even though each member was free to conduct its own fiscal policy. The UK, with Sweden and Denmark, opted out of the Euro to preserve its independent monetary policy.

The Single Market and the Euro were significant achievements that Europeans hoped would return the world’s economic center of gravity to Europe. However, despite twenty-years of initial success, the financial crisis of 2008 caused serious economic trouble within both the broader EU and the narrower Eurozone. Countries such as Greece, Ireland, and Portugal received significant (though reluctant) bailout assistance; having to assist larger countries like Italy and Spain would be hugely expensive and cut deeply into the resources of other member countries experiencing their own difficulties. Intra EU infighting and dissent blossomed. Economic growth dropped and unemployment rose.

Popular support for the EU and its principles were fading fast, but then really collapsed with the appearance of 1.3 million Syrian and other refugees finding their way into the EU through weak external borders in Greece and Italy. Once inside the EU, passports were not required to travel within it. Until, that is, individual countries began objecting to the unwanted flow of refugees and closed borders anyway. (The UK agreed to accept 20,000 Syrians, far lest than most of the larger EU members, but so far has only admitted 4,400).

About this time everyone of voting age in the UK was invited to vote for the UK to remain or exit the EU.

The Cameron government that called for the referendum to appease backbenchers always assumed that the voters would elect to remain in the EU; they lost largely because the voters did not really understand what they were voting for, seeing it, some observers said, as an opportunity to show their dissatisfaction with the government in place, which opened up opportunities to express dislike of immigrants, their distrust of globalization, and their longstanding grumpiness about giving up British sovereignty by letting a bunch of “foreigners tell us what to do.”

Since the vote in June 2016, the Cameron government has been replaced by one led by Teresa May, who officially began the two-year negotiation process with the EU in March 2017. She then called a snap election in June 2017 to fortify her majority, only to lose it. May’s government is now part of a coalition with the Democratic Unionist Party of Northern Ireland whose 10 seats in Parliament provide a very slender majority.

During the past year, the British economy has performed about the same as it had been before the vote. Growth in 2017 is expected to be about 1.5%, versus 2.0% for the EU as a whole. This is down from 1.6% in 2016. Some forecasts through 2020 show growth remaining at about this level. UK unemployment, however, is 4.4%, much lower than the EU average of 9.1%. The FTSE stock market index is up 8%. 

But the UK is still in the EU and will be for another two years. The real impact of Brexit won’t happen until then. Richard Portes, a prominent economist from London Business school, says both the EU and the UK will be worse off than before Brexit, but the impact on the UK will be greater than that on the EU. Fears are beginning to develop that in anticipation of Brexit, consumers will hold back and corporations will invest less and relocate facilities and personnel to the EU, which will slow growth in the UK further.

The May government, having committed itself originally to a hard-line “Brexit means Brexit” position, has argued for the past year that no deal was better than a bad one. Negotiations have now begun and many obstacles have emerged, but if no agreement is reached by March 2019, the UK “falls off the cliff” as all the benefits of EU membership are suddenly lost, tariffs are imposed, and hundreds of rules affecting Britons’ ongoing relationships with the 27 individual EU countries will have to be sorted out one at a time. 

Businesses with global supply chains and customers in the EU, and the Mayor of the City of London are among those lobbying hard for a less rigid approach. So, Mrs. May is now allowing talk about a “softer Brexit,” which would hang on to a “customs union” (access to the EU markets without tariffs) but avoid some of the other regulations imposed by Brussels. Norway is not a EU member but it was granted custom union status in exchange for adopting the EU’s principle of free movement of people across borders.  For the UK to do the same would require it to give up its resistance to the EUs free immigration rules.

The best thing might be to admit that the Brexit vote was taken without voters having a good understanding of it, as former prime minister Tony Blair has claimed, and have another one after an educational period in which credible and knowledgeable people debate the pros and cons. But that would be a very heavy lift for the May government, so it seems unlikely. The opposition parties, of course, probably will try to defeat a weakened Mrs. May in a vote of no confidence in Parliament, to bring on another election before 2019.  If that happened and the Conservatives were defeated, a second referendum or some other way out might be achieved.

In the meantime, the British people are hostages to the results of their ill-considered and poorly managed referendum.  Being cut off from Europe and stranded on their little island will bring unnecessary hardship to the UK, but there is still time to minimize it, or better yet, to have another vote that at least would enable people to know what they are in for.  Otherwise, the old British “bash on regardless” approach begun by Mrs. May is likely to end up having fallen off the cliff, which would be the worse of the possible outcomes.

Well, they survived Dunkirk, and they will survive Brexit too, but at what cost?
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Thursday, August 17, 2017

Democrats Need to Learn to Love Business More

by Roy C. Smith  

November 2016 was disastrous for Democratic Party office holders nationwide. Not only was the presidency lost to a person most democrats thought was horribly unqualified, so was control of both house of Congress.  And, according to the National Council of State Legislatures, over the past decade Republicans have gained control of 68% of state legislatures, the highest proportion ever. Some polls suggest that only 25% of voters identify themselves as “liberals” and two-thirds think “big government” is the main threat to the future.

This has occurred despite evidence that wage rates had been stagnant for years, US levels of income inequality have reached peak levels for modern times, and several years of blaming Wall Street and big business for the sufferings of the American “middle class.”  

Rescuing the middle class from all this was a strategy Barack Obama devised. But what the middle class was, was unclear. According the Urban Institute, the middle class represented 78% of the US population in 2016, of which the “upper middle class” was 29% (up from 13% in 1979), and the “lower middle class” was 17% of the population (down from 24% in 1979). “Working Class” Americans that account for approximately a third of the population, according to some sociologists, are sometimes defined as those without college degrees who are part of the lower and middle sectors of the middle class.

Democratic Party supporters over the years have come from the working class, minorities, women and an assortment of intellectuals and entertainers. It has relied heavily on support from labor unions, though union membership dropped to 11.3% of the workforce in 2013, down from 20.1% in 1983. The percentage of union members in the private sector was only 6.7% of the workforce, while those in the public sector represented 35.3%.

In 2016 the Democratic Party, represented by its centrist standard bearer Hillary Clinton, was splintered by assaults from two different directions: socialist Bernie Sanders, who promised a more radical platform, and by Donald Trump, who appealed to some deep-seated concerns of working class people angry with the way things had turned out for them.

The thumping Democrats took at the polls has called for a rethink of what the party considers to be its basic principles. Democratic Party strategists Mark Penn and Andrew Stein recently published an OpEd in The New York Times (“Back to the Center, Democrats”) calling for a shift to the center, but others have insisted that it move further to the left instead. Senator Elizabeth Warren, a likely candidate for the Democratic nomination for president in 2020, said in a recent speech, “Liberals (i.e., the far left) are not a ‘wing’ of today’s Democratic Party, we are its heart and soul.” She went on to indict a “rigged system,” that imposed basic inequities on women, African-Americans, undocumented immigrants, and LBGTs.   

The election revealed that many middle class Americans feel that both Republicans and Democrats have done a poor job running the country over the past two eight-year administrations. During that time, economic growth has averaged just 2% per year (as compared to 3.5% for the prior 50-years), despite government stimulus plans and steady increases in public entitlements (health care and social security now account for 60% of the federal budget) that have raised the federal debt level to 106% of GDP, the highest since WWII.

The dilemma for Democrats is that Keynesian policies don’t work well when unemployment is low (4.3%) and the debt level is at its limit, and to decrease income inequality it would have to increase entitlements, and/or raise taxes on the upper middle class and the affluent, something Barack Obama was unable to do.

Further, many in the middle class may not be suffering as much as advertised. For example, most of the country’s $89 trillion of “household net worth” reported by the Federal Reserve in 2016 is owned by middle class Americans.  This is the sum of families’ savings, pensions, real estate and other investments at market values, less mortgages and other debts, after taxes, tuitions and other essential payouts. Household net worth has grown by a third since 2006, despite the financial crisis and recession, indicating that average American families have not been missing out on prosperity improvements over the past decade, and may indeed be more concerned by higher taxes, more entitlements and increased federal debt.

So, perhaps not all of the 250 million Americans classified as middle class want to be rescued by policies that might hurt them elsewhere. Most of America’s 5.5 million small businesses are owned and operated by middle class people wanting to preserve and expand what they have worked hard to create.

American has long had a love affair with its small business community that produces 46% of US GDP and much of its growth. But the love affair has not extended to larger enterprises, even though about 50% of all private sector employees work for the 12,000 or so “large enterprises” that are publicly owned (of which only about 5,000 are traded on the NYSE or NASDAQ). This is partly because of innate distrust of Big Business in America, but also because of criticism, litigation and general disparagement of it by Democrats during the Obama years. Large enterprises, however, are essential to US economic growth, make most of the investment in research that provides the technology innovations that sustain the economy, and pay most of the taxes of the private sector.  Large and small corporations together employ 85% of working Americans. It makes little sense to turn them into enemies.

When it is explained to them, most Americans seem ready to believe that the governing principal of the American enterprise system, the world’s most successful for 200 years, has been free-market capitalism. But this particular form of capitalism operates within an active and robust democracy, which through its legislatures and courts imposes rules and regulations that limit the role and influence of corporations. And, the system has evolved significantly over the years to institutionalize rights of workers, women, and minorities and to check abuses of size and power.  Most Americans know how important the free enterprise system is to the country’s future prosperity and don’t want to risk damaging it.

Democrats today seem convinced that Donald Trump’s personal behavior and inexperience will cause him to stumble, and they will slide back into power. But there is no evidence as yet that anyone else, Democrat or Republican, has a level of support equal to Mr. Trump’s 40% approval rating, however low that may seem to some.  If the only thing going for Democrats is that they are not Trump, then they may be much weaker than they think. Voters have kept them from office for a reason – they don’t have confidence in their ability to govern, especially if the party moves further left.

Democrats need to pay attention to Messrs. Penn and Stein and move the other way, back to the center. At a recent conference for Democrat bigwigs in Aspen, Jon Cowan, president of Third Way, a research group, echoed their sentiments and added “income inequality is severe,” and some parts of the system are unfair, but these are not central concerns to most Americans and many of the approaches to addressing them interfere with their own aspirations. There was plenty of pushback to the idea, of course, but no consensus emerged as to how the party’s message or policies ought to change.

When asked what the main concern of voters was in 1990, Bill Clinton said “it’s the economy, stupid,” emphasizing how obvious this was. The economy is in worse shape today, and it is still the main concern, but there are fewer government resources available to try to fix it.

Rather than attempt big programs to address unfairness in the system, which Congress is unlikely to approve, Democrats should realize that being more business-friendly, less litigious and regulatory-minded might enable the free enterprise system to catch its breath and get back to its job of improving the growth rate.  That is something voters did like in the Clinton years.

Wednesday, August 9, 2017

Republicans Need to Embrace “Liberal” Economics

By Roy C. Smith

63 million people voted for Donald Trump in 2016, a flamboyant political outsider and neophyte, who somehow captured the primary elections by defeating a dozen more traditional Republican candidates, and then went on to beat a very well- known and well-entrenched Democratic superstar. It is true that fewer votes were cast for Trump than for Hillary Clinton, but his voters were in the right places so he won the electoral contest.

Just prior to the election, 39% of American voters (according to Pew Research) identified themselves as “independents,” 32% as Democrats but only 23% as Republicans.  Having such low popular appeal may be the reason why the Republican Party selected such an odd candidate, one with no Republican ties or credentials and little history of supporting Republican issues. This suggests that the ever more narrowly focused, post-Reagan GOP was already imploding even before the election.  

“Progressive” Democrats (as opposed to Progressive Republicans of Theo. Roosevelt’s time) led by Barack Obama were aiming to right the wrongs done to the American “middle class” by the George W. Bush administration, and make the economy fairer for all. But once Obama lost control of Congress after passing the controversial Affordable Care, and Dodd Frank Wall Street Reform Acts, there was little else he could do except by Executive Orders that could be reversed.  Hillary Clinton was seen to be Obama’s third-term, who would continue to swing the pendulum towards socialism. She won 66 million votes, but lost.

This happened after an unprecedented 16-year economic slowdown, involving two recession-producing financial crises, the 9/11 attack and two wars. Economic growth in the US that had averaged 3.5% for the previous fifty years was, since 2000, reduced to 2%. This period captured two eight-year presidential administrations, one Republican and one Democrat. Neither satisfied.

Both parties were seen also as having failed on the international front. Bush, for having launched a useless but intractable war in Iraq (and upsetting allies in doing so), and Obama for having “weakened” American power by turning soft in the Middle East, seeking a nuclear agreement with Iran, and generally loosing influence among allies and adversaries alike.  Both administrations, however, defended “globalization” as an unavoidable but beneficial fact of life for an economically connected world, and tried to bring about a sensible solution to America’s perceived immigration problems. Neither satisfied.

American wasn’t listening. Discontent with economic and foreign policies that Mr. Trump perceptively claimed was hurting the average person became rampant, and spread around the world. The UK approved of Brexit, apparently without understanding what it would mean; Western democracies in Europe and Japan began to reject elected governments and policies that had stood for openness and freedom; and other governments (Russia, China, Turkey, Poland, Hungary) that had previously been drawn towards these principles, began to turn away towards more authoritarian alternatives.

These developments prompted Bill Emmott, a former editor of The Economist, to write The Fate of the West, a thoughtful book published this year on what went wrong to tarnish the “world’s most successful idea,” that of Western liberal democracy. (“Liberal” used in the British sense, meaning being based on personal liberties). Emmott argues that the democratic system of governance that began in America two hundred and fifty years ago produced the best results history has ever seen in terms of economic development, prosperity, equality and the ability to preserve itself by being open to new ideas, free-market competition and political flexibility.  Emmott fears, however, that this best of all Western ideas has failed to deliver its expected promise over the past two decades, and is in danger of being replaced by “alternative” approaches to modern political-economic governance.

Certainly, Emmott is right in noting that the ability of the Republican Party, which has stood for trade, commerce, small government and free-markets for years, has lost its ability to sell them to the voters. Indeed, both political parties seem to have lost interest in promoting the notion of the broad common good in favor of sharply partisan programs that often are wrongheaded, ineffective or mistimed, and only appeal to narrow bases of the parties.

Republicans need a large tent so as to attract supporters from all walks of life and classes who must always be able to believe that there will be room for newcomers like themselves, or their children, to rise to the top. The tent could be filed with “independents” looking for common sense approaches to policies that will work for everyone, not just a hyperactive base of extreme true-believers.

Western liberal democratic ideas are perfectly suited to a big tent - the more under it the better. However, it is on the Republicans to make the case that free-market capitalism in a democracy only works well when it has the support of the people. The rights and privileges of capitalists have to be balanced by a system of laws and regulations that afford reliable protection for the rights of workers, minorities and, yes, property owners too. There must also be checks and balances throughout the system so the already rich and powerful don’t get to dominate outcomes, and everyone can have a fair shot at success. And, personal liberties to choose how one wants to live, pray, reproduce and protect oneself must be preserved, and limited only by the need not to endanger others. The less interference with these personal liberties, the better.

The Republican Party has to go back to its basics as it tries to rebuild the popular support it needs to be viable in the future; economic growth with fair play, efficient but minimal government, and the defense of personal liberties. There are other organizations people can join to advance their social, religious, or ethnic preferences.

But if the Party is going to go this way, it will need to be able to explain some of the basics of globalization, immigration, and health care to its supporters.  

For example, a 2014 study by The Economic Policy Institute reported that between 2008-2013, a net loss of 1.3 million American jobs occurred because of trade with China (3.2 million since 2001). This loss occurred when the US workforce averaged 156 million, so it only resented 0.8% over a five-year period, not so much. Though the US economy has underperformed prior post-recession growth rates, the workforce now has 160 million and an unemployment rate of 4.3%, and a great many workers affected by Chinese and other foreign competition have found other work. There really is no “carnage” here.

A good position for the Republican Party to take on globalization is that, on balance, free-trade keeps American corporations competitive and helps more Americans than it hurts through lower prices and jobs with foreign companies in the US, but some things need to be done to keep it better balanced. Such things as robust negotiations with foreign trade partners to be sure dumping of goods in the US does not occur and that barriers to US exports are removed. There also needs to be more and better job retraining provided for displaced workers.

Mr. Trump also got a lot of traction from his hardline immigration policies, with no one from the Republican Party arguing for the moderate and practical approach George W. Bush took, but could not carry, in 2006. The simple truth is that America needs immigrants to fill in for the loss of workers that our aging population has created, so we need to admit some immigrants, including a good number who prop up our agricultural, hospitality and construction industries. Recent studies have shown that first generation immigrants (legal and illegal) are an expense to taxpayers, but subsequent generations contribute far more tax revenues than they cost. But, border controls and enforcement of visitation rights are important too, and should be stressed.

And there is health care, an area where Republicans have been operating against their own interests and those expressed by the electorate through polls. An essential opposition to creeping socialism has caused Republicans to oppose national health care programs. And they have defended the liberties of doctors and others who don’t want to be told how to treat patients by government bureaucrats. But, over many years, changing technologies, the new economics of the insurance-based US healthcare industry, and some creeping socialism have reached a point that requires the traditional Republican positions to be reexamined in the interest of providing healthcare services all Americans want, but providing them more efficiently. 

A 2013 study published in The American Journal of Public Health showed that US government tax-funded expenditures accounted for 64.3% of all U.S. health spending, and The Affordable Care Act would increase that figure by only 3% to 67.3% by 2024.  The expenditures include direct government payments for Medicare, Medicaid and the Veterans Administration (47.8% of overall health spending), government outlays for government employees’ private health insurance coverage, and tax subsidies to other health care programs, made up the rest. US healthcare expenditures per capita are the highest in the world, exceeding those even of countries, like Mr. Emmott’s UK, with full universal coverage systems.

So, if the present system is already covering two-thirds of the population, and not cost-effectively, maybe the system would work better if Medicare covered everyone and everyone paid into it in some way (like everyone does for Social Security). This made be too heavy a lift for present Republican leaders, but future ones might offer an open mind on the subject.

The world’s most successful idea should not be forgotten by modern Republicans, especially at a time when Republicans control all the branches of government but the public does not think it is doing a good job. Realclear Politics scoring currently shows 26% more people think the country is heading in the “wrong direction” than in the right one.

There is still time to Republicans to embrace Liberal economic principles before this administration leaves office, though it probably won’t be easy. The party may not survive its conservative base if it doesn’t.



Sunday, July 9, 2017

Ramping-up Financial Sanctions on North Korea


Ingo Walter

With North Korea intent on developing operational nuclear-capable ICBMs able to strike the continental United States in the foreseeable future, things are coming to a head. There’s been plenty of debate on US military and diplomatic options, yet none are attractive or apparently workable. But one course of action can still be leveraged, does not require broad intergovernmental consensus and is hard to evade: Financial sanctions applied to North Korea and to any global financial organization seeking to assist it by transferring funds on its behalf or on behalf of another financial entity collaborating with Pyongyang. This tactic is workable, if not entirely fail-safe, and can cause the kinds of difficulties for North Korea that they have for Iran and Russia. China’s recent sharp reaction to pretty mild sanctions imposed on only one of its banks for aiding and abetting North Korea’s financial dealings is encouraging.

The sanctions enforcement route now runs through US dollar clearing of international payments. Financial transactions that enable sanctions-avoidance almost always touch the US dollar clearing system, and when they do, they attract US law enforcement. Indeed, US prosecution of major international banks for helping evade sanctions in order to preserve their business with targeted countries has changed the game. Without the intentional cooperation of these banks, economic sanctions cannot be avoided. By raising the cost of violating the rules to significant levels, US bank regulators and the Department of Justice have helped sanctions throttle the financial air supply.

Foreign banks and their home governments may or may not agree with the policies underlying the US sanctions. But the fact is that global banks today continue to settle most of their trade and financial transactions in US dollars. This is an important business for these banks, and they must have access to the US clearing and settlement apparatus to conduct it. Like it or not in the dollar world, US law is the law. Banks must comply or face consequences, pressure that has been escalating steadily since 2005.

Altogether, banks such as HSBC, ABN Amro, Standard Chartered, Lloyds, Barclays, Credit Suisse have each coughed up plenty in fines and penalties. BNP Paribas’ 2014 admission of a criminal violation of US payments sanctions involving Iran, Cuba and Sudan led to an $8.9 billion fine, forced resignation of key executives, and imposed a one-year suspension from dollar clearing. Shares in sanctions-busting banks lost value as a result of the settlements and increased transaction risk exposure - BNP Paribas stock lost about 4% of its value soon after it was reported to be in settlement discussions.

Perhaps more important than the size of the fines, penalties and stock market impact, however, is that enforcement action BNP Paribas was brought under criminal, not civil law. Only regulatory forbearance negotiated in advance avoided the Bank’s suspension from various US businesses. But they were warning shots. The specter of Arthur Anderson demise after a ‘guilty’ plea back in the days of the Enron scandal Enron days is ever-present.

Sanctions that restrict access to the dollar market can be very burdensome for targeted countries like North Korea, particularly those with mineral resources that need to be sold abroad, or that need to import strategic raw materials and components as part of a military buildup. Sanctions long applied to Iran are thought to have been significant in motivating the 2015 nuclear agreement. Sanctions on Russia in the wake of the Crimea annexation and destabilization of Ukraine seem to have had broadly negative effects on the Russian economy in the years that followed, although they did not involve restricted access to the US dollar payments infrastructure.

Still, Vladimir Putin recently said he hopes to switch Russia’s enormous dollar trade in oil to Chinese renminbi in order to reduce the impact of possible financial sanctions. That may be naïve, since the renminbi is neither convertible nor widely used as a currency for international trade. Russia may assume it can find banks willing to help subvert sanctions via the renminbi, but participating banks would run the risk of putting their US dollar business in jeopardy. On the other hand, as North Korea’s key enabler, the evolution of an internationally viable financial market in China could eventually help undermine trade and financial sanctions directed at the toxic regime.

Now and for the foreseeable future, the US can impose financial sanctions unilaterally in the dollar market without the kind of broad agreement required for other international policy issues. And it has the ability and the willingness to detect and meaningfully punish those who violate its laws, including denial of access to its financial market. Dealing with a North Korean threat that could become existential for the United States requires a fully equipped economic, financial, political and military toolbox. With many of those tools thought to be ineffective or too risky, ramping-up financial sanctions presents one realistic option to apply serious pressure on the rogue government.