Follow by Email

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?

Conversation opened. 1 read message.


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?
Using 4.75 GB
Last account activity: 3 minutes ago

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.

Friday, July 7, 2017

Will a Financial Crisis undo China’s Superpower Ambitions?

By Roy C. Smith

The media has been focused lately on the rising influence of China and the confrontational bi-polar superpower world that lies ahead.[1] But before we acknowledge China as a superpower, it needs to demonstrate that it can maintain the long-term economic power that enables its geopolitical rise: a challenge that past superpower aspirants failed to manage successfully.

China has to deal with a slowing growth rate that may be worse than it seems and carries the risk that a disgruntled citizenry will begin to question the legitimacy of the Communist Party to rule the country without either Communism or any sort of popular consent. For years, both Chinese and other observers have noted that, defacto, consent to rule was exchanged for economic growth and prosperity provided by the Party. No one was ever sure of what the minimum growth rate to retain consent was, but many suggested 7%-8%. This year, China is forecasting growth in the 6.5% – 7% range – high everywhere else, but low for China.

But even this target may be tough to meet without fudging. China’s export customers are growing at less than 2% and shifting economic resources to the consumer sector has continued to lag. Much of the growth that is occurring is from the agricultural sector and overproduction of basic materials and manufactures, which global trade scrutiny is making harder to dump in overseas markets. Some of the growth, too, is from costly roads and bridges being undertaken well in advance of demand for them, and from large-scale demonstration projects (e.g., the Asian Infrastructure Investment Bank, and the One Belt One Road project). Meanwhile, Chinese profit margins are weak and wealthy Chinese investors have been shipping capital out of the country. The Chinese stock market has been lackluster since the Shanghai index soared to 5,100 and then plunged back to 3,000 in 2015.

Importantly, in its efforts to support a sagging growth rate, China may have pulled back too far from the necessary economic and financial reforms needed to transform the country into a mature market-driven economic system, and increased the chances of a financial crisis that could halt or seriously slow growth rates, exacerbating the legitimacy-to-rule issue.

Under the Xi Jinping government, some reforms have been undertaken, but these have been offset or undermined by blunt-force efforts to increase growth through easy credit and government spending. Indeed, there seems to be significant competition between the financial regulators fearing systemic risks and those more politically minded officials who fear unemployment and labor unrest more. Balancing the two concerns, in an economy the size of China’s with many decentralized vested interests, and limited policy tools is a very difficult task.

Last year the Bank for International Settlements said China was three years away from a financial crisis.  How likely is this to happen?

Based on historical precedent for rapid growth Asian economies (Japan, Korea, Taiwan, Thailand, Indonesia), a debt-based financial crisis seems inevitable. China’s total debt has soared in recent years to $28 trillion, 277% of GDP, with non-government debt ($17 trillion) representing 170% of GDP, twice what it was in 2011. Moody’s recently downgraded China’s sovereign debt to A1.

Most of the increased lending has been to weak state owned or other government supported entities experiencing growth constraints, which has raised concerns about bad debts. Chinese bank loans have increased by 15-30% annually since 2008%, though Chinese estimates of non-performing loans increased only to 1.75% of outstanding loans, though this is the highest ratio in eleven years. Few foreign observers take this non-performing number seriously; indeed, in September 2016 Fitch estimated the ratio to be ten times larger, representing as much as $2 trillion.

Bank regulators have made some significant efforts to contain credit risk. Whether these will be sufficient in a crisis in which market values could be decimated, threatening systemic failure is hard to know. But, the efforts to reduce bank exposures are in conflict with central and regional governments’ and the central bank’s efforts to support credit for growth that began in 2014.  This has inspired borrowings by “local government financing vehicles” and several other makeshift off-the-books ways to get around the regulator’s controls that have sprung up in recent years. S&P has recently downgraded several LGFVs, which, together with other “shadow banking” entities, now represent $9 trillion of assets. Two-thirds of these are considered bank loans in disguise, as they were arranged and presumably are backed by banks.

The four largest Chinese banks (assets of $12 trillion, 40% of total bank assets) are captive to government demands. China has a high savings rate and the government has $3 trillion of foreign exchange assets that might be used to shore things up in the event of a crisis. Indeed, the government tapped into these reserves in 2006 to clean up the balance sheets of the big banks that were going public then. The banks are assumed to be backed by unspoken government guarantees, with risks containable within a closed-loop government credit mechanism that is insulated from foreigners and private capital markets.

But this closed-loop assumption that many foreign observers have used to shrug off fears of credit collapse in China, may be different from what it was. The many new initiatives to spread credit beyond the banking system, and a bond market now with $10 trillion of capitalization, have transferred substantial market risk to private institutions and investors, including international investors. This exposure is now huge and vulnerable to price and liquidity changes that could sink many institutions unless aided by the government. If this should happen, and today it seems likely despite China’s increasing global eminence, it could invoke consequences similar to those of other recent financial crises.

Japan learned in 1989, that its relatively closed-loop financial system was highly vulnerable to a credit crisis following the bursting of a stock market and real estate bubble. The financial crisis that ensued was crippling to the Japanese economy and ended the superpower ambitions Japan then had once and for all.

Similar crises affected the high-growth Asian economies in 1997-1998 as credit losses threatened banks that had to be assisted by their governments and the IMF. The rapid growth rates of these countries have been sharply curtailed ever since

And of course, we in the West also learned in 2007 and 2008 that a relatively modest market segment (subprime mortgages worth $600 billion, in a $5.5 trillion mortgage backed securities market in a combined US bond market of $30 trillion) could be subject to severe pricing shocks as some investors, fearing credit losses, ran for the exits and created a global liquidity crisis that contaminated most other asset classes, including corporate bonds, commercial paper, bank CDs, real estate and equity markets, and, a bit later, sovereign debt. This extraordinary crisis, unexpected and largely unprecedented, was significantly enhanced by global market linkages that required substantial governmental intervention to resolve, and has sapped growth rates for nearly a decade.

China has considerable power and resources to deal with a crisis, including its lack of need for parliamentary approval to do whatever it wants. But it lacks experience in managing an increasingly market-oriented financial system, and in making the internal political trade-offs to serve both growth and regulatory control simultaneously. Indeed Japan, and the US and the EU had resources also, and used them to fight their crises. But crises, particularly in countries accustomed to the government closely managing the economies, can destroy confidence necessary for the economies to maintain investment, consumption, and – most important, especially in China --confidence in the future of growth, employment and well-being for all the citizenry, not just the urban well-to-do constituting 12% of the population.

A financial crisis could end China’s hopes for superpower status, but if the crisis is deflected or skillfully managed, it could fortify superpower claims for a long time.

[1] See Graham Allison, Destined for War, Gideon Rachman’s Easternization, and Amitai Erzioni’s Avoiding War with China, among others.

Thursday, June 29, 2017

Brexit and Lingua France: Does Foreign Language Training Make Economic Sense?


Ingo Walter

Not known for his sparkling sense of humor, EU Commission president Jean-Claude Juncker may be seriously underrated in the “zinger” department. In a well-reported speech (in French) a couple of weeks ago, he prefaced his remarks by noting (in English) that after Brexit the English language would gradually lose its commercial importance to the 24 continental European languages, notably French and German - the two post-Brexit EU “working languages.” His remarks, widely reported in the media and overanalyzed by the global elite, raised some interesting questions.

Imagine how much brainpower is invested by the thousands of Eurocrats, members of the European Parliament, national delegates, lobbyists and other hangers-on who are fluent or at least competent in four languages - the three current working languages plus the language of their home countries. The English, French and Germans get one exemption   each as do the Irish and Maltese, for whom English is the official language.  Plus many countries retain local dialects that have been remarkably persistent over the centuries, part of the enduring charm of Europe.

Becoming fluent in a modern foreign language takes a lot of time and effort, and comes at the expense of other activities that might be more productive. In the implicit cost calculus of the EU bureaucracy, it probably ranks with moving the annual plenary sessions of the European Parliament to Strasbourg from its HQ in Brussels due to political concerns early in the EU’s history. But things being what they are, within the halls of the EU and its agencies, the extraordinary commitment to modern foreign languages is likely to continue well after Brexit. Except maybe at the European Central Bank, which works in English despite the absence of the UK among its members.

Modern foreign languages have both personal and commercial value. Learning them involves investment in consumption or production, or both. Consumption-driven language investment allows access to literature in the original language, the performing arts, ability to converse across cultures, enhancement of tourism and a generally better informed and more cultured existence. Production-driven language investment allows better market access, lower information and transaction costs that ease commerce – international trade in goods and services, foreign investment and all kinds of financial flows. It can pay off very directly for a tour guide, for example, or in much more subtle ways that result in higher incomes that come from functioning more effectively in a multi-lingual world.

Languages are economic catalysts. They create lots of benefits without themselves being consumed in the process. And the more a language gets used, the more it gets used, with a tendency toward a winner-takes-all lingua franca. Unfortunately for Jean-Claude Juncker, it isn’t French or German. The drift toward English began in the far distant past, with the British exploration, trading and colonial history depositing the language the world over. Others like Spain and Portugal provided alternatives, but none had the domestic commercial, legal and business infrastructure to form a serious global challenge - or a powerful US acolyte. Even a credible newcomer like China stands little chance.

Today English is far enough down the slope of lingua francaness that arguing against it is like challenging gravity. Outside of commerce, English has come to dominate much of academia and technology as well, where ideas are heavily globalized. Other languages have liberally contributed key words or phrases for which English has no easy replacements - like entrepreneur and Schadenfreude, fait accompli and Wanderlust - and the English language is happy to incorporate them.  It is also relatively easy to learn, constantly evolving (as annual additions to the Merryam-Webster English Dictionary show) and eager to export plenty of its own words and expressions to other languages free of charge.

Even in the EU. It seems that 66% of EU citizens are competent in a foreign language, according to Eurostat – the EU’s statistical office - with 94% of them studying English, 34% studying French and 23% studying German at the secondary school level. At the primary school level 79% are studying English versus 4% French.[1]

In a recent study one of my students, Jessica Yang, conducted an interesting empirical analysis of the relationship between commercial and financial integration and cross-border migration in the EU and investments in learning foreign languages among pairs of member countries.[2] The study was based on a data panel containing both language-education stats and economic flows among four countries - Spain, France, Germany and Italy – so that paired conclusions could be drawn.

The causality, of course, could run both ways. Language education could lead to higher intensity of economic relationships among the EU countries examined. Or stronger economic ties among these countries could increase the personal payoffs from investment in language education and encourage attainment of fluency.

The finding? Rien du tout, Garnichts, niente. nada. Nothing? For better or worse, is seems that English swamps everything else. Casual observation over a couple of decades savoring the delights of Paris or Madrid – on and off the beaten tourist track - confirms this English language-creep, and practical business-related motives doubtless have a lot to do with it. But go ahead and study modern foreign languages anyway. You will be better for it. But for most people it won’t pay the rent.

In the rarified EU halls in Brussels, of course, form doesn’t necessarily follow function and there seem to be plenty of resources to waste, including brainpower dedicated to mastering multiple languages. Even so, English will doubtless continue to gain market share in remaining 27 member states well after the EU’s official languages drop from three to two after Brexit. Britain will leave behind a gift that keeps on giving. Stay tuned for Jean-Claude Juncker’s next bon mot on the subject.

[1] As reported in The Economist, May 13, 2017, p.47.

[2] Jessica Yang, “Foreign Direct Investment, Trade and Cross-border Migration as Drivers of Foreign Language Education,” Stern School of Business, New York University, 2015.