Ready for a China Deal?

By Roy C. Smith

The only significant thing that happened at the G20 talks in Buenos Aires was the dinner between President Trump and Chairman Xi. It occurred six months after the two-day session in May during which the US side presented its “demands,” which were followed by a continuous and noisy barrage of incremental tariff hikes, criticisms and other threats. The tactics were more intense than those used by Trump’s immediate predecessors in dealing with the China trade imbalance, but not necessarily more so than the tactics used by Richard Nixon and Ronald Regan to get Japan to reduce its surplus in the 1970s and 1980s.

In May it was clear that the two negotiating sides hardly knew each other and the issues to be resolved were very wide ranging. It is also true that the US economy is growing faster than before, while China’s is in danger of sliding below the 6% level that many observers believe must be exceeded to prevent serious disruption in the labor force and society in general.

The leaders agreed to put future US tariff increases on hold for three months, while negotiations on the issues continue. The Trump team essentially wants to be able declare a victory in the talks by gaining concessions in four areas: (1) stop requirements for technology transfers to US-China corporate joint ventures, (2) reduction of stifling non-tariff barriers to US imports, (3) improved enforcement of intellectual property protections, and (4) increased purchases of US agricultural and other goods to reduce the trade deficit. These are the four right areas. China has already agreed to some accommodations on them, and Mr. Trump has already tweeted that great progress has been made, but he has also appointed his hardliners to manage the negotiations from here, replacing Treasury secretary Mnuchin. 

China joined the World Trade Organization in 2001, when its global trade surplus was $360 billion. In 2006 the surplus peaked at $761 billion, and since has declined to $560 billion in 2017.  But, China’s trade surplus with the US reached $276 billion in 2017, a record high, when exports to the US totaled $2.9 trillion. The greatest volume of goods are electronic devices and components, followed by toys, furniture, clothing and shoes, and household appliances. Imports of high volumes of these goods, well-made and at lost cost, constitute the carefully engineered supply chains of large US retailers and manufacturers. The US is China’s second largest trading partner behind the EU – China had a trade surplus with the EU of $176 billion in 2017.

Just as happened in Japan, China’s trade surplus is shrinking under its own weight. Its local manufacturing costs are rising, skilled labor is becoming scarce, and, particularly under the Trump administration, it is encountering stronger resistance to its trade policies from its major trade partners over practices prohibited by WTO rules. US importers are beginning to source supply chains from countries other than China, Chinese companies are seeking to acquire US businesses or establish factories in the US, and one of the founders of the China export boom, Foxconn Technologies, a Taiwanese company that assembles Apple iphones in China announced a $10 billion new factory in Wisconsin, and a $900 million acquisition of a US electronics manufacturer in 2018.

Calculating net job losses from trade with China is very inexact in a competitive economic system with lots of “creative destruction.” The perception of the public is that imports from China have been a major contributor to the “hollowing out” of the working-and-middle classes of the US.  However, whatever job losses resulted from China’s imports happened in the past, and are not much of a factor in today’s low unemployment economy.

Still, a tariff war could be harmful to growth in both countries and probably would affect China more than the US. Even so, economists do not believe tariffs will plunge the US economy into a recession – Justin Wolfers recently reported in the WSJ that the average US tariff rate in 2017 was only 1.4%, adding the metals and the first round of China tariffs raised the average to about 3.2% in 2018. Another incremental round of China tariffs in 2019 could boost the average to 4.5%, and if all Chinese imports are to be subject to a 25% tariff, as has been threatened, the average rate might go to 7.2%. This much of a change is unlikely to happen, but even if it did, it probably would not be sustained, but the magnitude of the economic drag on the US economy from price increases would be modest.

The idea is for both sides to undo their tariffs after negotiating improved arrangements in the four areas.

China has only authorized US manufacturers to invest in China through joint ventures with Chinese partners. To be approved, the incoming US corporation must agree to bring their latest technologies so the joint venture (i.e., the Chinese partner) can benefit from it. This has been the price of getting into the potentially vast Chinese market, and corporations have been willing to pay it. (Mr. Trump has called the requirement “stealing our technology”. If China emerges as the world’s largest market for autos, semiconductors and chips, the foreign companies will need to use their latest technologies there. Anyway, technology turnover requirement is obsolete (China is no longer justified in protecting” infant-industries”), and China should be willing to remove it and give Mr. Trump’s team  an easy victory. What foreign companies would prefer is eliminating the requirement that they operate in China only through joint-ventures.

Reducing other non-tariff barriers to entry in China is more difficult. Many US products sell easily in China because of their styles and other features. Other stuff does not because it doesn’t appeal to Chinese consumers. But a lot of stuff is blocked by tariffs (e.g., on US cars) which China should acknowledge it is time to reduce. Bit other non-tariff barriers remain, such as requirement for licenses, testing, distribution agreements, etc. These will be argued over piecemeal, and some cosmetic concessions may be gathered, but many of the barriers will persist.

The real stealing of intellectual property through illegal copying and industrial espionage through hacking has probably past its peak, but hacking skills are increasing and foreign companies may still be exposed to the risk. But most companies know they are vulnerable and it is up to them to protect themselves.  China is likely to agree to better enforcement and remedies, but there isn’t much that the US government can do to be sure they do.

Finally, there is the demand that China purchase more commodities from the US to offset the trade surplus. Agricultural products and possibly liquid natural gas, which the US is just starting to export. This should also be an easy fix.

This leaves one important topic on the table – the Trump Administration’s opposition to the “Made in China 2025” strategic initiative announced earlier by Mr. Xi.   This is a plan to use all necessary resources of the state to develop a world leading high technology manufacturing capability aimed at further reducing China’s export dependence and shifting to a consumer-driven economy. Most economists think this is something China must do as its next stage of development. It is also an industrial policy typical of a centrally controlled economic system, which China still is, so grants, subsidies and protections of various kinds can be expected. These sorts of overt assistance are prohibited by WTO rules, but China, many think, will simply ignore them. The best way to address this issue is for the US, EU, Japan and other counties to band together, using the WTO dispute resolution framework, to force China to come to terms with them. Mr. Trump is unlikely to pursue such a globalist program – he likes bi-lateral deals – so this will probably be a struggle for the future, but it doesn’t have to be dealt with now.

All in all, the makings of a deal are there. Mr. Trump will want to squeeze all he can out of it, so there may be some bluster yet come, but ending the trade war in three or six months seems likely. So far, we have the precedent of renegotiations of South Korean and NAFTA trade agreements that did not change things all that much, and allow business to be done much as before.

But with Mr. Trump you never know.

Updating Brexit’s Endgame

By Roy C. Smith

Prime Minister Theresa May’s 585-page Brexit deal with the EU has been widely deplored within her own party and by opponents.  It leaves the UK within the tariff-free custom union, still subject to most of its rules, but as a non-voting participant with no say over what the rules are. This is an anathema to the “take back control” Brexit hard-liners who cherish above all the preservation of British economic sovereignty.

And, it’s still not a fixed thing until complex Ireland-Northern Ireland-UK border issues can be worked out over the next year or two, which extends the uncertainty that has crippled the UK economy since the 2016 vote.  The UK GDP growth for 2018 is estimated at 1.3%, one of the lowest in the EU

On balance, this is a very soft Brexit (with a $50 billion exit bill) that leaves most economic elements the way they are for now, thus doing comparatively less harm, but leaves room in the future for creating different trade arrangements with other countries, each a long process. 

May says it’s the best that can be, much better that a no-deal crash-out in March 2019, and its either one of these, or maybe no Brexit at all.

Later this month the other EU member countries will vote on it, and then it has to be put to the UK Parliament in December, where it has about a 50-50 chance of passing.    

Meanwhile a group of Conservative Party members are trying to have her overturned as leader, though so far, no challenger with a different plan has emerged. Labour hopes the government will fall over the Parliamentary vote and Jeremy Corbin will win an election to follow. If either of these seems likely to Mrs. May, she may reverse herself and allow a “Peoples Vote” (what a second referendum on Brexit is now being called) to occur. Large demonstrations have been held in support of a second vote (endorsed by three former prime ministers and many business leaders) and polls now suggest that a majority of Britons would prefer to remain in the UK.

Stay tuned. There is still a lot to happen.

The basic idea of Brexit is that Britain’s economy, culture and social cohesion has been undermined by the EU, and the country would be better off out of it.  Though the government (and many independent economists) presented credible economic data to the contrary, the politics of the case inflamed British nationalism, distrust of immigration and fears of imported terrorism and the government’s case was simply not believed by a majority.

Many British observers have pointed to other factors, principally resentments accumulated by working and middle-class people who have been struggling in the Great Recession that followed the 2008 global financial crisis and have growth distrustful of elite leaders seemingly unconcerned with their deteriorating circumstances. During this time a British austerity program was installed to reduce the huge increase in the national debt to derived from dealing with bailouts and the recession, social services were cut back and poverty levels rose to unexpected levels.  In defiance, Britain voted itself back onto a little island.

Of course, much of the same nationalistic stuff was being stirred up in the US during the 2016 campaign for many of the same reasons. And the resentments and political concerns felt in the UK have been showing up in force in Germany, Italy, France, Sweden, Hungary, Poland and other EU countries, posing further threats to the integrity and solidarity of the EU in the future.  

An irony in all this is that the EU (compared to what preceded it) is the success it is because of a series of free-market, competition-increasing initiatives of Margaret Thatcher that were adopted by the EU in its seminal Single Market Act in 1986. She saw Britain’s future as part of the EU with a key role in formulating policies reflecting and reinforcing liberal economic thinking, i.e. deregulation, privatization, globalization and greater freedoms for the private sector.

It all worked, at least until the first of the two global financial crises in this century. Both were the results of bubbles and busts that, for centuries, have caused unexpected market failures with grievous economic consequences. Because of the vast size of the market economy and its global linkages, these two crises were among the worst, with deflationary effects of the second one lingering for a decade.  

This week’s Economist has a full report on the Brexit endgame but its cover story is “The Next Capitalist Revolution,” in which it blames the low-grow fiz-out of the liberal economic dream of Thatcher and others on excessive concentration of huge companies in major industries, increased barriers to entry from regulation, oligopolistic activity, lobbying and political power, and other maladies of big business. Nearly 20-years of relatively low growth (averaging about 2% in US, less in EU) has led to stagnant wage growth, deteriorated household balance sheets, and an underfunded healthcare and retirement safety net for large segments of the US and EU populations. 

When this happens, elections are bound to reflect the distress.

We may be facing a serious roll-back over the next several years of what was a global consensus in 2000 that economic optimization for all countries could best be achieved by open markets, world trade, a private sector driven by innovation, competition, and inward investment, and governments that intervened in markets as little as possible. 

But capitalism can only survive in a democracy with the consent of the people. That consent may have been eroded and will have to be earned back. For now, the more powerful attraction is economic nationalism, protectionism and pro-active governments intervening in markets. Most of economic history has been in this mode, but the UK and our best years have been in the other one, the liberal economics mode.

The Selloff – Is it Fundamentals or Market Dynamics?

By Roy C. Smith

Well its October, and that’s when the stock markets’ worst selloffs occur. With the change of seasons there comes an effort to rethink the year ahead. Stock prices, after all, are meant to reflect the future, not the past.

We had a selloff at the beginning of this year, a reality check on some of the Trump tax-cuts-and-deregulation euphoria, but the market turned around and found new highs by September. This was supposed to be because strong second and third quarter growth and corporate profits and other economic fundamentals were strong enough to justify stock price increases. The Economist now predicts US GDP growth for the year to be 2.9%, with unemployment at 3.7%. 

A few weeks later, market went into correction mode, driving prices down 10% from the most recent highs. Did the fundamentals change all that much in a month?

Fundamentals are fundamental so they don’t change very fast. After a decade of strong stimulus from low interest rates, easy money, quantitative easing, increased government spending and some deregulation, all boosted by a late in the game tax cut, the economy gradually dug itself out from the wreckage of the Great Recession and saw annual GDP growth rates approach the 3.0% level for the first time since 2005.  Things were looking quite good compared to the past decade, but the long-term average US GDP growth rate is 3.5%, so even 3% is well below average. And, most economists are forecasting lower growth over the next two years. The Federal Reserve for example, is predicting GDP growth of 2.5% in 2019 and 2.0% for 2020. 

Economists will tell you that the fundamentals are actually in trouble. The labor force is not growing fast enough to sustain 3% growth - the Department of Labor predicts average annual growth in the US labor force of 0.2% for 2015-2025, down from 1.2% from 1980-2015. Total Factor Productivity, which is now less than 1%, averaged 1.9% growth from 1947 to 1970. Inflation has risen to about 3% in 2018, from 0.76% in 2014, a long-term decline in interest rates has been reversed (10-year Treasury bond yields have increased to 3.1% from 1.6% in 2016), and domestic capital investment is flat from a year ago. 

US corporations have skillfully managed around some of these obstacles by globalizing their complex supply chains, importing skilled workers from Europe and Asia, and locking in low cost debt. Foreign companies have helped with major investments in manufacturing and distribution facilities to serve markets in the US, but they too face the problems of sagging fundamentals. Twelve-month revenue growth of the S&P 500 companies declined from 7.9% in July 2018 to 6.6% in September 2018. Much of the corporate profits growth was from the lower tax rate and the Trump trade and immigration policies will likely slow growth and increase inflation further in the years ahead.

Periodically, market dynamics have more to do with stock prices than fundamentals.  These dynamics essentially reflect the changing supply and demand for stocks. They involve everything from changes in asset allocation into or out of stocks, changes in foreign funds flows (foreigners now own 22% of the US equity markets after a recent two-year buying spree), the appeal of growth stocks relative to value (the price differential between the two is the greatest since the tech bubble in 1999), corporate stock repurchases and mergers, changing sectoral concentrations in market indices (the technology sector now accounts for 21% of the S&P 500 index), and changes in the portion of the markets represented by ETFs and passive funds (now about 40%). 

After 2009, when the long bull market began, investors significantly increased allocation to stocks to avoid low bond yields. Foreign investors did too, but also to avoid lower growth rates at home and enjoy the stronger dollar. The “momentum” in the markets has been highly focused on tech stocks, despite a doubling of price-earnings ratios since 2009, just as it was in 1999 when Alan Greenspan called it “irrational enthusiasm.” After the 2017 tax cut, corporations increased their purchases of own-company shares to record levels, expected to be about $1 trillion in 2018. Merger activity and a slowdown in IPOs reduced the number of public companies in America and therefore the supply of different stocks available for purchase. And, every time someone buys shares in the popular S&P 500 index fund (SPY), the fund has to buy additional shares of 500 companies. Once such changes start to stir in a global equities market of $80 trillion (US share, $32 trillion), money can move quickly into and out of things, and liquidity flows have their own price effects.

Market dynamics had a lot to do with providing much better returns than could be explained by economic growth in the US after January 1, 2009. From then until now, US annual economic growth has averaged only 2.04%, but the total return (including dividends) of the S&P 500 index fund, after adjusting for inflation, averaged 13.4% for the same period. It is hard to imagine how the value of 500 of the largest companies in America can have increased six and a half times faster than the growth rate of the economy these companies principally serve.  

But as we learned in October 1929, 1987 and 2008, market dynamics can suddenly take away some of what it had so generously provided in preceding years. But these dynamics have their own fish to fry – retirement, insurance, endowment and other institutions and wealthy investors still need to own stocks, and yields on ten-year Treasury bonds after inflation and taxes are still close to zero. US companies, sweetened by a lower tax rate, are performing well, and everything is relative. Would you rather have all your money in Europe or Japan, or China? 

Trump’s Economic Nationalism, Two Years In

By Roy C. Smith

Last week, Peter Navarro, Assistant to the President for Trade and Manufacturing Policy, published an op-ed in The New York Times, entitled “Our Economic Security at Risk.” The piece elaborated on Mr. Trump’s “maxim” that “economic security is national security,” by adding that economic security depends on a strong manufacturing base and trade policies that protect certain industries and attempt to turn past deficits to surpluses.

Few would argue that national security needs to be based on a strong economy, which reflects growth, prosperity and wealth, but also few would agree with Mr. Navarro that economic strength today derives from mercantilism and economic nationalism, two policy ideas now long out of date.

“Mercantilism” was the economic policy of Britain and other European countries in the 17^th and 18^th centuries, that was largely based on the idea that exports should be maximized to increase bullion reserves and thus national power and prestige. It was a zero-sum game rooted in colonialism. Mercantilism faded into “economic nationalism” in the 19^th and 20^th centuries in which governments intervened extensively in economic activity through tariffs and other means to protect local industries and boost defense spending that turned into arms races to showcase military power. Economic nationalism created a lot of conflict in the global economic system that contributed to both World Wars.

Indeed, after WWII, the allied powers chose to create new institutions to avoid such conflicts in the future and provide for a world of shared economic success through trade enhancement and financial stability.  These new institutions included a global currency accord, the IMF and the World Bank, the United Nations, and the World Trade Organization. The economic policy that emerged was one of global economic activity based on the common principles of free markets, free exchange of currencies, and the personal freedoms provided by democracies that stimulate innovation.

As a result, world trade has grown from 20% of world GDP in 1960 to 60% today. Trade in the US has grown from 5% of GDP to 25%. Twenty-eight European countries have joined the European Union devoted to a single, tariff free marketplace, with free passage among the countries of people, money and ideas. The economic prosperity of the West (and its ability to outspend the USSR on national defense) led to the collapse of the Soviet Bloc and end the 45-year Cold War. This event motivated an isolated, backward Communist China to change policies to become part of the global open-market economic system. Thus, China enjoyed extraordinary growth lifting half a billion people out of poverty.

In his article, Mr. Navarro cites a number of Trump economic achievements that have improved national security. The 2017 tax cuts, a “wave of deregulation,” “buy America programs,” and a major boost in defense spending led the way, he said, followed by “tough steps on trade,” and most recently, a Department of Defense report that highlights “vulnerabilities” in national defense caused by a declining manufacturing base and looming labor shortages that Mr. Trump pledges to remove by further applications of nationalistic industrial policies.

Economic policies have to be judged by their outcome. Two years since the Trump election, how have these turned out so far?

The $1.5 trillion tax cuts and $1.3 trillion increased spending in 2017 were Keynesian actions missuited to the times – the economy was already recovering nicely, capital was being expended and unemployment was low, so the stimulus would likely result in increased prices for goods and assets (including stocks), which is what has happened – inflation for 2018 is estimated to be 3%, up from 2.1% a year earlier. The tax savings received by most Americans were nullified by increased inflation. But fiscal stimulus did increase the federal debt levels by about $1 trillion, and will push this year’s annual fiscal deficit to about 5%, double what it was in 2015.

The tax cuts were largely a windfall for the private sector that had limited plans for increased investment and used much of the money ($1 trillion estimated for 2018) for stock buybacks and dividend increases instead of additional job-creating capital expenditures. Labor shortages, of course, have been increased by the Trump immigration policies.

The wave of deregulation, mostly in environmental sectors, has been met with a wave of litigation that has slowed it considerably. The Defense Dept. budget is already pretty big - $716 billion for 2019, 54% of fiscal discretionary spending, far greater than any collection of countries that might threaten the US. The budget we have now enables the US to deploy troops in 150 countries. 

Tough steps on trade, Mr. Navarro’s specialty, have so far accomplished little to aid growth, but have created considerable confusion and uncertainty in the world economic sector. Some say these steps are necessary and will force concessions by trading partners that have been “ripping us off.” Judged by the modest net changes in the trade agreements with Korea and NAFTA, both of which were renegotiated this year, neither was worth the rancor and bad feelings with important neighbors and trade partners. But steel, aluminum, and maybe car tariffs still threaten the EU and Japan, and have raised prices in the US, and our standoff with China may cause serious reductions in the growth rates in both countries before things are settled.

Indeed, a recent economic forecast for 2018-2020 prepared by the Federal Reserve shows US growth this year to be 3.1%, but shrinking in 2019 to 2.5% and to 2.0 % in 2020, far from Mr. Trump’s announced long-term goal of 3.5% to 4.0%.

One reason why: mercantilism doesn’t work anymore. Acting as if it did only make business forecasting and planning more difficult. China’s exports to the US include essential parts for American supply chains (which helps to maintain US corporate competitiveness with global rivals) as well as low-price goods made available to American consumers by American retailers. And, almost all of China’s and Japan’s, Korea’s and other country’s trade surpluses are reinvested in US Treasury and other securities, so the money actually comes back. Indeed, trade deficits don’t last forever with one country - China’s success, for example, forces higher prices for local land, utilities and labor, which shifts business to other places like Viet Nam. Also, China will export less and import more as it transitions to a consumer-driven economy, much as Japan did in the 1980s.

Bob Woodward’s recent book, Fear, on the Trump White House reported a conversation in which Gary Cohn, then Chairman of the National Economic Council, was trying to talk Mr. Trump into softening his views on trade. According to Woodward, Mr. Trump told Cohn that he had held his views on trade and manufacturing for 30 years, and if Cohn didn’t agree with them then Cohn was simply wrong.

All the trade angst is unnecessary. The WTO provides mechanisms for dispute resolution, and linking the US, the EU and Japan together to curtail China’s economic nationalism would have been a better, more compelling way to deal with it. Accepting the 12-country Trans Pacific Partnership accord would have been another source of leverage on China, available without pushing China into a one-on-one standoff with the US.

The heavy-handed Trump approach is wrong-headed and out of date, but it may yet work. The US market is very important to all its trade partners so they may be willing to put up with some one-sided demands, especially if they are no more burdensome than those imposed on Korea, Mexico and Canada. But the EU and China, in particular, are capable of significant retaliation and their domestic politics may require them to use it. Neither has to buy US soya-beans or other agricultural products, or airplanes, LNG, or computers. They can develop their own industries and cooperate with each other, isolating the US, and they can undermine US sanctions and other pressuring policies applicable to Russia, Iran, North Korea and others.

Messing with the big boys is an entirely different game.

A Decade Later, Understanding 2008 Financial Crisis

By Roy C. Smith

The 2008 Financial Crisis is best remembered for the dramatic weekend of Sept. 13-14, after which Lehman crashed, AIG was rescued, and Merrill merged. But, it began much earlier, in late 2006, and still raged through the first quarter of 2009. Substantial and unprecedented actions were taken by the Treasury and the Federal Reserve to stem the tide, and afterward, many regulatory changes were made to prevent or moderate the next global financial crisis. These regulatory changes include the Dodd Frank Wall Street Reform Act, Basel III, the Financial Stability Board of the G20, and the creation of several new financial regulatory entities in Europe.

The crisis spawned the “Great Recession” in the US, and despite great efforts to stimulate the economy, a decade of growth rates averaging 2%, well below the long-term average of 3.5%. The crisis led to similar growth-killing results around the world, tested the strength of the European Union and the euro and the future of Emerging Market economies, and sparked tensions with Russia and China. 

It was a nasty event we don’t want to see repeated.

Ten years and a great deal of study by economists and others leave us still lacking a consensus on (a) what caused the crisis, (b) whether the reforms it generated will be enough to prevent another systemic collapse of the financial system, and (c) whether the reforms are worth their cost in enforcement and compliance expense and lost economic growth due to constraints on lending.

Here are some of my observations and conclusions:

Causes of the Crisis:

The collapse was mainly the result of a massive liquidity squeeze that began slowly in 2007 in the relatively small but riskier, sub-prime end of a line of mortgage-backed investment products. Sub-prime was a relatively small part of the US fixed income market with $600 billion outstanding in 2006, but it was the fastest growing - it represented only 8% of new mortgage-backed issues in 2003 but 24% in 2005. In Jan. 2007 all mortgage-backed securities amounted to $5.5 trillion (another $6.4 trillion of debt secured by assets other than mortgages was also outstanding), out of some $177 trillion of tradable debt outstanding globally. The liquidity squeeze steadily accelerated, however, spreading first to other mortgage and fixed income instruments, then, after the unexpected bankruptcy of Lehman Brothers, it rolled into an avalanche that carried everything away.  

The liquidity squeeze was enhanced by new technology that enabled large quantities of complex, non-transparent, securitized mortgage debt to be issued, hedged with credit-default insurance, and leveraged by derivatives and in other ways. These apparently safe and relatively high yielding securities, for which demand was enormous after three years of low interest rates and negative stock market returns (2000-2002), were sold into a globally integrated capital market that had become huge: on the eve of the Lehman bankruptcy, the market capitalization of all tradeable stocks, bonds and bank loans in the world was $242 trillion, 3.5 times world GDP.  Investors from Europe, China, Japan and other countries had acquired substantial US and European mortgage-backed positions. But, rising fears of mortgage defaults, contamination of opaque prime mortgage pools by added pieces of sub-prime, and reports of write-offs in the industry triggered a run on all mortgage-backed securities. Falling prices would send trillions of dollars of sell orders into the market that virtually destroyed buy-side liquidity and began a vicious cycle of margin calls and mark-to-market write-downs that caused further write-offs that wiped out the capital of the banking system. This was the biggest market collapse in financial history, for which neither industry participants nor regulators were prepared.

Though major banks clearly turbo-charged their activities in all parts of the mortgage-securitization business, they believed they were simply (and lawfully) taking advantage of opportunities in a bull market that was driven by demand from informed institutional investors.  Doing so, however, required a willingness to hold very large trading positions. Most banks were no greedier or more reckless than usual, but their top managers were notably clueless about what was coming and they were unprepared for the market run when it came. These banks were in an industry that is more highly regulated and supervised than almost any other, because of the consequences of their collective mistakes. The largest banks were considered too big for the government to allow to fail, so some moral hazard affected the banks’ actions. But the banks’ watchers and minders were equally unaware of what was coming, and did nothing to constrain the aggressive risk taking of some of the banks during the run up to the crisis.

Indeed, the watchers had been asleep all through the Alan Greenspan years as Fed Chairman (1987-2006) when all of government was enjoying the “Great Moderation” economy (1985-2007) of low inflation, disappearing business cycles and rising security prices brought on by the widespread and large-scale adoption of free-market economic principles that linked the global economy and financial system as never before. Greenspan’s view was that markets could regulate the behavior of banks and other financial institutions by adjusting prices of their shares and bonds more effectively than the controls of regulators could. This view, applying the “efficient market hypothesis,” proved to be completely wrong. Markets were cheerleaders in the run up to the crisis, not restrainers.

The Great Moderation also brought about a time of great deregulation, which many economists believed would increase competition and force companies to lower prices and be more efficient. This was the main thought (encouraged by substantial Wall Street lobbying and political contributions for a decade) behind the repeal in 1999 (with full the support of the Clinton Administration and the Fed) of the 1933 Glass Steagall Act that separated banking from the securities business. I was among the few critics of this action at the time because I thought the banks would rapidly increase their exposure to securities dealing (in which they had little training or experience) to take market share away from the investment banks.  This would increase risks to banks and their depositors who were insured by the US government through the FDIC. As the FDIC guaranteed the deposits of banks, it ought to have a say in the risk levels associated with them. But, neither the FDIC, the Fed nor the Treasury ever attempted to assess, limit or manage the increased risks that repeal of Glass Steagall brought about.

After repeal there were several large bank mergers that increased the size of the largest banks considerably and enabled some of them, particularly Citigroup with assets of $2.2 trillion after its gun-jumping merger with Travelers in 1998, to expand aggressively into the securities underwriting, trading and brokerage businesses. This expansion encouraged the investment banks, now all publicly traded companies, to further leverage their balance sheets to remain competitive with the banks. The new competition did bring down fees and trading spreads, but the loss in revenues was made up by more aggressive proprietary trading (relatively easy in a falling interest rate environment), servicing of hedge funds and sovereign wealth funds, and innovative “structuring” of bespoke investment products for sophisticated investors.  In short, the risks inherent in the securities business increased with leverage and the complexity of traded instruments, without commensurate increases in risk management capabilities.

Probably in no other financial crisis in world history has the role of a few key government officials (particularly Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke) been so important in managing through the uncertainties and the politics of the crisis and enabling a reasonably quick return to normal economic activity.  These individuals deserve high marks for their energy and determination, despite some serious miscalculations and mistakes that are clearer in retrospect than they were at the time.  Both claim that if they hadn’t done what they did, the impact of the crisis would have been worse, and lasted longer than it did. This is probably true but unproveable.

Paulson was the captain of the ship in extremis, and he provided the leadership that enabled confidence that the ship would escape the shoals. He ignored his Republic Party’s deep-set notions of the sanctity of the free market and sought to find interventionist actions, including bailouts, that would quell the panic in the markets. He did not hesitate to try different things, and to move on if they did not work as intended.  He signaled that the government was deeply involved and would get it right eventually. But what really saved the day was the tide-shift that allowed the ship to float over the shoals altogether – i.e., the massive and totally unprecedented infusion of liquidity into the markets by the Fed that amounted to about $5 trillion (14x the size of Treasury’s “Troubled Assets Relief Program”), according to a Bloomberg news report.

Bernanke understood the essential importance of restoring liquidity at whatever cost, and, though he deferred to Paulson on Lehman Brothers, he was unhesitating in committing it from the Fed’s own resources. Politics severely limited what the Treasury could do, but the Fed was independent of the government and had more leeway. The Fed’s infusions were not bailouts per se, but they stabilized market prices in commercial paper, money market funds, bank deposits and term loans, and other financial instruments and included major foreign banks in its assistance efforts. It quadruped its own balance sheet – printing money as necessary to expand its resources, without having to ask permission of Congress or, after Lehman, worry too much about the quality of the collateral it was taking on. The Fed just did it. And what it did was essential to the financial turnaround of the US, which came out of the crisis just as the European Sovereign Debt crisis of 2010 was beginning. These efforts by the Fed preceded its later, more questionable, commitment to “quantitative easing” purchases of securities to lower long-term interest rates.

Post-Crisis Actions and Reforms

Though the banking system was secure by mid 2009, the future of banks was not. Banks were widely blamed for the crash and the severe effects that followed, and loathed for having been bailed out by the TARP at very low cost to them while many other Americans were losing their jobs and their homes to the crisis. President Obama called the banks greedy and reckless, and politicians and media commentators were calling for their leaders to be jailed.  The Fed’s intervention in markets was not widely known or opposed, even though it was an indirect form of bailout for some. The Fed’s provision of liquidity, however, was only a different form of acting in its traditional role as a “lender of last resort” to assist “solvent” banks facing a run on deposits (or their inability to roll them over in the institutional market) to protect the whole financial system from failing.  

“Insolvent” banks, however, are supposed to be taken over by the FDIC, which replaces management and boards and funds a restructuring of the bank until it can be broken up, sold or refloated. This is what happened (without disturbing markets) to the Continental Illinois Bank, the seventh largest, in 1984, and to Washington Mutual, the largest US savings bank with assets of $330 billion, the largest bank ever taken over by the FDIC, in 2008. There were many questions about the solvency of Citigroup and Bank of America (after its acquisitions of Countrywide and Merrill Lynch) during the crisis, but there were also fears that each was many times larger than Washington Mutual and “too big to fail” (especially after Lehman) and therefore had to be bailed out by the TARP or the Fed to avoid further contagion and continuation of the crisis.

The public anger over bailouts provoked two responses – the Justice Department sued the shareholders of all the major banks for fraud (mismanagement, really) and collected nearly $200 billion in settlement payments from them (though no officer or director of a major bank was charged with a civil or criminal offense), and the passage of the Dodd Frank bill in 2010. Both were shots fired in anger that weakened, rather than strengthened, the banking system.

The preamble to Dodd Frank says it is to end "too big to fail," to protect the American taxpayer by “ending bank bailouts,” and …other purposes.  Only one of sixteen sections addresses “financial stability,” so there is a lot of extraneous stuff in it. But the bill prevents the Treasury from organizing another TARP in the future, and limits the Fed’s crucial role as a lender of last resort. The Fed is restricted to assisting only solvent banks in a liquidity crisis. Insolvent banks (whatever their size) will have to be taken over by the FDIC. Overall, the law is cumbersome and burdens banks with redundant regulations and high compliance costs. Whether its terms reduce the risk of systemic failure in the future is debatable; I believe it may do so indirectly, but its cost to the banks is a serious burden to their ability to provide credit in a growing economy, but time will tell.

Dodd Frank increases some of the regulatory powers of the Fed, especially regarding “systemically important financial institutions” that are now subject to “stress tests” to determine the capital adequacy and risk management capability of large banks under different economic scenarios. These tests are powerful because failure can result in the curtailment of dividends or stock buyback programs, and so far, have reduced some of the risk-taking activities banks might otherwise have wished to continue. The Fed, however, probably had the power to conduct stress tests before Dodd Frank, but did not elect to do so. Now that they are in place, however, they will probably continue indefinitely.

A more important regulatory change was the agreement to Basel III (a third revision of the Basel Accord, a voluntary agreement between 28 countries to maintain common standards of risk-adjusted capital adequacy of banks, first adopted in 1987). This agreement tightened standards considerably – it doubled the amount of capital banks had to have, halved their permitted leverage and imposed new liquidity measures. These measures have considerably reduced the flexibility and risk-taking abilities of banks and limited their earnings potential.

Because of Basel III and other regulatory changes, the world’s top ten capital market banks have averaged returns on equity less than their cost of equity capital in every year since 2010. This has severely affected the banks’ business models and required many of them to reduce commitments to capital market activity significantly.  The 2017 corporate tax cuts, however, have improved after-tax returns to the banks.

Will the Reforms Do the Job?

Based on all the regulatory actions since 2010, large banks that were seen to be free-wheeling traders and aggressive enablers of client financial transactions have been transformed into regulated public utilities with growth potential not much different from the economy as a whole. This is probably not what was intended in the effort to reregulate finance, and is certainly not what the banks wanted, but it may be an acceptable outcome for the public. The system is less exposed to sudden market write-offs that destroyed capital and extended the crisis in 2008. “Shadow banking” players (i.e., hedge funds, private equity funds and some other non-bank financial institutions – of which only one remains as a systemically important financial institution as determined by Dodd Frank) -- are filling in where banks used to operate, but these are not thought to increase systemic risk very much because of the widely diversified nature of their holdings.

Meanwhile, global market capitalization is today over $300 trillion, up 40% since 2007, so capital markets are continuing to function and few enterprises qualified to raise capital are unable to do so.  Debt buildups continue to occur, particularly in government sectors, where some point to dangers of future crises, though any that may occur are likely to be local rather than global, and more easily sustained.

One thing we can say about the ten years prior to and since 2008, is that they demonstrate that governments are imperfect regulatory organizations at best.  Politics confuse policy debates and almost always result in programs that have weaknesses in design and in execution.  Responses to crises must be energetic and purposeful, even if they are sometimes ineffective. The most serious risks in the future lie in accumulations of financial risk that can suddenly trigger an avalanche that causes much damage before it runs its course. Global market runs can only be halted with massive liquidity assistance that can only come from governments, and Ben Bernanke set a durable precedent on how to provide it. Though the regulatory actions since 2008 contain contradictions, they should be enough to temper the accumulation of such high levels of market risk in the hands of a small number of banks required to mark-to-market -- at least for a while.

Meanwhile, several other important issues remain unresolved after ten years. Are we satisfied that the best way to assess credit quality of marketable instruments is through a small number of rating agencies paid by those they rate? What is to be the future of the federal housing entities, FNMA and FMAC? How is the government to unwind its position in AIG? Is the FDIC to be fortified and prepared to intervene in very large bank failures? And perhaps most important, has the curtailment of risk taking in the broad global banking sector affected the private sector’s ability to finance new entrepreneurial activity, innovation and growth? In an age when the “new normal” levels of economic growth are said to be in the 2.5% area (as compared to a long-term average US growth rate of 3.5%) are the marginal benefits of additional financial safety worth the cost of reduced growth due to increased financial conservatism by banks forced to function as regulated public utilities?

During his presidential campaign, Mr. Trump promised to repeal or revise Dodd Frank, but has not done so, nor does there seem to be much energy behind doing so in the future. The other issues have not been addressed. Most likely, the next few years will not involve important new regulatory changes. Few observers, however, believe that the regulatory composition we have now will end financial crises in the future. As hard as these are to predict, it is even harder to predict where they will come from and how they will impact the structures we have in place to absorb them. Finance has always been like this, but we do learn from what we go through.

Will Crypto-currencies Disrupt the Global Financial Secrecy Business?

Ingo Walter

Financial secrecy is central to global finance. It has great value to individuals, businesses, banks, governments and many others. Some even consider secrecy a “human right.” It plays a vital role as a catalyst in creating economic and social benefits that wouldn’t be possible without proprietary information.

But financial secrecy also makes possible the dark underbelly of the system – tax evasion, the narco-plague, human trafficking, organized crime, sanctions-busting and money laundering, terrorism, corruption, espionage, suborning elections, and an array of other nefarious activities. Classic tools include cash transactions and money laundering, as well as clandestine accounts and complex chains between them.

Every once in a while somebody leaks, steals data, cuts deals with prosecutors or otherwise spills the beans on secret financial flows and stashes. The 2015 Panama Papers disclosure, and its trail of red faces among the global rich and famous, is among the latest. So is the eye-watering $4.5 billion diversions from Malaysia’s 1MDB sovereign development fund, first revealed in 2016 with severe political and economic consequences and plenty of international spillovers. Investigations are launched, explanations are offered, blame is pinned, prosecutions follow, and the financial firms involved scramble to “put the matter behind us.”

Now, along come crypto-currencies like Bitcoin, offering total transparency inside their blockchain platforms and anonymity between crypto-wallets and their real owners. Is crypto a threat or an opportunity for those looking for financial secrecy? The answer matters for the future of global finance, and it doesn’t look good for connoisseurs of confidentiality.

If financial secrecy has value there must be a “market” for it. So what’s it worth? That depends on where secret money came from and the consequences of disclosure. The damage can range all the way from increased family tensions to the firing squad.

Who can be trusted with safeguarding financial secrets? The usual candidates range from uncle Harry (known in the family for keeping things confidential) to a whole coterie of lawyers, bankers, accountants and investment advisers, and others who market trust and discretion. Pick the wrong “secret agent” who leaks or can be made to leak, and the game’s over. Traditionally the ultimate gold standard has been highly reputable financial institutions operating beyond national disclosure and enforcement jurisdictions and based in politically and economically stable countries with a tradition of tough secrecy laws and blocking statutes.

Usually you get what you pay for. As long as bankers and other secret agents can convincingly promote secrecy along with professionalism there’s a treasure trove of fees to be earned and high-paying jobs to be had. This is, after all, a global market for financial secrecy with plenty of demand, enough willing suppliers, nice profit margins, and one that is not very capital-intensive. It also carries  –an array of risks. As in any good market, financial secrecy is bought and sold, and both sides can be happy. But in this case happiness usually comes at the expense of somebody else, and it creates exposure to agency problems – what to do if the secret agent starts overcharging or stealing from you? What’s your recourse?

Much has changed in the global financial secrecy game in recent years. After 9/11 the US launched a no-holds-barred search for terrorist financing - a needle in a haystack that caused great misery for ordinary secrecy addicts who happen to come up in the net – a kind of financial “bycatch.” The US applied the 2001 PATRIOT Act, which stiffened anti-money laundering (AML) requirements for banks. The Foreign Account Tax Compliance Act (FATCA) of 2010 forced American taxpayers and asset managers worldwide to disclose critical information annually on foreign financial holdings. Predictably, it sent “tax-sensitive” people and foreign banks scurrying for various IRS deals to fess-up and come clean. The FINCen arm of the US Treasury Department is now action-central on money laundering. Other countries have their own approaches, but none can equal the ability of the US Department of Justice and the New York State Department of Financial Services to leverage the global dominance of dollar clearing as a big bazooka in disrupting money laundering and the financial secrecy game.

The long-reigning king of high-quality financial secrecy, Switzerland, was brought into line in a 2015 bilateral tax evasion deal with the IRS and the DoJ, following years of better Swiss cooperation on outright financial crimes. With their US tax evasion business mortally wounded and other countries cracking down as well, many Alpine bankers have had to find other lines of work. Countries like Singapore, ready to eat Switzerland’s lunch, have instead been at pains to promote relatively clean financial platforms. So serious financial secrecy clients have had to consider more questionable venues and take their chances – narrower channels, less reputable countries, less scrupulous characters, fewer legal protections, and higher secrecy costs and risks.

Meantime, the OECD in 1989 created its own principles under the Financial Activities Task Force (FATF) to combat “… combating money laundering, terrorist financing and other related threats to the integrity of the international financial system.” After a slow start, FATF has become far more effective in implementing sensible standards and coordinating national policies, sometimes motivated by the threat of international blacklisting. The ultimate goal is full exchange of financial information among signatory countries. In short, things have become a lot more challenging in the traditional financial secrecy business.

Along come crypto-currencies – possibly a Godsend for beleaguered secrecy seekers. Here we have a “distributed ledger” that is internally transparent, immutable and verifiable, and does away with central clearing and custody. No need to trust financial intermediaries or governments. Transactions are immediate and low cost. No hold-ups or secret-agent problems. Anonymous crypto-wallets designed to be impervious to prying eyes. Unregulated crypto exchanges in various parts of the world that bridge to conventional currencies. Plus a proliferation of initial coin offerings (ICOs) to widen choice among competing players that offer a dual crypto-currency role - a store of value and means of payment.

In short, here’s a miraculous innovation that is especially appealing to those searching for financial secrecy and weighing it against the associated risks and returns. Guesstimates suggest that plenty of people buy this story today, with maybe half of crypto transactions motivated by illicit activities of some sort.

Not so fast. There are drawbacks. Fraudulent ICO issuers have found an easy mark among buyers blinded by the prospects of confidentiality. Crypto-currency exchanges, which also serve as custodians, have been subject to cyber-attacks and big thefts, with limited or no recourse for victims unwilling to reveal their identities. And there is plenty of scope for shady practices such as classic pump-and-dump market manipulation and “spoofing” in trading practices on some crypto exchanges. For a secrecy-driven stash, it’s buyer beware.

But the real show-stopper is the prospect of linking “anonymous” crypto wallets to real identities. Everything rides on preventing this. If prying eyes can make the connection, which some think is not that difficult, it’s all over for crypto as a financial secrecy tool. Governments have plenty of incentives to obtain insight, ranging from loss of fiscal revenues to cyber-crime, and they have scored some notable successes like the 2013 Silk Road shutdown and the 2017 Bitcoin-enabled hacking indictments handed down in the United States against Russians.

What are the prospects? The high-tech that is your friend can also be your mortal enemy. Reconnecting anonymous crypto identities to people is facilitated by “big data” analytics scraped from a completely transparent transaction record. New artificial intelligence techniques  can help back-out real identities. Assuring secrecy involves higher costs, complexity and reliance on programmers and third-party vendors to run the crypto infrastructure. And the crypto-currency exchanges can be arm-twisted to cooperate. A US Treasury requirement to obtain true client identities for US-based exchanges in 2013 evidently cause a stampede to European-based exchanges - only a temporary solution since the EU has similar requirements pending for 2019.  Comoro Islands, anyone

A lot depends on the success of crypto-currencies themselves – so far comprising less than 1% of the global state-issued money supply - and what they are used for. For now, global crypto-currency regulation among nations is still a dog’s breakfast total bans, registration requirements, taxation, financial market regulation practices and the encroachment of disclosure rules. But that will change.

We know that regulation imposes both benefits and costs on market participants. Benefits of regulation include improved robustness and fair dealing - a few crypto exchanges have already pushed to register with financial certification authorities like the US CFTC in order to gain confidence among investors. The costs include reporting and compliance expenses and capital requirements imposed on exchanges to assure solvency. Crypto-currency players motivated by financial secrecy benefit from regulation, just like everyone else. But they bear extraordinarily costs if the cover of anonymous wallets gets blown and it’s “open kimono” time. Regulation always comes with greater intrusion.

Governments certainly have plenty of incentives to make the link, and they have already scored some notable successes – there are a few coins (ZCash, Monero) that are meant to be more anonymous than Bitcoin and the others, but they are not widely used and it is not clear they’re truly private.

If financial disclosure is bad news for those in need of secrecy and crypto-currencies offered new hope, disappointment may lie ahead. The fast-evolving crypto market is a welcome addition to their secrecy toolbox. But it’s hardly free of tricks and traps, and financial anonymity isn’t assured as crypto matures and attracts greater regulatory attention. It may soon be back to the future – financial secrecy fans and their enablers will continue relying on some of the well-trodden but crypto-refreshed paths to confidentiality.