Brexit’s Doldrums before the Storm

By Roy C. Smith

This past week I have been reading email comments from a group of establishment Brits who have been discussing a recent petitioning for a second referendum on Brexit by the Independent newspaper. Though the idea was proposed a year ago by former prime minister Tony Blair (because of the poor quality of the Brexit debate prior to the vote), Blair has been sufficiently discredited by his endorsement of George W. Bush’s Iraq war that the thought never went very far. But after a year of Brexit gridlock, a dramatic slowdown in the UK growth rate to 1.3%, one of the EU’s lowest, and fear that achieving no agreement by March 2019 would make it all worse, has moved public concern over Brexit to the point of entertaining radical moves, which a second referendum would be.

Why radical? Because Teresa May has said “Brexit means Brexit,” and there is no going back. The people voted, so that’s it. That and the fact that agreeing to a second referendum would almost certainly result in May being replaced as Conservative leader or losing a vote of confidence in Parliament that would bring in Labour.

Comments from the email group have been erudite, diverse, and witty. All express frustration that an event as important to the future of the UK as Brexit should be hostage to entrenched political stalemate. May’s dilemma is that whatever both sides of her Conservative Party might accept would not be acceptable to the EU. The public too remains sharply divided over whether Brexit would be good for them or not. No matter what happens, several emailers have noted, half the country will still be unhappy. And yet, say some who have been summering outside the UK, as important as the matter is to the Brits, no one in the US or Europe seems to care very much about it.  

The Independent’s editorial that proposed the second referendum was accompanied by a petition to be submitted to the government. In a week, over 400,000 signatures in favor of a second referendum were gathered. A Reuters poll on July 30, showed two-thirds of Britons now believe that Brexit will be a “bad deal” for the UK, and 50% support a second referendum. The poll also reported that 48% said if there was another vote they would choose to remain in the EU, 27% said they preferred to leave the EU even without a deal, and only 13% supported the Prime Minister’s plan announced after a cabinet meeting ultimatum at Chequers last month.

In June, the governor of the Bank of England, Mark Carney, said that the cost of Brexit so far was about £900 per household, as GDP had shrunk by 2.1% over what had been forecast two years earlier. Another report in July by consultants Oliver Wyman and law firm Clifford Chance estimated tariffs of £31 billion per annum on goods imported from the EU and £27 billion on UK exports would adversely affect the supply chains of both UK and EU manufacturers. The IMF said it was worried about inflationary pressures in an economy with near full employment, bringing back memories of the painful period of “stagflation” in the 1970s. These realizations have caused new capital investment plans in the UK to be cancelled or deferred.

Ms. May has also said UK taxpayers would be obliged to pay the EU approximately £35 billion for past unfulfilled commitments as part of the “divorce settlement.” The net financial effect of all this is to lower growth over an extended time and reduce funds available for health and other public services. None of this was known or expected by voters at the time of the original referendum in 2016. British voters, concerned about their own futures, apparently are now starting to pay attention to the economic forecasts, which the die-hard Brexiters brush aside as “fake news.”

The Economist and some other commentators, probably including most of the email group, have come out for a “soft Brexit,” which means staying inside the common market and accepting EU immigration and some other policies. This would mean avoiding tariffs on “goods,” but also keeping an open border with Ireland. “Services” could be outside the EU rules, which the City of London would like. Immigration is a contentious issue but overblown for political purposes. In 2017, 311,000 non-EU immigrants arrived in the UK (0.5% of the population), though net immigration from all countries was 227,000.  Even so, the hardcore, deeply resistant to the notion of a dominating European political union that would swallow British sovereignty, won’t buy the soft version. Rather than compromise they are willing to end up with no deal at all.  

The Independent’s second referendum idea is gathering support from former political big wigs from both sides. Even though it might be the best and most responsible road to take now that information about the real Brexit has been circulating for a couple of years, the May government seems unlikely to undertake it. If she should fall in a vote of no-confidence a new election would result, which likely would place socialist Jeremy Corbyn in charge of the next government. There is no indication yet that Corbyn would initiate a second referendum either, but the Independent’s move may create grass-root political pressure that could force his hand.

American’s observing all this should have some sympathy for the email group and the rest of the British public concerned about a suicidal course of action set in motion by a minority of true believers. We face mid-term elections that are thought to be a second referendum on Donald Trump and his commitment to tariff wars, retreating from international agreements, and immigration policies that harm the economy and are greatly disproportionate to the illegal entry volumes that currently exist.  Recent US polls show that only about a third of “independent” voters currently support the president, and nearly half of American registered voters now claim to be independent. Polls also find that 88% of Republican voters still solidly support Mr. Trump, suggesting that he totally controls his party, but there are plenty of silent dissidents. In mid-term elections, first term presidents usually lose seats in the House of representatives. Republicans will have to lose 23 seats to lose control of the House, something Democrats regard as more than likely. But, it will be a test of grass root support across the country for the Trump persona and agenda.

Trump’s election was the second of two shocks in 2016, the other being the Brexit vote. In both cases the polls had it wrong, and an underlying sense of anxiety and anger shaped both outcomes.  Now we are about to test the waters in the US after two years of Mr. Trump, and in the UK as to whether the government can deliver an acceptable Brexit outcome. In both cases, we can anticipate stormy times after the summer doldrums.

  

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

by 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 that 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.

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[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.

David Solomon will Face Tough Challenges

By Roy C. Smith

Goldman Sachs‘ announcement on Tuesday that David Solomon will replace Lloyd Blankfein as CEO was expected, but when the actual change occurs on Oct 1 it will brings to an end the super-eventful 16-year period in which Blankfein reshaped the firm – not once but twice – while maintaining its preeminent role as one of the world’s foremost investment banks even through the worst financial crisis since the 1930s.

Blankfein took over as Fixed Income Commodities and Currency chief in 2002 just as the three-year “tech-wreck” crisis was ending. Working with Hank Paulson, Goldman’s CEO at the time, Blankfein smoothly managed a massive expansion of the firm’s trading business, transforming Goldman Sachs from a cautious, client-oriented investment bank into a global trading colossus engaged with “counterparties” all over the world. By 2006, when Blankfein replaced Paulson as CEO, more than 70% of the firm’s profits were from trading.

But, by the end of that year Blankfein and others among the firm’s top managers noticed changes in the housing market and sharply adjusted trading positions, which enabled the firm to survive the maelstrom that followed better than any of its competitors. But the crisis, and the regulatory aftermath that followed changed everything, so Goldman had to affect another transition -- to decrease its reliance on trading. In 2017, trading accounted for only about 20% of profits, about the same as 2000.

This second transition, however, has been Blankfein’s major undertaking of the past ten of his 12 years as CEO. He has called the process “re-engineering” in a labyrinth of regulation to strike the right balance between the firm’s traditional businesses, while investing heavily in new technology to make the process more efficient and to open up opportunities. Today 25% of Goldman’s total headcount of 36,000 are engaged in various engineering roles. 

Though the combined market value of all tradable financial assets in the world, according to McKinsey Global Institute, has grown from $200 trillion in 2007 to more than $300 trillion today, the financial services industry has been in a slump. Besieged by an avalanche of regulatory costs, restrictions and litigation settlements, and hamstrung by a slow growth economy with markets distorted from intervention by central banks and competition from new and different sources, the “systemically important financial institutions” have struggled to get things right. Though Goldman Sachs has performed better than almost all of its peers, its returns on equity capital have only marginally exceeded its cost of equity capital since 2010, and its price-to-book value ratio today is only 1.18.

Many banking industry observers believe that the highly-leveraged, go-for-glory days of the industry are permanently in the past and that most banks now can only look forward to a regulated public utility existence.

Blankfein’s approach throughout the transition has been to keep all four wheels on the road, tinker with the engine and the chassis, but let the vehicle do what it has always done well. He has looked at strategic possibilities – spin offs, mergers or investing in retail banking or insurance – but (in traditional Goldman fashion) found nothing better than sticking with the tried and true.

David Salomon’s job will be to figure out a way back to double digit growth that will be worthy of the Goldman DNA of the past. First, he will have to form a management team of his own, get around and schmooze up all Goldman’s important clients, regulators and the financial media in the US, the EU and Asia, and then figure out how and when he is going to address the tough strategic questions that face the firm.

When he gets to it, he will have to ask himself three simple questions: (1) can the $1 trillion (assets) business model we have, weighted down by the combined burdens of regulation, damaged industry public relations and now permanent exposure to big-ticket litigation, ever get back to sustainable double-digit growth? (2) if we are going to end up as a glorified public utility, how do we keep all the overachieving hot-shots around here from going somewhere else? and (3) can we transform some of the high valued-added stuff we do in lending, investing, venture capital and FinTech into a more entrepreneurial, private equity format and split if off from the overburdened rest? 

David Salomon has more than 30-years’ experience in the industry, most of it at Goldman Sachs in fixed income and investment banking, which he led.  But being CEO is a tough job for which no one is ever adequately trained or prepared. But the selection process has been solid from among highly qualified inside candidates that are well and truly steeped in the Goldman Sachs culture. And, as a graduate of Hamilton College, he well knows the line from the musical about the school’s namesake in which the young Hamilton announces “I am not throwing away my shot!” Nor should he. It’s his turn now.

From Financial News, July 17, 2018

The Tariff Wars Begin

By Roy C. Smith

Officially the trade war with China has now begun as the first wave of tariffs has been imposed and retaliated against. Escalation is likely to follow. Except for Peter Navarro, no serious economist thinks tariff wars can be anything but lose-lose exercises.  Anyway, the timing is all wrong.  

Rising costs in China have made their export machine less competitive with other Asian countries, and China is trying to shift its economy to one with more domestic consumption. Indeed, Chinese exports have dropped from 68% of GDP in 2009 to 38% in 2017 and in Feb 2018, China’s current account balance (goods, services and foreign income) was a $25 billion deficit. This was probably a temporary event, but it signified that China is being driven by market forces to becoming less dependent on exports.  Indeed, as its export capacity declines, China must develop its domestic consumption and employment base to sustain even a (modest for China) 6% growth rate. China’s most important economic initiative – its “Made in China 2025” program that aims to develop the country’s domestic technology industries -- is an example of how it is trying to restructure the economy.

Meanwhile the US economy is recovering. Inflation remains relatively low despite considerable fiscal and monetary stimulus, and unemployment is the lowest since the 1970s. Much of China’s trade surplus is the result of the global supply chain developed over the years by US companies to improve their competitiveness and lower consumer prices. China also invests most of its surplus in US government and other securities and in direct investments in US companies and factories.

All things netted out, China does not pose a threat to the US economy.

So why is Mr. Trump doing this?  There is the “base,” of course, but there are probably more Trump supporters among the customers of Walmart than those whose jobs were lost because of China’s exports.  Whatever the base may believe now, the history of tariff wars is that they hurt people from the working classes (i.e., the base) more than anyone else.  

Mr. Trump invented the China threat, then promised to remove it by negotiating a better deal.

Well, there is room for improving our bi-lateral terms of trade and investment with China, even if they are not essential to our own well-being. Most serious economists believe that while tariff wars are not a good way to settle things, they may be effective as bargaining chips to gain concessions that otherwise might never be given. And the concessions Trump seems to have in mind could be good for all Americans.  Martin Feldstein, an eminent Harvard economist and former Chairman of the Council of Economic Advisers under President Reagan, in a recent op-ed in the Wall Street Journal, points out that if the tariff bargaining chip could be traded for China’s dropping its requirement that US companies doing business in the country have a Chinese partner to whom it must divulge its latest technologies, this alone would be worth all the fuss that departure from international economic orthodoxy has created.

There is a lot more to negotiate as well. Opening of Chinese markets to financial and other services, agreeing to acceptable governance structures for overseas investments, and perhaps most important, limiting government subsidies to state owned enterprises that compete in markets with private companies.  This last one is an especially tough one because there are 150,000 state owned companies of various sizes in China, and even those that are not state owned are beneficiaries of China’s command system for allocating economic resources.  The Made in China 2025 initiative, Mr. Trump suspects, will be laden with direct and indirect subsidies for the technology companies China wants to support.

But negotiations appear to be on hold – not much is happening as the initial tariffs go into effect. China had previously indicated a willingness to discuss many of the demands that the Trump team presented on its two-day visit to Beijing in May, but since then China and most other observers have been searching to learn what the Deal King’s real objectives are.  In the meantime, things are marinating in an environment that seems to favor the US. The US economy may produce a growth rate for the second quarter as high at 4%, and its financial markets and the dollar are strong. China’s stock market, on the other hand, is down 17% this year and the yuan dropped 3.6% against the dollar just since the beginning of June. China’s growth rate is decelerating, despite easy credit conditions, too much debt and too much of it in danger of default. The US is China’s largest export market, and tariffs will slow growth further.  Mr. Trump is probably just waiting for China to blink first.

The situation, however, also presents a great opportunity for the developed world (i.e., the US, EU, Canada and Japan) to present the budding Chinese colossus with a common front to set new trading and investment rules for the next decade. The new rules would update the lax ones that China has been able to get away with since joining the World Trade Organization as a developing country in 2001. If China wants to avoid tariffs in all the world’s largest markets for its goods and services, and have free access to investments in these markets, it needs to make some reciprocal concessions. Negotiating as a bloc would increase the group’s bargaining power to levels China could not resist.

But Mr. Trump is not big on multi-lateral economic agreements such as the Trans Pacific Partnership or NAFTA and he has unilaterally imposed tariffs on steel and aluminum exports from the EU, Canada and Japan.  Nor is he much interested in strengthening and modernizing the World Trade Organization that the US established in 1948 to expand world trade.  Trade now accounts for 60% of global GDP – but it is almost entirely multi-lateral, not bi-lateral as Mr. Trump seems to think.

Nevertheless, Mr. Trump is likely to agree something with the Chinese that he can claim to be a victory, probably just before the mid-term elections in November.  He has already deferred the NAFTA negotiations “until after the mid—terms,” so it is clear he has them in mind, but he might have been better off to have wrapped up NAFTA before the new Mexican president, a populist- socialist assumed office.

He is also waiting for the EU to offer to drop tariffs on imported cars from the US from 10% to the US rate of 2.5%, in exchange for removing the steel tariffs. This seems likely, but relations with the EU have soured significantly since Mr. Trump’s withdrawal from the Paris Environmental Accord and the Iran Nuclear Agreement, and his threats to reconsider NATO if the members don’t increase their contributions to it. There is also the effect of US sanctions on EU businesses doing business with Iran, which are scheduled to go into effect soon even though Europe still maintains the agreement.

The market appears to believe that Mr. Trump’s opening salvos in his multiple trade wars will end up in deals that may provide some marginal gains to the economy, or at least not hurt it very much.

But there is a deeper downside. If, annoyed and humiliated as some of our major trade counterparties may be, they may come under political pressure to push back harder than Mr. Trump expects and not do the deals he wants. There may be a lengthy standoff that could decrease US exports, increase the cost of imports, screw up corporate supply chains and earnings, and slow down foreign direct investment, which together could materially slow US growth in the latter part of 2018 and 2019, when current growth forecasts begin to turn back to the 2% level. Similar, possibly worse, effects could occur outside the US, jeopardizing global growth and triggering a global market sell off, all of which could be blamed on Mr. Trump’s policies.

So far, markets have believed that Mr. Trump’s actions have been part of a broad ranging plan to renegotiate the US’ economic relations with the world, from which no serious harm is likely to result. But if it turns out that there really is no master plan and he’s just winging it, then the emperor may be seen to have no clothes after all, and a major market reaction could result.

As Mr. Trump often says, “we will just have to wait and see.”

Is North Korea Another Cuba?

By Roy C. Smith

Last week’s 1-day US – North Korea summit ended with a joint statement promising "mutual confidence building" to "promote the denuclearization of the Korean Peninsula." President Trump and Supreme Leader Kim Jong Un also made commitments to build a "lasting a stable peace regime on the Korean Peninsula," to work toward denuclearization and to recover POW/MIA remains from the 1950s. Though the statement was vague, expectations soared that North Korea would stand down its nuclear weapons and the US would withdraw sanctions and assist in developing North Korea’s economy. 

Evan Osnos, a China expert for The New Yorker who visited North Korea recently, suggests the unexpected change of heart by Kim Jong Un to be the result of the increasing amounts of foreign information leaking into North Korea through social and other media that show how so very badly off the country is relative to its neighbors. After 70 years of a “socialist paradise,” North Korea’s GDP per capita, stagnant for years, is only $583 -- China’s is $8,123 and South Korea’s $27,538. By this measure, North Korea is the poorest country in the world by a significant amount. Knowing this to be so, Osnos says, makes Kim’s regime vulnerable to upheaval from within, despite its harsh rule with 200,000 political prisoners. So, after seven years as chief of state, maybe Kim figures it is better to use North Korea’s newly achieved nuclear deterrent to bargain for relief from sanctions to get some economic development before it’s too late. 

The event brings to mind another momentously staged announcement, one in December 2014, when the US and Cuba agreed to normalize relations. Raul Castro replaced his brother as Supreme Leader in 2006, and he knew very well that the Cuban economy was crumbling, it had run out of credit with other socialist nations, and its main benefactor, Venezuela, was on its last legs. Something had to be done, so Raul liberalized some things -- permitting sales of personal property and real estate and freeing up local markets to small time entrepreneurs. But the only way out, Raul also seemed to know, was to restore relations with the hated US, in the hope that economic fallout would be enough to get the economy out of the no-growth slump it was in. But this was a big step and carried many risks. Raul took five years to think about it before commencing pre-announcement negotiations.

I was in Cuba a couple of weeks after the 2014 announcement and there was no doubt that the excitement it generated was considerable. All the Cubans one could see were talking about how much better things would become when the US trade “blockade” was lifted and incoming foreign investment would create a new world of enhanced economic activity.  In March of 2016, the US embassy was reopened and President Obama visited to celebrate the event.

Since then, not much else has happened on the normalization front. GDP growth shot up to 4.4% in 2015, because of a spike in tourism and increased expectations. But nothing else was reformed in the economic sector, no large-scale investments by multi-national corporations, no banking reform, and no effort to upgrade the agricultural sector so as to avoid having to import 70% of Cuba’s food. Growth rates plummeted to -0.9% in 2016, then rebounded a bit to 1.5% in 2017. Cuba’s GDP per capita is $7,600, much higher than North Korea’s but still less than China’s. Raul recently retired, though no one doubts he still runs things from his rocking chair.

Raul distrusts everything American, especially its big businesses that flourished in Cuba during the Batista regime that the Castros overthrew in 1959.  Once in power, the Castros’ forced fed the Cubans with their version of a socialist paradise, aided by 30 years of economic aid from the USSR. The Soviets played the Cuban nuclear deterrent card in 1963 – installing missiles that nearly led to a US invasion or nuclear exchange – from which they backed off.  However, without the support of the USSR, which imploded in 1991, Cuba experienced a very difficult, near-starvation, decade, only to be bailed out again by another socialist paradise, Venezuela.  Then, as Venezuela’s economy collapsed, Cuba had to look to other options to stay intact. If Raul did nothing, rising economic discontent might lead to the end of Cuban “Socialismo” after his death. If he patched things up with the US, the economy might rekindle and the regime could survive.

The Castros have long since ceased to be any kind of threat to the US, but their rule, like the North Koreans, is a testimony to the ability of an authoritarian police state to stay in power indefinitely, despite dreadful economic results. But it seems than both Raul Castro and Kim Jong Un saw handwriting on the wall – do nothing and our economies finally do crash and political change may be next. Do something with the US, and we can buy some time: sanctions may be reduced, and foreign money may be attracted to a less confrontational future.

Like the Castros, the Kims are a cautious family business unlikely to open up more than a little. Perhaps a little can go a long way if it makes local street market entrepreneurs happy. But, really big changes usually take a new guy to pull them off. Deng Xiaoping engineered China’s 180-degree turnaround strategy skillfully, but only after Mao Zedong, who launched the disastrous Red Guards to rekindle revolutionary ardor, had died and Deng had gained power.  

In Korea, post-summit meetings continue to see what might be done. Mr. Pompeo has said that he and Mr. Trump expect nuclear disarmament to be achieved by the end of the president’s first term, but sanctions will remain until it happens. Some observers who know, say disarmament is a process that will take a decade or more.  Some who know North Korea say the thirty-year effort to secure nuclear weapons and missiles was only to be able to deter threats from the US, its longstanding enemy-in-chief.  Maybe Kim will give up some stuff, as his father did in previous negotiations with the Clinton administration, but never all of it and not quickly without sanctions relief. Really big changes by North Korea seem hard to imagine.

In Cuba, a really big change didn’t happen with normalization because Raul didn’t want it to. For him, opening up Cuba’s economy to global investment entailed too big a risk of capitalism getting into the country and creating a surge of money and market forces that might overwhelm government policies, information and controls. What Raul did want was a repeal of the US trade embargo with Cuba. Mr. Obama may have been ready for this, but the Republican-controlled US Congress was not. To repeal the trade embargo will require restoration of human rights and property seized by the Castro government.  Nevertheless, some normalization is better than none. The US and the Cubans can wait for Raul, now 87, to pass on and then maybe somebody new will appear to make the really big changes Cuba needs and the US would welcome.

But Mr. Kim, in his thirties, isn’t about to pass on.  If the deal with Mr. Trump proves too risky, he probably figures he can back away as before. But, he may be in a tighter spot than he thinks.  The Americans may not be willing to trade unless they get everything they want, and Mr. Trump has promised to achieve disarmament one way or another. Both Trump and the Kim are dealing in a vast area of mutual misunderstanding and distrust, but with high expectations for political success.  Still, there is no need to rush -- North Korea’s nuclear threat to the US, never great or imminent to begin with, is “on hold.”

A Cuban type of slow-go in North Korea could be what both sides need. A few signs of good faith, lots of talks off stage, visits by diplomats, more aid and encouragement from South Korea and Japan, and who knows, maybe in time something better than the status quo ante will emerge.

It Could Only Happen in Italy

By Roy C. Smith

Though a founding member of the European Economic Community and of the European Union, and a first round participant in the euro, Italy has always posed an existential threat to these institutions because its heavily working class voting population has never trusted the so-called elites, was always suspicious that the wheeling and dealing politicians that came forth were corrupt or incompetent, and never felt very European.  

In 1946, after more than 20 years under Mussolini, Italy established by referendum a democratic republic. But Italy was not a normal country then; from 1943 when the Italians surrendered until well after the German forces exited in 1945, Italian partisans rose up aid allied forces fighting the Nazis, but also to seek revenge on Italian fascists and/or supporters of the Germans and their collaborators. As many as 30,000 Italian were killed by their countrymen in 1945 and 1946 alone.

For most of the next 50 years, however, the dominating political party was the center-left Christian Democrats, whose main job was to keep the Italian Communist Party (the largest and most accepted in Europe) from gaining control of a government. In these 50 years, however, Italy had more than 50 governments, as the Christian Democrats wheeled and maneuvered to stay in control through coalitions, alliances, pay offs and deals of various kinds. But, the Christian Democrats kept their hands on the tiller through this time (making Italy less volatile than it seemed), but voters continued to seethe with a long list of discontents (including too many politicians with their hands in the till).

In the 1970s, the extreme left Brigate Rosse (Red Brigades) emerged and introduced terrorism to Italian politics in a “Decade of Lead.” The group was not part of the Communist Party but seemed aligned in political objectives. In 1978 the Red Brigades assassinated prime minister Aldo Moro.  They have been associated with 14,000 acts of violence. But they had some public support from the working class, whose sentiments were portrayed by the hugely popular Italian comic playwright Dario Fo (Nobel Prize in Literature 1997) in The Accidental Death of the Anarchist and Can’t Pay! Won’t Pay! (Fo is now a mentor to the populist-left, protesting Five Star Movement founded by a popular TV comedian and social media blogger, Beppo Grillo, in 2009).

In the 1990s and 2000, Silvio Berlusconi, a media billionaire with characteristics resembling Donald Trump, entered politics and was elected prime minster three times, serving a total of 9 years, longer than any other post-war Italian leader.  Though a successful businessman, Italy’s economy lagged the EU average during this time, and unemployment was higher. Berlusconi never attempted any of the labor and other reforms that other countries in Europe were undertaking at the time. He was very popular with the working class - running for office as an in-your-face conservative but governing as a populist. In 1994 his first government was defeated and a “technocratic government” headed by a former government official was appointed to run things.

Berlusconi resigned again in 2011 during the European Sovereign Debt crisis, and economist and former EU commissioner, Mario Monti, was appointed prime minister of another technocratic caretaker government until 2013.

During this time, Matteo Renzi formed a new Democratic Party to bring about needed reforms and bring Italy into the European mainstream. He was elected prime minister at 39 in 2014, with 60% of the vote and immediately began to introduce long overdue labor reforms, and to modernize Italy’s state-owned-industries and sell off assets. Despite much opposition he was successful in getting labor and other laws changed. He also introduced a change in Italy’s constitution to reduce the power of the Senate and make the Italian legislative voting system more democratic. Though the constitutional reform had the approval of the legislature, it had to pass a referendum, which in late 2016 it failed to do. Renzi then resigned as prime minister.

Italy’s next election in 2018 resulted in a surprise victory by the Five Star Movement, which gained a plurality of 32.2% of the vote, beating out the Democratic Party (18.9%), still led by Matteo Renzi, that only barely outdid an upstart, far-right League Party (17.7%), forcing an awkward coalition attempt between the far-left and the far-right.  

This effort, which involved the designation of a prominent lawyer without government experience to be prime minister (instead of either party’s head, a difficult and cumbersome compromise) failed when the two parties proposed an 81-year old anti-euro former Bank of Italy economist to be Minister of the Economy.

President Sergio Mattarella, acting within the constitutional powers of his office, rejected the coalition proposal on the grounds that the election was not about leaving the euro, which the proposed ministerial appointment foretold, and voters did not know when they voted that the parties might attempt a ”back-door exit” from the currency system that Italy had supported from the beginning. Instead, President Mattarella designated Carlo Cottarelli, a former IMF official, to become prime minister and to form another (a third) caretaker government. This new government, though, is opposed by the two parties that are attempting the coalition, so it is certain to not gain parliamentary approval, therefore triggering a snap election in the fall of 2018.

Such an election may legitimately be presented as a referendum on the euro, which considering populist sentiment in Italy could result another ill-informed Brexit.  Referendums in Europe are dangerous things.

Mattarella was not eager to have an early election under these conditions, so he was open to a different proposal from the coalition - to appoi9nt a different Minister of the Economy and let the 81-year old economist take another position in the government. Talks continue, but meanwhile, interest rates on Italian government bonds rose by  150 basis points in just a day. 

Departing the euro would be far more painful to Italy than Brexit would be to the British. Leaving the euro would mean readopting the Lira, watching it fall in value relative to the euro and increasing the burden of Italy’s $3.2 trillion debt (173% of GDP) on its citizens, and limiting the availability of new credit to Italy’s government and private sector. Banks would be forced to curtail loans, interest rates and unemployment would rise, probably sharply. Growth rates would slump into a recession that could last a long time, like Greece’s. And, in its economic distress, it would get no help from the European Stability Mechanism or European Central Bank, which can only aid euro members. As in the case of Brexit (where the issue was leaving the EU, not the euro), it is unlikely that the average voter will be aware of these consequences of an anti-euro vote or believe what they are told about them.

All this could be worse for Italians if the Five Star/League consortium also choses to leave the EU, something that some of their fervent anti-immigrant advocates believe is necessary. Italy has been awash with immigrants from Africa for several years. Leaving the EU would mean leaving the custom union (the Single Market) and the Schengen Area (no passports needed) that could curtail Italian economic growth and inward investment flows further.

Some Italian observers believe that a September election will ignite the worse of Italy’s populist complaints. Mattarella, who believed the coalition’s government proposal was harmful to Italians of all classes, nevertheless is seen as being outrageously wrong in cancelling the results of a democratic election. The populists also believe that the “establishment” political parties are not listening to the common pleading of all Italians to limit immigration and unwanted, unfair pressures on Italian life by the EU that leaves too many Italians poor and unemployed. They want the government to extend social services further to help all who need it, whatever the cost. Italy’s government debt, already 131% of GDP (the highest in the EU except for Greece) would likely explode if the coalition’s announced plans to block immigration and increase social spending were implemented.

Italy’s EU allies, some of which are fighting similar political battles in their own countries, are powerless to help. They know that an exit from the euro by Italy would be a grave threat to the ability to hold the currency together. But also, that Italy could face a banking and sovereign debt liquidity crisis similar to that confronted by Greece, Ireland, Portugal and Spain. Such a crisis would be too big to handle, and beyond the limits of voters in Germany, Holland, Denmark and other countries to tolerate as a cost of being in the currency.

Brexit may not be enough to break up the EU, but an Italexit could break the euro.   

True enough, but this is Italy – anything can still happen.

  

China, Trade and Trump

By Roy C. Smith

Perhaps it is now not unusual in the age of Trump to send an inexperienced team of officials with differing views on trade to Beijing for a two-day photo-op to deliver their “demands” for adjusting the “unfair” US-China trade balance. Among the seven US delegates, only Robert Lighthizer, the official US Trade Representative, has expertise in negotiating the endless minutia of trade issues. Though nominally led by Treasury Secretary Mnuchin, no one on the delegation seemed to be in charge or to speak for the president, something Commerce Secretary Wilbur Ross knows very well - last summer he negotiated a deal with China to reduce steel production that Mr. Trump later rejected as insufficient.

The Chinese side, quickly banged together by Liu He, president Xi Jinping’s new economic chief, replaces officials from the Commerce Ministry that were the previous trade experts. Liu’s team, trained in economics and finance, but inexperienced in trade details, seems to be fielded particularly to respond to the Trumpian form of blustery, highly politicized negotiations.

Neither side knows each other very well. Mr. Lighthizer said “we are going to spend the next year developing how we deal with each other.” If so, Mr. Lighthizer must assume his Chinese counterparts will not respond to the demands soon, or even take them seriously until they know each other better.

The US demands were an opening salvo of an economic artillery barrage that will go back and forth for a while. They include a unilateral reduction in China’s trade surplus with the US of $200 billion by 2021 (increased from $100 billion indicated before the meeting, which the Chinese said would be impossible), the ending of subsidies to Chinese tech companies competing in world markets, an immediate end to cyberespionage of commercial trade secrets and a strengthening of intellectual property protections, a lowering of Chinese tariffs on products in “non-critical” areas, opening of Chinese markets to foreign investments and services, and a promise to take no action, especially in the agricultural sector, in response to unilateral US tariff increases and other moves. These include the recent US announcement of higher tariffs on $150 billion of Chinese exports, restrictions on acquisitions in the US by certain Chinese companies and of exports to China of certain high-tech products, and penalties imposed last month on ZTE, a Chinese telecom company, for violating US sanctions on Iran.

China has already said it might open its markets to easier terms for foreign investment and is considering lowering some tariffs, but was unwilling to commit unilaterally to slashing the trade deficit. China recently announced a Made in China 2025 program as an essential upgrading of the economy with an emphasis on high technology industries. On May 5, a day after the Beijing talks ended, China announced the formation of a $47 billion China Integrated Circuit Industry Investment Fund to advance the 2025 plan. The US objects to this plan because of the large amount of government subsidies it will contain.

So, a year-long set of trade negotiations has begun with both sides firmly dug in. Nothing much is likely to happen for a while. China is not in a hurry and doesn’t face mid-term elections in the fall.  

But, China too has large political interests at stake in these negotiations. Newly anointed president-for-life Xi Jinping is in the process of consolidating all powers in China in the Chinese Communist Party (and himself).  His propaganda machine is constantly busy promoting Xi’s dynamic leadership, his “thought” and his “Chinese dream” even though growth is slowing, financial risks are increasing, and the problems of China’s huge aging population are becoming apparent. Like Mr. Trump, Mr. Xi has a populist side that appeals to nationalistic sentiments that the propaganda folks keep warm. He wants China to be recognized by the US and other countries as a great power, and not appear as Japan in the 1980s, so driven by economic ambitions that it could be forced into concessions by the US. Indeed, after the recent negotiations with the US team, Xinhua, China’s official news agency, pointed out that in a trade war, China was better off because of its strong centralized leadership, strong domestic consumer base, and “greater desire” (than the presumably soft Americans) to protect the current global trade system.

Mr. Trump’s style of deal-making is not unique in trade negotiations. Indeed, Richard Nixon, frustrated that Japan was not conceding to his trade policy demands, suddenly imposed a 10% surtax on all Japanese imports to the US. Japan responded by offering some concessions on quotas that solved the political problem Nixon had with US job losses for a while. But the trade imbalances continued and Ronald Regan followed a similar strategy a decade later.

China has emphasized that it is in a stronger bargaining position than Japan in the 1980s. Maybe it is, but the US is China’s largest trade partner, and its open markets continue to be important to China’s future. Meanwhile, China’s economic growth rate has declined from the 10% range to something around 6% despite enormous stimulus efforts and lose credit standards that threaten its financial stability. A trade war with the US certainly would not be convenient.

Economic forces already at work, however, will reduce the trade deficit on their own over time – rising costs for labor, land and raw materials have already caused some companies to move their manufacturing to a lower cost locale, and China will have a growing requirement to import goods as it becomes more of a market-driven consumer society. Meanwhile, while the deficits remain, US consumers enjoy lower prices and corporations pay lower interest rates as China recycles the surplus to invest in US securities, factories and acquisitions to protect its global market access. A great many Americans benefit a little from our present trade with China, but a few have lost their livelihoods. Cold-blooded economists don’t lose any sleep over the disparity, but hot-blooded politicians do.

China was admitted to the World Trade Organization in 2001 at president Bill Clinton’s strong urging. The US trade deficit with China was then less than $100 billion (it is now $375 billion, 2% of US GDP). China was granted some relief from WTO rules because it was a developing country. Some say because of China’s enormous growth since then, and the impact of its concentrated export activity on local businesses in the US and the EU, China should be regarded as a fully developed country and play by all the rules. China says with 60% of its population still poor and an urgent need to upgrade local manufactures to supply local markets, it should not be required yet to do so. And, China is still a one-party state with 150,000 state-owned enterprises that retains many aspects of the command economy it once was.

What's needed now is a set of practical compromises that both sides can live with and feel good about because they add real value.

These might start with a revised accounting system for calculating export values – The iPhone X costs about $370, according to one expert, for its various software and hardware components. Chinese content for assembling the units, however, is only 3% to 6%, or only $10 to $20 per unit. (The rest goes to companies in South Korea, Japan, Taiwan, the EU and the US, illustrating how Apple’s global supply chain works). On the other hand, Chinese content of commodity items like steel exports is nearly 100%.  If we ran the accounting to count only Chinese content, the pressure points would be different. China has excess and unprofitable capacity in steel and other commodity items that China needs to shut down in its own interest. If they are not shut down, the US can file dumping charges with the WTO and impose a special tariff on steel. Such tariffs have been imposed by almost all of Mr. Trump’s predecessors on a case-by-case basis. Mr. Trump could score some points by claiming his metal tariffs would be used for job retraining for displaced workers. But shutting down excess capacity, as Mr. Ross tried to do would be better. China knows it must do this sooner or later and would be better off doing so now.

Mr. Trump might propose that China agree to use its best efforts to offset the adjusted, net trade deficit with the US by increasing imports from the US, which could be of agricultural commodities, liquid natural gas (soon to be abundant in the US) and various forms of financial and other services. An accounting could be kept, and the process monitored to be sure that China conforms to the agreement, but how it does so would be left to it.

A special US-Chinese unit could also be established to continually monitor and address mutual security issues. The US wants to be sure that Chinese hacking of commercial trade secrets is ended and intellectual property protected. The Chinese want to be able to develop their technology industries, which the US should not object to if the effort conforms with restrictions on government subsidies recognized by the WTO and the EU. The US should leave private sector trade and investment in the high-tech sector to market forces, except for highly specific cases involving national security.

Having had the necessary dramatic opening session to satisfy local populations that each country is hanging tough on this important round of trade talks, it is time to get them off the stage and settled into quiet discussions of the complicated but hugely important trade relations between the two countries. A pragmatic solution awaits.