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. 

Is the NAFTA Deal Only Trump Theater?

By Roy C. Smith

Donald Trump announced last Monday that at a Mexican trade deal had been agreed and Canada, our second largest trade partner after China, had until Friday to get on board or be left out. Trade deals are hard to analyze unless you can get deeply into the weeds, but the essence of this one seems to be to favor auto workers in both countries whose wages would increase, and to require more car production in the US.

Mr. Trump had previously led us to believe that the NAFTA renegotiations had been put off until after the mid-term elections. The surprise announcement seems to have been driven by the need to get the deal signed by the unpopular Mexican president Enrique Peña Nieto before his successor, socialist Andrés Manuel López Obrador, takes office on Dec. 1, 2018.  

The original NAFTA deal, proposed and developed by George H. W. Bush but supported and rammed through by Bill Clinton, was more popular with Republicans than Democrats. It was a free trade proposition in which overall trade would benefit but some industries, like autos, would probably lose jobs. Most economists looking at the 25-year old agreement believe NAFTA has been a net positive contributor to US economic growth. This deal, however, reverses direction, favoring one industry at the expense of overall economic growth. The Financial Times said it would be destructive of longstanding supply chains of major car companies that would lead to higher cars prices, which might work to the advantage of European and Asia car manufacturers selling in the US.

It is not at all clear that the Canadians can accept the terms presented as a fait accompli by Friday, which would effectively terminate NAFTA unilaterally by executive order.

The Canadians may come up with some sort of fudge to get by the Friday date, but the Trudeau government has strongly objected to the revised dispute resolution provisions of the new agreement that weakens Canada's ability to resist unilateral tariff changes made by the US, such as the newly imposed tariffs on steel and aluminum. Gains to the US from the Mexican agreement would be minimal, but Canadian trade and investment would be stymied by tariffs, confusion, disputes and a political disaffection that could take years to rectify.

So, is this it? Will trade policy by executive order stand, or will checks and balances render Monday’s announcement meaningless?

Well, the North American Free Trade Agreement was not established by executive order in 1993, it was incorporated in a statute passed by Congress in accordance with provisions in the US Constitution granting Congress express authority to establish tariffs and regulate commerce with foreign nations. According to Senator Pat Toomey (Republican from Pennsylvania), “a president can no more repeal NAFTA than he can repeal ObamaCare or create a new NAFTA without Congress’s approval.”

Further, existing law requires the president to notify Congress 90-days in advance of signing any trade agreement. Friday, by which time the Canadians must adopt the revisions or be excluded, is 90-days before December 1, when President Lopez Obrador takes office in Mexico. Obrador, has been neutral on NAFTA so far, but could easily find fault with it if it ends up on his desk to be signed.  

By Dec 1, the 2018 mid-term elections will have been decided, with a new Congress to be seated on Jan. 1, 2019, which many observers believe will increase the number of Democrats in the House of Representatives, if they don’t end up controlling it.

Even though the revised NAFTA plan would satisfy some labor unions, it is highly unlikely that Democrats in the House would vote for it if it came to a vote before Jan. 1. There are only eight days when the House and Senate are scheduled to be in session from Dec. 1 to Jan. 1. Mr. Trump may be able to force some Republicans in the House to vote for it, but it is questionable whether there would be enough Republican votes to get it done without Democrat support. Nor is the departing Speaker of the House, Paul Ryan, likely to be willing or able to get such a vote through. And, the Republican majority in the Senate is too small to cover for dissenters like Sen. Toomey to pass a bill, assuming the Democrats did not invoke the filibuster rule requiring 60 votes to pass.

If Congress fails to act and Mr. Trump signs the agreement, with or without Canadian participation, it will not be long before a federal court rules that it is unconstitutional and must make its way to the Supreme Court. Until it does, the agreement cannot go into effect. If it gets to the Supreme Court, the more conservative members in the majority are unlikely to take the view that the powers clearly granted to Congress by the Constitution are to be set aside in favor of the executive branch.

Surely Mr. Trump knows all this. The odds of getting the deal he announced through are very low. So, why did he do it this way? It can only be that it’s an effort to influence the mid-terms to get his base excited and vote to maintain control of the House for the remainder of his term.  But even if he does preserve his majority in the House, he is still constrained by the checks and balances put into the Constitution to restrain excessive executive power.

Lessons from the Turkish Lira Crisis

By Roy C. Smith

Turkey is the world’s 17^th largest economy by GDP ($850 billion in 2017), bigger than all but six of the 28 EU countries, and just a bit smaller than Spain. It is the largest and most modern economy of the Middle East, and last year it grew at 7% (more than China). It is also a NATO member.

Last week, however, the Turkish lira dropped 20% against the US dollar, bringing its year to date decline to 46% and igniting fears of a financial crisis in the country. This is because Turkey has $460 billion (53% of GDP) in “external debt” (i.e., denominated in currencies other than the lira, mostly US dollars), about half of which is private sector debt. Approximately $30 billion of this debt is estimated to come due this year when it must be repaid or refinanced in global capital markets.

The plunge in the value of the lira has made meeting maturing dollar payments much more expensive for borrowers, and foreign banks more reluctant to roll the loans over. The cost of credit insurance on Turkish debt increased by 20% just in the last week (higher than Greece or Pakistan) as the probability of wider debt default increased.  Bloomberg reports that Turkish banks are in the process of restructuring more than $20 billion of distressed corporate debt.  

Investors have shown concern about investment conditions in Turkey even before the powers of strongman President Recep Tayyip Erdogan were further increased after his recent reelection. To retain his political support, Erdogan has been an aggressive driver of the economy, promoting large debt-financed construction projects and forcing interest rates down to encourage growth, despite rising inflation that reached 15.9% in July. Erdogan’s increasingly populist and nationalist policies have eroded relations with the EU (which Turkey has sought to join for many years) and the US. Indeed, the sharp drop in the lira in the past week was attributed to Donald Trump’s doubling tariffs on Turkish steel and aluminum exports to the US because of Erdogan’s refusal to release an American pastor charged with participating in the 2016 unsuccessful coup attempt against Erdogan.

Mr. Trump’s action may have sparked a market reaction to a changed political-economic outlook for Turkey, but sooner or later the underlying facts would have brought about a similar response. Markets react, however, not just to changed information but also to changed psychological factors – anticipating what other investors will do to get out ahead of a panic.

Turkish stocks have dropped 20% since the beginning of the year, not a panic yet. But markets are now worried that one could happen if the economy drops into recession, bankruptcies increase and strain the banking system already weakened by the falling lira (and banks having to refinance their own maturing dollar debts). Under these conditions the banks will have nowhere to turn but to the government.

But the government has foreign debt coming due also, which it will only be able to rollover at much higher interest rates. Yields on 10-year lira bonds are already at 21%.

This is what happened in the Greek crisis in 2010 that took years and more than $320 billion in three bailouts by the Eurozone countries to bring to a minimal level of resolution. But the Turkish economy is about four times larger than Greece’s and there is no Eurozone community to cushion Turkey’s problems.

To try to avoid a financial crisis the Turkish central bank pushed up local interest rates to a growth-killing 18% in June. The drop in the lira has caused many Turkish investors and bank depositors to try to get their money out of the country into something safe. Repaying foreign currency debt that banks won’t rollover has strained Turkey’s foreign exchange reserves, but these reserves are quite small and may soon be exhausted. When they are, the country will have little choice but to either default on all its foreign debt (which takes several years of recession and austerity to remedy) or to call on the International Monetary Fund for assistance, which only comes with harsh economic remediation measures, to restore normal conditions.

There are a few lessons to be found in these events.

One.  Whether they prefer it or not, all countries are bound together by their use and dependence on global capital markets. These now represent about $300 trillion of market value that is subject to changing investor concerns. Emerging market countries like Turkey have benefited enormously from access to this source of funding for its economic development. Denied foreign credit, most countries are subject to reductions of growth rates, market values and general prosperity. But to retain access to foreign credit, countries must conform to acceptable economic and political norms. Turkey’s relatively high growth rate in recent years was financed by foreign capital, but access to this capital involves accepting the norms and disciplines associated with it.

Two. Too much foreign currency borrowing is dangerous for emerging market countries. Access to it can be denied suddenly if global financial markets lose confidence in the country, for whatever reason. When it does, big trouble inevitably follows. And, contagion to other countries can occur when a major country is under pressure. The Turkish situation has not led to wide contagion yet; the JP Morgan Emerging Market Bond Index is down 9% from the beginning of the year, and down 5% since July, but not in contagion range. However, signs are already visible that foreign investors are extracting money from Argentina, Indonesia and some other countries with problems like Turkey’s.

Three.  US tariffs and sanctions can make things substantially worse. They can be powerful particularly because they can halt dollar funds flows of various types that connect countries to the global economy.  Because of the size of the US market for goods and services, and because the US dollar is used to enable more than 70% of foreign trade, US sanctions are by far the most potent of all as Iran, Russia, North Korea, and Cuba have experienced. 

Four. But, especially because they are potent, sanctions (or tariffs imposed in lieu of sanctions) can be dangerous too for those that impose them. Sanctions aim to weaken countries and induce them to behave differently, but the behavior change cannot happen quickly. Sanctioned countries first respond politically by threatening retaliation (ineffective) and to replace imports with locally manufactured goods (impossible in the short to mid-term).  Mr. Erdogan has said Turkey will not yield to US pressure, though it has little capacity to resist. But reversing sanctions can take years to play out (Cuban sanctions have been in place for more than 50 years), during which time the targeted countries suffer economic hardship, and relations deteriorate significantly. These results interfere with other political goals and intentions of the sanction imposers. It can hardly be in the US interest to cripple the Turkish economy to such an extent that is driven into the arms of the Russians or Chinese, NATO is weakened, and/or tumultuous “Arab Spring” regime-change conditions emerge with uncertain consequences.

Five. No matter how authoritarian a government may be, it can be brought to its knees by the consequences of the withdrawal of foreign credit. After the run on the lira, President Erdogan blamed it on the actions by Mr. Trump and threatened retaliation and other measures. He has also disclaimed the idea of requesting assistance from the IMF. But he is in the grip of a major crisis that will only get worse if he avoids coming to terms with it. Market forces are more powerful than he is, though apparently, he doesn’t know that yet.

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.”