The US Dollar and the Cone of Uncertainty

By John Mauldin
Dec 22, 2014

Currently we have an international monetary non-system. Nobody has to follow any rules. Everybody does what they consider is in their own short-term best interest. The real difficulty is: What is in their short-term interest – for example, following ultra-easy monetary policy – could well backfire somewhere. It might be not in their long-term best interest. And as the easy monetary policy influences the exchange rates, it influences other countries. Almost every country in the world is in easing mode, following the Fed, and we have absolutely no idea how it will end up. We are in absolutely unchartered territory here.

– William S. White, former Chief Economist, Bank for International Settlements, in an interview for Finanz und Wirtschaft

I visualize this process [of forecasting the future] as mapping a cone of uncertainty, a tool I use to delineate possibilities that extend out from a particular moment or event. The forecaster’s job is to define the cone in a manner that helps the decision maker exercise strategic judgment. Many factors go into delineating the cone of uncertainty, but the most important is defining its breadth, which is a measure of overall uncertainty.

Drawing a cone too narrowly is worse than drawing it too broadly. A broad cone leaves you with a lot of uncertainty, but uncertainty is a friend, for its bedfellow is opportunity – as any good underwriter knows. The cone can be narrowed in subsequent refinements. Indeed, good forecasting is always an iterative process. Defining the cone broadly at the start maximizes your capacity to generate hypotheses about outcomes and eventual responses. A cone that is too narrow, by contrast, leaves you open to avoidable unpleasant surprises. Worse, it may cause you to miss the most important opportunities on your horizon.

Paul Saffo, technology forecaster

Saffo borrows the term “cone of uncertainty” from weather forecasting. While you may not be familiar with the concept, you see it in use every time there is a hurricane forecast. The further away you get from where the hurricane actually is at the moment, the wider the “cone” predicting its possible paths.

For the past two letters we’ve been looking at the global scene and trying to figure out which issues will help us outline scenarios for 2015. We finish the series today by looking at the impact of the dollar bull market on the probabilities for various 2015 developments.

Let me say at the outset that I think a global currency war (kicked off by Japan last year and just now heating up) and a rising bull market in the US dollar are the big macroeconomic drivers not just for 2015 but for the next four to five years. I think all future economic outcomes pivot along with these two major forces – they are the lever and fulcrum, so to speak. As we look at all possible futures, as we map our own cones of uncertainty, it is certainly true that that our assessment could change with the emergence of important new trends at the outer fringes of the cone; but I believe (and have believed for some time) that we need to organize our forecasts around the currency war and the dollar bull market.

(Let me note that even though this letter is much shorter than usual in terms of actual words, for which readers may be grateful, it will print longer, as there are an unusually large number of charts.)

The Beginning of a US Dollar Bull Market

Currencies are not supposed to have large movements in short spans of time and certainly not violent moves such as we have recently seen with the Russian ruble. Relatively stable currencies – ones that make moves measured in single digits over multiple years – are what you want to see for stable trade and world GDP growth.
Violent moves like the ruble’s signal that something is seriously wrong, so wrong that it may well precipitate a deep recession. You very seldom if ever see a similarly rapid upward move in a currency. (Off the top of my head, I can’t think of one, but surely somewhere in history… and if I said “never,” I would probably be corrected by my astute readers.)

Over the last few centuries, as the world moved away from the gold standard and gold-backed currencies, the valuations of fiat currencies began fluctuating, sometimes wildly, over time. Currency wars following the onset of the Great Depression certainly contributed to the length of the downturn. After World War II, the financial leaders of the nations of the world came together and created a monetary system called Bretton Woods, named after the mountain resort in New Hampshire where it was created. Basically it was an anchored dollar system, where the dollar was convertible into gold and the rest of the world used the dollar for their reserves and generally pegged their currencies to it. The linchpin of the deal was the understanding that the US dollar would remain a stable currency.

We didn’t live up to that deal, printing too much money during the Vietnam War; and the nations of the world, led by France, began to ask to convert their dollars into gold. Since that would have drained the gold out of the United States, Nixon closed the “gold window.” We won’t get into the argument about the propriety of his move here.

The chart below shows the US Dollar Index (the DXY, which is heavily weighted to a comparison with the euro) since 1967. Prior to 1967 the dollar was generally stable.
As the value of the dollar began to slide in 1970 – a troubling development if you were holding dollars in Europe – the world began to wonder if perhaps the United States was taking advantage of its position. Note that after the closing of the gold window in ’73 the dollar continued to fall but with greater volatility. This was mostly due to the Federal Reserve’s allowing inflation and printing money.

Then Paul Volcker came along and began to raise interest rates, and a major dollar rally ensued. The dollar doubled in value in less than five years. As interest rates came down from nosebleed highs in the late ’80s, the US dollar fell back to its original level and more or less drifted sideways for the next 10 years before once again climbing to 120. Then, in the early’00s, low rates and easy money took their toll, and the dollar fell to an all-time low in the middle of the credit crisis and has traded around the “80 handle” for the last six years. This is in spite of the Fed’s undertaking massive quantitative easing and flooding the world with dollars, which you would think would put downward pressure on the dollar. That is generally what happens when a central bank floods the world with its currency. Certainly, it is what is happening in Japan, and it is what we expect to happen in the Eurozone.

Something is different about the dollar, then. That difference can be explained mostly by the fact that the US dollar is the world’s reserve currency and the demand for dollars for global trade, which is growing at a rate the world has never seen, is stronger than ever. If the Federal Reserve had not entered into a policy of massive quantitative easing, it is entirely possible that we would have seen the dollar rise significantly over the last five years rather than languishing as it has.

Now that quantitative easing is finally done and the Federal Reserve is thinking about   raising interest rates at a slow drip back to something that looks normal (possibly, maybe, perhaps, conceivably – we aren’t in any hurry and you may need to be patient for a considerable period of time and anyway everything is data-dependent), the coiled spring that is the dollar may be set free.

And since we are in background mode, we need to understand that there are many ways to measure the strength of the dollar. As I mentioned, in the standard US Dollar Index (the DXY), significant weight is given to the euro. To more accurately reflect the strength of the dollar relative to other world currencies, the Federal Reserve created the trade-weighted US dollar index (for more about it see here and here), which includes a bigger collection of currencies than the US Dollar Index.

The composition of the US Dollar Index (DXY) is

-          Euro (EUR), 57.6%

-          Japanese yen (JPY), 13.6%

-          Pound sterling (GBP), 11.9%

-          Canadian dollar (CAD), 9.1%

-          Swedish krona (SEK), 4.2%

-          Swiss franc (CHF), 3.6%

Thus a fall in the euro, as we’ve seen recently, changes the valuation of the index more than it might another index like the Bloomberg Dollar Index (BBDXY), which is composed of a broader basket, including emerging-market currencies, with less emphasis on EUR/USD:

-          Euro (EUR), 31.4%

-          Japanese yen (JPY), 19.1%

-          Mexican peso (MXN), 9.6%

-          Pound sterling (GBP), 9.5%

-          Australian dollar (AUD), 6.2%

-          Canadian dollar (CAD), 11.5%

-          Swiss franc (CHF), 4.2%

-          Brazilian real (BRL), 2.2%

-          Korean won (KRW), 3.3%

-          Offshore Chinese yuan (CNH), 3.0%

Note in the chart below that at times one index is stronger than the other. This is primarily a reflection of the strength or weakness of the euro and the fact that the Bloomberg Dollar Index contains a much higher proportion of emerging-market currencies.

So the takeaway here is that, when we say “the dollar is strong,” we are really talking about its strength relative to particular groupings of currencies. It’s a generalization. If an index included the Russian ruble or the Argentine peso, then the dollar would even be “stronger” as measured by that index.

There Has Been No Deleveraging

In general, nature keeps a balance in a given ecosystem. There is a continual adjustment between the number of predators and the number of prey, but over time the system tends toward balance.

Just as nature has a way of forcing balance in the order of things, basic accounting (math is its own force of nature) has a way of forcing balance in currency flows and valuations. Quantitative easing and the developing currency war have created a great imbalance in the global economic order. The process of rebalancing the world monetary system is somewhat chaotic and crisis-prone in the best of times. Now, the massive amount of debt, both public and private, that has been created in the past decade is making that process even more chaotic.

It is usual in a crisis like the Great Recession that there is a resolution in the amount of outstanding debt, through a process called deleveraging. The process can take many forms, but in the past it has almost always meant that at the culmination of the process there is less debt. However, in recent months I’ve highlighted papers demonstrating that this time around there has been no deleveraging. Central banks and governments simply did not allow it to happen. That means we have pushed the inevitable process of deleveraging into the future. Debt cannot grow to the sky – at some point it has to be dealt with.

Four years ago in Endgame and in speeches since, I’ve been proclaiming that the dollar is going to get stronger than anyone can possibly imagine. I was saying this even as the yen and the euro were strengthening at times against the dollar. Those who have been proclaiming the destruction of the dollar are just seeing one small part of the equation: quantitative easing. There is a far larger and more complicated process going on in the world, and the rebalancing that is underway is going to mean that the dollar will increase in value against most currencies, and against some currencies by a great deal.

The Biggest Consequence of a Rising US Dollar

The beginning of a bull market in the dollar has multiple consequences, many of them not benign. Let’s start with the BIG one, the USD breakout and unwind of the USD-funded carry trade.

The yen and euro are dropping fast as the USD strengthens. As of today, the EUR/USD is below 1.23, while the USD/JPY has climbed to nearly 120. This is a function of central bank policy divergence… which in turn is a function of economic divergence among the major developed economies… which in turn is a function of debt divergence in those various economies. Total debt-to-GDP is approximately 334% in US, 460% in the Eurozone, and 655% in Japan, according to Lacy Hunt’s latest note.

With such divergence comes the major macro risk that the US Dollar Index (DXY) is breaking out in a big way. To anyone who believes in technical analysis (and skeptics should keep in mind that a lot of macro and currency traders DO), it looks like the USD is ready to break out of a 29-year downtrend that began with the Plaza Accord way back September 1985. The reversal of a trend that has been in place for that long is going to catch a number of people offsides. Unfortunately in investment and economics, you get more than a five-yard penalty for being offsides on a trend this big.

We are now going to look at a number of charts in rapid-fire fashion. As noted above, the dollar bull trend is exacerbated by debt. Global debt-to-GDP has been rising over the past several years.

The pool of developed-world financial assets is still growing, after a minor decrease in 2008. Again, there has been no deleveraging.

Even though debt and financial assets have been growing in the developed world, the real explosion in debt and financial assets has occurred in emerging markets, where the unwarranted flow of easy money has fueled a borrowing bonanza on the back of a massive USD-funded carry trade.

These QE-induced capital flows have kept EM sovereign borrowing costs low and enabled years of elevated emerging-market sovereign debt issuance, even as many of those markets displayed profound signs of structural weakness. I’m seeing estimates for the USD-funded carry trade around the world ranging from $3 TRILLION to $9 TRILLION. Raoul Pal believes it is roughly $5T, with nearly $3T of that going directly into China. (Other estimates for China suggest a somewhat lower number, but whatever it is, it is massive.)

Earlier this year, Bridgewater argued that total portfolio flows into emerging markets had doubled between 2008 and early 2014, from $5T to $10T.

Their study gave us some very specific data on flows into the larger EMs.

The following slide from Hyun Song Shin, head of research for the Bank for International Settlements, estimates that total USD-denominated credit to non-banks outside the United States is more than $9T.

What I’m getting at here is that a reversal in flows from a forceful unwind in USD capital flows could have disastrous effects on emerging markets... and there are a number of ways the unwind could blow back on the USA and other developed markets in coming quarters. The crazy thing is that EM currencies as a group have already given back more than 10 years of gains… and their losses can get a LOT worse.

Companies and governments in emerging markets have borrowed in dollars because of the ultralow interest rates available, but they earn the money to pay those loans back in local currencies. If the local currency is dropping significantly faster than the dollar, then no matter how profitable a business is, it is sinking deeper into debt with every tick up in the dollar. That’s what happened in 1998, and it’s happening again today.

The Fourth Arrow

Moving on in our survey of the world, we see the Japanese yen continuing to fall as the Bank of Japan engages in the most massive experiment in quantitative easing the world has ever seen. And they are doing it at the time when Japan’s current account and trade balance are both deeply negative.

These three realities combined mean that the yen is going to fall much further. The fourth, unstated, poison-tipped arrow of Abenomics is the launching of a major currency war, the consequences of which are now starting to be felt, as we can see in the next chart.

The potential for policy mistakes or monetary crises on the part of other Asian nations is very real and very troubling. We could see a country lose control of its currency as it tries to respond to Japan, and it is not altogether unlikely that at some point Japan itself will lose control, which would bring about a whole different set of problems and crises. Meanwhile, the US dollar’s rise will go on creating further problems for dollar-denominated debt in emerging markets, including China, which may decide that it needs to respond by devaluing the renminbi.

Adding China into the Mix

China’s investment boom is cooling; its competitiveness is eroding; and markets may already be pricing in a renminbi devaluation. China’s boom was largely a result of foreign direct investment and a massive increase in debt in a short period of time.
Even though bank lending has grown substantially, the real growth in debt in recent years came through an explosion in non-bank loan funding. China has created a shadow banking system that is staggering in size.

There have been a number of studies on the relationship between the rapidity of growth of debt and subsequent financial crises. Even if we look to a broad sample of 48 instances over the last 50 years where total social finance expanded by as little as 30% over five years (less than half the magnitude of China’s credit explosion), history suggests there is still a 50% chance of a banking crisis or an abrupt fall in growth during the post-boom period. My point is that there is a clear relationship between the intensity of a credit boom and the subsequent adjustment (downward) in GDP growth rate. There are no cases in modern history where an economy has managed to avoid a banking crisis or outright bust after experiencing rapid lending growth anything like China’s ongoing credit boom.

The world is simply not prepared for a major China slowdown, let alone a hard landing. And gods forbid that the Chinese have a problem at the same time that Europe slides back into crisis.

The big question is, what happens next in China? Personally, I think it will be very difficult to avoid a real fall in the Chinese growth rate in the next 3-5 years. The reforms required to rebalance China to a more sustainable growth model will be very painful, and there is a real chance they could bring on a banking panic in the short term; but without those reforms, China literally has no chance. The Chinese Dragon is attempting a very intricate and delicate dance. The world needs China to succeed, but we must recognize that a Chinese hard landing is very much within our cone of uncertainty.

A Dangerous Illusion

I want to close this letter with a quote from William White, who recently did an interview with Finanz und Wirtschaft, perhaps the leading business and economics newspaper in Switzerland. White is the highly regarded former chief economist of the Bank for International Settlements. Longtime readers may recall that I have quoted him at length over the years, as his writing is some of the most thought-provoking in the economics world.

The interview focused on the decision by the Swiss National Bank to go to negative interest rates on January 22, 2015. Not coincidentally, the European Central Bank will be meeting that day to decide whether or not to implement its own quantitative easing program. The Swiss are quite concerned about the massive capital inflows that are pushing their currency to very uncomfortable levels. In a highly unusual move, they are going to start charging banks for the privilege of holding Swiss currency accounts.

For the Swiss to enact such a move means that they must be convinced that the ECB is actually going to do something on January 22. Technically, it is against the rules for the ECB to buy sovereign debt, and the Germans are adamantly opposed. But my highly connected friend Kiron Sarkar asks:

What if the ECB does introduce a QE programme, involving the purchase of EZ government debt, though only on the basis that the relevant countries meet pre-agreed targets? You have provided a massive incentive to introduce structural reforms, dealt with the German's/Bundesbank objections, and those countries that play ball will benefit from lower interest rates and a weaker euro. On the other hand, if EZ countries do not cooperate, yields on their bonds will blow out massively – just the right stick to wield. It's the classic carrot and stick approach. Too fanciful? Well, maybe, but...

I guarantee you just such a solution is being talked about. We will see what actually gets implemented. Now let’s turn to the conclusion of White’s interview:

The SNB has to follow the ECB in its monetary policy. Is it not dangerous when the monetary policy of one country affects another?

Currently we have an international monetary non-system. Nobody has to follow any rules. Everybody does what they consider is in their own short-term best interest. The real difficulty is: What is in their short-term interest – for example, following ultra-easy monetary policy – could well backfire somewhere [else]. It might be not in their long-term best interest. And as the easy monetary policy influences the exchange rates, it influences other countries. Almost every country in the world is in easing mode, following the Fed, and we have absolutely no idea how it will end up. We are in absolutely unchartered territory here. This worries me the most. The Swiss National Bank has been doing well in what it was forced to do by this international monetary non-system. The Swiss have to do the best they can, because that is what everybody else is doing.

What are the risks of this non-system?

There is no automatic adjustment of current account deficits and surpluses, they can get totally out of hand. There are effects from big countries to little ones, like Switzerland. The system is dangerously unanchored. It is every man for himself. And we do not know what the long-term consequences of this will be. And if countries get in serious trouble, think of the Russians at the moment, there is nobody at the center of the system who has the responsibility of providing liquidity to people who desperately need it. If we have a number of small countries or one big country which run into trouble, the resources of the International Monetary Fund to deal with this are very limited. The idea that all countries act in their own individual interest, that you just let the exchange rate float and the whole system will be fine: This all is a dangerous illusion.

My associate Worth Wray will join us next week, presenting his forecast for 2015, which will concentrate on the emerging markets and China. I will return after the first of the year with my own 2015 forecast – there is much to ponder over the next couple of weeks.

I am home for the rest of the month, but the calendar for next year is beginning to fill up. I see Cincinnati, Grand Cayman, Zurich, and Florida on my schedule. It has been awhile since I was in the Cayman Islands, and this time I’ll take a short hop over to Little Cayman to visit my friend Raoul Pal for a few days. A brilliant macroeconomist and trader, Raoul has now based himself in Little Cayman, although he frequently flies to visit clients. He is also a partner with Grant Williams in Real Vision Television, a fascinating new take on internet investment TV. I’ll be writing more about it in the future.

And speaking of Grant, I wish him well as he embarks upon a new endeavor, that of turning his passionate avocation of writing his brilliant newsletter Things That Make You Go Hmmm… into a business. It has been an honor and privilege to publish Grant for these last years and to help bring his wicked (not to say warped) humor and dazzling writing style to a larger audience. But the far greater reward has been getting to know Grant personally. I appreciate the kind words he wrote about me in his letter last week, and the feeling is mutual. Grant is just one of the most genuinely nice people I have ever met.

It is time to hit the send button. Let me take this opportunity to wish you and all your families and friends the merriest of Christmases and the happiest of New Years. This is one of those times when our tribe expands to encompass the globe, to become part of a greater celebration, one in which the other “team” does not have to lose in order for us all to be happy.

Have a great week. I forecast that the final episode of The Hobbit will be coming to a theater very near me very soon. And that forecast has a very narrow cone of uncertainty.

Your gathering my own small tribe together this week analyst,
John Mauldin
John Mauldin

The Fed Sets Another Trap

Stephen S. Roach

DEC 23, 2014    

NEW HAVEN – America’s Federal Reserve is headed down a familiar – and highly dangerous – path. Steeped in denial of its past mistakes, the Fed is pursuing the same incremental approach that helped set the stage for the financial crisis of 2008-2009. The consequences could be similarly catastrophic.
Consider the December meeting of the Federal Open Market Committee (FOMC), where discussions of raising the benchmark federal funds rate were couched in adjectives, rather than explicit actions.
In line with prior forward guidance that the policy rate would be kept near zero for a “considerable” amount of time after the Fed stopped purchasing long-term assets in October, the FOMC declared that it can now afford to be “patient” in waiting for the right conditions to raise the rate. Add to that Fed Chair Janet Yellen’s declaration that at least a couple more FOMC meetings would need to take place before any such “lift-off” occurs, and the Fed seems to be telegraphing a protracted journey on the road to policy normalization.
This bears an eerie resemblance to the script of 2004-2006, when the Fed’s incremental approach led to the near-fatal mistake of condoning mounting excesses in financial markets and the real economy.
After pushing the federal funds rate to a 45-year low of 1% following the collapse of the equity bubble of the early 2000s, the Fed delayed policy normalization for an inordinately long period. And when it finally began to raise the benchmark rate, it did so excruciatingly slowly.
In the 24 months from June 2004, the FOMC raised the federal funds rate from 1% to 5.25% in 17 increments of 25 basis points each. Meanwhile, housing and credit bubbles were rapidly expanding, fueling excessive household consumption, a sharp drop in personal savings, and a record current-account deficit – imbalances that set the stage for the meltdown that was soon to follow.
The Fed, of course, has absolved itself of any blame in setting up the US and the global economy for the Great Crisis. It was not monetary policy’s fault, argued both former Fed Chairmen Alan Greenspan and Ben Bernanke; if anything, they insisted, a lack of regulatory oversight was the culprit.
This argument has proved convincing in policy and political circles, leading officials to focus on a new approach centered on so-called macro-prudential tools, including capital requirements and leverage ratios, to curb excessive risk-taking by banks. While this approach has some merit, it is incomplete, as it fails to address the egregious mispricing of risk brought about by an overly accommodative monetary policy and the historically low interest rates that it generated. In this sense, the Fed’s incrementalism of 2004-2006 was a policy blunder of epic proportions.
The Fed seems poised to make a similar – and possibly even more serious – misstep in the current environment. For starters, given ongoing concerns about post-crisis vulnerabilities and deflation risk, today’s Fed seems likely to find any excuse to prolong its incremental normalization, taking a slower pace than it adopted a decade ago.
More important, the Fed’s $4.5 trillion balance sheet has since grown more than fivefold. Though the Fed has stopped purchasing new assets, it has shown no inclination to scale back its outsize holdings. Meanwhile it has passed the quantitative-easing baton to the Bank of Japan and the European Central Bank, both of which will create even more liquidity at a time of record-low interest rates.
In these days of froth, the persistence of extraordinary policy accommodation in a financial system flooded with liquidity poses a great danger. Indeed, that could well be the lesson of recent equity- and currency-market volatility and, of course, plummeting oil prices. With so much dry kindling, it will not take much to spark the next conflagration.
Central banking has lost its way. Trapped in a post-crisis quagmire of zero interest rates and swollen balance sheets, the world’s major central banks do not have an effective strategy for regaining control over financial markets or the real economies that they are supposed to manage. Policy levers – both benchmark interest rates and central banks’ balance sheets – remain at their emergency settings, even though the emergency ended long ago.
While this approach has succeeded in boosting financial markets, it has failed to cure bruised and battered developed economies, which remain mired in subpar recoveries and plagued with deflationary risks. Moreover, the longer central banks promote financial-market froth, the more dependent their economies become on these precarious markets and the weaker the incentives for politicians and fiscal authorities to address the need for balance-sheet repair and structural reform.
A new approach is needed. Central banks should normalize crisis-induced policies as soon as possible. Financial markets will, of course, object loudly. But what do independent central banks stand for if they are not prepared to face up to the markets and make the tough and disciplined choices that responsible economic stewardship demands?
The unprecedented financial engineering by central banks over the last six years has been decisive in setting asset prices in major markets worldwide. But now it is time for the Fed and its counterparts elsewhere to abandon financial engineering and begin marshaling the tools they will need to cope with the inevitable next crisis. With zero interest rates and outsize balance sheets, that is exactly what they are lacking.


December 23, 2014 6:48 pm

Let us enjoy the greatest human escape of all

Martin Wolf

More prosperity is not necessary nor sufficient for improved health. It just makes it easier

Ingram Pinn illustration
The highest life expectancy recorded for women anywhere in the world has risen by a year every four years since 1840. This inexorable advance in longevity is, arguably, the most important of all the changes to human life in the past two centuries.

These gains in health are also widely shared: “India today has a higher life expectancy than Scotland in 1945 — in spite of a per-capita income that Britain had achieved as early as 1860.”

This remark comes from a wonderful book, The Great Escape: Health, Wealth, and the Origins of Inequality , by Princeton University’s Angus Deaton, published last year, which documents the revolution in both health and wealth since the early 19th century. Of the two, the former is the more important. Who would not give up many material comforts if, in return, they could avoid the agony of watching their children die or enjoy the company of their loved ones in old age?

No blessing is unmixed. Prolonged survival “sans teeth, sans eyes, sans taste, sans everything” is to be neither envied nor desired. Yet the revolution in health is still a blessing. As Professor Deaton notes: “Of all the things that make life worth living, extra years of life are surely among the most precious.” Someone whose standard of living is twice as high and expects to live twice as long as someone else could even be deemed to be four times better off.
So what has happened?

Start with mortality rates (deaths per thousands) over time of three of today’s high-income countries: Sweden in 1751; the US in 1933; and the Netherlands and the US in 2000 (see chart).

Back in 1751 the mortality rate of Swedish newborns was more than 160 per thousand people.

It was more than 40 per thousand in the US in 1933. By 2000 it was below 10 per thousand. At subsequent ages mortality rates have become consistently lower over time, with the lowest rates of all for children aged about 10. Today we see a rise of mortality rates in the late teens, largely because of the riskier behaviour of young men. After a plateau in the late 20s and early 30s, death rates rise, but they do not reach 10 per thousand before age 60. US mortality rates are higher than those in the Netherlands, except for the over 80s. That is where the US concentrates its resources.

Martin Wolf comment data

Back in 1850 life expectancy was about age 40 in England and Wales. Today it is close to 80. In the case of Italy it has risen from 30 in 1875 to above the English level. The chart also shows the devastating effects of the Spanish flu epidemic of 1918. This is explained by how life expectancy is computed: the assumption is that the risks of dying at a particular age are produced by the ages of death of the population in a specific year. In 1918 a large proportion of young people died in the epidemic.

This reduced life expectancy drastically. But those born in 1918 had far longer lives than these figures suggest. Similarly, a small proportion of the English and Welsh population actually died at 40 in 1850. Instead, a great many died aged as babies and many lived to be more than 60.

Forty was merely the average age of death. Finally, notes Prof Deaton: “Saving the lives of children has a bigger effect on life expectancy than saving the lives of the elderly.” Thus, as death “ages”, the rise in life expectancy slows.

The health revolution has spread worldwide since the middle of the 20th century — dramatically so in east Asia; least so, alas, in sub-Saharan Africa partly because of HIV/Aids. A big element has been the collapse in child mortality. According to the Gapminder website, mortality among Indian children under five fell from 267 per thousand in 1950 to 56 in 2012.

Over the same period it fell from 317 to 14 in China. These improvements occurred at much lower income levels than was the case in today’s high-income countries. This is partly because of improved knowledge (oral rehydration, for example), partly because of medical technology (vaccination, for example) and partly because of public services (clean water and sanitation, for example).
Martin Wolf comment data
Unfortunately, the improvements are not as complete as they should be. In Angola the under-five mortality rate is 164 per thousand. In Nigeria it is 124. Yet these are relatively well-off countries. In general, a link exists between prosperity and health. Yet greater prosperity is neither a necessary nor a sufficient condition for improved health outcomes. It just makes it rather easier.

The health revolution is not just a good in itself. It has beneficial consequences, the most important of which is the transformation of women’s lives. As child mortality tumbles, so does fertility: fewer births are needed to achieve a given family size. This is irrespective of religion: in Muslim Iran, for example, the number of children per woman fell from 6.5 in 1980 to 1.9 in 2012; similarly, in Catholic Brazil it fell from 6.2 in 1960 to 1.8 in 2012. As women live longer and have fewer children, they can invest more in each child and pursue their own careers. Thus the health revolution underpins another of the revolutions of our era: the change in the role of women.

Martin Wolf comment data

What has driven the improvements in health, particularly among the middle aged? A decline in smoking is a factor. Improved treatment for heart disease is another. Even cancer is succumbing to treatment. Increasingly, in high-income countries, the remaining diseases are those of old age, including dementia. But in most developing countries the old afflictions linger, including poor sanitation, contaminated water and malaria.

Yet for all that remains to be done, and all the inequality of health services across the globe, it is important to appreciate the great and increasingly widely shared improvement in health. An increasing proportion of humanity has a good chance of living healthily into what has traditionally been viewed as old age. A rising proportion of children is reaching maturity. We cannot escape death. But we do keep out of its grasp for ever longer. That is to be celebrated.

Heard on the Street

Fed Stumbles Upon a New Problem

By Justin Lahart

Dec. 23, 2014 3:31 p.m. ET

Last week, Federal Reserve policy makers offered up their final projections on what the economy would end up looking like in 2014. The fact that there were only two weeks left in the year didn’t stop those forecasts from being wrong, underscoring how tricky the interest-rate terrain will be for investors next year.

The Commerce Department on Tuesday said gross domestic product expanded at a 5% annual rate in the third quarter, faster than its earlier estimate of 3.9%, on upward revisions to consumer and business spending. That, and a separate Commerce Department report showing that consumers ratcheted up spending last month, had economists raising forecasts for the current quarter.

Macroeconomic Advisers now sees GDP expanding at a 2.8% pace in the fourth quarter. This would translate into 2.6% growth for the full year, based on the change from the fourth quarter a year earlier. The Fed’s projections call for full-year growth of just 2.3% to 2.4%.

The Commerce Department also reported that its gauge of consumer prices fell 0.2%, pressured by falling gasoline costs. Prices excluding food and energy, the core measure the Fed watches closest, were flat, putting them up just 1.4% from a year earlier. That contrasts with Fed projections for core prices to rise 1.5% to 1.6% in the fourth quarter from a year ago.

The Fed’s forecasts for next year could be wrong as well, and wrong in the same direction.

Fed policy makers’ projections are centered on an expectation that GDP will expand 2.8% in the fourth quarter next year from this year’s fourth quarter, or just a smidgen faster than this year. Yet lower gasoline prices are providing a powerful boost to consumer spending that will carry over into next year. At the same time, the healthier job market is providing people with further impetus to spend more and the means to do it. So faster growth may be in the cards.

Meanwhile, the drop in energy prices will to some extent filter into prices for other items, and that will help cool inflation. So, too, will the lower import prices that are coming via the dollar’s strength. Fed policy makers’ forecast for core prices to increase 1.5% to 1.8%, while still low, risks not being low enough.

But if the Fed’s projections are wrong, what will it do about it? It wants to get around to “normalizing” rates—that is, raising them toward the 3.75% it thinks are right for a fully functioning U.S. economy—and faster growth should give it cover to do that. So long as low inflation persists, though, it will be hard to do so quickly, if at all.

This counts as a good problem for the Fed. But it still counts as a problem, one that both it and investors will have to figure out.

The Geopolitics of U.S.-Cuba Relations

By George Friedman

December 23, 2014 | 09:00 GMT

Last week, U.S. President Barack Obama and Cuban President Raul Castro agreed to an exchange of prisoners being held on espionage charges. In addition, Washington and Havana agreed to hold discussions with the goal of establishing diplomatic relations between the two countries. No agreement was reached on ending the U.S. embargo on Cuba, a step that requires congressional approval.

It was a modest agreement, striking only because there was any agreement at all. U.S.-Cuba relations had been frozen for decades, with neither side prepared to make significant concessions or even first moves. The cause was partly the domestic politics of each country that made it easier to leave the relationship frozen. On the American side, a coalition of Cuban-Americans, conservatives and human rights advocates decrying Cuba's record of human rights violations blocked the effort. On the Cuban side, enmity with the United States plays a pivotal role in legitimizing the communist regime. Not only was the government born out of opposition to American imperialism, but Havana also uses the ongoing U.S. embargo to explain Cuban economic failures. There was no external pressure compelling either side to accommodate the other, and there were substantial internal reasons to let the situation stay as it is.

The Cubans are now under some pressure to shift their policies. They have managed to survive the fall of the Soviet Union with some difficulty. They now face a more immediate problem: uncertainty in Venezuela. Caracas supplies oil to Cuba at deeply discounted prices. It is hard to tell just how close Cuba's economy is to the edge, but there is no question that Venezuelan oil makes a significant difference. Venezuelan President Nicolas Maduro's government is facing mounting unrest over economic failures. If the Venezuelan government falls, Cuba would lose one of its structural supports. Venezuela's fate is far from certain, but Cuba must face the possibility of a worst-case scenario and shape openings. Opening to the United States makes sense in terms of regime preservation.

The U.S. reason for the shift is less clear. It makes political sense from Obama's standpoint.

First, ideologically, ending the embargo appeals to him. Second, he has few foreign policy successes to his credit. Normalizing relations with Cuba is something he might be able to achieve, since groups like the U.S. Chamber of Commerce favor normalization and will provide political cover in the Republican Party. But finally, and perhaps most important, the geopolitical foundations behind the American obsession with Cuba have for the most part evaporated, if not permanently than at least for the foreseeable future. Normalization of relations with Cuba no longer poses a strategic threat. To understand the U.S. response to Cuba in the past half century, understanding Cuba's geopolitical challenge to the United States is important.

Cuba's Strategic Value

The challenge dates back to the completion of the Louisiana Purchase by President Thomas Jefferson in 1803. The Territory of Louisiana had been owned by Spain for most of its history until it was ceded to France a few years before Napoleon sold it to the United States to help fund his war with the British. Jefferson saw Louisiana as essential to American national security in two ways: First, the U.S. population at the time was located primarily east of the Appalachians in a long strip running from New England to the Georgia-Florida border. It was extremely vulnerable to invasion with little room to retreat, as became evident in the War of 1812. Second, Jefferson had a vision of American prosperity built around farmers owning their own land, living as entrepreneurs rather than as serfs.

Louisiana's rich land, in the hands of immigrants to the United States, would generate the wealth that would build the country and provide the strategic depth to secure it.

What made Louisiana valuable was its river structure that would allow Midwestern farmers to ship their produce in barges to the Mississippi River and onward down to New Orleans. There the grain would be transferred to oceangoing vessels and shipped to Europe. This grain would make the Industrial Revolution possible in Britain, because the imports of mass quantities of food freed British farmers to work in urban industries.

In order for this to work, the United States needed to control the Ohio-Missouri-Mississippi river complex (including numerous other rivers), the mouth of the Mississippi, the Gulf of Mexico, and the exits into the Atlantic that ran between Cuba and Florida and between Cuba and Mexico. If this supply chain were broken at any point, the global consequences — and particularly the consequences for the United States — would be substantial. New Orleans remains the largest port for bulk shipments in the United States, still shipping grain to Europe and importing steel for American production.

For the Spaniards, the Louisiana Territory was a shield against U.S. incursions into Mexico and its rich silver mines, which provided a substantial portion of Spanish wealth. With Louisiana in American hands, these critical holdings were threatened. From the American point of view, Spain's concern raised the possibility of Spanish interference with American trade. With Florida, Cuba and the Yucatan in Spanish hands, the Spaniards had the potential to interdict the flow of produce down the Mississippi.

Former President Andrew Jackson played the key role in Jeffersonian strategy. As a general, he waged the wars against the Seminole Indians in Florida and seized the territory from Spanish rule — and from the Seminoles. He defended New Orleans from British attack in 1814.

When he became president, he saw that Mexico, now independent from Spain, represented the primary threat to the entire enterprise of mid-America. The border of Mexican Texas was on the Sabine River, only 193 kilometers (120 miles) from the Mississippi. Jackson, through his agent Sam Houston, encouraged a rising in Texas against the Mexicans that set the stage for annexation.

But Spanish Cuba remained the thorn in the side of the United States. The Florida and Yucatan straits were narrow. Although the Spaniards, even in their weakened state, might have been able to block U.S. trade routes, it was the British who worried the Americans most. Based in the Bahamas, near Cuba, the British, of many conflicting minds on the United States, could seize Cuba and impose an almost impregnable blockade, crippling the U.S. economy. The British depended on American grain, and it couldn't be ruled out that they would seek to gain control over exports from the Midwest in order to guarantee their own economic security. The fear of British power helped define the Civil War and the decades afterward.

Cuba was the key. In the hands of a hostile foreign power, it was as effective a plug to the Mississippi as taking New Orleans. The weakness of the Spaniards frightened the Americans. Any powerful European power — the British or, after 1871, the Germans — could easily knock the Spaniards out of Cuba. And the United States, lacking a powerful navy, would not be able to cope. Seizing Cuba became an imperative of U.S. strategy. Theodore Roosevelt, who as president would oversee America's emergence as a major naval power — and who helped ensure the construction of the Panama Canal, which was critical to a two-ocean navy — became the symbol of the U.S. seizure of Cuba in the Spanish-American War of 1898-1900.

With that seizure, New Orleans-Atlantic transit was secured. The United States maintained effective control over Cuba until the rise of Fidel Castro. But the United States remained anxious about Cuba's security. By itself, the island could not threaten the supply lines. In the hands of a significant hostile power, however, Cuba could become a base for strangling the United States. Before World War II, when there were some rumblings of German influence in Cuba, the United States did what it could to assure the rise of former Cuban leader Fulgencio Batista, considered an American ally or puppet, depending on how you looked at it. But this is the key: Whenever a major foreign power showed interest in Cuba, the United States had to react, which it did effectively until Castro seized power in 1959.

The Soviet Influence

If the Soviets were looking for a single point from which they could threaten American interests, they would find no place more attractive than Cuba. Therefore, whether Fidel Castro was a communist prior to seizing power, it would seem that he would wind up a communist ally of the Soviets in the end. I suspect he had become a communist years before he took power but wisely hid this, knowing that an openly communist ruler in Cuba would revive America's old fears. Alternatively, he might not have been a communist but turned to the Soviets out of fear of U.S. intervention. The United States, unable to read the revolution, automatically moved toward increasing its control. Castro, as a communist or agrarian reformer or whatever he was, needed an ally against U.S. involvement.

Whether the arrangement was planned for years, as I suspect, or in a sudden rush, the Soviets saw it as a marriage made in heaven.

Had the Soviets never placed nuclear weapons in Cuba, the United States still would have opposed a Soviet ally in control of Cuba during the Cold War. This was hardwired into American geopolitics. But the Soviets did place missiles there, which is a story that must be touched on as well.

The Soviet air force lacked long-range strategic bombardment aircraft. In World War II, they had focused on shorter range, close air support aircraft to assist ground operations. The United States, engaging both Germany and Japan from the air at long range, had extensive experience with long-range bombing. Therefore, during the 1950s, the United States based aircraft in Europe, and then, with the B-52 in the continental United States, was able to attack the Soviet Union with nuclear weapons. The Soviets, lacking a long-range bomber fleet, could not retaliate against the United States. The balance of power completely favored the United States.

The Soviets planned to leapfrog the difficult construction of a manned bomber fleet by moving to intercontinental ballistic missiles. By the early 1960s, the design of these missiles had advanced, but their deployment had not. The Soviets had no effective deterrent against a U.S. nuclear attack except for their still-underdeveloped submarine fleet. The atmosphere between the United States and the Soviet Union was venomous, and Moscow could not assume that Washington would not use its dwindling window of opportunity to strike safely against the Soviets.

The Soviets did have effective intermediate range ballistic missiles. Though they could not reach the United States from the Soviet Union, they could cover almost all of the United States from Cuba. The Russians needed to buy just a little time to deploy a massive intercontinental ballistic missile and submarine force. Cuba was the perfect spot from which to deploy it. Had they succeeded, the Soviets would have closed the U.S. window of opportunity by placing a deterrent force in Cuba. They were caught before they were ready. The United States threatened invasion, and the Soviets had to assume that the Americans also were threatening an overwhelming nuclear attack on the Soviet Union. They had to back down. As it happened, the United States intended no such attack, but the Soviets could not know that.

Cuba was seared into the U.S. strategic mentality in two layers. It was never a threat by itself. Under the control of a foreign naval power, it could strangle the United States. After the Soviet Union tried to deploy intermediate range ballistic missiles there, a new layer was created in which Cuba was a potential threat to the American mainland, as well as to trade routes. The agreement between the United States and the Soviet Union included American guarantees not to invade Cuba and Soviet guarantees not to base nuclear weapons there. But Cuba remained a problem for the United States. If there were a war in Europe, Cuba would be a base from which to threaten American control of the Caribbean, and with it, the ability to transit ships from the U.S. Pacific Fleet to the Atlantic. The United States never relieved pressure on Cuba, the Soviets used it as a base for many things aside from nuclear weapons (we assume), and the Castro regime clung to the Soviets for security while supporting wars of national liberation, as they were called, in Latin America and Africa that served Soviet strategic interests.

Post-Soviet Cuba

With the collapse of the Soviet Union, Castro lost his patron and strategic guarantor. On the other hand, Cuba no longer threatened the United States. There was an implicit compromise. Since Cuba was no longer a threat to the United States but could still theoretically become one, Washington would not end its hostility toward Havana but would not actively try to overthrow it. The Cuban government, for its part, promised not to do what it could not truly do anyway: become a strategic threat to the United States. Cuba remained a nuisance in places like Venezuela, but a nuisance is not a strategic threat. Thus, the relationship remained frozen.

Since the Louisiana Purchase, Cuba has been a potential threat to the United States when held by or aligned with a major European power. The United States therefore constantly tried to shape Cuba's policies, and therefore, its internal politics. Fidel Castro's goal was to end American influence, but he could only achieve that by aligning with a major power: the Soviets. Cuban independence from the United States required a dependence on the Soviets. And that, like all relationships, carried a price.

The exchange of prisoners is interesting. The opening of embassies is important. But the major question remains unanswered. For the moment, there are no major powers able to exploit Cuba's geographical location (including China, for now). There are, therefore, no critical issues. But no one knows the future. Cuba wants to preserve its government and is seeking a release of pressure from the United States. At the moment, Cuba really does not matter. But moments pass, and no one can guarantee that it will not become important again. Therefore, the U.S. policy has been to insist on regime change before releasing pressure. With Cuba set on regime survival, what do the Cubans have to offer? They can promise permanent neutrality, but such pledges are of limited value.

Cuba needs better relations with the United States, particularly if the Venezuelan government falls. Venezuela's poor economy could, theoretically, force regime change in Cuba from internal pressure. Moreover, Raul Castro is old and Fidel Castro is very old. If the Cuban government is to be preserved, it must be secured now, because it is not clear what will succeed the Castros. But the United States has time, and its concern about Cuba is part of its DNA. Having no interest now, maintaining pressure makes no sense. But neither is there an urgency for Washington to let up on Havana. Obama may want a legacy, but the logic of the situation is that the Cubans need this more than the Americans, and the American price for normalization will be higher than it appears at this moment, whether set by Obama or his successor.

We are far from settling a strategic dispute rooted in Cuba's location and the fact that its location could threaten U.S. interests. Therefore, opening moves are opening moves. There is a long way to go on this issue.


Good Medicine for Bad Bankers

One way to keep bankers from behaving badly is to hit them in their pocketbooks with penalties that affect bonuses.

By Alan S. Blinder
Dec. 23, 2014 6:12 p.m. ET

Maybe someone should launch a reality show called “Bankers Behaving Badly.” Because too many of them are. That’s the conclusion of William Dudley , president of the Federal Reserve Bank of New York, one of America’s most powerful financial regulators and (full disclosure) a friend.

In a remarkable Oct. 20 speech at the New York Fed that didn’t receive as much attention as it deserves, Mr. Dudley highlighted the “ongoing occurrences of serious professional misbehavior, ethical lapses and compliance failures” at giant financial institutions. And he warned the audience, which included a number of the world’s leading bankers, that unless the epidemic of bad behavior stops, “the inevitable conclusion will be reached that your firms are too big and complex to manage,” in which case “your firms need to be dramatically downsized and simplified.”

Virtually all the transgressions that Mr. Dudley wants stopped—say, traders conspiring to fix London interbank offered rates or advisers helping clients evade taxes—typically originate several levels below the C-suite. But Mr. Dudley wasn’t letting CEOs off the hook on the “few rotten apples” theory. No, he said, “the problems originate from the culture of the firms, and this culture is largely shaped by the firms’ leadership.” So “as a first step, senior leaders need to hold up a mirror to their own behavior.” The not-very-subtle hint: You shouldn’t like what you see.

Given what we have all witnessed since the 2008 financial crisis, it is hard to be optimistic that big banks will reform themselves unless pushed—hard. Apparently, neither the revelation of the horrible behavior that led up to the crisis nor the publicly financed rescue operations that saved their hides (and for which the industry has shown little gratitude) were enough. Mindful of this, Mr. Dudley offered several suggestions.

First, firms that self-report transgressions they discover internally should be treated more leniently than “those that drag their feet.” In other words, if you watch out for bad behavior and report it to your regulators, you should get lighter penalties.

Second, top management should encourage, support and even reward whistleblowers. It is the people on the ground who see legal and ethical problems as they develop.

Third, companies should tone down some of the high-powered, short-term-oriented compensation incentives that tempt people to cut corners or look the other way. Specifically, Mr. Dudley suggested that more of the pay of traders and other risk takers should be deferred—and for longer periods of time. (Some of that seems to be happening.)

Fourth, he would like to see more people who break the law or violate their firm’s code of conduct barred from further employment in banking. The Fed can actually do something about that. Right now, it is handing out far fewer bars from banking than the Financial Industry Regulatory Authority is from the securities business.

Let me add two more items to Mr. Dudley’s list. Both ideas originate with Joseph Fichera, CEO of Saber Partners in New York and also a friend. Mr. Fichera suggested in a New York Times op-ed last month that, in addition to whatever fines or penalties are imposed, each violation should earn the offending bank “points,” the way the Department of Motor Vehicles assigns a driver points for traffic violations. As with the DMV, more points would come with more severe offenses. A recidivist bank that accumulated enough points would lose its banking license—just as serial traffic-law violators lose their driver’s licenses. But a bank would see this danger lurking as it accumulated points, and that, presumably, would give it powerful incentives to clean up its act.

Mr. Fichera has another clever idea on his blog: When regulatory fines and civil penalties are imposed on a financial institution, bank supervisors should insist, as part of the settlement, that the losses be pushed down to the business unit or profit center where the violations occurred—where they will affect the local bonus pool, probably heavily.

As things stand now, penalties are borne mostly by the bank’s shareholders, as the company’s profits decline. That system makes it all but certain that most of the pain is shifted to innocent parties such as outside investors, that only a small fraction accrues to the bank’s employees, and that only a negligible portion finds its way to the miscreants themselves.

But if bankers in, say, a particular trading unit know that any financial penalties for wrongdoing will be shared within the group, rather than dispersed among shareholders, they are more likely to answer Mr. Dudley’s call and either get the offenders in line or blow the whistle on them. In other words, when bankers discover bad behavior that threatens their own bonuses, these Masters of the Universe may turn into Protectors of Integrity. Wouldn’t that be nice?

Mr. Blinder, a professor of economics and public affairs at Princeton University and former vice chairman of the Federal Reserve, is the author of “After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead” (Penguin, 2013).