Now What?

Doug Nolan

September 18 – Reuters: “The world's leading central banks are facing the risk that their massive efforts to revive economic growth could be dragged down again, with some officials arguing for bold new ideas to counter the threat of slow growth for years to come. A day after the U.S. Federal Reserve kept interest rates at zero, citing risks in the global economy, the Bank of England's chief economist said central banks had to accept that interest rates might get stuck at rock bottom. In Japan, where interest rates have been at zero for more than 20 years, policymakers are already tossing around ideas for overhauling the Bank of Japan's huge monetary stimulus program as they worry that it will be unsustainable in the future, according to sources familiar with its thinking. Separately a top European Central Bank official said the ECB’s bond-buying program might need to be rethought if low inflation becomes entrenched.”
Most just scoff at the notion that there has been a historic global Bubble, let alone that this Bubble has over recent months begun to burst. Talk of an EM and global crisis is viewed as wackoism. Except that the Federal Reserve clearly sees something pernicious in the world that requires shelving, after seven years, even the cutest little baby step move in the direction of policy normalization.

The Fed and global central banks responded to the 2008 crisis with unprecedented measures.

When the reflationary effects of these measures began to wane, the unfolding 2012 global crisis spurred desperate concerted do “whatever it takes” monetary stimulus. This phase has now largely run its course. And there is at this point little clarity as to what global central bankers might try next.

Clearly, great pressure will remain to hold rates tight at zero. I fully expect policymakers at some point to see no alternative than to implement additional QE. But under what circumstances? Will it be orchestrated independently or through concerted action? What about timing? How much and how quickly? Might global central banks actually consider adopting negative rates? Well, there’s enough here to really have the markets fretting the uncertainty, especially with global central bankers not having thought things through.

There is today extraordinary confusion and misunderstanding throughout the markets. 

Policymakers are confounded. Years of zero rates, Trillions of new “money” and egregious market intervention/manipulation have left global markets more vulnerable than ever. Now What? I’m the first to admit that global Credit, market and economic analyses are these days extraordinarily complex – and remain so now on a daily basis. We must test our analytical framework and thesis constantly.

I am confident in my analytical framework and believe it provides a valuable prism for understanding today’s complex world. The current global government finance Bubble is indeed the grand finale of serial Bubbles spanning about 30 years. Importantly, each Boom and Bust Bubble Cycle – going back to the mid-eighties (“decade of greed”) – spurred reflationary policy measures that worked to spur a bigger Bubble. Inevitably, each bursting Bubble would ensure only more aggressive inflationary policy measures.

It is fundamental to Credit Bubble Theory (heavily influenced by “Austrian” analysis) that the scope of each new Bubble must be bigger than the last. Credit growth must be greater, speculation must be greater and asset inflation must be greater. This Financial Sphere inflation is essential to sufficiently reflate the Real Economy Sphere – i.e. incomes, spending, corporate earnings/cash flows, investment, etc. Reflation is necessary to validate an ever-expanding debt and financial structure, including elevated asset prices. Ongoing rapid Credit growth is fundamental to this entire process, much to the eventual detriment of financial and economic stability.

There are a few key points that drive current analysis (completely disregarded by conventional analysts). First, the government finance Bubble saw historic Credit growth unfold in China and EM – Credit expansion sufficient to reflate a new Bubble after the bursting of the mortgage finance Bubble. Central to my thesis: when the current Bubble bursts – especially with regard to China – it will be near impossible to spur sufficient global Credit growth to inflate a bigger ensuing Bubble. Second, with the global government finance Bubble emanating from the very foundation of contemporary “money” and Credit, it will be impossible for governments and central banks to extricate themselves from monetary stimulus (any tightening would risk bursting the Bubble). Third, extreme measures - monetary inflation coupled with market manipulation – spurred enormous “Terminal Phase” growth in the global pool of speculative finance. It’s been a case of too much “money” ruining the game.

“Moneyness of Risk Assets” has played prominently throughout the government finance Bubble period. Unlimited Chinese stimulus seemed to ensure robust commodities markets and EM economies generally. Limitless sovereign debt and central bank Credit appeared to ensure ongoing liquid and continuous global financial markets – “developed” and “developing.” And with governments backstopping global growth and central bankers backstopping liquid markets, the perception took hold that global stocks and bonds offered enticing returns with minimal risk. Global savers shifted Trillions into perceived “money-like” (liquid stores of nominal value) ETFs and stock and bond funds. Government policy measures furthermore incentivized leveraged speculation.

Why not leverage with global fiscal and monetary policies promoting such a predictable backdrop? Indeed, speculative finance has over recent years played an unappreciated integral role in global reflation. This process has created acute fragility to risk aversion and a reversal of “hot money” flows.

Central to the bursting global Bubble thesis is that Chinese and EM Bubbles have succumbed – with policymakers rather abruptly having lost control of reflationary processes. Measures that elicited predictable responses when Bubbles were inflating might now spur altogether different behavior. A year ago, Chinese stimulus incited speculation – and associated inflation – in domestic financial markets, while bolstering China’s economy and EM more generally. Today, in a faltering Bubble backdrop, aggressive Chinese measures weigh on general confidence and stoke concerns of destabilizing capital flight and currency market instability.

In the past, a dovish Fed would predictably bolster “risk-on” throughout U.S. and global markets. Times have changed. As we saw this week, an Ultra-Dovish Fed actually exacerbates market uncertainty. The global leveraged speculating community is these days Crowded in long dollar trades. Federal Reserve dovishness – and resulting pressure on the dollar - thus risks reinforcing “risk off” de-risking/de-leveraging. In particular, the yen popped on the Fed announcement, immediately adding pressure on already vulnerable yen “carry trades” (short/borrow in yen to finance higher-yielding trades in other currencies). While EM currencies generally enjoyed small bounces (likely short covering) this week, for the most part EM equities traded poorly post-Fed. European equities were hit hard, while the region’s bonds benefited from the prospect of more aggressive ECB QE.

The bullish contingent has clung to the view that EM weakness has been a function of an imminent Fed tightening cycle. In the market’s mixed reaction to Thursday’s announcement, I instead see support for my view that the bursting EM Bubble essentially has little to do with current Federal Reserve policy.

The bursting China/EM Bubble is the global system’s weak link. Surely the activist Fed would prefer to do something. They must believe that hiking rates – even if only 25 bps – would support the dollar at the risk of further straining commodities and EM currencies. Moreover, the FOMC likely sees any “tightening” measures as exacerbating general market nervousness and risk aversion. Moreover, the Fed must believe that dovish surprises will be effective in countering a tightening of financial conditions in the markets, as they were in the past.

Major Bubbles are so powerful. It was amazing how long the markets were willing to disregard shortcomings and risks in China and EM (financial, economic and political). Similarly, it’s been crazy what the markets have been so willing to embrace in terms of Federal Reserve and global central bank doctrine and policy measures. With their Bubble having recently burst, Chinese inflationary measures are now significantly hamstrung by an abrupt deterioration in confidence in policymaker judgment and the course of policymaking. I believe yesterday’s Fed announcement marks an important inflection point with respect to market confidence in the Fed and central banking.

Japan’s Nikkei dropped 2% Friday, and Germany’s DAX sank 3.1%. Both have been global leveraged speculating community darlings. Crude was hammered 4.18% Friday, with commodities indices down about 2%. Notably, the Brazilian real was trading at 3.83 (to the dollar) prior to the Fed announcement, before sinking 3% to a multi-year low by Friday’s close. Reminiscent of recent market troubles, financial stocks led U.S. equities lower on Friday. Financials badly underperformed for the week, with Banks down 2.7% and the Securities Broker/Dealers sinking 2.6%.

The market deck has been reshuffled for next week. A lot of market hedging took place during the past month of market instability. And a decent amount of this protection expired (worthless) with Friday’s quarterly “triple witch” options expiration. This means that if the market resumes its downward trajectory next week many players will be scampering again to buy market “insurance.” This creates market vulnerability to another “flash crash” panic “risk off” episode.

I am not predicting the market comes unglued next week. But I am saying that an unsound marketplace is again vulnerable to selling begetting selling – and another liquidity-disappearing act. Bullish sentiment rebounded quickly after the August market scare. The bear market will be well on its way if August lows are broken. I’m sticking with the view that uncertainties are so great – especially in the currencies – the leveraged players need to pare back risk. And the harsh reality is that central bank policymaking is the root cause of today’s extraordinary uncertainties and market instability.

In closing, I’m compelled to counter the conventional view that the Fed should stick longer at zero because there is essentially no cost in waiting. I believe there are huge costs associated with thwarting the market adjustment process. Measures that contravene more gradual risk market declines only raise the likelihood of eventual market dislocation and panic. This was one of many lessons that should have been heeded from the 2007/2008 experience. 

Fed is riding the tail of a dangerous global tiger

Janet Yellen had to hold fire this week, but risks an even nastier crunch later if inflation forces the Fed has to slam on the brakes suddenly

By Ambrose Evans-Pritchard

Janet Yellen, chair of the U.S. Federal Reserve, listens to a question during a news conference following a Federal Open Market Committee (FOMC) meeting in Washington, DC, US

Photo: Bloomberg
The US Federal Reserve would have been mad to raise interest rates in the middle of a panic over China and an emerging market storm, and doubly so to do it against express warnings from the International Monetary Fund and the World Bank.

The Fed is the world’s superpower central bank. Having flooded the international system with cheap dollar liquidity during the era of quantitative easing, it cannot lightly walk away from its global responsibilities - both as a duty to all those countries that were destabilized by dollar credit, and in its own enlightened self-interest.
Dollar debt outside the jurisdiction of the US has reached $9.6 trillion, on the latest data from the Bank for International Settlements. Dollar loans to emerging markets have doubled since the Lehman crisis to $3 trillion.
The world has never been so leveraged, and therefore so acutely sensitive any shift in monetary signals. Nor has the global financial system ever been so tightly inter-linked, and therefore so sensitive to the Fed.
The BIS says total debt in the rich countries has jumped by 36 percentage points to 265pc of GDP since the peak of the last cycle, and by 50 points to 167pc in developing Asia, Latin America, the Middle East, Eastern Europe, and Africa.

It is wishful thinking to suppose that the world can brush off a Fed rate rise on the grounds that most of the debt is in local currencies. BIS research shows that they will face a rate shock regardless. On average, a 100 point move in US rates leads to a 43 point move in local currency borrowing costs in EM and open developed economies.

Given that the Fed was forced to reverse course dramatically in 1998 when the East Asia crisis blew up – for fear it would take down the US financial system – it can hardly go ahead nonchalantly with rate rises into the teeth of the storm today when emerging markets are an order of magnitude larger and account for 50pc of global GDP.

Even if you reject these arguments, Goldman Sachs says the strong dollar and the market rout in August already amount to 75 basis points of monetary tightening for the US economy itself.

Headline CPI inflation in the US is just 0.2pc. Prices fell in August. East Asian is transmitting a deflationary shock to the West, and it is not yet clear whether the trade depression in the Far East is safely over.

The argument that zero rates are unhealthy and impure is to let Calvinist psychology intrude on the hard science of monetary management. The chorus of demands – and just from ‘internet-Austrians’ – that rates should be raised in order to build up reserve ammunition in case they need to be cut later, is a line of reasoning that borders on insanity.

If acted on, it would risk tipping us all into the very deflationary trap that we are supposed to be protecting ourselves against, the Irving Fisher moment when a sailing boat rolls beyond the point of natural recovery, and capsizes altogether. So hats off to Janet Yellen for refusing to listen to such dangerous counsel.

However, the Fed is damned if it does, and damned if it does not, for by recoiling yet again it may well be storing up a different kind of crisis next year.

We do not really know whether capital flows from China are slipping out of control. There is a high likelihood that this scare is exaggerated – or based on technical misunderstandings – and that draconian curbs will slam the gate shut in any case.

Contrary to much noise, China is not in fact collapsing. It had a recession earlier this year as a result of a triple shock: a fiscal cliff from a botched reform of local government, a monetary squeeze that went too far, and the sharpest appreciation of its trade-weighted exchange rate of any country in the world.

Capital Economics gauge of true GDP

There was also an equity crash on the Shanghai and Shenzhen casinos, though this is of no relevance beyond puncturing the illusion that the Chinese authorities known what they are doing. Self-evidently they do not.

These shocks have been absorbed. The recession touched bottom in April. Credit is growing at the fastest pace in two years. Fiscal spending is back on track. House prices are shooting up again in Beijing, Shanghai, Tianjin, Guangzhou, and Shenzhen. Bond issuance by local governments is soaring.

You might argue that the Communist Party is reverting to its bad old ways, dooming its long-term prospects, but the immediate implication is that data from China will soon start looking a great deal better, lifting the whole world out of its summer sulk.

Indeed, it is not impossible that China will come roaring back, if only for a few months, in keeping with its pattern of stop-go mini-cycles.

Simon Ward from Henderson Global Investors said his measure of the Chinese money supply – `true M1’ – is has been rising at a pace of 8.4pc in real terms over the last six months, the strongest since early 2013.

The eurozone is also picking up. The era of self-defeating fiscal contraction is over. Broad M3 money is growing at 5.3pc, the fastest since the EMU depression began in 2008. The growth in M1 soared to 12.1pc in July as QE flooded the banking system.

While the US money data is more sedate, it is not flashing a recession signal. The unemployment rate has dropped to 5.1pc and is now very close to the inflexion point of ‘NAIRU’ – probably 4.8pc – when wage pressures start to build up.

The risk for Janet Yellen, if risk is the right word, is that the August squall will prove to be a false alarm. Within a few months the Fed may find itself badly behind the curve, chasing a full-fledged rebound in the world’s three biggest economic blocs.

It might too face an asset boom that slips control, just as it uncorked the dotcom bubble by yielding to global events in 1998, and some would say just as it uncorked the 1929 stock bubble by cutting rates in 1927 to help Britain stay on the Gold Standard at pre-war parity.

That is the moment when they may have to slam on the breaks. Once the bond vigilantes start to suspect that five or six rates may be coming in rapid succession – perhaps by the middle of next year – the long-feared crisis for emerging markets will hit in earnest.

Nobody said central banking was easy.

Groundhog Day at the Fed

By: Peter Schiff

Every dictator knows that a continuous state of emergency is the best means to justify tyrannical policies. The trick is to keep the fictitious emergency from breeding so much paranoia that routine activities come to a halt. Many have discovered that its best to make the threat external, intangible and ultimately, unverifiable. In Orwell's 1984 the preferred mantra was "We've always been at war with Eurasia," even though everyone knew it wasn't true. In its rate decision this week the Federal Reserve, adopted a similar approach and conjured up an external threat to maintain a policy that is becoming increasingly absurd.

In blaming its continued inaction on "uncertainties abroad" (an excuse never before invoked by the Fed in the current period of zero interest rates), the Fed was able to maintain the pretense of a strong domestic economy, and its desire to lift rates at the earliest appropriate moment while continuing the economic life support of zero percent rates. Unbelievably, the media swallowed the propaganda hook, line, and sinker.

Over the summer it all seemed so certain. In mid-August the Wall Street Journal conducted a poll revealing that 95% of economists expected a rate hike by the end of 2015, with 82% expecting the first move to come in September. On July 29, Marketwatch reported that changes in Fed language were the "smoking gun" that made a September move a certainty. I was one of the few who publicly predicted that all the tough talk from the Fed was a bluff, and that there would be no hike in 2015.

For taking that stance, I was largely ignored and ridiculed. In a July 16 interview on CNBC's Futures Now (I am no longer invited to be on their television broadcasts), pundit Scott Nations took me to task for making the "outlandish" suggestion that the Fed would not raise in 2015, saying (to paraphrase):

"If price is truth and Fed funds futures are the collective wisdom of everybody in the world, and they are absolutely a lock for the Fed to raise rates by the end of the year, why is everybody else wrong and you are right?"

But now, in mid-September, it has all changed, far fewer economists expect a hike this year.

However, despite this dramatic reversal, few have downgraded their forecasts or weakened their belief that the Fed remains committed to tighten policy...eventually. In other words, the Fed has achieved a complete communications victory.

Just like it has in prior statements, the Fed painted a picture of a stable and growing economy that was ready for a hike. In fact, in her press conference, Janet Yellen said that the Fed was "impressed" by the strength of the domestic economy. Although such statements began to resemble the film Groundhog Day, no one seems to tire of it.

A cornucopia of metaphors should have come to mind: The Fed's bite had failed to live up to its bark; its "open mouth" operations wrote a check that its Open Market Committee was unable to cash; the Fed has become Lucy of the comic strip Peanuts, always promising to hold the football for Charlie Brown to kick, but always taking it away before he kicks it. Instead, the dominant theme of the coverage was that the Fed's understanding of the global economy was just better than the rest of us. It apparently understood that a 25 basis point increase in rates in the U.S. could ripple through to the world markets and could potentially push China's tottering stock market into the abyss. That was a risk it believed was not worth taking.

To keep the story line going requires that the steady torrent of negative data be ignored (see manufacturing data in September Manufacturing Business Outlook Survey of Philly Fed].

Similar weakness is evident in business investment, productivity, and consumer confidence numbers. Based on those data sets, conventional Keynesian "wisdom" suggests the Fed should be preparing a fresh round of stimulus, not readying its first economic sedative in nine years.

The big news is the introduction of "international developments" as an ongoing input into the Fed's rate deliberation process. This addition allows the Fed nearly limitless latitude to perpetually kick the can down the road. After all, it is a great big world, and it will always be possible to find a problem somewhere. A Reuters article issued after the decision describes the new reality (9/18/15, Howard Schneider):

"It is a situation that could leave the Fed stranded in its hunt for a rate liftoff until the entire global economy is growing in sync, and the horizon is clear of risks."

So there you have it. The Fed is no longer just the central bank of the United States, but the central bank of the entire world. As such it will need to consider any possible negative impacts, anywhere, before it pulls the trigger. This isn't just moving the goalposts; it is dismantling them completely, putting them in crates, and losing them in a government warehouse...much like the Ark of the Covenant at the end of the first Indiana Jones movie.

The height of yesterday's absurdity came during Janet Yellen's press conference when Ann Saphir from Reuters asked her about the possibility that interest rates could stay at zero "forever." While characterizing that likelihood as "extreme," Yellen incredibly stated that she could not rule out the possibility. Of course the absurd suggestion that American civilization may never see rates above zero did not even raise eyebrows in the mainstream media. But the statement itself raises some interesting questions about Yellen's actual thinking. First, how can she really be contemplating at 2015 rate hike, if she cannot even rule out the possibility of rates remaining at zero forever? Second, is she really that naïve and arrogant to believe that currency markets would allow the Fed to hold interest rates at zero indefinitely, without creating a dollar crisis, even if the Fed wanted to hold them there?

As I have maintained continuously, rate hike talk from the Fed is just a bluff to disguise its inability to tighten, as even small increases could be sufficient to prick the biggest bubble it has ever inflated.

It is no coincidence that the stunning 170% increase in the Dow Jones, that occurred between March 2009 and the end of 2014, happened while the Fed was stimulating the economy almost continuously with QE, and that the rally came to an abrupt end when the QE stopped.

The recent 10% correction on Wall Street confirms to me just how sensitive the markets remain to the prospect of any rates higher than zero. In reality, that sell-off was a much greater factor than China in keeping the Fed quiet. That steep correction occurred at a time when most forecasters believed that a September hike was in the cards. For years, they had known that a rate hike was coming, but they always thought it would arrive when the economy was healthy. 

But when the big day became a clear and present danger, and the economy was still less than optimal, markets began to panic. It was only when Fed officials came out with publicly dovish statements that the sell-off ended. Despite this obvious connection, the markets are still blaming China, despite the fact that big sell-offs in China had been occurring for much of 2015 without sparking follow on panics in the U.S.

As a result, it should be clear that ongoing Fed decision-making is not just "data dependent" (and now we are talking about international, not just domestic, data), but also "market dependent," meaning the Fed won't raise rates if markets sell off sharply on expectations that it will raise. Given these impossible conditions, perhaps a perpetual zero rates are not so outlandish. But the reality is Central banks can't really control interest rates across the spectrum, just the short end of the curve...when markets really panic, they won't be able to stop economically devastating interest rate spikes on the long end.

In the meantime, I can only hope that the foreign exchange and commodity markets are finally getting the picture that the Fed appears impotent. The tremendous rally in the dollar over the past 18 months was predicated on the belief that interest rates would be rising in the U.S. just as they were falling everywhere else. Now that that premise is in tatters, the dollar should be giving back its undeserved gains. Recent moves in the foreign exchange market reveal that this is the case.

When the year began, opinion was divided between those who thought the Fed would move in March, and those who thought it wouldn't happen until June. When June came and went, September became the odds-on favorite. Now those same experts are once again divided between December and sometime in 2016. When will these "experts" finally connect the real dots and discover that the monetary medicine that the Fed has doused over the economy since 2008 has only created a weak and utterly dependent economy. A rate hike is supposed to be a signal that the economy has a clean bill of health. But as the patient fails to recover, another dose of QE will be just what the doctor orders.

The Pentagon Is Preparing New War Plans for a Baltic Battle Against Russia

But the really troubling thing is that in the war games being played, the United States keeps losing.

By Julia Ioffe

For the first time since the collapse of the Soviet Union, the U.S. Department of Defense is reviewing and updating its contingency plans for armed conflict with Russia.

The Pentagon generates contingency plans continuously, planning for every possible scenario — anything from armed confrontation with North Korea to zombie attacks. But those plans are also ranked and worked on according to priority and probability. After 1991, military plans to deal with Russian aggression fell off the Pentagon’s radar. They sat on the shelf, gathering dust as Russia became increasingly integrated into the West and came to be seen as a potential partner on a range of issues. Now, according to several current and former officials in the State and Defense departments, the Pentagon is dusting off those plans and re-evaluating them, updating them to reflect a new, post-Crimea-annexation geopolitical reality in which Russia is no longer a potential partner, but a potential threat.

“Given the security environment, given the actions of Russia, it has become apparent that we need to make sure to update the plans that we have in response to any potential aggression against any NATO allies,” says one senior defense official familiar with the updated plans.
“Russia’s invasion of eastern Ukraine made the U.S. dust off its contingency plans,” says Michèle Flournoy, a former undersecretary of defense for policy and co-founder of the Center for a New American Security. “They were pretty out of date.”

Designing a counteroffensive

The new plans, according to the senior defense official, have two tracks. One focuses on what the United States can do as part of NATO if Russia attacks one of NATO’s member states; the other variant considers American action outside the NATO umbrella. Both versions of the updated contingency plans focus on Russian incursions into the Baltics, a scenario seen as the most likely front for new Russian aggression. They are also increasingly focusing not on traditional warfare, but on the hybrid tactics Russia used in Crimea and eastern Ukraine: “little green men,” manufactured protests, and cyberwarfare. “They are trying to figure out in what circumstances [the U.S. Defense Department] would respond to a cyberattack,” says Julie Smith, who until recently served as the vice president’s deputy national security advisor. “There’s a lively debate on that going on right now.”

This is a significant departure from post-Cold War U.S. defense policy.

After the Soviet Union imploded, Russia, its main heir, became increasingly integrated into NATO, which had originally been created to counter the Soviet Union’s ambitions in Europe.

In 1994, Moscow signed onto NATO’s Partnership for Peace program. Three years later, in May 1997, Russia and NATO signed a more detailed agreement on mutual cooperation, declaring that they were no longer adversaries. Since then, as NATO absorbed more and more Warsaw Pact countries, it also stepped up its cooperation with Russia: joint military exercises, regular consultations, and even the opening of a NATO transit point in Ulyanovsk, Russia, for materiel heading to the fight in Afghanistan. Even if the Kremlin was increasingly miffed at NATO expansion, from the West things looked fairly rosy.

After Russia’s 2008 war with neighboring Georgia, NATO slightly modified its plans vis-à-vis Russia, according to Smith, but the Pentagon did not. In preparing the 2010 Quadrennial Defense Review, the Pentagon’s office for force planning — that is, long-term resource allocation based on the United States’ defense priorities — proposed to then-Secretary of Defense Robert Gates to include a scenario that would counter an aggressive Russia. Gates ruled it out. “Everyone’s judgment at the time was that Russia is pursuing objectives aligned with ours,” says David Ochmanek, who, as deputy assistant secretary of defense for force development, ran that office at the time. “Russia’s future looked to be increasingly integrated with the West.” Smith, who worked on European and NATO policy at the Pentagon at the time, told me, “If you asked the military five years ago, ‘Give us a flavor of what you’re thinking about,’ they would’ve said, ‘Terrorism, terrorism, terrorism — and China.’”

Warming to Moscow

The thinking around Washington was that Mikheil Saakashvili, then Georgia’s president, had provoked the Russians and that Moscow’s response was a one-off. “The sense was that while there were complications and Russia went into Georgia,” Smith says, “I don’t think anyone anticipated that anything like this would happen again.” Says one senior State Department official: “The assumption was that there was no threat in Europe.” Russia was rarely brought up to the secretary of defense, says the senior defense official.

Then came the Obama administration’s reset of relations with Russia, and with it increased cooperation with Moscow on everything from space flights to nuclear disarmament. There were hiccups (like Russia’s trying to elbow the United States out of the Manas base in Kyrgyzstan) and less-than-full cooperation on pressing conflicts in the Middle East (the best the United States got from Russia on Libya was an abstention at the U.N. Security Council). But, on the whole, Russia was neither a danger nor a priority. It was, says one senior foreign-policy Senate staffer, “occasionally a pain in the ass, but not a threat.”

Ochmanek, for his part, hadn’t thought about Russia for decades. “As a force planner, I can tell you that the prospect of Russian aggression was not on our radar,” he told me when I met him in his office at the Rand Corp. in Northern Virginia, where he is now a senior defense analyst. “Certainly not since 1991, but even in the last years of Gorbachev.” Back in 1989, Ochmanek thought that Washington should be focusing on the threat of Iraq invading Kuwait, not on the dwindling likelihood of Soviet military aggression. For the last 30 years, Ochmanek has shuttled between Rand, where he has focused on military planning, and the nearby Pentagon, where he has done the same in an official capacity: first in the mid-1990s, when he was the deputy assistant secretary of defense for strategy, and then for the first five years of Barack Obama’s administration, when he ran force planning at the Pentagon.

It was there that, in February 2014, Russian President Vladimir Putin caught Ochmanek and pretty much every Western official off guard by sending little green men into Crimea and eastern Ukraine. “We didn’t plan for it because we didn’t think Russia would change the borders in Europe,” he says. Crimea, he says, was a “surprise.”

War games, and losing

In June 2014, a month after he had left his force-planning job at the Pentagon, the Air Force asked Ochmanek for advice on Russia’s neighborhood ahead of Obama’s September visit to Tallinn, Estonia. At the same time, the Army had approached another of Ochmanek’s colleagues at Rand, and the two teamed up to run a thought exercise called a “table top,” a sort of war game between two teams: the red team (Russia) and the blue team (NATO). The scenario was similar to the one that played out in Crimea and eastern Ukraine: increasing Russian political pressure on Estonia and Latvia (two NATO countries that share borders with Russia and have sizable Russian-speaking minorities), followed by the appearance of provocateurs, demonstrations, and the seizure of government buildings. “Our question was: Would NATO be able to defend those countries?” Ochmanek recalls.

The results were dispiriting. Given the recent reductions in the defense budgets of NATO member countries and American pullback from the region, Ochmanek says the blue team was outnumbered 2-to-1 in terms of manpower, even if all the U.S. and NATO troops stationed in Europe were dispatched to the Baltics — including the 82nd Airborne, which is supposed to be ready to go on 24 hours’ notice and is based at Fort Bragg, North Carolina.

“We just don’t have those forces in Europe,” Ochmanek explains. Then there’s the fact that the Russians have the world’s best surface-to-air missiles and are not afraid to use heavy artillery.

After eight hours of gaming out various scenarios, the blue team went home depressed. “The conclusion,” Ochmanek says, “was that we are unable to defend the Baltics.”

Ochmanek decided to run the game on a second day. The teams played the game again, this time working on the assumption that the United States and NATO had already started making positive changes to their force posture in Europe. Would anything be different? The conclusion was slightly more upbeat, but not by much. “We can defend the capitals, we can present Russia with problems, and we can take away the prospect of a coup de main,” Ochmanek says. “But the dynamic remains the same.” Even without taking into account the recent U.S. defense cuts, due to sequestration, and the Pentagon’s plan to downsize the Army by 40,000 troops, the logistics of distance were still daunting. U.S. battalions would still take anywhere from one to two months to mobilize and make it across the Atlantic, and the Russians, Ochmanek notes, “can do a lot of damage in that time.”

Ochmanek has run the two-day table-top exercise eight times now, including at the Pentagon and at Ramstein Air Base, in Germany, with active-duty military officers. “We played it 16 different times with eight different teams,” Ochmanek says, “always with the same conclusion.”

The Defense Department has factored the results of the exercise into its planning, says the senior defense official, “to better understand a situation that few of us have thought about in detail for a number of years.” When asked about Ochmanek’s conclusions, the official expressed confidence that, eventually, NATO would claw the territory back. “In the end, I have no doubt that NATO will prevail and that we will restore the territorial integrity of any NATO member,” the official said. “I cannot guarantee that it will be easy or without great risk. My job is to ensure that we can reduce that risk.”

Protect the Baltics

That is, the Pentagon does not envision a scenario in which Russia doesn’t manage to grab some Baltic territory first. The goal is to deter — Defense Secretary Ashton Carter announced this summer that the United States would be sending dozens of tanks, armored vehicles, and howitzers to the Baltics and Eastern Europe — and, if that fails, to painstakingly regain NATO territory.

The Pentagon is also chewing on various hybrid warfare scenarios, and even a nuclear one. “As you look at published Russian doctrine, I do believe people are thinking about use of tactical nuclear weapons in a way that hadn’t been thought about for many years,” says the senior defense official.

“The doctrine clearly talks about it, so it would be irresponsible to not at least read that doctrine, understand what it means. Doctrine certainly doesn’t mean that they would do it, but it would be irresponsible to at least not be thinking through those issues. Any time there is nuclear saber rattling, it is always a concern, no matter where it comes from.”

There is a strong element of disappointment among senior foreign-policy and security officials in these discussions, of disbelief that we ended up here after all those good years — decades, even — in America’s relations with Russia.

“A lot of people at the Pentagon are unhappy about the confrontation,” says the State Department official. “They were very happy with the military-to-military cooperation with Russia.” There are also those, the official said, who feel that Russia is a distraction from the real threat — China — and others who think that working with Russia on arms control is more important than protecting Ukrainian sovereignty. Not only would they rather not have to think about Moscow as an enemy, but many are also miffed that even making these plans plays right into Putin’s paranoid fantasies about a showdown between Russia and NATO or between Russia and the United States — which makes those fantasies, de facto, a reality. In the U.S. planning for confrontation with Russia, says the Senate staffer, Putin “is getting the thing he always wanted.”

Yet despite this policy shift, the distinctly American optimism is confoundingly hard to shake. “We would like to be partners with Russia. We think that is the preferred course — that it benefits us, it benefits Russia, and it benefits the rest of the world,” the senior defense official says. “But as the Department of Defense, we’re not paid to look at things through rose-colored glasses and hence must be prepared in case we’re wrong about Russia’s actions and plan for if Russia were to become a direct adversary. Again, I don’t predict that and I certainly don’t want it, but we need to be prepared in case that could happen.”

Provocation or preparation?

So far, the Pentagon’s plans are just that — plans. But they are also signals: to Russia that the United States is not sitting on its hands, and to Congress that America’s foreign-policy priorities have shifted drastically since the last Quadrennial Defense Review, which was released as the crisis in Ukraine was unfolding and barely mentioned Russia. It is also a signal that the Pentagon feels that sequestration hobbles its ability to deal with the new threat landscape. In his July confirmation hearing to ascend to the chairmanship of the Joint Chiefs of Staff, Gen. Joseph Dunford made headlines when he said that Russia posed an “existential threat” to the United States and said that America must do more to prepare itself for hybrid warfare of the type Russia deployed in Ukraine.

“It’s clearly a signal to the Hill,” says Smith. “When I come and ask for a permanent presence in Europe or money for a European presence, I don’t want you to say, ‘Gee, this is a surprise. I thought it was all about [the Islamic State].’” Dunford’s statement angered the White House, which saw it as potentially provocative to Moscow, but it was also a signal to everyone else. The commander in chief has the final say on whether to use these new contingency plans, but Obama’s days in office are numbered, and the Pentagon isn’t taking any chances.

Three Reasons Why the U.S. Government Should Default on Its Debt Today

by Doug Casey

The overleveraging of the U.S. federal, state, and local governments, some corporations, and consumers is well known.

This has long been the case, and most people are bored by the topic. If debt is a problem, it has been manageable for so long that it no longer seems like a problem. U.S. government debt has become an abstraction; it has no more meaning to the average investor than the prospect of a comet smacking into the earth in the next hundred millennia.

Many financial commentators believe that debt doesn’t matter. We still hear ridiculous sound bites, like “We owe it to ourselves,” that trivialize the topic. Actually, some people owe it to other people.

There will be big transfers of wealth depending on what happens. More exactly, since Americans don’t save anymore, that dishonest phrase about how we owe it to ourselves isn’t even true in a manner of speaking; we owe most of it to the Chinese and Japanese.

Another chestnut is “We’ll grow out of it.” That’s impossible unless real growth is greater than the interest on the debt, which is questionable. And at this point, government deficits are likely to balloon, not contract. Even with artificially low interest rates.

One way of putting an annual deficit of, say, $700 billion into perspective is to compare it to the value of all publicly traded stocks in the U.S., which are worth roughly $20 trillion. The current U.S. government debt of $18 trillion is rapidly approaching the stock value of all public corporations -- and that’s true even with stocks at bubble-like highs. If the annual deficit continues at the $700 billion rate -- in fact it is likely to accelerate -- the government will borrow the equivalent of the entire equity capital base of the country, which has taken more than 200 years to accumulate, in only 29 years.

You should keep all this in the context of the nature of debt; it can be insidious.

The only way a society (or an individual) can grow in wealth is by producing more than it consumes; the difference is called “saving.” It creates capital, making possible future investments or future consumption. Conversely, “borrowing” involves consuming more than is produced; it’s the process of living out of capital or mortgaging future production. Saving increases one’s future standard of living; debt reduces it.

If you were to borrow a million dollars today, you could artificially enhance your standard of living for the next decade. But, when you have to repay that money, you will sustain a very real decline in your standard of living. Even worse, since the interest clock continues ticking, the decline will be greater than the earlier gain. If you don’t repay your debt, your creditor (and possibly his creditors, and theirs in turn) will suffer a similar drop. Until that moment comes, debt can look like the key to prosperity, even though it’s more commonly the forerunner of disaster.

Of course, debt is not in itself necessarily a bad thing. Not all debt is for consumption; it can be used to finance capital goods intended to produce further wealth. But most U.S. debt today finances consumption -- home mortgages, car loans, student loans, and credit card debt, among other things.

Government Debt

It took the U.S. government from 1791 to 1916 (125 years) to accumulate $1 billion in debt.

World War I took it to $24 billion in 1920; World War II raised it to $270 billion in 1946.

Another 24 years were needed to add another $100 billion, for a total of $370 billion in 1970.

The debt almost tripled in the following decade, with debt crossing the trillion-dollar mark in October 1981. Only four and half years later, the debt had doubled to $2 trillion in April 1986.

Four more years added another trillion by 1990, and then, in only 34 months, it reached $4.2 trillion in February 1993. The exponential growth continued unabated. U.S. government debt stood at $18 trillion in 2015. Off-balance sheet borrowing and the buildup of massive contingent liabilities aren’t included. That may add another $50 trillion or so.

When interest rates rise again, even to their historical average, the U.S. government will find most of its tax revenue is going just to pay interest. There will be little left over for the military and domestic transfer payments.

When the government borrows just to pay interest, a tipping point will be reached. It will have no flexibility at all, and that will be the end of the game.

In principle, an unsustainable amount of government debt should be a matter of concern only to the government (which is not at all the same thing as society at large) and to those who foolishly lent them money. But the government is in a position to extract tax revenues from its subjects, or to inflate the currency to keep the ball rolling. Its debt indirectly, therefore, becomes everyone’s burden.

As I've said before, I think the U.S. government should default on not just some, but all of its debt.

There are at least three reasons for that. First is to avoid turning future generations into serfs.

Second is to punish those who have enabled the State by lending it money. Third is to make it impossible for the State to borrow in the future, at least for a while.

The consequences of all this are grim, but the timing is hard to predict. Perhaps the government can somehow borrow amounts that no one previously thought possible. But its creditors will look for repayment. Either the creditors are going to walk away unhappy (in the case of default), or the holders of all dollars are going to be stuck with worthless paper (in the case of hyperinflation), or the taxpayers’ pockets will be looted (the longer things muddle along), or most likely a combination of all three will happen. This will not be a happy story for all but a few of us.

Banks Warn of Cost Cuts Ahead

Fed’s move to keep interest rates near zero could continue to crimp revenue

By Rachel Louise Ensign

Bank of America says it may have to cut costs further if interest rates remain low.Bank of America says it may have to cut costs further if interest rates remain low. Photo: emmanuel dunand/Agence France-Presse/Getty Images

No news was bad news for the country’s banks on Thursday.

After years of having their profits pinched by low interest rates, banks—and their investors—had been itching for the Federal Reserve to make a move. Now that the Fed decided to stand pat, some lenders are warning they could have to cut expenses further to compensate for the revenue that would have come in if rates had ticked upward.

Rising interest rates are generally good for banks, because they typically accompany strong economic growth and because they tend to widen the spread between the interest banks charge on loans and what they pay for deposits. That bolsters earnings.

Bank of America Corp. BAC -1.95 % Chief Executive Officer Brian Moynihan said at an investor conference in New York on Thursday that his firm, which has been reducing expenses for years, would double down on those efforts if rates didn’t rise.

“Let me assure you, if the revenue environment weakens or interest-rate structures don’t move up and the economy slows down, we’ll have to take out more costs,” Mr. Moynihan said.

At the same event, U.S. Bancorp USB -1.67 % CEO Richard Davis announced plans to trim the firm’s expenses. He said focusing on costs allows him to “care less” about whether or not interest rates rise. The bank already is known for its lean operations. Its efficiency ratio, a measure of expenses versus revenue, was 53.2% in the second quarter, better than those of many competitors.

Mr. Davis has compared the bank’s situation waiting for interest rates to rise with the last few grueling moments of a gym-class test, hanging on a bar for 90 seconds.

“It’s going to take a bit longer for banks to see some relief,” said John Pancari, a bank analyst at Evercore ISI.

The Fed’s benchmark rate has been near zero since 2008.

Investors sold off bank shares after the Fed announcement. The KBW Nasdaq Bank Index fell 2.3%, a much deeper drop than the 0.4% decline in the Dow Jones Industrial Average. Some bank stocks fell even more, with Citizens Financial Group Inc. CFG -3.04 % dropping 3.4%, Fifth Third Bancorp FITB -2.37 % falling 3.5% and Zions Bancorp ZION -2.82 % pulling back 3.4%.

Many bankers had been rooting for a rate increase. J.P. Morgan Chase JPM -2.55 % & Co. CEO James Dimon said Thursday afternoon that he didn’t expect a move, even though he wanted one.

“It would be a good thing to raise rates,” he said. “It would be a good sign.”

When asked about rate increases recently, BB&T Corp. BBT -2.49 % CEO Kelly King said: “I dream about it every night.”

The price of shares in big banks, including J.P. Morgan and Wells Fargo WFC -2.72 % & Co., have fallen sharply over the past month, as investors bet a rate increase was less likely. J.P. Morgan dropped 2.3% on Thursday, while Wells Fargo fell 2.8%.

The effect of the Fed decision was possibly compounded by a gloomy outlook on third-quarter trading by some banks. Mr. Moynihan said he expected revenue from the unit that trades bonds, currencies and commodities would be down, but revenue from the smaller equities-trading unit would increase.

His statements echoed a similar prediction Wednesday by Citigroup Inc. C -2.79 % Chief Financial Officer John Gerspach, who said his bank’s trading revenue could fall 5% in the third quarter.

The pain of persistent rock-bottom rates might not be confined to bank investors. Some analysts have said bank struggles could impede a broader economic recovery.

The Fed’s decision was broadly treated with disappointment throughout the banking industry.

At Citizens Financial’s Boston trading floor, where more than 30 staffers clustered around televisions for the afternoon announcement, the decision was a letdown for some.

“We were out on the trading floor waiting with bated breath,” said Tony Bedikian, head of global markets at the firm. He said the outcome “wasn’t as exciting as we were hoping it would be.”

At J.P. Morgan’s seventh-floor trading desk in midtown Manhattan, Troy Rohrbaugh’s eyes darted back and forth from three computer screens to his television, where Fed Chairwoman Janet Yellen explained the central bank’s decision. He said the explanation surprised some, as it indicates the Fed is open to keeping rates low for a longer period.

“This is more dovish than the market expected,” said Mr. Rohrbaugh, who runs J.P. Morgan’s interest-rate, commodities and currency trading businesses. “There’s a segment of the client base that remains in limbo.”

Huntington Bancshares Inc. HBAN -2.70 % Chief Financial Officer Mac McCullough said the Fed’s decision raised questions about what conditions would have to be in place for the central bank to be comfortable increasing rates.

“It just creates more uncertainty,” he said. “If not now, then when and what?”

But others saw a silver lining for banks. Tom Digenan, head of U.S. equities at UBS Global Asset Management, said he believes the sector is oversold.

“We’re seeing some stuff that’s really cheap,” he said. “The toughest thing on financials is everyone wants a catalyst or a story, but sometimes the answer is just they’re really cheap.”

Brazil’s sagging economy

Recession’s sharp bite

The shrinking of a once-vibrant economy is shocking ordinary folk as well as number-crunchers

JOB centres are rarely upbeat places. In Brazil, where they are often a last resort for those who lack the personal connections that lubricate much of life in the country, they can be particularly bleak. Francisco, a 54-year-old driver queuing at one in downtown São Paulo, has had no work for over two years. The lines have never been longer, he sighs. “It’s the crisis.”

Brazil’s growth has been anaemic for years. It averaged 2% a year during President Dilma Rousseff’s first term in office from 2011 to 2014—despite booming global demand for the country’s soyabeans, iron ore and oil. Government meddling with the private sector, combined with excessively loose monetary and fiscal policy, sapped confidence; investment dried up and inflation soared. Without the crutch of high commodity prices, GDP has now collapsed (by 1.9% in the second quarter of 2015, compared with the first), pulling the hitherto resilient labour market with it.

Nearly 500,000 jobs have been cut since January. Researchers at Fundação Getulio Vargas, a business school, reckon another 2.5m will be shed before the end of 2016. Unemployment rose to 7.5% in July, from 4.9% a year earlier—the fastest annual rise on record (see chart 1). It is expected to hit roughly 10% at the end of next year, and stay there for some time. Speak to Brazilians and it is hard to find anyone without a friend or family member on the dole.

From flophouses to boardrooms, moods darkened further in the wake of the decision last week by Standard & Poor’s to demote Brazil’s debt to junk status, following Ms Rousseff’s inept efforts to cast onto an unco-operative Congress the responsibility for balancing the budget. The rating agency subsequently downgraded dozens of big Brazilian companies, including several large banks.

Petrobras, the state-controlled energy firm which is also at the centre of Brazil’s biggest-ever corruption scandal, earned another dubious distinction as the world’s largest company without an investment-grade credit rating. At the start of the year Petrobras accounted for about one-tenth of total Brazilian investment; now it may need to trim its capital expenditure by even more than the 40% it announced in June.

S&P’s decision mainly reflected pre-existing worries about the Brazilian economy. Neither the stockmarket nor the real—down by 30% against the dollar since January—nosedived in the days after the announcement; this suggested that a return to junk status had largely been priced in. But the news has certainly added to the gloom. Already-high borrowing costs for both the public and private sector will rise, and with them the risk of further downgrades.

Pension and mutual funds that can only hold investment-grade assets will offload Brazilian bonds at a brisker pace, in anticipation of similar moves by Moody’s and Fitch. (Typically, two of the big three rating agencies need to slap a “junk” label on a country’s bonds before such funds are obliged to divest.)

This will not cripple the Brazil of today, with its diversified economy and plump foreign-exchange reserves, as it might have in earlier, more chaotic times. Ilan Goldfajn of Itaú, a big Brazilian bank, expects net inflows into Brazil’s capital markets to bottom out at $10 billion in 2016, down from $45 billion in 2014.

But divestment will make it harder for Brazil to shake off its worst recession in decades. This week analysts polled by the Central Bank once again once took an axe to growth forecasts (see chart 2).

The OECD, a rich-country club, thinks GDP could shrink by 2.8% this year and 0.7% next. A weaker currency has stoked inflation, which the Central Bank has been trying hard to quench with (contractionary) interest-rate rises. This has failed to boost exporters much—leaving aside Brazil’s hyper-competitive farmers. Few expect growth to rebound before 2018, when the next presidential election is due. Income per person, which peaked in 2011, may take longer to recover.

Since disavowing the interventionist policies of her first term, Ms Rousseff has tried, unsuccessfully, to pick a path between fiscal orthodoxy, championed by her finance chief, and stimulus demanded by her planning minister and many in her left-wing Workers’ Party. To appease the former camp, on September 14th the government presented another set of belt-tightening measures worth 65 billion reais ($17 billion), including a pay freeze for some public servants and a controversial tax on financial transactions.

Just like the government’s earlier efforts, these look half-hearted: insufficient to repair public finances and unleash a spirit of exuberance, but more than enough to enrage Congress, over which the increasingly unpopular president has no control and where a movement to oust her is gaining steam. Ms Rousseff is clinging on to her job for the time being. Many ordinary Brazilians have not been so lucky.

Unapologetic, Unequivocal

The Real Merkel Finally Stands up

A Commentary by Roland Nelles

 Charity means one thing to Angela Merkel, another to CSU leader Horst Seehofer.   REUTERS Charity means one thing to Angela Merkel, another to CSU leader Horst Seehofer.

German Chancellor Angela Merkel this week defended her embrace of refugees with an uncharacteristic outburst of compassion that is likely to go down in history. In doing so, she finally revealed a bit of her true political thinking.

In the course of her political career, journalists and indeed her own party colleagues have variously described Angela Merkel as a tactician, a strategist and a pragmatist. But she's mainly been seen as an equivocator, someone who plays her cards close to her chest.

But for all her hedging, Merkel's 10 years in the Chancellery have regularly been punctuated with short, sharp shocks of clarity, when her political grounding and mindset bubble to the surface. As a qualified physicist, she undoubtedly always took an interest in climate protection.

She also stayed true to herself during the Greek crisis in the role of the Swabian housewife who steadfastly avoids overspending. It was a role that matched the frugality and modesty she favors in her private life.

The next crisis is now underway, and she has reacted indignantly to the criticism that Germany is allowing in too many refugees. "If we now have to start apologizing for showing a friendly face in response to emergency situations, then that's not my country," she said on Tuesday.

Although delivered in her usual sober way, it was an unexpectedly heartfelt comment that will be remembered for a long time to come.


It wasn't a political tactician speaking this time, but a compassionate pastor's daughter from the eastern state of Brandenburg -- a politician who remains acutely aware of the Christian element in her party's agenda. In this respect she provides a welcome contrast to Horst Seehofer, leader of the Christian Democrats' Bavarian sister party, the CSU. In his book, charity more or less stops at the garden fence.

But Angela Merkel has not necessarily turned her back on realpolitik completely. As the refugee crisis unfolds, she too will inevitably make compromises and alter direction. Among these compromises are the newly instated border controls. Germany cannot take in all the world's refugees, as Merkel well knows.

But she has now made it obvious that she won't be deviating from her basic course. She is sending a message against knee-jerk xenophobia. That the conservatism of Bavaria's lederhosen brigade and some of her own party colleagues has always remained a foreign concept to Angela Merkel has never been more apparent than it is now. Ten years in office have clearly changed Merkel. She now has the strength and independence to state her opinion more stridently, even if it earns her the opprobrium of her allies.

Ultimately, it demonstrates that she has truly arrived in the autumn of her leadership. From Helmut Schmidt to Helmut Kohl and Gerhard Schröder, many a chancellor has begun to speak more uninhibitedly towards the end of their time in office, swimming against the tide of their party's mainstream opinion and in the process putting distance between themselves and their own people.

At the end of the day, it's a primal human instinct. Who wants to spend their life watching what they say?

World trade


A slowdown in global trade growth is bad news for many emerging markets

AT THE blustery Port of Tilbury, on the eastern outskirts of London, the word in the air is diversification. Less space is being given over to conventional container shipping. Instead, the port’s owners are investing in new projects. A large metal skeleton will soon become a refrigerated storage unit, to hold perishables on their way to Britain’s supermarkets. According to Tilbury’s chief operating officer, Perry Glading, the country’s container ports have a problem with overcapacity. Tilbury’s response is to use the port’s 1,000-acre site as flexibly as possible.

World trade data bear out Mr Glading’s caution. In South Korea, a bellwether for the global economy, exports of goods fell by almost 15% year on year in August in dollar terms. In China, the most important link in global supply chains, exports were down by over 5%. British and American exports have also been slipping. In the first six months of the year global merchandise trade shrank by more than 13% year on year. From the mid-1980s until the middle of the last decade, annual trade growth stood at 7%.

The recent falls can be partly explained by changes in prices. The dollar is strong, reducing the notional value of goods priced in other currencies. Commodity prices have plunged: that not only reduces the value of the raw materials shipped around the world, but also helps hold down input costs, and thus the price, of all manner of manufactured goods. In volume terms, trade is still growing—by 1.7% year-on-year in the first half of 2015 (see chart 1). But that is far below the long-term average, of around 5% a year. In emerging markets, volume growth was weaker still, at 0.3% year on year.

In the early 1990s trade grew slightly faster than world GDP. But later in that decade, China and the former Soviet Union began to integrate into the global economy, the World Trade Organisation (WTO) was founded to bolster exchange, and technological change started making it easier to manage long, dispersed supply chains. As a result, trade grew twice as fast as the world economy in 2003-06. Since then, however, it has been slowing. For the past two years world GDP has grown more quickly than trade. The slowdown is all the more remarkable given that declining transport costs thanks to cheap oil should be boosting international commerce.

The problem is partly cyclical. Europe, which accounts for around a quarter of global output but one-third of world trade, is enduring “an extremely long cyclical downturn”, according to Paul Veenendaal of the Netherlands Bureau for Economic Policy Analysis. Its GDP growth was 0.8% in 2012-14, compared with 3.5% in 2005-07.

At the same time, falling demand for raw materials in China is harming the economies of many commodity exporters. These countries are also final markets for many Chinese exports, creating something of a vicious cycle.

One-off events have also contributed. In early 2015 trade with America was hit both by a strike at ports on the west coast, which absorb 50% of imports, and unseasonably cold weather, which put off shoppers. These disruptions to supply and demand saw imports fall by 3.4% in the first quarter of the year compared with the previous one. A study by Emine Boz, Matthieu Bussière and Clément Marsilli at the Centre for Economic Policy Research estimated that such passing factors were responsible for around half of the slowdown in trade in rich economies in 2012-14.

Yet structural factors play a part, too. A recent IMF working paper argues that trade elasticity—the amount of trade generated as incomes rise—has fallen significantly in both China and America. China is making more at home: the share of imported components in exports has fallen from 60% in the 1990s to 35% this decade (see chart 2). America, meanwhile, has begun to exploit its huge domestic reserves of shale oil; imports of crude fell by 1.9m barrels a day between 2010 and 2014. At an average price of $93 a barrel, that represents savings of $60 billion, or the equivalent of 25% of what America did spend on crude oil in 2014, according to its Energy Information Agency.

The slowing pace of trade liberalisation is another drag. In 2010-14, 109 new trade deals came into force, down from 128 in the previous five years, according to the WTO. The biggest deal currently under negotiation, the 12-country Trans-Pacific Partnership (TPP), seems to have run aground. Negotiating new pacts is becoming harder as average tariffs have fallen; deals now hinge on much thornier subjects such as labour standards and protection of intellectual property.

It would have been naive to imagine that the remarkable confluence of trade-boosting circumstances of the early 2000s would last forever. The falling dollar value of world trade is not necessarily a terrible thing. Cheaper products help consumers to buy more goods. By the same token, the slump in volumes is not a disaster for the world economy if it reflects growing domestic output in America and China.

But many economies will suffer. Commodity exporters in the rich world, such as Australia and Canada, are relatively diversified. Their falling currencies will boost tourism and exports of manufactured goods, among other industries. Of greater concern are the many economies without much manufacturing. Rapid trade growth in the 1990s and 2000s led to a golden age of convergence between incomes in emerging economies and the rich world, as poor countries joined global supply chains. Yet many have barely begun the process of industrialisation: average income in sub-Saharan Africa is about one-quarter of that in China. Weaker trade growth and shorter, leaner supply chains mean the ladder Chinese workers climbed is being pulled up behind them.

If the world is unlikely to repeat the trade boom of the 2000s, there are nonetheless ways to prevent trade from stagnating. Rich countries should push ahead with the trade deals they have begun, and ratify the ones they have already negotiated. The deal on trade facilitation the WTO reached in 2013, which aims to reduce the cost of trade in poor countries in particular, requires ratification by two-thirds of the organisation’s 161 members to come into force. So far, just 16 have signed on. Efforts to pass TPP have been undermined by electoral politics. Barack Obama, having won “trade promotion authority” (the power to submit trade deals for an up-or-down vote in Congress) should strive to finish TPP, lest the political capital already spent on the deal go to waste. TPP is especially worthwhile as it lowers barriers to agricultural imports and services, which will be of critical importance to developing economies that can no longer count on manufacturing to carry them to greater wealth.

Reforms within emerging economies, to liberalise agriculture and prepare workers for jobs in the service sector, will also be necessary. But as leaders from Indonesia to Brazil are discovering, the slump after the boom is not the easiest moment to take hard decisions.

The Fed Gives Growth a Chance