Anti-Trade America?

Kenneth Rogoff

tech factory


CAMBRIDGE – The rise of anti-trade populism in the 2016 US election campaign portends a dangerous retreat from the United States’ role in world affairs. In the name of reducing US inequality, presidential candidates in both parties would stymie the aspirations of hundreds of millions of desperately poor people in the developing world to join the middle class. If the political appeal of anti-trade policies proves durable, it will mark a historic turning point in global economic affairs, one that bodes ill for the future of American leadership.
 
Republican presidential candidate Donald Trump has proposed slapping a 45% tax on Chinese imports into the US, a plan that appeals to many Americans who believe that China is getting rich from unfair trade practices. But, for all its extraordinary success in recent decades, China remains a developing country where a significant share of the population live at a level of poverty that would be unimaginable by Western standards.
 
Consider China’s new five-year plan, which aims to lift 55 million people above the poverty line by 2020, a threshold defined as just CN¥2,300, or $354, per year. This compares with a poverty line of around $12,000 for a single person in the US. Yes, there are significant cost-of-living differences that make direct comparisons dubious, and, yes, poverty is as much a social condition as an economic one, at least in advanced economies; but the general point that inequality between countries swamps inequality within countries is a very powerful one.
 
And China’s poverty problem is hardly the world’s worst. India and Africa both have populations roughly comparable to China’s 1.4 billion people, with significantly smaller shares having reached the middle class.
 
Democratic presidential candidate Bernie Sanders is a far more appealing individual than “The Donald,” but his anti-trade rhetoric is almost as dangerous. Following prominent left-leaning economists, Sanders rails against the proposed new Trans-Pacific Partnership (TPP), even though it would do much to help the developing world – for example, by opening up Japan’s market to Latin American imports.
 
Sanders even hammers his opponent Hillary Clinton for her support of earlier trade deals such as the 1992 North America Free Trade Agreement (NAFTA). Yet that agreement forced Mexico to lower its tariffs on US goods far more than it forced the US to reduce its already low tariffs on Mexican goods. Unfortunately, the resounding success of Sanders’s and Trump’s anti-trade rhetoric has pulled Clinton away from her more centrist position, and might have the same effect on many members of the House and Senate. This is a recipe for disaster.
 
The TPP does have its flaws, particularly in its overshoot on protection of intellectual property rights. But the idea that the deal will be a huge job killer for the US is highly debatable, and something does need to be done to make it easier to sell high-tech goods to the developing world, including China, without fear that such goods will be instantly cloned. A failure to ratify the TPP would almost certainly condemn tens of millions of people in the developing world to continued poverty.
 
The right remedy to reduce inequality within the US is not to walk away from free trade, but to introduce a better tax system, one that is simpler and more progressive. Ideally, there would be a shift from income taxation to a progressive consumption tax (the simplest example being a flat tax with a very high exemption). The US also desperately needs deep structural reform of its education system, clearing obstacles to introducing technology and competition.
 
Indeed, new technologies offer the prospect of making it far easier to retrain and retool workers of all ages. Those who advocate redistribution by running larger government budget deficits are being short sighted. Given adverse demographics in the advanced world, slowing productivity, and rising pension obligations, it is very hard to know what the endgame of soaring debt would be.
 
Do pro-deficit progressives realize that the burden of any future debt crises (or financial-repression measures) are likely to fall disproportionately on poor and middle-income citizens, as they have in the past? Simple redistribution of income through taxes and transfers is far more direct and more potent, and would certainly serve to expand aggregate demand.
 
Anyone who portrays the US as a huge loser from the global economic status quo needs to gain some perspective on the matter. I have little doubt that a century from now, Americans’ consumption-centric lifestyle will no longer be viewed as something to envy and emulate, and the country’s failure to implement a carbon tax will be viewed as a massive failure. With under 5% of the world’s population, the US accounts for a vastly disproportionate share of carbon-dioxide emissions and other pollution, with much of the blame falling on America’s middle class.
 
But the idea that trade fuels inequality is a very parochial perspective, and protectionists who shroud themselves in a moralistic inequality narrative are deeply hypocritical. As far as trade is concerned, the current US presidential campaign is an embarrassment of substance, not just of personality.
 
 
 


J.P. Morgan: We’re Too Big Not to Succeed

In its 2016 proxy, bank also sheds light on Chief Executive Dimon’s $27 million pay package for 2015

By Emily Glazer


J.P. Morgan Chase & Co. says it is huge, but only in the best way, and just sprawling enough to serve its clients without being unmanageable.

J.P. Morgan Chase & Co. has continued to face more forceful questions from analysts, investors and shareholders in the past year. It responded in its 2016 proxy statement Thursday morning.

J.P. Morgan Chase & Co. has continued to face more forceful questions from analysts, investors and shareholders in the past year. It responded in its 2016 proxy statement Thursday morning. Photo: Bloomberg News
 

Those were among the takeaways as the country’s biggest bank by assets again argued that its size is a benefit and not a problem that should worry shareholders or regulators.

In a proxy released Thursday morning, J.P. Morgan pushed back against a shareholder proposal for a bank breakup, pointing to its business synergies, benefits of scale and value to clients.

The bank also said it has slimmed down even more in the last year, reducing assets by about $200 billion, dropping its regulatory capital surcharge by 1 percentage point and nearly wrapping up an effort to simplify its business.

Less than 24 hours earlier, however, Chairman and Chief Executive James Dimon’s annual shareholder letter touted the virtues of the bank’s size and ability to absorb losses—for the entire industry in certain cases.

J.P. Morgan “alone has enough loss absorbing resources to bear all the losses, assumed by [a stress test issued by the Federal Reserve], of the 31 largest banks in the United States,” Mr. Dimon wrote in his 50-page letter. He added that large U.S. banks are “far stronger” because of regulations and higher capital requirements.

Yet J.P. Morgan has continued to face more forceful questions from analysts, investors and shareholders during the past year over whether it might be better for shareholders if the global bank broke itself up into smaller, more manageable units. The issue of whether banks should be broken up is also a consistent topic on the presidential campaign trail.

The bank said in its proxy that the board reviewed a breakup analysis with management that was presented throughout its February 2015 investor day. It “concurred in the conclusion that continuing our strategy and delivering on our commitments is the highest-certainty path to enhancing long-term shareholder value.”

That presentation also referenced $18 billion in pretax synergies, and the bank added Thursday that each of its businesses benefits from its $9 billion in annual technology spending, which includes more than $600 million the bank expects to spend this year on cybersecurity.

The shareholder vote was requested by Bartlett Naylor, a shareholder activist and a financial policy advocate at the liberal lobbying group Public Citizen. He and others have raised the issue multiple times in previous years with other big banks as well, without getting much traction.

Mr. Naylor proposed that J.P. Morgan as well as Citigroup Inc. each create an independent board committee to address whether the bank would be more valuable to shareholders by divesting all noncore banking business segments. The committee would be required to report back to shareholders within 300 days.

The bank said that wouldn’t be necessary or valuable to shareholders, breaking down details of shareholder communications that already include strategy discussions. For instance, J.P. Morgan hosted more than 90 shareholder calls and meetings on topics including strategy, participated in more than 50 investor meetings, presented at 13 investor conferences and conducted 10 investor trips in the U.S., Europe and Asia.

“The Board and management do not favor size for its own sake or support or oppose any strategy on ideological grounds, but instead analyze strategy from the perspective of serving the Firm’s clients, customers and communities and how we believe any particular strategic initiative will affect long-term shareholder value,” according to the proxy.

The proxy also shed light on Mr. Dimon’s $27 million pay package for 2015, the highest among large U.S. bank CEOs.

J.P. Morgan’s board said Mr. Dimon deserved the $7 million boost from the prior year, or 35%, because of strong multiyear results, business simplification efforts and strengthened “control” environment, among other factors, according to the proxy statement.

“Mr. Dimon has led a multiyear effort to fortify our controls, which includes addressing issues that resulted in supervisory and enforcement actions,” according to the proxy.

Mr. Dimon’s pay package comprises $20.5 million in performance-related restricted stock and $5 million in cash, along with his base salary of $1.5 million, according to a January filing.

This is the first year Mr. Dimon is being paid in performance share units, a type of restricted stock that has requirements on how long it must be held and has the possibility of being worth nothing based on the performances of Mr. Dimon and the bank.

The new features are designed to respond to a shareholder proposal last year that nearly garnered a majority in voting against Mr. Dimon’s pay package.

The bank also disclosed that the board updated its policy on director age in 2015, beyond the previous 72-year-old retirement rule. J.P. Morgan’s board has two key directors who passed the threshold: lead independent director Lee Raymond, 77, and audit committee chair Laban Jackson, 73, who is a liaison to regulators across the world. They both offered not to stand for re-election this year, according to the proxy.

“The Board believes that, while refreshment is an important consideration in assessing Board composition, the best interests of the Firm are served by being able to take advantage of all available talent and the Board should not make determinations with regard to membership based solely on age,” according to the proxy.

The bank disclosed that the board in January amended its bylaws by adding for a right of proxy access, allowing “eligible shareholders to include their nominees for election as directors,” according to the proxy.

It was adopted following “extensive discussions with shareholders and reflects their expressed desire to have additional access to the director nomination process.” The terms include allowing a shareholder to nominate up to 20% of the board, at least two directors in any event, and allows up to 20 shareholders to group together to reach the required threshold.

The bank also said that it would hold its annual shareholder meeting in New Orleans on May 17.


The Fed Can't Save Us

by: Mises Institute

By Robert P. Murphy
[This article first appeared in the March-April issue of The Austrian.]
 
 
In December, the Fed hiked its target for the Federal Funds rate, which is the interest rate banks charge each other for overnight loans of reserves. Since 2008, the Fed's target for the Fed Funds rate had been a range of 0-0.25 percent (or what is referred to as 0-25 "basis points"). But last month, they moved that target range up to 0.25-0.50 percent, ending a seven-year period of effectively zero percent interest rates.
 
From our vantage point, we already see carnage in the financial markets, with the worst opening week in US history. This, of course, lines up neatly with standard Austrian business cycle theory, which says that the central bank can give an appearance of prosperity for a while with cheap credit, but that this only sets the economy up for a crash once rates begin rising.
 
However, there is something new in the present cycle. The Fed is trying to raise rates, while simultaneously maintaining its bloated balance sheet. It is attempting to pull off a magic trick whereby it can keep all of the "benefits" of its earlier rounds of monetary expansion (i.e., "quantitative easing" or "QE"), while removing the artificial stimulus of ultra-low interest rates. As we'll see, this attempt will not end well for the Fed officials or for the rest of us. In the meantime, Ben Bernanke will look on with concern, writing the occasional blog post and perhaps giving a speech about poor Janet Yellen's tough predicament.
 
Austrian Business Cycle Theory
 
One of the seminal contributions of Ludwig von Mises was what he called the circulation credit theory of the trade cycle. In our times, we simply call it Austrian business cycle theory, sometimes abbreviated as ABCT. The Misesian theory was subsequently elaborated by Friedrich Hayek, and it was partly for this work that Hayek won the Nobel Prize in 1974.
 
In the Mises/Hayek view, interest rates are market prices that perform a definite social function. They communicate vital information about consumer preferences regarding the timing of consumption. Entrepreneurs must decide which projects to start, and they can be of varying length. Intuitively, a high interest rate is a signal that consumers are "impatient," meaning that entrepreneurs should not tie resources up in long projects unless there are large gains to be had in output from the delay. On the other hand, a low interest rate reduces the penalty on longer investments, and thus, acts as a green light to tie capital up in lengthy projects.

So long as the interest rate is set by genuine market forces, it gives the correct guidance to entrepreneurs. If consumers are willing to defer immediate gratification, they save large amounts of their income, and this pushes down interest rates. The high savings frees up real resources from current consumption - things like restaurants and movie theaters - and allows more factories and oil wells to be developed.
 
However, if the interest rate drops not because of genuine saving, but instead, because the central bank electronically buys assets with money created "out of thin air," then entrepreneurs are given a false signal. They go ahead and take out loans at the artificially cheap rate, but now, society embarks on an unsustainable trajectory. It is physically impossible for all of the entrepreneurs to complete the long-term projects they begin.
 
In the beginning, the unsustainable expansion appears prosperous. Every industry is growing, trying to bid away workers and other resources from each other. Wages and commodity prices shoot up; unemployment and spare capacity drop. The economy is humming, and the citizens are happy.
 
Yet, it all must come crashing down. In a typical cycle, price inflation eventually rises to the level that the banks become nervous. They halt their credit expansion, allowing interest rates to start rising to a more correct level. The tightening in the credit markets causes pain initially for the most leveraged operations, but gradually, more and more businesses are in trouble. A wave of layoffs ensues, with large numbers of entrepreneurs suddenly realizing they were too ambitious. The painful "bust," or recession, sets in.
 
This Time Is Different (Sort of)
 
Since the financial crisis of 2008, the stock market's surges have coincided with rounds of QE, and the market has faltered whenever the expansion came to a temporary halt. The sharp sell-off in August 2015 occurred when investors thought the first rate hike was imminent (it had been scheduled for September 2015). That particular hike was postponed, but after it went into effect in December, we soon saw the market tank to the 2014 levels.

As we would expect in times of Fed tightening, the official monetary base has fallen sharply in recent months, but this doesn't mean the Fed is selling off assets (as it would in a textbook tightening cycle).
 
Indeed, the Fed's assets have been constant since the end of the so-called taper in late 2014.
 
This is unusual, since the monetary base and the Fed's total assets typically move in tandem.

Yet, since late 2014, there have been three major drops in the monetary base that occurred while the Fed was dutifully rolling over its holdings of mortgage-backed securities and Treasuries, keeping its total assets at a steady level.
 
The explanation is that the Fed has been testing out new techniques to temporarily suck reserves out of the banking system, while not reducing its total asset holdings.
 
Meanwhile, in December, it bumped up the interest rate that it pays to commercial banks for keeping their reserves parked at the Fed. I like to describe this policy as the Fed paying banks to not make loans to their customers.
 
What Does It All Mean?
 
So why is the Fed trying to tighten the money supply without selling off assets as it has done in the past? It boils down to this: In order to bail out the commercial and investment banks - at least the ones who were in good standing with DC officials - as well as greasing the wheels for the federal government to run trillion-dollar deficits, the Federal Reserve, in late 2008, began buying trillions of dollars worth of Treasury debt and mortgage-backed securities (MBS). This flooded the banking system with trillions of dollars of reserves, and went hand in hand with a collapse of short-term interest rates to basically zero percent.
 
Now, the Fed wants to begin raising rates (albeit modestly), but it doesn't want to sell off its Treasury or MBS holdings for fear that this would cause a spike in Uncle Sam's borrowing costs and/or crash the housing sector. So, it has increased the amount it is paying commercial banks to keep their reserves with the Fed (rather than lending them out to customers), and - for those institutions that are not legally eligible for such a policy - the Fed is effectively paying to borrow the reserves itself. By adjusting the interest rate it pays on such transactions, the Fed can move the floor on all interest rates up. No institution would lend to a private sector party at less than it can get from the Fed, since it can create dollars at will and is thus the safest place to park or lend reserves.

We thus have the worst of both worlds. We still get the economic effects of "tighter monetary policy," because the price of credit is rising as it would in a normal Fed tightening. Yet, we don't get the benefit of a smaller Fed footprint and a return of assets to the private sector.
 
Instead, the US taxpayer is ultimately paying subsidies to lending institutions to induce them to charge more for loans, while the big banks and Treasury still benefit from the effective bailout they've been getting for years.
 
It Can't Last
 
Will the Fed be able to keep the game going? In a word, "No." We've already seen that even the tiniest of interest rate hikes has gone hand in hand with a huge drop in the markets.
 
Furthermore, the Fed's subsidies to the banks are now on the order of $11 billion annually, but if they want to raise the Fed Funds rate to, say, 2 percent, then the annual payment would swell to more than $40 billion. That is "real money" - in the sense that the Fed's excess earnings would otherwise be remitted to the Treasury. Therefore, for a given level of federal spending and tax receipts, increased payments to the bankers implies an increased federal budget deficit.
 
Janet Yellen and her colleagues are stuck with a giant asset bubble that her predecessor inflated. If they begin another round of asset purchases, they might postpone the crash, but only by making the subsequent reckoning that much more painful.
 
You don't make the country richer by printing money out of thin air, especially when you then give it to the government and Wall Street. The Fed's magic trick of raising interest rates without selling assets can't evade that basic reality.


TIPS and Gold -- Cousins, Not Brothers

By: Michael Ashton


A longtime reader (and friend) today forwarded me a chart from a well-known technical analyst showing the recent correlation between TIPS (via the TIP ETF) and gold; the analyst also argued that the rising gold price may be boosting TIPS. I've replicated the chart he showed, more or less (source: Bloomberg).

TIPS and Commodity Index


Ordinarily, I would cite the analyst directly, but in this case since I'm essentially calling him out I thought it might be rude to do so! His mistake is a pretty common one, after all. And, in fact, I am going to use it to illustrate an important point about TIPS.

The chart shows a great correlation between TIPS and gold, especially since the beginning of the year. But here's the problem with drawing the conclusion that rising inflation fears are boosting TIPS - TIPS are not exposed to inflation.

Bear with me, because this is a key point about TIPS that is widely misunderstood. Recall that nominal interest rates represent two things: first, an amount that represents the return, in real terms, that the lender needs to realize in order to defer consumption and instead lend to the borrower. This is called the real interest rate. The second component of the nominal interest rate represents the compensation the lender demands for the fact that he will be paid back in dollars that (in normal times) will be able to buy less. This is the inflation compensation.[1] Irving Fisher said that nominal interest rates are approximately equal to the sum of these two components, or

n ≈ r + i

where n is the nominal interest rate, r is the real interest rate, and i is the inflation compensation.[2]

In a world without TIPS, you can only trade nominal bonds, which means you can only access the whole package and nominal interest rates may change when real rates change, expected inflation changes, or both change. (And when interest rates are negative, this leads to weird theoretical implications - see my recent and fun post on the topic.) Thus changes in real interest rates and changes in expected inflation affect nominal bonds, and roughly equally at that.

But once you introduce TIPS, then you can now separate out the pieces. By buying TIPS, you can isolate the real interest rate; and by trading a long/short package of TIPS and nominal bonds (or by trading an inflation swap) you can isolate the inflation expectations. This is a huge advance in interest rate management, because an investor is no longer constrained to own a fixed-income portfolio where his exposure to changes in real rates happens to be equal to his exposure to changes in inflation expectations. Siegel and Waring made this argument in a famous paper called TIPS, the Dual Duration, and the Pension Plan in 2004,[3] although it should be noted that inflation derivatives books were already being managed using this insight by then.

Which leads me in a roundabout way to the point I originally wanted to make: if you own TIPS, then you have no exposure to changes in inflation expectations except inasmuch as there is a (very unstable) correlation between real rates and expected inflation. If inflation expectations change, TIPS will not move unless real rates change.[4]

So, if gold prices are rising and TIPS prices are rising, it isn't because inflation expectations are rising. In fact, if inflation expectations are rising it is more likely that real yields would also be rising, since those two variables tend to be positively correlated. In fact, real yields have been falling, which is why TIP is rising. The first chart in this article, then, shows a correlation between rising inflation expectations (in gold) and declining real interest rates, which is certainly interesting but not what the author thought he was arguing. It's interesting because it's unusual and represents a recovery of TIPS from very, very cheap levels compared to nominal bonds, as I pointed out in January in a piece entitled (argumentatively) "No Strategic Reason to Own Nominal Bonds Now."

Actually (and the gold bugs will kill me), gold has really outstripped where we would expect it to go, given where inflation expectations have gone. The chart below (source: Bloomberg) shows the front gold contract again, but this time instead of TIP I have shown it against 10-year breakevens.

TIPS and Commodity Index Chart 2>

No, I don't hate gold, or apple pie, or America. Actually, I think the point of the chart is different. I think gold is closer to "right" here, and breakevens still have quite far to go - eventually. The next 50bps will be harder, though!


 
[1] I abstract here from the third component that some believe exists systematically, and that is a premium for the uncertainty of inflation. I have never really understood why the lender needed to be compensated for this but the borrower did not; uncertainty of the real value of the repayment is bad for both borrower and lender. I believe this is an error, and interestingly it's always been very hard for researchers to prove this value is always present and positive.
 
[2] It's technically (1+n)=(1+r)(1+i), but for normal levels of these variables the difference is minute. It matters for risk management, however, of large portfolios.
 
[3] I expanded this in a much less-famous paper called TIPS, the Triple Duration, and the OPEB Liability: Hedging Medical Care Inflation in OPEB Plans in 2011.
 
[4] What the heck, one more footnote. I had a conversation once with the Assistant Treasury Secretary for Financial Markets, who was a bit TIPS booster. I told him that TIPS would never truly have the success they deserve unless the Treasury starts calling 'regular' bonds "Treasury Inflation-Exposed Securities," which after all gets to the heart of the matter. He was not particularly amused.