Post-Real Economics

By John Mauldin

“Too large a proportion of recent ‘mathematical’ economics are mere concoctions, as imprecise as the initial assumptions they rest on, which allow the author to lose sight of the complexities and interdependencies of the real world in a maze of pretentious and unhelpful symbols.” 

John Maynard Keynes

“Simplicity does not precede complexity, but follows it.”

– Alan Perlis

“Stop trying to change reality by attempting to eliminate complexity.”

– David Whyte

One of the most important concepts that my economic, philosophical, and political mentors have drilled into my head is this simple statement: Ideas have consequences. As a corollary to that, bad ideas have bad consequences. Mauldin’s corollary is that bad ideas can often overwhelm good ideas when applied by government bureaucrats, and that long after the market has rejected bad ideas, they may live on in academia and government bureaucracies.

Let me offer a somewhat controversial statement: Economics in general is populated at its core by a lot of bad ideas. And these bad ideas have come to be accepted as the correct interpretation of how the economy functions and thus have become the basis for economic policy.

Thus it should come as no surprise that, like so many other hidebound institutions these days, the economics profession is experiencing a crisis of confidence. Theories advanced by some of its supposedly most talented members have proven time and again to be wrong when applied to the real world. But rather than rejecting their theories, most of the economic establishment continues to tinker around the edges.

This is not the first time that such a crisis has occurred in economics. We have seen economists espouse mercantilism, Malthusianism (a particularly pernicious branch of economics), Marxism and communism, socialism and its twin brother fascism, Austrian economics, capitalism, the gold standard and its cousin bimetallism, monetarism, protectionism, and a whole list of corollary theories like rational expectations, the efficient market hypothesis, and dynamic stochastic general equilibrium. Add to these the growing popularity of New Monetary Theory and variations on it. This list is by no means exhaustive, but just reading it is somewhat exhausting. Some of these theoretical bulwarks have already been dismantled, but others still clutter the halls of academia and policymaking.

I have been quite scathing in my treatment of economists who rely on models that are consistently wrong. I’ve been critical of Keynesianism and the worlds of rational expectations and the efficient market hypothesis, but I have not actually offered an alternative view other than to generally espouse a more Hayekian approach, with more than a casual nod to Adam Smith and the French economist Bastiat, along with the rest of the classicists. But this eclectic mixture is not really an economic basis for policy-setting in the future. My lack of specificity can pretty much be explained by my ongoing search for a better approach.

This week’s letter is going to be an examination of academic economics today and why it fails to explain reality, and I’ll point readers in a direction that can offer a more fruitful explanation of how the economy really works. I readily accept that I will be drummed out of most economists’ Lamb’s Book of Life for espousing too many heresies of the first order. I should hasten to say that much economic research is quite useful and does help to explain how the world works. It is just certain specific branches of economics that have been problematic, but these are the branches that have most influenced government and Federal Reserve policy.

Economics in general has a problem. It wants to be seen as a true science, on the level of physics or biology or chemistry, rather than one of the soft sciences like sociology or history. At various times, economics has been called “political economy” or “philosophical economy.” Political economy was, in the words of Adam Smith, “an inquiry into the nature and causes of the wealth of nations,” and in particular “a branch of the science of a statesman or legislator [with the twofold objectives of providing] a plentiful revenue or subsistence for the people… and to supply the state or Commonwealth with a revenue sufficient for the publick services.”

That is still a pretty good definition of what economics should be. What many in the profession have attempted to do, however, is to make economics a branch of mathematics.

True science has rules you can’t break. The law of gravity makes for very specific physical behavior that can be mathematically modeled. Economists want us to believe that their own theories and models of reality are similarly reliable. Utilize them faithfully and they will lead us to economic bliss: a state of Equilibrium where all factors exist in Blessed Balance. And the really wonderful thing about this notion is that if the system you are describing is said to be in balance, you have some chance of describing it mathematically. And that allows your philosophical economic science, which can discuss only possibilities about how the world works (as the lowly sociologists and psychologists do), to be elevated above the mere social sciences.

By the way, this is not a slam aimed at the so-called “soft sciences.” There is an enormous amount of solid research that is being done to help us understand the intricacies of the human mind and society. That it is not mathematical makes it no less useful. And that is pretty much my view of economics. Economics is an enormously useful tool for those of us who are trying to understand business and investments and government policy. But to paraphrase Dirty Harry, “An economist has to know his limitations.”

The whole concept of an economy’s being in equilibrium is simply academic nonsense. Equilibrium is a chimera that exists only inside assumption-ridden equations. The real world is a complex, dynamic, out-of-balance mess that doesn’t fit inside anyone’s box. Those theories and equations only work when you assume away the real world. So is it any wonder that the models don’t give us results that look like the real world?

Economists and Madmen

One of my favorite Keynes quotes (and there are lots of them) is:

Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. 

The problem in economics is that not only economists but politicians and people in general take economic models and the academics who create them seriously. After all, the people offering these dictums are the best and brightest among us. They give each other degrees and go to conferences where they confirm their brilliance. Sadly, they are often what Nassim Taleb describes as “intellectuals yet idiots.” Seriously, how do you argue with a PhD economist, especially when he has a Nobel prize to back up his pronouncements? He looks down on you as a naïve child who doesn’t have the understanding of a mature adult.

How can the very people who claim to understand how the economy works be so bad at predicting and managing it? The quick answer is that the real economy is far more complicated than they’re willing to admit. I can imagine this is hard medicine to swallow when you have spent years trying to simulate an almost infinitely complex system with computer models that are necessarily limited as to inputs, variables, and algorithmic sophistication. But if your model tells you very little about reality, what good is it?

Fortunately, some economists recognize these limitations and are looking for better ways to understand the economy. Unfortunately, that group is vastly outnumbered by old-school economists in government, central banks, international institutions, corporations, and universities. They are everywhere, and they have the ear of those who make important decisions that affect all of us.

The Fatal Assumption

As much as I like to quote John Maynard Keynes (he does have the best quotes in economics), I find his basic thesis to be the fundamental flaw in current macroeconomic thinking. Quoting from Wikipedia,

In the 1930s, Keynes spearheaded a revolution in economic thinking, challenging the ideas of neoclassical economics that held that free markets would, in the short-to-medium term, automatically provide full employment, as long as workers were flexible in their wage demands. He instead argued that aggregate demand determined the overall level of economic activity and that inadequate aggregate demand could lead to prolonged periods of high unemployment. According to Keynesian economics, state intervention was necessary to moderate “boom and bust” cycles of economic activity. Keynes advocated the use of fiscal and monetary policies to mitigate the adverse effects of economic recessions and depressions.

And there you have it. The fatal assumption is that aggregate demand is the most important factor in economics, and that if aggregate demand isn’t sufficient, then it is up to the government to run deficits to stimulate that demand. This of course made all proponents of government intervention happy, and they latched onto Keynes’s theory with relish. The theory has since morphed into all sorts of interventionist neo-Keynesian nonsense.

Essentially, Keynesians of all stripes see the recovery that followed a recession as the result of the deficit spending enacted to rescue the economy. Look, they say, it has happened every time. They fail to recognize that the activities of individual businessmen and women, plus the self-interested acts of millions of individuals, were the true driving force behind the recovery. Thus they unwisely prescribe even greater deficit spending and more debt to counter recessions but routinely fail to adhere to Keynes’s dictum that during good times that debt is to be paid down. They refuse to recognize the obvious connection between distorted debt levels and the lack of growth in an economy – a connection that has been demonstrated time and time again all over the world. (Yes, bad policy can inhibit growth, but at some point debt becomes an inhibitor in and of itself. Please remember that this is a letter and not a book, so I can’t go into the detail many o f you would like to have.)

The point – as we will confirm in a moment when we reconsider classical economics – is that it is income that is the driver for the economy.

Once Keynesianism began to hold sway in government circles, Franklin Roosevelt, in an obvious political move, chose to include the activities of government in the models they were using to estimate gross domestic product (GDP). Government spending does influence an economy, but it is largely an accounting fiction. We take money from taxpayers and give it to other people. Often the money is actually put to quite good uses, like building roads and paying for police services, education, and so on. Infrastructure improvements can, over the long term, increase the productivity of the economy, but spending on them does not necessarily add to productivity. The same goes for entitlement payments (Social Security and the like) and other transfer payments from one segment of the (hopefully) tax-paying population to another. While these may be fair and useful, they do not increase productivity in any direct sense.

I understand that this is a contentious argument. The great majority of economists have been trained to see consumption and government spending as principal drivers of the economy. I see these two as secondary, and productive behavior in the private economy as the primary driver. Government serves a very necessary societal function. I am not arguing for a particular size of government here, but rather arguing what the basis of government policy-making should be. And it should not be consumption, aided and abetted by government spending.

Model Behavior

Then we come to the concept of general equilibrium. Pretty much every economist accepts some variant of the concept of general equilibrium. I have come to the point where I completely reject the notion: it’s utterly false. There is no general equilibrium of any kind.

Scientists thrive in a laboratory setting. They establish controlled conditions and then test their variables, observing how each affects the outcome of the experiment. This works well if you are studying chemistry or physics. Whether it also can work if you’re trying to determine the state of the economy, much less forecast it, is far from clear – but that hasn’t stopped economists from trying.

Today’s most popular macroeconomic models come in a flavor called “Dynamic Stochastic General Equilibrium.” The cool kids call them “DSGE” models. They are dynamic because they show economic changes over time, and stochastic because unexpected shocks to any of the inputs can drastically change the outputs.

Central banks are the most enthusiastic DSGE model users. If you believe their policies have worked well in recent years, then you may be a DSGE believer. I am not. I think a main reason DSGE models fail is that they assume everyone is similarly informed and always makes rational decisions. Neither of those things is true in the real world. Actually, central bankers think they are so much better informed than the rest of us that they can decide the direction of the economy for us. And they think their decisions are rational – never mind that, time after time, the outputs of their models fail to predict what actually happens.

As I said, there is growing discontent in the economics community. Listen to Robert Solow, winner of the 1987 Nobel Prize in Economics (who contributed enormously to our understanding of growth and the importance of technology on growth). Three of his doctoral students are also Nobel laureates. I don’t agree with Solow on everything, but he is not at all a fringe figure. Here’s what he said (at the age of 85!) about DSGE models (under oath, no less) in 2010 House committee testimony.

I do not think that the currently popular DSGE models pass the smell test. They take it for granted that the whole economy can be thought about as if it were a single, consistent person or dynasty carrying out a rationally designed, long-term plan, occasionally disturbed by unexpected shocks, but adapting to them in a rational, consistent way.... The protagonists of this idea make a claim to respectability by asserting that it is founded on what we know about microeconomic behavior, but I think that this claim is generally phony. The advocates no doubt believe what they say, but they seem to have stopped sniffing or to have lost their sense of smell altogether.

Ouch. That’s a harsh condemnation, but Solow doesn’t let up. He offers an example:

An obvious example is that the DSGE story has no real room for unemployment of the kind we see most of the time, and especially now: unemployment that is pure waste. There are competent workers, willing to work at the prevailing wage or even a bit less, but the potential job is stymied by a market failure. The economy is unable to organize a win-win situation that is apparently there for the taking. This sort of outcome is incompatible with the notion that the economy is in rational pursuit of an intelligible goal. The only way that DSGE and related models can cope with unemployment is to make it somehow voluntary, a choice of current leisure or a desire to retain some kind of flexibility for the future or something like that. But this is exactly the sort of explanation that does not pass the smell test.

What Solow is getting at in his testimony above is the idea of “equilibrium.” That’s the end state of DSGE models. The economy attains a kind of balance where all the variables are happy with each and stay that way until something comes along to change them.

In fact, this sort of equilibrium never exists in the real world because the real world never stops changing. Thus neither we nor our estimable central bankers should be surprised when DSGE models don’t deliver much useful information.

Post-Real Economics

The concerns I am expressing aren’t new to macro-oriented economists. They’ve been arguing them for years, without the public’s noticing or caring. To the extent that non-economists have heard anything of this argument at all, most have probably dismissed it as more incomprehensible ivory-tower babble.

The dismissals have morphed to criticism over the last year or two as the global economy has stubbornly refused to recover from the Great Recession at anywhere near the rate of past post-recession growth cycles. Economics has come under fire along with other “establishment” institutions that are perceived as uncaring and out of touch. The criticism grew more intense – and more effective in the past year as Brexit and then the Trump victory proved that the masses are real people and not just faceless numbers dwelling inside someone’s model.

To my point, while I was putting the finishing touches on another rant on this very subject last September (see “Negative Rates Nail Savers,” in which I argue that low and negative rates are a drag on the economy, not a boost as the models assume), contrarian NYU economist (and now World Bank chief economist) Paul Romer published what professors like to call a “seminal paper,” titled “The Trouble With Macroeconomics.” It is only 26 pages and not too technical, so I urge everyone to read it. (Interestingly, Romer has also done further work on Solow’s growth theories, showing not only that technological progress is a primary driver for growth but also that this technological change is the result of intentional actions of people involved in research and developmen t.) Romer lights into his peers in colorful language not often encountered in the halls of academe. From his introduction…

For more than three decades, macroeconomics has gone backwards. The treatment of identification now is no more credible than in the early 1970s but escapes challenge because it is so much more opaque. Macroeconomic theorists dismiss mere facts by feigning an obtuse ignorance about such simple assertions as “tight monetary policy can cause a recession.” Their models attribute fluctuations in aggregate variables to imaginary causal forces that are not influenced by the action that any person takes.

Romer then makes a very interesting comparison between what he calls “post-real” economics and string theory, which is a branch of physics. Like macroeconomics, string theory deals with vast systems jam-packed with unknown variables and incomplete data. Here’s Romer (emphasis mine):

The conjecture suggested by the parallel is that developments in both string theory and post-real macroeconomics illustrate a general failure mode of a scientific field that relies on mathematical theory. The conditions for failure are present when a few talented researchers come to be respected for genuine contributions on the cutting edge of mathematical modeling. Admiration evolves into deference to these leaders. Deference leads to effort along the specific lines that the leaders recommend. Because guidance from authority can align the efforts of many researchers, conformity to the facts is no longer needed as a coordinating device. As a result, if facts disconfirm the officially sanctioned theoretical vision, they are subordinated. Eventually, evidence stops being relevant. Progress in the field is judged by the purity of its mathematical theories, as determined by the authorities.

Ouch. “Eventually, evidence stops being relevant” smells a lot like central bank and political decisions we have seen the last few years. We have seen our deciders act opposite the evidence on more than one occasion.

Physics is unquestionably a science. But is macroeconomics a science? I’ve never thought so. To me, it is intuitively obvious that no model can capture the impact of untold trillions of human decisions that add up to the complex, dynamic system that we call the economy. If you can’t form an economic hypothesis and then test it, then you may be doing valuable work; but your results are merely descriptive in nature and necessarily imprecise. The usefulness of your research may be observable in the real world, but it should not necessarily be taken as prescriptive.

Now, economics does have some sub-fields that are much closer to hard science. Behavioral economists study how individuals make decisions under certain conditions. They can design experiments, administer them to actual people, and observe results. This work can give us some useful insights. Macroeconomics, as currently practiced, not so much.

Information Theory and Complex Systems

I think that to have any hope of correctly analyzing the economy, we are going to have to continue trying to understand the complexity of natural systems – because that exactly what the economy is. The basis for creating policy should be to foster dynamic, growth-oriented complexity in the form of entrepreneurial activity. To understand that activity and promote it, we need to marry information theory with the new field of complexity economics.

(Next week I’ll be arguing that the current protectionist impulse is precisely the wrong way to go about creating jobs. As in 180° wrong. As in a job-destroying nightmare. At its root lies the same impulse that gives rise to centralized, command-and-control economies. If you want to create jobs, you make it easier to create new businesses, not harder. That is what all the data tells us. But that’s for next week. This is a good place to mention, though, that Matt Ridley has just been added to our roster of speakers for the upcoming Strategic Investment Conference…)

Free trade causes mutual prosperity while protectionism causes poverty... incredible that anybody ever thinks otherwise - Matt Ridley (just announced for the SIC!)

Let’s look at information theory first. It may have been best explained by my friend George Gilder in his must-read book Knowledge and Power.

Information theory, at its root, is about distinguishing signal from noise. A signal is broadcast into the air or goes down a telephone line or through a fiber-optic cable, and the challenge is to sort out the actual signal from the noise that accompanies it.

In the world of economics, an entrepreneur has to distinguish amidst the market noise a signal that a particular good or service is needed. But if some force – a government or a central banks, for instance – distorts or corrupts the transmission of the signal by adding noise to the system, the entrepreneur may have difficulty interpreting the signal and may potentially respond to the wrong message. (Of course, there are times when government has to step in and signal that certain types of behavior are not acceptable for the overall good of the society.)

“The economy is not chiefly an incentive system,” George asserts; “it is an information system.” And information, truly understood, is about the introduction of novelty, or “surprise,” into a system. In the case of the economy, it’s about invention and entrepreneurship. The new information that is injected gets converted into knowledge; and thus, says George, it is accumulated knowledge, rather than money or material, that constitutes true wealth. The economy is driven not so much by powerful people and institutions wielding the levers of the economic machine as it is by the ever-growing power of information and knowledge.

Economists and the governments they work for often appear to prefer a deterministic, no-surprises (and too-big-to-fail) economy, but that way lies economic stagnation. If determinism worked, socialism would have thrived. Knowledge is centrifugal: it’s dispersed in people’s heads, and that has never been more true than in the Age of the Internet. And it is this universal distribution of knowledge, which feeds back to the economy through the creative insights and entrepreneurial efforts of people worldwide, that constitutes our chief hope for economic growth in the era opening up before us, where the limits of monetary manipulation and material extraction are becoming painfully apparent.

Here is a telling sentence from George:

Whether fueled by debt or seized by taxation, government spending in economic “stimulus” packages necessarily substitutes state power for knowledge and thus destroys information and slows economic growth.

The writing is on the wall: Either we reinvent ourselves and our global economy, or the noise that is obviously building in the system will overwhelm the creation and transmission of knowledge, and the great human quest for the democratization of wealth will fail. But, as George says, “[C]apitalism is not a system of equilibrium; it is an engine of disruption and invention…. A capitalist economy can be transformed as rapidly as human minds and knowledge can change.” So we do have plenty of grounds for hope.

And then we have the newly emerging field called complexity economics, which is much better suited than Keynesianism to what we all want from macroeconomic research. It comes out of a broader complexity theory that encompasses many disciplines. The common thread is they all examine “complex systems.”

Your body, for instance, is a complex system. You have trillions of cells that specialize in certain tasks but also adapt to changing conditions. Your white blood cells perceive an infection, respond to it, and then stop responding when they detect it is gone. Other systems respond in various ways to support the defensive reaction. How do all these different kinds of cells know what to do, when to start doing it, and when to stop? That’s a complex system for you.

Economies are likewise complex. Millions of consumers and producers each have their own resources: capital, land, labor, knowledge, etc. They are constantly buying, selling, learning, creating, destroying, and otherwise modifying the system’s elements. It’s a giant mess, when you think about it, yet somehow order emerges from the chaos.

Or does it? What we perceive as order may be anything but, because conditions never stop changing even if we can’t readily detect the change. This reality points to a fundamental difference between classical and Keynesian economics and their equilibrium models and the new complexity economics. The latter recognizes that there can be no equilibrium in a constantly changing system. Complexity economics also recognizes that people don’t have perfect information and therefore don’t make perfect decisions.

Some of the best complexity research, in economics as well as other fields, comes out of the Santa Fe Institute. Rolling Stone magazine described SFI as “A sort of Justice League of renegade geeks, where teams of scientists from disparate fields study the Big Questions.” So you can imagine I feel considerable affinity with them. They do truly cutting-edge research that I have been exploring for several years, and I hope to do more.

Complexity economics doesn’t pretend to deliver the kinds of answers that DSGE models do, and that’s a good thing. The field recognizes its own limitations. Ironically, I think that humility is exactly what will lead to deeper understanding when central bankers and political policymakers finally learn to better consider the impacts of their decisions on the populations they supposedly serve.

Everything Old (in Economics) Is New Again

And while complexity mathematics and information theory may be relatively new, the general concepts contained in them were well known to previous generations of economists dating back to Adam Smith. Matt Ridley, who you met above, is one of my favorite economics writers. He authored the powerhouse books The Rational Optimist: How Prosperity Evolves and The Evolution of Everything.

I have literally scores of pages underlined in The Evolution of Everything and am especially enamored of Ridley’s chapter on the evolution of economics. Let me close with this selection of quotes from that chapter (emphasis mine):

This decentralised emergence of order and complexity is the essence of the evolutionary idea that Adam Smith crystallised in 1776. In his famous metaphor, Smith made the guiding hand invisible: each person ‘intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention’.

Yet when Smith wrote his Wealth of Nations, there was little good evidence for his central idea that free exchange of goods and services would produce general prosperity. Up until the late eighteenth century much wealth creation had been by plunder in one form or another, and  there was nothing remotely resembling a free-market government in power anywhere in the world.

As Deirdre McCloskey puts it, in the great enrichment of the past two hundred years average income in Britain went from about $3 a day to about $100 a day in real terms. That simply cannot be achieved by capital accumulation, which is why she (and I) refuse to use the misleading, Marxist word ‘capitalism’ for the free market. They are fundamentally different things.

Adam Smith is no paragon. He got plenty wrong, including his clumsy labour theory of value, and he missed David Ricardo’s insight about comparative advantage, which explains why even a country (or person) that is worse than its trading partner at making everything will still be asked to supply something, the thing it or he is least bad at making. But the core insight that he had, that most of what we see in society is (in Adam Ferguson’s words) the result of human action but not of human design, remains true to this day and under-appreciated. This is true of language, of morality and of the economy. The Smithian economy is a process of exchange and specialisation among ordinary people. It is an emergent phenomenon….

The really big thing that both Smith and Ricardo – and Robert Malthus and John Stuart Mill and all the other British political economists of the time – missed, however, was that they were living through the Industrial Revolution. They had no conception that they stood ‘at the threshold of the most spectacular economic developments ever witnessed’, as Joseph Schumpeter put it a century later: ‘Vast possibilities matured into realities before their very eyes. Nevertheless, they saw nothing but cramped economies struggling with ever-decreasing success for their daily bread.’

This was because their world view was dominated by the idea of diminishing returns. Ricardo, for example, watching local farmers struggle with bad harvests in the 1810s, agreed with his friend Malthus that corn yields must stagnate, because the best land was already in cultivation and every marginal acre brought under the plough would be worse than the one before. So Smith’s division of labour, and Ricardo’s comparative advantage, could improve the lot of people only up to a point. These were just a more efficient way of squeezing prosperity out of a limited system.

Even after living standards began to rocket upwards in Britain from the 1830s, Mill saw it as a flash in the pan. Diminishing returns would soon set in. In the 1930s and 1940s, John Maynard Keynes and Alvin Hansen saw the Great Depression as evidence that some limit of human prosperity had been reached. Demand for cars and electricity was satiated and returns on capital were falling, so the world faced a future of chronic unemployment, once the sugar rush of war spending faded.

The end of the Second World War would bring stagnation and misery. Again in the 1970s, and in the 2010s, there was widespread talk of sharing out the existing wealth of society rather than hoping living standards could go higher. Stagnationism has its fans in every generation.

Yet repeatedly the opposite happened. Far from diminishing, returns kept increasing thanks to mechanisation and the application of cheap energy. The productivity of a worker, rather than reaching a plateau, just kept on rising. The more steel was produced, the cheaper it got. The cheaper mobile phones grew, the more we used them. As Britain and then the world grew more populous, the more mouths there were to feed, the fewer people starved: famine is now largely unknown in a world of seven billion people, whereas it was a regular guest when there were two billion.

Even Ricardo’s wheat yields, from British fields that had been ploughed for millennia, began to accelerate upwards in the second half of the twentieth century thanks to fertilisers, pesticides and plant breeding. By the early twenty-first century, industrialisation had spread high living standards to almost every corner of the globe, in direct contradiction to the pessimistic fears of many that they would forever remain a Western privilege. China, a country mired in misery for centuries, and plunged into horror for decades, sprang to life and saw its billion people create the world’s largest market.

Even though contemporary economists pay lip service to the marvels of technological change, I think that, like the classical economists mentioned above who missed the fact that they were tumbling into the Industrial Revolution, current economists vastly underestimate the amount and variety of change that is going to occur in the next 20 years. That is the process I am writing about in my next book, The Age of Transformation. But it won’t be all sweetness and light. Creative destruction is going to happen very rapidly and forcefully, and the adjustments are going to be painful for many individuals and many countries.

Conservatives and free-market economists are going to have to completely rethink their concepts of what government should be and how society should be structured. It is not clear that we will be up to the task. That said, the next 20 years will be far and away the most exciting period of human history. You won’t want to miss it.

Florida, Dallas, and the Caymans

Briefly, as the letter is already long, I’ll be speaking at a one-afternoon conference hosted by S&P Down Jones at the Ritz-Carlton here in Dallas on February 1. I strongly encourage you to register for the free afternoon.

In conjunction with S&P Dow Jones Indices Forum that afternoon, if you are an RIA, I would like to invite you to a private luncheon immediately before the forum, where we will discuss a separate topic: “What Our New Administration May Mean for the Investment Landscape.” If you would like to be my guest at the luncheon, simply respond to and confirm you are registered, and we will make sure you get the information you need. Space is quite limited, so do email us back to secure your reservation.

I will then be at the Orlando Money Show February 8–11 at the Omni in Orlando. Registration is free. I am also scheduled to speak at a large alternative investment conference called CAIS in the Cayman Islands, February 14 to 18.

I am paying particular attention to and am much concerned, even distressed, by the seeming endorsement of tariffs (disguised by all sorts of other names) that is seemingly a part of the Republican agenda. If I don’t see some substantial change and direction by Tuesday, then next week’s letter is going to be a full-throated evisceration of this protectionist tendency. This mercantilist impulse is precisely the wrong prescription for jobs and will negate the positive effects of tax cuts and deregulation. I can think of nothing that would gut the economy more surely than protectionism, not to mention destroy the Republican and conservative brand. Think Herbert Hoover. I have been writing about the dangers of protectionism for 15 years as my number one concern for the future, and for it to potentially happen on a theoretically conservative watch is truly distressing.

That said, it is time to hit the send button. Let me wish you a great week; in spite of some of the above, I remain the most optimistic person in the room. The future is going to turn out just fine.

Your almost finished with the agenda for SIC2017 analyst,

John Mauldin

Is Europe Headed for a Political and Financial Crisis in 2017?

While most eyes are on the dramatic shifts possible for U.S. economic policy as Donald Trump is sworn in as president on January 20, similarly deep political currents are on the move in Europe. Indeed, the state of economic and political affairs there mirrors the seismic shift in the United States in many ways.

“In the U.S., the wave of populism has taken the form of the Republican Party. In Europe, it’s mostly manifested itself through the growth of extremist parties both on the left and the right,” explains Mauro Guillén, Wharton international management professor and director of The Lauder Institute.

This year, Europe’s economic growth will depend to an unusual degree on political developments, with three key elections coming up. Ground zero could turn out to be Italy. “Italy is where they were 20 years ago — they haven’t grown,” says Franklin Allen, an emeritus Wharton finance professor and executive director of the Brevan Howard Centre at Imperial College in London. Such sluggishness could have major consequences for Italian banks, whose growing trove of nonperforming loans have the potential to bring down banks all over Europe, he adds.

But one silver lining is the potential growth of European exports due to a stronger dollar, sparked by the U.S. Federal Reserve’s shift to a more hawkish stance that sees interest rates rising. Notes Guillén: “The rising value of the dollar represents an opportunity as eurozone exports become more competitive.”

The wrinkle, of course, is Trump’s unpredictability. His public comments about the U.S. dollar as being too strong compared to the Chinese yuan promptly sank the greenback, according to MarketWatch. The news site noted that Trump’s stance deviates from longstanding policies on the dollar adopted by prior administrations: “The strong dollar policy — a mantra of Democratic and Republican administrations for more than two decades — may be headed for the scrap heap.” So, growth in Europe from exports might not be a done deal.

Another problem for Europe is the coming set of unknowns on the political realm. “All countries are on a bit of a cliff,” says Olivier Chatain, strategy and business policy professor at the HEC business school in Paris and an academic senior fellow at Wharton’s Mack Institute for Innovation Management. “You have a risk of self-perpetuating political instability that can result in a self-reinforcing cycle of slow economic growth.”

Major leadership elections in the Netherlands, France and Germany in 2017 could indelibly change the course of the EU as an economic entity. Last year, both the U.K. and Italy saw the resignations of their prime ministers as a result of referendums, with the U.K. voting to leave the European Union in a “Brexit” and Italy rejecting constitutional reform that would have reduced political instability and bureaucracy, according to the European Council on Foreign Relations.

While the U.S. had a surprise upset by Trump and the U.K. experienced Brexit last year, Europe was spared any dramatic economic crisis. Wharton finance professor Joao Gomes explains says that 2016 presented no big problems and “wasn’t a bad year.” Most countries showed some growth. “Germany did very well. The U.K. didn’t do very badly. Italy didn’t do very badly. Spain had no government and did very well,” he said. “It could’ve been worse.”

However, despite some European countries making some big political decisions, there has been no serious focus on the economy, which needs attention, Gomes says.

One positive note from the EU point of view was that 2016 ended with “no anti-Euro governments in power,” Gomes adds. Given the major elections on tap — each with anti-European Union candidates as strong contenders — that may not be the case a year from now, he says. That includes Marine Le Pen, France’s far right candidate who has taken the lead in the polls recently in the presidential race, according to The Daily Beast.

The Shape of Brexit

Probably the biggest shock in Europe last year was the U.K. vote to leave the EU. While the Brexit vote’s immediate consequence was the weakening of the pound to a 31-year-low against the U.S. dollar, the long-term consequences remain to be seen. When the U.K. Prime Minister Theresa May invokes Article 50 of the Lisbon Treaty, which starts the process of withdrawing from the EU, formal negotiations will commence and could take two years. May pledges to pull the trigger at the end of March. However, much of the framework has yet to be decided, and trade deals between U.K. and the EU will have to be negotiated.

On Jan. 17, May drew a proverbial line in the sand by indicating that after Brexit, the U.K. aims to fully control its immigration and regulation policies. That will almost certainly result in the U.K. leaving the EU’s single market entirely with the EU itself wanting few if any remaining ties. The U.K. would have to negotiate trade deals with individual nations in Europe.

Even before May’s comments, it seemed clear that U.K. was likely headed for a tough time with the EU over Brexit. Chatain notes that other EU countries are not likely to let the U.K. exit smoothly with favorable conditions because it could tempt other members to exit, too. What is more, the U.K. has probably overestimated the willingness of governments in the EU, sore at Brexit, to keep the status quo in trade relations in some way.

Allen also points out that the outcome of the French elections in the spring, and possibly an Italian election if it comes up in 2017, in part depending on the health of Prime Minister Paolo Gentiloni, could significantly affect the conditions for Brexit. “If the EU starts breaking up, then the other European leaders will try to introduce things that have consequences for Brexit,” says Allen.

As big a move as Brexit appears to be, however, Allen points outs that “trade agreements aren’t as important as they used to be. Services are more significant in today’s economy. Most services take place over the Internet and it’s not clear where the transactions take place.”

Italy’s Banks – the Elephant in the Room

In December 2016, the political carousel in Italy took another turn. Nearly 60% of the Italian voters rejected a referendum for constitutional reform, which would have reduced the size of its Senate and given more powers to the prime minister with the goal of reducing bureaucracy and political gridlock.

Anti-establishment political parties, like the populist Five Star Movement and the far right Northern League, campaigned to defeat the referendum. For those favoring a strong EU, “The outcome in Italy was very bad,” notes Guillén. What happened in Italy reflected more of a dissatisfaction with the current government than with the reforms the government wanted to enact, explains Allen.

While the big story out of Italy recently is the country’s political upheavals, the situation in Italy’s troubled banking sector does not always get as much attention as referendums and elections, yet that is where the biggest potential economic risks lie.

About a fifth of Italian banks’ loans — nearly $400 billion — is considered nonperforming, according to a 2015 International Monetary Fund report. The figure accounts for 40% of all troubled loans in the eurozone. In a sign of how shaky the underpinnings are, the Italian government recently approved an multi-billion bail out of Monte dei Paschi di Siena, Italy’s third-biggest lender and the world’s oldest bank, after an unsuccessful attempt to raise investor backing.

The focus is now on Italy’s largest bank, UniCredit SpA., which is hoping to raise $14 billion in a rights issue and clean up its balance sheet by shedding $19 billion in non-performing loans, bundled into securities to be sold to investors. Some observers say this is potentially the key flashpoint in all of Europe. As “a very big bank with a major subsidiary in Germany,” Allen notes, “the Italian banking industry could potentially have a huge impact across Europe.” That subsidiary, HypoVereinsbank, is one of Germany’s largest banks by total assets.

With Germany’s second-largest bank — Deutsche Bank — struggling as well, it’s possible that the finance world could return to “where we were in 2008,” Allen says. “It’s still not that likely of an outcome, but it’s certainly a significant possibility.” Expect markets to closely watch how the UniCredit offering is received.

In other election developments in 2016, the vote on Austrian leadership dragged on. Pro-Europe forces ultimately prevailed when voters finally elected Independent candidate Alexander Van der Bellum. “The Austrian outcome was good” for Europe, in Guillén’s view.

However, the election wasn’t a smooth victory.

Last April, the first presidential runoff took place to decide on the two most popular candidates to go head-to-head in May 2016. The election result, where the anti-EU candidate would have been the winner, was annulled by Austria’s highest court due to voting irregularities. In December 2016, the Independent candidate won by 53.8%. “That was somewhat close. The Far Right had a very strong showing in the polls,” Allen points out.

Kick-off to Elections

The first major election in Europe in 2017 will take place in the Netherlands, in March. The populist, anti-European Party for Freedom has been winning the opinion polls, prompting the possibility of a “Nexit” — the Netherlands exiting the EU. While the structure of the Dutch coalition government would probably prevent such a scenario, the election nevertheless could test the waters for the subsequent French presidential elections.

The world will be watching as French citizens begin casting their ballots on April 23, which could have serious repercussions for the continuation of the eurozone. The first round of voting is open to several candidates and is not based solely on political affiliations. Le Pen is the leader of the National Front, who runs on an anti-European, anti-immigrant platform, and is expected to do well enough to progress to the next round on May 7, which will determine who will become the new French president.

Chatain predicts that former Prime Minister Francois Fillon likely will be the “viable candidate” to face Marine Le Pen and win. “Fillon isn’t too right wing but might be able to peel off voters from Le Pen. Fillon will be acceptable to a very large swatch of the right. His platform is not about exiting the EU. Le Pen is about destroying the EU.”

In the end, Chatain believes the center left and center right will support Fillion over Le Pen.

Moreover, Le Pen cannot campaign as the next “new thing,” says Chatain. “Le Pen is not new to the political arena. She will be a candidate for the second time. Also, she is the [political] heir to her father. Claiming to be new will be much harder for her this time around. That’s the whole point of populism.” Such movements gain momentum with promises to upend the establishment.

Allen takes a different view. “Marine Le Pen has a good chance of winning,” he says. If Le Pen did prevail and France wants to leave the EU, “Brexit will be a minor problem” since France is a founding member of the eurozone and a core member of the European Union while U.K. never even adopted the euro as its currency.

Le Pen’s popularity base is similar to Trump’s, as she reaches out to those feeling frustrated about their economic situation, observers pointed out. Last year, France’s GDP growth hovered around 1%. “France’s economic outlook is gradually getting better after five years of a mess,” Chatain says. “Unemployment is starting to go down a little bit. It’s not a freefall. France is not yet causing too much economic uncertainty or instability.”

Germany’s Stalwart Leadership

The last foreseeable important vote in 2017 will be in September when Germany holds leadership elections, and Angela Merkel will campaign to become chancellor again. The German election is critical. “I can’t imagine anyone else besides Merkel” as chancellor, says Gomes. “The question is how far more right does her party have to go to quell the anti-immigrant attitudes that will come up during the campaign?”

Guillén notes that Europe is facing renewed uncertainty as the terms of Brexit will need to be negotiated, and elections in France and Germany could introduce new volatility. Add to the political turmoil the precarious state of Italy’s banking system — with a key test being the UniCredit offering –- and one has the makings of a perfect political and economic storm.

The collapse of one or more Italian banks could trigger troubles elsewhere in the EU, and even affect Germany’s Deutsche Bank, as well as U.S. financial institutions. Meanwhile, the exit of another country from the EU could lead to more countries leaving and possibly fracture the union even more. Politically, the trigger for change has been voter dissatisfaction with the establishment. “Things in Europe are changing,” Allen notes. “Before, the populist movement was growing, and now they’re winning.”

China’s Limits in the Indo-Pacific

Taking stock of competition between India, China and the U.S. in the Indian Ocean.

By Jacob L. Shapiro

India held an annual geopolitics conference Jan. 17-19 from which two global news stories emerged, based on statements made at the conference. The Press Trust of India reported the first on Jan. 18, stating that a Sri Lankan government official said that Sri Lanka and India are close to finalizing talks on India’s development of Trincomalee port. The second story was a Jan. 19 report by NDTV regarding comments by the commander of the U.S. Pacific Command, who said that the United States and India are sharing intelligence on the movement of Chinese warships and submarines in the Indo-Pacific, and that “clearly” China could operate a carrier battle group in the Indian Ocean today, if it wanted to.

International conferences are great media fodder. Many important people gather in one place to give presentations and make statements. Most of the time one cannot predict when events will happen. Conferences such as these offer sound bites presented in articles that make it appear that an issue has suddenly become more important. It is not a coincidence that a spate of recent articles focused on tensions between India and China in the Indian Ocean. This Reality Check will address those tensions, but to determine if any of this open-source chatter is important, we must first identify the sources.

Sri Lanka China
Pedestrians in Sri Lanka walk on the waterfront near the port of Colombo as a dredger pumps sand on Dec. 19, 2016. The works are part of $1.4 billion in real estate development by China. ISHARA S. KODIKARA/AFP/Getty Images

Sri Lanka is located about 30 miles off the southern coast of India, on major maritime trade routes connecting the Middle East and the Pacific Ocean. Due to Sri Lanka’s strategic location, major powers – especially the United States, India and China – have competed for influence there. China’s influence has increased markedly in recent years, with investment and loans pouring into Sri Lankan infrastructure. The Institute of Policy Studies of Sri Lanka estimated that from 2006-15, China provided Sri Lanka more than $5 billion, and Sri Lanka’s minister of development strategies and international trade said last October that China has pledged over $10 billion more for investment in Sri Lanka in the next three years.

Sri Lanka’s problem is that Chinese investment has turned into Sri Lankan debt totaling more than $8 billion. (According to the latest figures from the International Monetary Fund (IMF), Sri Lanka’s debt-to-GDP ratio is 77.2 percent.) One of the most ambitious Chinese projects in Sri Lanka is a deep-sea port at Hambantota and an international airport in nearby Mattala.

The port hasn’t attracted the anticipated amount of business. In addition, the Sri Lankan economy is in shambles, facing a balance of payments crisis so severe that the country had to reach out to the IMF for a $1.5 billion loan last year. In dire need of capital, Sri Lanka reportedly reached a deal with China Merchants Port Holdings at the end of last year to sell an 80 percent stake in Hambantota to China for $1.1 billion and to lease China 15,000 acres of nearby land for 99 years. The agreement set off protests in Sri Lanka and raised concerns in both India and the U.S. that China was gaining a foothold in the Indian Ocean.

Those who read Geopolitical Futures know that we are highly skeptical of the practical import of China’s investments and moves in its coastal waters, much less in the Indian Ocean. That said, China’s purchase of an ownership stake in a key strategic Indian Ocean port must be taken seriously, because it raises the possibility that China might eventually establish a permanent base for the People’s Liberation Army Navy at a key point in the Indian Ocean.

Other notable developments would seem to confirm that China is making some headway in achieving this goal. For example, China is investing $1.4 billion in infrastructure development in Sri Lanka’s capital and main port, Colombo; it is leasing a Maldives island for 50 years for $4 million; it has promised to pour $46 billion into infrastructure development in Pakistan, most notably at Gwadar port; and it is building its first foreign military outpost in Djibouti by the end of the year.

There are two reasons to continue taking such developments with a grain of salt. One is the limitations of gaining influence through infrastructure investment, and Sri Lanka is a good example. Sri Lanka is not interested in picking a side in the great game being played out in the Indo-Pacific; rather, it is trying to take advantage of the great game. Sri Lankan officials have been adamant that infrastructure projects agreed to with China do not entail basing rights for Chinese ships. And while Sri Lanka accepted money from China, it simultaneously began negotiations with India to take over a stake in another important Sri Lankan port. The U.S. has gotten involved in recent years, reversing a policy of reducing U.S. Agency for International Development funding to Sri Lanka in 2015. The U.S. also is increasing military cooperation with Sri Lanka. U.S. Marines held a theater security cooperation exchange with Sri Lanka in November, and the head of the U.S. Pacific Command attended a conference there the same month in which he highlighted the strengthening relationship between the two countries.

The second reason is that soft power is ultimately useless if it isn’t backed by hard power. Some would say that China has developed enough hard power that its moves should be taken seriously.

After all, a U.S. naval commander said that a Chinese carrier battle group could sail into the Indian Ocean whenever it wants. This line of thinking has a few problems. First, China does not have an operational carrier battle group. China has an old, refurbished aircraft carrier it did not build that made its maiden voyage just over a month ago. Because of technological limitations, the Chinese carrier can only field a complement of half the aircraft as a U.S. carrier. China has only graduated two cohorts of domestically trained pilots to fly China’s carrier-borne J-15 fighter jets. China has almost no experience in the coordination necessary to sail a carrier battle group. It has relatively limited anti-submarine warfare capabilities, which means that its carrier would be an easy target for enemy submarines. And China will not have a replacement for at least a few years in the event its carrier is sunk.

China would be operating extremely far from its main base of operations on the mainland.

While China is investing in shipbuilding, it has a relatively small number of nuclear-powered ships compared to the U.S. Navy. That means that China must be constantly worried about refueling. China has no permanent basing rights anywhere in the Indian Ocean, despite its investments in infrastructure in various Indo-Pacific countries. For Chinese ships to reach the Indian Ocean, they must first make it out of the first island chain, which is not a foregone conclusion in any large-scale naval conflict. They then would have to make it through the Strait of Malacca. These are both maritime choke points that could be closed off if China becomes too aggressive. China is playing a very long game, and if it is able to overcome some of the obstacles discussed above, some of its investments – and the influence they have created – may become important. But to suggest that they are shifting the balance of power now is to put the cart before the horse.

Chinese moves in the Indian Ocean – whether port calls by Chinese naval ships to Pakistan or new infrastructure deals in countries like Sri Lanka – attract a great deal of attention in India and by extension in the U.S. And joint naval exercises in the South China Sea by the U.S., India and Japan make waves in China, as do U.S. bases in South Korea, Japan and the Philippines. On one hand, these exacerbate tensions and create a need for each side to continuously display their increasing strength.

On the other, each side needs to perpetuate the myth of the enemy’s aggressiveness to continue making aggressive moves of its own. For countries in the Indo-Pacific, this can be an unnerving cycle of posturing. But as countries like Sri Lanka and the Philippines demonstrate, it also creates an excellent opportunity to play great powers off each other and attract investment and attention. Until China’s naval capability increases, and until it has permanent bases to project power beyond its coastal waters, most of these displays are for show. That should be kept in mind anytime a rash of articles appears regarding some new tension in the Indo-Pacific.

China GDP hits 2016 target as Trump headwinds loom
Stimulus averted hard landing but financial and geopolitical risks are building
by: Gabriel Wildau in Shanghai, Tom Mitchell and Yuan Yang in Beijing

China’s economy avoided a hard landing in 2016 thanks to robust monetary and fiscal stimulus, but policymakers are now bracing for headwinds as a possible trade war looms under the US presidency of Donald Trump.

China’s gross domestic product, the world’s second-largest in nominal terms but already the largest at purchasing power parity, grew 6.7 per cent for the full year and at an annual rate of 6.8 per cent in the fourth quarter in real terms, down from 6.9 per cent in 2015. It was the slowest full-year growth figure since 1990 but comfortably within the government’s target range of 6.5-7 per cent. The fourth-quarter performance topped economists’ expectations of 6.7 per cent, according to a Reuters poll.

In a speech to the World Economic Forum in Davos on Tuesday, Mr Xi defended free trade and globalisation, drawing an implicit contrast with Mr Trump. Economists say a trade war could exact a heavy toll on China.

“I believe that, once he is in position, Mr Trump will consider the issue from the perspective that both sides benefit, and he will expand the co-operation that the two countries have long had,” Ning Jizhe, director of China’s National Bureau of Statistics, said on Friday.

Zhu Haibin, chief China economist at JPMorgan in Hong Kong, notes that gross exports are more than 25 per cent of Chinese GDP, while labour-intensive export industries are disproportionate sources of employment. That means that large swaths of workers could be affected if exports suddenly fell.

“China is a very export-orientated country. Many people work in these areas. If you have a 10 per cent decline in exports to the US, that will affect lots of workers,” said Mr Zhu.

While employment would suffer from a trade war, the impact on GDP would be less severe, economists say. With imports falling alongside exports, net exports — the variable that directly affects GDP — would be little affected.

Beyond a trade war, the main threat to China’s economy is continued reliance on debt-fuelled investment to drive growth, economists say. Lower exports could force policymakers to rely even more heavily on this model to defend its growth target.

In a sign of how China’s traditional growth drivers are faltering, fixed-asset investment — which includes spending on new factories, housing, and infrastructure — grew at 8.1 per cent, the slowest pace since 1999, Manufacturing was the biggest drag, as private factory owners held off on expansion amid weak demand and excess capacity.

But housing was a bright spot. Property sales grew 22.5 per cent in floor-area terms, the fastest pace in seven years, while prices in major cities soared, prompting warnings of a bubble. Analysts expect the housing market to slow in 2016, as the government moves to cap runaway house prices that are a source of popular anger.

In May, a widely cited opinion piece in Communist party mouthpiece People’s Daily by an “authoritative person” — presumed to be a senior adviser to Mr Xi — warned that the economy remained dangerously reliant on debt. At the time, analysts thought the article would signal a policy shift, but strong credit growth continued for most of the year.

“The excess money supply in 2016 created problems with bubbles. Going forward, more deleveraging will be necessary. Monetary policy can’t be loosened further,” said Zhang Yiping, economist at China Merchants Securities in Beijing.

Meanwhile, progress has been slow on politically difficult reforms such as shuttering inefficient “zombie” companies and overhauling property rights for rural land.

With the Communist party due to meet at the end of 2017 to pick its top leaders for the next five years, economists broadly expect another year of muddling through. Few believe Mr Xi will tolerate the short-term growth slowdown that would result from more aggressive reform measures while he seeks the political leverage necessary to place his allies in key positions.

Additional reporting by Ma Nan