Tax Reform: The Good, the Bad, and the Really Ugly—Part Three
“We have a system that increasingly taxes work
and subsidizes nonwork.”
– Milton Friedman
“You must be the change you wish to see in the
world.”
– Mahatma Gandhi
“Real change requires real change.”
– Former Speaker of the House Newt Gingrich
Today we come to part 3 of my tax reform series. So far, we’ve
introduced the challenge and begun to describe the main proposed GOP solution.
Today we’ll look at the new and widely misunderstood “border adjustment” idea
and talk about both its good and bad points. What follows may make more sense
if you have first read part
1 and part
2. Next week we’ll explore what I think would be a far superior option,
though one that is based on the spirit of the current proposal. If House
leadership thinks they can get the present proposal through (doubtful), then
they should stop messing around and do something really controversial by
changing the entire terms of engagement. As my friend Newt Gingrich has often
told me , “John, real change requires real change.”
Warning: There is something in this series to offend almost
everyone. Everything is fair game. If nothing else, I hope that no one can
accuse me of simply talking the Republican book. I think this letter will
pretty much eviscerate the key component of the proposed Republican tax plan. I
hope the plan will be seriously changed. Many of you have direct contacts with
your Senators and Representatives on both sides of the aisle. I urge you to
send this letter to them and talk to them. This is one of the most serious
national conversations we have ever had.
We can all argue about how big government should be, but whatever
we decide upon, we must pay for, if not through taxation then through a massive
debt-deflationary depression or serious inflation. (Next week we’ll talk about
how to avoid these problematic outcomes. Yes, it can be done.) It’s not a
question of cost or no cost, it’s a matter of who will pay and how much. The
question is how to allocate the cost efficiently, equitably, and with the least
possible economic distortion.
I have talked to many of the participants in the tax reform
process, both in Congress and in think tanks. The one point of agreement is
that the tax system must be massively reformed. That point, unfortunately, is
where agreement ends. Tax reform ideas usually fail because the status quo
gives everybody some kind of perceived benefit. In reality, the benefit may be
worth less than people think, but it’s preferable to the uncertainty of a new
system. This is basic game theory stuff, where the status quo is seen as what
the economist types would describe as a “Nash equilibrium,” or a situation in
where everybody has figured out how to make the system work for them, whether
or not they are happy with it in toto. As long as nobody disturbs the
equilibrium, things go on as they have done – until they don’t. The topic
of equilibrium is one we’ve covered in past weeks, and we’ll be returning to
it.
Last week I described the tax reform ideas that House Speaker Paul
Ryan and his caucus include in their “Better Way” blueprint. As I said, there’s
a lot to like in their plan. There are parts of it I love. I am most
enthusiastic about the pro-business/entrepreneurial encouragement they offer.
Truly, we cannot resolve our national economic dilemma without growing the
entrepreneurial and business side of our equation. One of the few things that
the Paul Krugmans of this world and I agree on is that we must figure out how
to grow our way out of the problems we face.
However, we must remember that the “Better Way” is simply a set of
proposals at this time. President Trump announced on Feb. 9th that
his economic team is drawing up its own “phenomenal” business tax reform
proposal. He said the White House would reveal it in the next few weeks. We
have no idea whether it will resemble the House GOP plan. We do know the
president hasn’t sounded enthusiastic about the border adjustment tax idea. We
are also reading about major pushback on the BAT from many Senators and
Congressmen.
I’m not enthusiastic about the BAT either, to say the least. I
fear it would come with serious macroeconomic side effects, and not just for
the US. Cutting to the chase, when I say serious macroeconomic side effects, I
am talking about its potentially triggering a global recession, which would
mean a major bear market and a total reset of valuations in every asset class.
Not the end of the world, but certainly not without pain and cost. Let’s pick
up the story right there.
Before I describe how border adjustment works, let’s note why it
is part of the Republican plan. The features I described last week, while
attractive to many taxpayers, also cut deeply into the government’s tax
revenue. Here is how the Tax Foundation calculates the plan’s impact, under
both static conditions and a dynamic model that tries to assess economic
changes.
![](http://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/170219-01.jpg)
Under static conditions, the plan would reduce tax revenue by some $2.4 trillion over ten years. A dynamic scoring reduces that amount to $191 billion. The reality is probably somewhere in between, but no one really knows. I tend to lean toward the dynamic scoring, but the plan is still not revenue-neutral in a world where the US is already running nearly $1 trillion deficits. I give Chairman Brady and the House Republicans (who are constitutionally responsible for initiating tax proposals) an A+ for trying to avoid increasing the deficit and the national debt with their tax cuts, and without offsetting the cuts with tax increases somewhere else. Seriously, two thumbs up! Longtime readers know I am a deficit hawk, and I appreciate the budget-balancing intentions of my fellow Texan who is chairman of the Ways and Means Committee. However, the tax cut proposals we discussed last week mean that Congress must find new revenue to make up for them. The borde r adjustment tax (BAT) is their idea to help fill that gap.
Here is how it works: Businesses that import goods from outside
the US would not be able to deduct the cost of those goods from their corporate
tax returns. But companies that export products to other countries would not
count as income the revenue received from the exports.
The hopeful effect of this measure is to encourage exports and
discourage imports, which is in keeping with President Trump’s objectives. It
also helps offset the proposed lower corporate income tax rates that bring the
US more in line with other developed countries. However, the proposal also
assumes that running a trade deficit is something the United States should try
to avoid. There are serious pluses and minuses to that view.
Most Americans may not realize how different our tax system is
from those of every other country in the world. Almost every other nation has
some variation of a value-added tax (VAT), a form of sales tax added at every
level of production. Many also have corporate income tax, but the rates are
lower than ours.
![](http://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/170219-02.jpg)
The House GOP plan (the red, dotted “Blueprint” line at the far
right in the chart above) brings our corporate tax rates much closer to the
average. Other countries make up the revenue gap with a VAT. The Better Way
plan does it with border adjustment, which is sort of a halfway VAT.
The problem is that the US runs an enormous trade deficit because our whole economy depends on
imports. We do not presently have the capacity to replace those
imports with domestic goods. Can we build that capacity? Yes, but not
overnight. In the meantime, this plan would cause prices for everything
imported to rise sharply (think a 20% increase on much of what you buy at
Walmart or Amazon), or the importers will go out of business, or both.
This is obviously not good for job creation if you are an
importer. So what are the Republicans thinking? Why propose something that
seems so daft? Well, in theory the BAT will bring in a lot of revenue,
something like $1 trillion over 10 years if their assumptions are correct. This
revenue is necessary to keep the Better Way plan’s other tax cuts from adding
to the debt. And it will also theoretically increase jobs tied to exports. More
on that below.
The Republicans also pitch the BAT as simple fairness. Other
countries apply their VAT taxes to goods shipped to the US, so the US should do
likewise. The problem here is that the US doesn’t have a VAT, so we’re
adjusting for something that doesn’t exist. That makes this idea look less like
an adjustment and more like an outright import tariff. In discussing this whole
border adjustment concept with other economists, I find general agreement that
my description of the BAT as a “half-assed VAT” is generally correct. That is
perhaps not a politically correct way to state the matter in a letter that may
be read by the faint of heart, but it does paint an accurate picture that will
save you a lot of reading time, so I’ve just gone ahead and put it that way.
Here I need to stop and explain something. I believe that truly free trade helps
everyone, but that’s not what recent so-called free trade deals have given us.
Instead, they delivered something quite different from the kind of free trade
that Adam Smith and David Ricardo envisioned. I explained this at length last
July in “The
Trouble with Trade.” Here’s an excerpt:
“Free trade” deals are no longer simple documents. The
Trans-Pacific Partnership (TPP) weighs in at 5,544 pages. It’s a boatload of
rules and regulations. I know there is talk that this deal was negotiated in
secret, but that is far from the truth. You and I weren’t asked for input; but
lots of people were, let me assure you. I can guarantee you that rice farmers
in Texas and California were pressing their congressmen and others for access
to the lucrative Japanese market, and Japanese rice farmers were trying to
figure out how to limit the damage. For the record, Japan imports about 10% of
its rice from the US, most of which they turn around and export as foreign aid
or use for animal food. It is not that Japanese rice is that much better; indeed,
the fact that US rice is so close in quality makes Japanese farmers nervous.
And US rice is 1/3 to 1/2 the cost of Japanese rice.
Of course Japanese companies want access to US markets, where they
can compete quite well, thank you, against US firms. And those US firms want to
keep the protections and prices they have. This tit for tat has gone back and
forth in hundreds of industries in the 12 countries involved in the TPP. I can
guarantee you that wheat farmers or corn farmers or cattle or hog producers
have a different view of the whole process than US rice farmers do. And their
views are different again from those of equipment manufacturers or software
developers, or pick any of 1,000 industries. Rice farmers in Japan have to
negotiate terms of trade with other national industries, and do you think New
Zealand avocado farms or sheep farmers or movie firms have any less interest in
the process?
Every country is worried about US companies coming in and
overwhelming their businesses, and the US is worried about “unfair” competition
– that is, competitors in other countries producing products that are cheaper
or better. Often, the higher cost of products here is attributable to the
regulations that we impose on our own industries. So we want other countries to
abide by our regulations (and they want us to abide by theirs).
The problem with global deals like TPP and its
US-European counterpart, TTIP, is that while they may be good for the economies
as a whole, citizens will find that “good” very unevenly distributed, which is
why Trump calls such agreements “a job and independence threat.” After
supporting the TPP for several years, Clinton now says she will not sign. Both
candidates are responding to the very real problems generated by the uneven
distribution of globalization’s benefits over the last 30 years [emphasis mine].
Read that last paragraph again, because it’s critical. In fact,
it’s the core problem behind most of our current ills. Global trade grew
enormously in recent decades, but its benefits were distributed in ways that
left many people out.
I have used the following line from William Gibson over and over
again, but I do so because it is the single best description of our world
today: “The future is already here; it’s just unevenly distributed.” The
benefits of technological advancement and economic globalization have been
unevenly distributed. See, for reference, the Rust Belt of the US. Note that
this is why a Donald Trump was elected. He recognized and addressed the
suffering before other presidential candidates did and capitalized on it. Good
on him as an observer of our times.
For a variety of social, political, and economic reasons, we can’t
let this uneven distribution continue. A significant number of our fellow
citizens are demanding change. But the uneven distribution will continue if the US
enacts this border adjustment tax plan.
It should be clear to everyone that Brexit and Trump and all the
other nationalist movements are not happening in a vacuum. Trump is not the
final expression but the harbinger of a swelling trend that will be felt
throughout the world. Those who are left out of participating in future
economic abundance are going to be pushing back; and while this time the
Republicans were able to take advantage of the situation, the next time it will
be the Democrats or some other group that does so if the Republicans don’t
figure it out. If we don’t learn how to more evenly distribute the benefits of
accelerating technological changes and globalization, we are going to see ever
more pushback, not less. And the next time it will not be the Democrats who are
worried about the end of the world, but the Republicans.
I just want to say that it is really, really, really, really
important that we get it right this time. The cost of screwing this up will be
far greater than you can possibly imagine. Conservatives may not have another
shot for a very long time. Think Herbert Hoover. (See more below.)
Under the BAT plan, imports will be penalized and exports
rewarded, which, theoretically, in a perfect world without pushback, would
leave our economy nicely balanced and undisrupted. That’s the idea. But I doubt
it will happen that way, because the
importers and exporters are not the same businesses.
A vast number of businesses import products from other countries
and sell them to Americans. Toy companies are a good example. Virtually all the
shiny presents under your Christmas tree were made outside the US. The
companies that import them could be border-adjusted right out of business under
the Better Way plan.
Here’s an example. Suppose you are a toy company and you spend $1
million to bring in toys from China. You package and distribute them to
retailers around the country, generating an additional $500,000 in costs for
yourself. You sell them at wholesale for $2 million. What’s the tax
consequence?
You just spent $1.5 million to generate $2 million in revenue. But
the $1 million you spent on the imports is no longer deductible on your tax
return. So your taxable
profit isn’t $500,000, it’s $1.5 million. At 20%, your corporate income tax is
$300,000 instead of $100,000. This
plan triples your taxes.
Would you stay in business under this plan? Maybe, but you would
certainly raise your prices. Would the retailers and consumers still buy as
many toys? Probably not. You will have to downsize and probably lay off
workers. That’s not good for anyone.
What the Republicans want
us to do is to buy American-made toys instead of Chinese imports. Does that
manufacturing capacity exist in the US, with the same net prices and quality
you get from the Chinese suppliers? Probably not, or we would already be using
it. It will emerge if the demand exists, but not instantly. And, with the BAT
in place, US-manufactured products that compete with the products we buy from
foreign producers will cost 20% more, priced in US dollars.
Meanwhile, those who export
products from the US will see the reverse effect. Their tax bills will be
slashed since their foreign revenue will no longer count as taxable revenue.
They’ll probably expand and hire more workers. So maybe it will work out.
Exporters will hire the laid-off import workers. Maybe – if the skills they
possess are the same as those that were just rendered unnecessary at the
importers’ operations, and if automation doesn’t cost less than paying humans.
At best there will be an adjustment period, which will be far
longer than those who propose this plan think, as workers retrain for new jobs.
We’ve heard this story before, and it didn’t work out as advertised. So count
me skeptical.
The problem is that the importers and exporters don’t all operate
in the same states and counties, so the people who lose their jobs because of
the import tax will end up having to move to where the exporting jobs are. How
did that work out for the Rust Belt when the steel jobs left? For whatever
reason, the data clearly shows we are moving less than we ever have before. But
that’s a topic for another letter.
As you might expect, the retailing industry is dead set against
the BAT. Walmart, Target, and the like are already lobbying hard against it.
One of the experts I spoke with, when I asked about retailer opposition, let
out a big sigh and said the National Retail Federation has always been against any kind
of consumption tax.
As I thought about that later, it made sense. “Consumption” is
what retailers sell. They want us all to consume more stuff from their stores.
Consumption taxes reduce the amount their customers have available to spend, so
these taxes are a direct revenue loss to retailers, at least in the short term
– and the short term is 5 to 10 years. These types of adjustments do not come
quickly.
The retailers aren’t just whistling Dixie. The BAT would hit them hard at a
time when they can’t afford many more hits. The 2016 holiday season was a
blazing success for Amazon and its online brethren (including Walmart, which
now has a large online presence). For everyone else, not so much. E-commerce
finally seems to have reached critical mass. It is now proceeding to vaporize
the competition.
Retailing at scale is all about logistics. You need to get the
right products in front of the right consumers at the right time, and not a
minute sooner or later. The big box stores actually do a pretty good job of
that, but now they have a new problem. Consumers carry these little
comparison-shopping supercomputers (courtesy of Apple, Samsung and others – and
by the way, these are imported products and would cost 20% more, post-BAT) in
their pockets and are not shy about finding a better price. Amazon usually has
what you want for less if you are willing to wait a day or two.
Worse, Amazon is compressing
that time. They have built a stunning network of highly automated warehouses
around major cities. They’re in the process of building a drone air force to further speed
deliveries. Here in Dallas you can get same-day
delivery of many items, at the same or better prices than brick and mortar
retailers charge. A few clicks and it’s on its way; you don’t have to drive to
the store only to discover it doesn’t have the brand that got the best reviews.
The Amazon business model is working better in today’s economy. That’s just a
fact.
Now, Amazon sells many imported products. So does Walmart. The
border adjustment will hit both of them, but it will hit the old-style
retailers just as hard, at the very time they are struggling to compete with
Amazon. Walmart may survive. I’m not sure companies like Sears will.
I’m very frustrated with some of my Republican friends who don’t
see this, or who blithely assume new jobs will magically appear for those
displaced. We have seen in the present “recovery” that this is no longer true.
This is a time of wrenching change. We have to find better ways to help people
adjust to these changes. Yes, the market will provide new opportunities, but
human beings are not identical bricks that you can just rearrange in new piles.
In conversations with border adjustment proponents, I’ve heard
very little about implementation plans. They don’t seem to have considered how
to get the economy and the population from here to there in a way that avoids
negative transition costs.
That’s a big problem. Even if it all works according to plan,
there will be pain in the transition. This is like the weather bureau’s
cheerily telling us it will be sunny and warm day after tomorrow, right after
the category 5 hurricane passes through. They are getting a little ahead of
themselves.
Understand, I wouldn’t be so against the BAT if we could
fast-forward five years and arrive at the new equilibrium point without all the
adjustments that will have to happen in the meantime. These adjustments are
going to be more problematic than you can imagine.
As I mentioned in part one, 80% of the manufacturing jobs that
have gone away in the past 20 years have been displaced by technology, not
“offshoring.” That trend is not going to stop anytime soon, and those jobs are
not coming back. Please note that we are now manufacturing more than we ever
have, just with dramatically fewer people.
Also note: Some of the people in the Trump administration are
critical of Germany and their export-heavy model. I agree that Germany is a
problem. But let me point out that in the next global recession (and there’s
always a next global recession) a country that depends on exports for 50% of
its GDP is going to get its throat ripped out. Especially when the euro breaks
up and nobody has the ability to buy Germany’s high-priced products. There is a
cost that comes with being a manufacturing power, and you need to be careful
what you wish for. The manufacturing fetish that some Republicans are gripped
by comes with a price tag. And note that some of the products we think of as
“US-manufactured” have significant components made all over the world. I could
literally offer you 100 major examples, but consider the Boeing 787. Boeing
sales are a big part of our dollar exports and technological prowess. How
much more American could you get than Boeing? Well, a lot more than you might
think.
![](http://ggc-mauldin-images.s3.amazonaws.com/uploads/newsletters/170219-03.jpg)
But that eye-opening reality still misses a most important point: Manufacturing jobs are truly the last war.
The next front in the “jobs war” is going to be the service
economy. When (I consider when
more likely than if)
Sears goes under, that is 178,000 mostly service jobs that will be gone. Saving
a few manufacturing jobs here and there is nice, but it doesn’t balance out
losing 178,000 service jobs.
Starting in about five years, automated driving will put truck
drivers and taxi drivers out of work. Where will those 3 million workers find
jobs?
There are hundreds of small stores and establishments in the
service industry that are going to be “disintermediated” out of business, which
is a fancy way of saying that online and more efficient establishments will be
taking or eliminating their jobs. There are literally going to be millions of
service jobs at risk in the near future if we don’t come up with some way of
creating new industries from whole cloth. (That challenge will be the subject
of a number of future letters. It’s critical to the future of every country in
the world.)
That is why I applaud the idea
of what the Republicans are trying to do with the Better Way plan,
because they are trying to stimulate new businesses in the United States. New
businesses are the font from which growth and new jobs spring. However, the
mechanism by which they plan to accomplish this laudable goal is going to create
more problems than it solves.
In their defense, Paul Ryan and House Ways & Means Committee
Chair Kevin Brady know everything I just said and probably agree with much of
it. They believe the BAT’s negative effects will disappear quickly due to
currency flows. As the trade deficit shrinks, fewer dollars will flow from the
US to the rest of the world. That trend will make the dollar rise against other
currencies, thereby nullifying the higher prices we will pay for imported
goods.
That’s the theory. In fact, most economists do agree that the
dollar is likely to rise significantly if this proposal is adopted. So, the
theory is that Walmart shoppers really won’t pay higher prices, at least in
dollar terms. I do not think things will work that way in practice, at least
not as quickly as they hope. My Camp Kotok friend Megan Greene, who is the
chief economist at Manulife Asset Management, explained why in a Financial Times column
earlier this month:
The US dollar will take years to adjust. There has historically
been about a five-year lag between a current account shock and a full
adjustment in the real effective exchange rate. Prices tend to be sticky [This is a critical point! Pay
attention! – JM], particularly when 93 per cent of US imports and more than 40
per cent of global trade is invoiced in US dollars. These prices would have to
be renegotiated over time. Furthermore, the Federal Reserve and
the People’s Bank of China would do their best to lean against such a currency
move.
In the short to medium term, importers would pass the cost of the
border tax on to US consumers, who have been driving the economic recovery.
Hitting them could significantly undermine growth at a time when inflation is
accelerating, resulting in stagflation.
Eventually, the dollar will appreciate. But the impact of the tax
may then be even more grim because of the US dollar’s role as the global
reserve currency. Nearly $10tn of outstanding offshore debt is denominated in
dollars.
According to the Bank for International Settlements, about 90 per
cent of Turkey’s sovereign debt and more than 80 per cent of China and South
Korea’s non-financial corporate debt is dollar-denominated. A 15–25 per cent
appreciation of the dollar would make this debt much harder to service and
would tighten financial conditions in these countries and across emerging
markets.
Here we see once again how debt constrains us from doing what
might otherwise make sense. Emerging-market countries own massive amounts of
dollar-denominated debt. A stronger dollar means they must somehow come up with
more of their local currencies to repay their dollar debts. And they will have
to do it fast, even as their exports are shrinking because US consumers are
being encouraged to “buy American.”
It gets worse. To whom is all that emerging-market debt owed?
Primarily to Western banks and bondholders, who are often themselves
excessively indebted. The potential financial contagion is massive. Ambrose
Evans-Pritchard of the London Telegraph describes it
in his characteristically colorful style:
Yet getting there constitutes a global shock of the first order.
“This will trigger a series of emerging market crises,” said Stan Veuger from
the American Enterprise Institute. He estimates that the burden for companies
and states in developing countries with dollars debts will jump by $750bn.
Turkish firms alone would face a $60bn hit.
It does not end there. Studies by the Bank for International
Settlements show that a rising dollar automatically forces banks in Europe and
the Far East to shrink cross-border lending through the mechanism of hedge
contracts.
A dollar spike of anywhere near 20pc would send the Chinese yuan
smashing through multiple lines of psychological resistance. The People’s Bank
(PBOC) is already intervening heavily to defend the line of seven yuan to the
dollar. Ferocious curbs would be needed to stop the Chinese middle classes
funneling money out of the country if it crashed by a fifth.
Junheng Li from Warren Capital says the China’s exchange regime is
more brittle than it looks. Official data overstates the PBOC’s fighting fund
by $1 trillion, either because reserves are “encumbered” by forward dollar
sales or because they must be held in reserve as a “fiscal backstop” for
Chinese firms at risk of default on dollar debts. She expects the system to
snap at any time, and without warning.
I strongly doubt whether the Trump-Ryan axis in Washington has any
idea what could happen if they detonate a debt-deflation crisis in China, or if
they ignite a short-squeeze on $10 trillion of off-shore dollar debt with no
lender-of-last-resort behind it. Nor do they care.
I disagree with that last part. I think Trump and Ryan certainly
do care about setting off a global crisis. They just don’t think they will. And
this is where I think they are ignoring basic game theory.
The world economy is currently ensconced in the equivalent of a
Nash equilibrium. What that means is that everybody has adjusted to the present
rules by which the dollar is the world’s reserve currency; the US agrees to run
large trade deficits, flowing dollars to the rest of the world so that the USD
can remain the reserve currency; and global trade is based largely around
current global tax policies remaining largely stable.
When you talk to Republican leaders and ask them why other
countries wouldn’t react to the BAT and impose larger tariffs or sanctions on
US goods, they respond with a question of their own; and it’s a logical one:
“But why would they? We’re only doing with the BAT what they’re already doing
to us.” And they are correct. US corporations are at a massive competitive
disadvantage today because we have high corporate taxes and no VAT. Other nations
do not charge a VAT tax when their companies export products. That means a
German car sold in Asia or a Japanese car sold in Europe has a competitive tax
advantage over a car made in the US and on sale in those countries. The
Republicans are simply trying to rectify that competitive disadvantage.
The problem is that other countries are simply not going to say,
“Oh, the United States finally figured it out that we were taking advantage of
its silly, complicated tax system. There’s really nothing we can do, so let’s
just get on with the program.” No, they are going to protect their own
businesses. In international trade, it’s every country for itself. They are all
going to react to losing anything that they think is a competitive advantage.
If you don’t get this, go back to kindergarten and study children trading toys
in their sandbox. This behavior is ingrained in every human being.
Game theory clearly demonstrates that when one player interrupts
the Nash equilibrium, the other players will respond; and the responses will go
back and forth, tit for tat, until there is a new equilibrium. The question is,
what will be the process that the world has to go through in order to find that
new equilibrium, and do we really want to see that process play out?
We are going to revisit that process in just a bit, but first I
want to go back and show you again a few paragraphs from Charles Gave’s piece
that I quoted extensively in part one of this series. You really should go
back and read it in full if you haven’t.
I exaggerate for effect, but this example shows that the US’s
“exorbitant privilege” [because ours is still the world’s reserve currency –JM]
has little to do with free market principles as it means the US (i) lacks a
foreign trade constraint, and (ii) can force other countries to accept payment
in dollars. Should either of these conditions end then the credit pyramid would
implode. And indeed for decades commentators have fretted that the rest of the
world may one day lose confidence in the US dollar as a store of value,
resulting in soaring US interest rates and an economic crash – the Japanese,
Chinese and a Brazilian supermodel have, at different times, all been touted as
potential liquidators.
I never believed such scare stories so long as the US remained a
superpower capable of corralling international respect. What worried me was a situation where
the US, for domestic political reasons, pulled up the drawbridge and chose to
pursue a current account surplus. Such an outcome was always going to be driven
by Americans at large concluding that the global production system was being
run against their interests. [This is the critical understanding that you must grasp! –
JM]
While I don’t think (please God) we are anywhere close to
implementing a policy as draconian as Herbert Hoover’s was in the late 1920s,
it would behoove us to remember his Mexican
Repatriation, by which somewhere between 500,000 and 2 million American
residents of Mexican ancestry were forcibly returned to Mexico. Many of these
deportees were actually US citizens. And this was done without due process. I
kid you not. By the way, this program was continued by Franklin D. Roosevelt
for another four years. This program is a dark blot on American history, one
that I think was even worse than the Japanese internment camps of World War II.
The expulsion was carried out in the name of “protecting American jobs” and
putting America first; and then it was followed up with policies that were
designed to make America productive again, including the Smoot-Hawley Tariff
Act, which was a contributing factor in the Great Depression.
I have written for over 17 years – since I first started to pen
this letter, that the single thing that scares me more than any other potential
economic event is a move toward protectionism and a resulting global trade and
currency war. There is simply no other force that would be more destructive to
your personal wealth and lifestyle than this.
The situation of the late ’20s and early ’30s is precisely the one
that Charles was referring to: America decided that the global production
playing field was tilted against American interests and needed to be leveled. I
don’t think anybody today would want to go back to the 1930s. Nobody wants
another Great Depression. Again, let me remind you that FDR did not repeal
Smoot-Hawley and continued many of Hoover’s destructive policies . There is
plenty of bipartisan blame and shame to go around here.
The global economy is orders of magnitude more intertwined than it
was in the 1920s and ’30s. Let me list a few of its challenges for you, things
that we have touched on in previous letters and a few new ones:
1. The developed countries are awash in debt that totals around
$150 trillion.
2. As mentioned above, emerging-market countries have $10 trillion
of US dollar-denominated debt that they would be unable to pay back if the
dollar were to rise by 20%. We would experience a global banking crisis whose
proportions would dwarf anything we’ve seen to date. Think subprime debt on steroids.
3. It is going to take at least a trillion euros to solve the
Italian banking crisis, which is an amount of money that the Italians simply do
not have. The only way they can get it is for the European Central Bank to buy
the bonds that the Bank of Italy would have to issue. That means Germany would
have to blink and participate in the financing of that debt.
That rescue would raise Italy’s debt-to-GDP ratio well north of
175%. Think Greece writ large. How in the wide, wide world of central banks and
monetization do you think the Italians, whose economy is growing at barely 1%,
can ever repay that debt? Seriously? You think I’m exaggerating about €1
trillion? Do the math and then factor in that the NPLs on the Italian balance
sheets will be double or triple the current stated size in a crisis.
I was told I was crazy when I said in 2006 that we would lose $400
billion to the subprime crisis. That was about the time when Fed Chair Bernanke
was telling us the subprime crisis could be contained. I was an optimist by at
least a trillion dollars, give or take. Looking ahead, €1 trillion may be a
similarly overoptimistic estimate of what it will take to resolve the Italian
banking crisis.
4. Brexit? Do you really think the Brexit negotiations are going
to be a walk in a park, given the nationalist tendencies that are emerging in
Europe?
5. Japan is continuing to massively monetize its debt. The
Japanese have no choice. Their currency is going to continue to fall. I know
that Abe and Trump were playing nice last week, but when the yen hits 140 or
150 because the dollar is rising and you can buy a Lexus cheaper than you can
buy a Hyundai, how does that work for the trade protectionists in the Trump
administration?
6. President Trump has expressed concern about certain currencies
being manipulated and thus being too weak. A crisis in Europe and Britain would
result in their currencies dropping, along with the yen, forcing China to allow
its currency to drift downward, too, since China is exposed to all of those countries
through its own trade. China simply does not have enough dollars to support its
currency at the current level if the dollar were to rise by 20%. To try to do
so would destroy their balance sheet. But to allow the yuan to fall would
sabotage their current push toward becoming a consumer society and would create
an enormous amount of instability. They would be forced to double down on their
mercantilist strategy. In other words, an escalating trade war!
7. One thing that nearly all economists agree on is that if we
pass the border adjustment tax as currently proposed, the dollar would
(eventually if not quickly) rise by about 20%. In fact, the Republicans
actually use that as a selling point to show that the BAT wouldn’t really
increase the cost of our imports, never mind the fact that our imports are
priced in dollars and not in foreign currencies. (Remember Megan’s point about
“price stickiness” above.) To say that the transition would be messy is an
understatement.
8. Global market valuations of all asset classes are about as high
as they have been in a long time. When was the last time we had interest rates
so low and equity market valuations so high? Does this seem like a bubble do
you? Or at least the beginning conditions for one?
9. If the dollar does rise too much, does President Trump instruct
the Department of the Treasury to monetize our debt in order to weaken our own
currency in response? Isn’t that called a currency war?
10. If our currency rises, the advantage that our exporters get
from having to pay no income tax on their exports disappears at the border.
Okay, you get the picture. The world is in a pretty $#&^%
fragile place right now, and you want to be very careful if you aim to upset
and reset the Nash equilibrium. Understand, I am not arguing that we don’t need
to change things. We just need to be $&%%&* (multiple expletives
deleted) careful about how we go about it.
I know this is going to offend a few of my friends, but I’m going
to say it anyway: I am afraid that this border adjustment tax, if implemented,
will throw the world into a global recession. All of the wonderful tax cuts and
beautiful plans that are being proposed along with the BAT will not be enough
to keep the US from participating in that recession as well.
Understand, I’m a believer in free markets, and I know that the
American enterprise and entrepreneurial system, when given an opportunity, can
respond and create growth in this country. But the BAT is not the way to do it.
More on how to do it later in next week’s letter.
Striking Out at the WTO
The Republican plan has another problem, too. It likely violates
World Trade Organization rules. The European Union is already preparing its
challenge. President Trump has talked of possibly leaving the WTO, which might
not be all that bad a move, though it would set off a complete reworking of how
global trade is done. That process could spin out of control quickly. And
remember, while the US may be the largest player, we’re only 25% of the global
economy. The rest of the world might just say, let’s see what we can do without
the US and go ahead and create our own reserve currency so that we don’t have
to depend on the US’s injecting massive amounts of dollars into global markets.
America may be first, but there are a lot of other countries that think they
are second or third, and they have nationalist movements of their own.
The proponents of the BAT argue that it is technically within the
rules of the WTO. I am neither a global trade lawyer nor the son of a global
trade lawyer, and I don’t know the technicalities of those rules. But I am
pretty good country boy observer of the political process. The WTO is not like
the US Supreme Court, which is bound to operate according to the US
Constitution. The WTO is a political process. Call me skeptical, but I don’t
think President Trump has a lot of political capital to spend at the WTO. I
think the likelihood that he would lose a WTO ruling is damn near certain.
If he does, we can either try to change the rules or leave the
WTO. The volatility that would surround the US’s departure from the WTO would
be quite impressive. Global markets would absolutely collapse, and the Trump
bull market would quickly morph into the Trump bear market. Think Hoover. Which
is one reason I don’t think Trump will actually support the BAT. Fingers
crossed.
The broader point is that all this potential turmoil is avoidable.
There is a much better way that Trump and Ryan and the Republican team, in
cooperation with the Democrats, can simplify the tax code without risking trade
chaos, a global recession and possibly a global depression. We can achieve
everything we are trying to do, give US entrepreneurs and businesses the
impetus and capital they need to launch one new business after another, create
the jobs that we so desperately need, and simplify the tax system while
balancing the budget. And we can give every worker in the United States a
significant pay raise without even touching the concept of increasing the
minimum wage.
Sound like pie in the sky? No, but it means real change … which
will require real change.
Understand, there are winners and losers in every serious tax
change, including in my proposal. And my proposal will mess with the Nash
equilibrium, but it will do so in a less abrupt manner and allow for a
transition to a smoother and new equilibrium without instigating a trade war.
US businesses will still get their border advantage, and we can actually find
the capital for literally hundreds of thousands of new businesses that will
create millions of jobs.
You can say that I’m a dreamer, but I’m not the only one.
I know I’m going to be making a number of impromptu one-day trips,
but the next one that’s planned will have me in New Jersey, where I’ll be
speaking on March 14 and 15 to potential individual investors about our new
Mauldin Smart Core Portfolios strategy at a seminar with Steve Blumenthal of
CMG and The Financial
Quarterback’s Josh Jalinski of WOR and WABC in the New York City
metropolitan area and New Jersey. You must reserve a spot with Josh’s office at
888-988-5674(JOSH).
I finish this letter at the brand-new Kimpton Seafire Resort in
the Cayman Islands. I’m at one of my favorite conferences of the year, the
Cayman Alternative Investment Summit, which is normally held at the Ritz here
on the island. I was a little concerned about its moving from the Ritz, but the
Kimpton is actually quite the superior hotel. If you’re looking for a vacation
in the Caymans, you should consider it.
This has been an extremely interesting conference. The attendees
are generally institutional and family office investors, and the conversations
this year were remarkably candid. There is a concern about how long the current
status quo can continue and what these institutions, which generally have
mandates that limit their flexibility, can actually do to protect themselves
from what everybody tends to agree will eventually be a crisis. I listened to a
number of the presentations, and what I heard is forcing me to think through
some new alternatives for how we can hit the global reset button on too much
debt and handle the popping of the bubble of government promises. We are truly
going to have to learn to think the unthinkable. When we come to the next
crisis, we will be forced choose the least painful path, a choice that might
normally have us run screaming for the exits. But that may be what we have to
do. More on that happy topic in later letters.
We actually had Arnold Schwarzenegger here yesterday. He gave a most
encouraging and uplifting speech. At the end of his talk I was allowed to ask a
question. I wanted to know what it was like to come to the United States, go to
“Muscle Beach” in Venice, and work out in Gold’s Gym, otherwise known as the
Dungeon, with the likes of Dave Draper and all the other weightlifting heroes.
That was not a question I think he was expecting, and he thought
about it for a second, then began to describe the weightlifting and
bodybuilding scene of that era (the late ’60s and early ’70s). Not only
bodybuilders but power lifters and Olympic weightlifters all trained in this
one small gym. They all pushed each other to outperform. Literally, he would
work out with three to four former Mr. Universes, Olympic gold medalists, and
multiple other champions in a variety of competitive sports. It was truly
something that will never happen again, because you will never see that
concentration of highly competitive people in one small space, with only the
most rudimentary of gym equipment at the very dawn of an industry.
Now every hotel you go into has a gym. Hospitals routinely put you
into resistance training in your rehab. These guys changed the way we think
about growing old and maintaining our bodies. By the way, let me give a shout
out to my friend Dave Draper, known as the Blonde Bomber, who was the Mr.
Universe right before Arnold began his amazing run of championships. Dave
simply has the best protein powder I have ever tried, and if you are looking
for something that actually tastes good to help control your weight, I
recommend what he calls his Bomber Blend. It is the best combination of
nutrients and protein that I’ve ever been able to find. You can get it at davedraper.com/fitness_products/product/QPD-SBB.html.
You should also consider subscribing to his free weekly letter, which is part
of my motivational routine to keep me in the gym. Iron and steel are your
friends. (Read Dave&rs quo;s book, Brother
Iron, Sister Steel.)
Last night Shane and I had tickets for the legends tennis match,
where we watched 58-year-old John McEnroe, 48-year-old Jim Courier, and
62-year-old Chris Evert run around on the court with their competitive genes
still obviously alive and kicking, even if their serves and returns did not have
their former zing. And they were having fun with the crowd and each other. They
played legends music between games – Queen, AC/DC, Bon Jovi, Kiss, the Eagles,
etc. After McEnroe dispatched Courier, he celebrated by dancing with the
young kids. It was a hoot.
Between the tennis greats and 71-year-old Arnold, they just
make me want to work out more and stay in shape. Or maybe get in shape.
And with that, I will hit the send button, momentarily ignore my
inspirations, and go sit on the beach for an afternoon and read and maybe relax
before heading back to a full workload in Dallas. You have a great week!
Your fighting the good fight against aging too fast analyst,
John Mauldin
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