Capitalism and democracy — the odd couple

We are making a bad job of reconciling the tensions to hold this marriage together

by Martin Wolf

Democracy is in recession. After spreading across the globe between the 1970s and early 2000s, it is in retreat. Also in retreat is the belief in a liberal global economy. Is there a connection between the two? Yes. Democracy and capitalism are married, yet it has often been a turbulent union. Today, it is going through a rough patch.

Larry Diamond of the Hoover Institution has propounded the idea of a “democratic recession”. Roberto Foa of the University of Melbourne and Harvard’s Yascha Mounk have referred to “the democratic disconnect”, pointing to a depressing loss of belief in democracy in the US and Europe. In its latest annual report, Freedom House states that “a total of 67 countries suffered net declines in political rights and civil liberties in 2016, compared with 36 that registered gains. This marked the 11th consecutive year in which declines outnumbered improvements.”

Meanwhile, the election of Donald Trump as US president demonstrates hostility to liberal trade. Post-crisis hostility to Wall Street and free-flowing global finance is also strong, on both right and left. Opposition to the movement of people is pervasive.

The Polity IV database from the Center for Systemic Peace provides an invaluable picture of the progress of democracy since 1800. Between 1800 and 2016, the number of political regimes it rates “democratic” rose from zero out of 22 to 97 out of 167. Indeed, back in 1800 nearly all regimes were autocracies (see charts). The number of democracies then rose in the second half of the 19th century, jumped at the end of the first world war, fell sharply in the 1930s and early 1940s, jumped again at the end of the second world war, rose steadily up to 1988 and then exploded upwards in the 1990s and early 2000s. The number of autocracies reached a peak of 89 in 1977. Then, the number of autocracies collapsed, as the Soviet Union fell and the failings of dictatorships became more evident. Unfortunately, since 1990, about 50 states have been “anocracies”, that is, politically chaotic.

The number of notionally sovereign states has risen greatly, especially since 1945. So it is sensible to focus on the proportion of the world’s regimes that are democratic. It is also possible to relate this proportion to the ratio of world trade to output. (Not coincidentally, other measures of globalisation — movement of people and capital — are closely correlated with trade.)

This correlation, though far from perfect, is quite close. The late 19th and early 20th centuries were a period of globalisation and democratisation. The 1920s and 1930s were, conversely, a period of de-globalisation and de-democratisation. The 1950s and 1960s were a period of rough stability on both fronts (as the opening up of the economies of high-income countries was offset by the closing down of the economies of most newly independent ones). Globalisation re-emerged in the 1970s, followed by democratisation. Apart from globalisation, the other powerful leading indicator of democratisation was the victory of the democracies in the world wars and the cold war. Jumps in the number of democracies followed the victories.

In brief, the industrial revolution has ultimately led to a political revolution, from autocracy towards democracy. Moreover, periods of globalisation have been associated with the spread of democracy and periods of de-globalisation with the reverse.

This is not surprising. As Harvard’s Benjamin Friedman has argued, periods of prosperity strengthen democratisation and vice versa. Since 1820, average global real incomes per head have risen 13-fold and even further in high-income countries. As economies progress, people needed to be educated. Such changes, and, alas, mass mobilisation for industrialised warfare, strengthen demands for political inclusion.

In reverse, the financial crises that destroyed globalisation in the 1930s and damaged it after 2008 led to poverty, insecurity and anger. Such feelings are not conducive to the trust necessary for a healthy democracy. At the very least, democracy requires confidence that winners will not use their temporary power to destroy the losers. If trust disappears, politics becomes poisonous.

The link is not just empirical. Democracy and capitalism rest on an ideal of equality: everybody may share in political decision-making and do the best they can in the market. These freedoms were revolutionary not that long ago.

Yet deep conflicts also exist. Democratic politics depends on solidarity; capitalists do not care about nationality. Democracy is local; capitalism is essentially global. Democratic politics is founded on the equality of citizens; capitalism cares little about the distribution of riches.

Democracy says all citizens have a voice; capitalism gives the rich by far the loudest.

Electorates desire some economic security; capitalism is prone to boom and bust.

The tensions between national democracy and global capitalism can be ruinous, as the 1930s proved. Yet history also shows that the two systems do go together, albeit uneasily.

This is not to argue that all market economies are democracies or that all market economies must be globalised. It is to argue that stable democracies also possess at least reasonably open market economies. No alternative way of managing the affairs of complex societies has proved workable.

The aim must now be to manage capitalism so that it supports democracy and to manage democracy so that it makes global capitalism work better for all. Today, we are making a mess of this marriage.

We must do far better.

Steve Bannon’s Bad History

Immigration and rapid industrialization—not tariffs—made the 19th-century economy great.

By Douglas A. Irwin

Sen. Reed Smoot (left), actress Mae Murray and Rep. Willis Hawley, 1929.. Photo: The Granger Collection

So far, the Trump administration’s trade policy has seen an internal division among economic nationalists and “globalists” on the president’s senior staff. The economic nationalists, and the president himself, believe protectionism will strengthen the American economy. “Look at the 19th century,” said former White House chief strategist Steve Bannon in his recent “60 Minutes” interview. “What built America’s so called ‘American system,’ from Hamilton to Polk to Henry Clay to Lincoln to the Roosevelts? A system of protection of our manufacturing, financial system that lends to manufacturers, OK, and the control of our borders.”

In the nationalists’ narrative, high tariffs were responsible for America’s growth and industrialization in the 19th century. This is not only a misreading of history, it’s a bad policy prescription for the 21st century. A return to high tariffs would sap America’s economy today.

Mr. Bannon’s simple story is historically and economically off base. As Treasury secretary, Alexander Hamilton wanted moderate tariffs, not protectionist duties. In his day, tariffs accounted for nearly all federal revenue. He wanted to keep imports flowing so he could finance the federal government’s Revolutionary War debt and secure the young nation’s credit. President Polk, far from being a protectionist, was a small-government Democrat. He slashed tariffs dramatically in 1846.

Mr. Bannon even gets the Roosevelts wrong. Theodore Roosevelt recognized the need to reduce tariffs but was uncharacteristically afraid of crossing old-guard Republicans in Congress, leaving the dirty work to his Republican successor, William Howard Taft. And Franklin D. Roosevelt was a “globalist” who got Congress to delegate tariff authority to the executive so that import duties could be cut in trade agreements with other countries.

Economic nationalists always conveniently skip the story of the 1930 Smoot-Hawley tariff, probably because it doesn’t fit their narrative. Smoot-Hawley—passed by Republicans and signed by a Republican president—didn’t cause the Great Depression, but the trade wars it inspired certainly damaged the world economy and backfired badly against the United States.

More important, America didn’t boom during the 19th century because it was a closed economy. The U.S. industrialized rapidly between 1833 and 1860, when tariffs were being cut.

While tariffs were high after the Civil War, the U.S. was open to foreign capital inflows. It was also open to the best industrial technology from Britain and Germany, and—importantly given Mr. Bannon’s assertion that the U.S. had control of its borders back then—to massive immigration. The textile mills and steel furnaces of the late 19th century were largely staffed by foreign-born workers. As in our own era, many native-born Americans weren’t interested in doing tedious and grinding jobs at low wages.

Economic nationalists also ignore the more sordid history of American protectionism.

Clay—who served as a senator, House speaker and secretary of state—was a staunch advocate of protection, but he overplayed his hand. High tariffs meant high taxes, and Clay failed to anticipate how politically divisive they would be.

The South nearly revolted after the “Tariff of Abominations” in 1828, which was aimed at protecting industry in the Northern states. South Carolina threatened to secede from the Union.

The Compromise of 1833 defused the crisis, putting tariffs on a downward trend for nearly three decades. Post-Civil War tariffs were just as controversial because they bred political corruption. Producers lobbied Congress for higher tariffs on their foreign competitors, while other special interests wanted the revenue spent on pet projects. Protectionism didn’t drain the swamp; it created it.

The claim that protectionism made America’s economy great in the past, and can do so again today, is wrong. When the government boosts domestic steel prices to protect a few firms from foreign competition, it also hurts domestic steel users who need cheap inputs to remain competitive in a global marketplace. Making the U.S. a “high price island” for steel, semiconductors, sugar and solar panels favors some businesses at the expense of others.

Protectionism can even push manufacturers to leave the country in order to remain competitive. And protectionism hurts exporters—not just the many American farmers who sell to foreign markets, but big manufacturers, such as Boeing and General Electric , which produce goods for sale abroad.

Economic nationalists say their protectionist program will ignite an economic boom. In fact their poor understanding of history will damage the American economy and leave the country weaker.

Mr. Irwin is a professor of economics at Dartmouth and author of “Clashing over Commerce: A History of U.S. Trade Policy,” to be published in November by the University of Chicago Press.

The Global leadership Vacuum

Javier Solana

MADRID – Germany and China are chief among the countries whose economic policies have drawn US President Donald Trump’s ire. While the United States has the largest current-account deficit in the world, Germany and China , and that irritates Trump and his advisers to no end.              

Trump’s top trade adviser, Peter Navarro, insists that China is suppressing the value of its currency, the renminbi. More surprisingly, Navarro has also accused Germany, an American ally, of “exploiting” the US and its European partners through an undervalued euro. Most economists agree that Navarro’s accusations are largely unfounded. Trump himself has flip-flopped on these issues, contradicting Navarro on occasion, even as he remains openly suspicious of US trade partners’ policies generally.
Since Trump was elected last year, Germany and China have also been chief among the countries expected to supplant US global leadership. But Germany and China are profoundly different, and there is no consensus on whether either country can or will fill America’s shoes.

In a case of curious timing, both German Chancellor Angela Merkel and Chinese President Xi Jinping are approaching domestic political events that are widely expected to solidify their leadership positions in the coming years. In Germany, Merkel is favored to win a fourth term as chancellor in the upcoming federal election on September 24. A victory will put her on track to match Helmut Kohl’s 16 years in office – a tenure exceeded only by Otto von Bismarck.
Campaign-season debates in Germany have centered on Merkel’s “open doors” policy in response to the refugee crisis in 2015. Merkel’s welcoming of refugees has exposed her to ferocious attacks – including from Trump himself – and energized the German far right, which, through the Alternative for Germany (AfD) party, will probably elect representatives to the Bundestag for the first time since World War II.
Fortunately for Merkel, her relentless defense of humanitarian values does not seem to have cost her much support among those who voted for her previously. She and her party, the Christian Democratic Union, experienced a backlash in polls and state elections after the summer of 2015, but that storm has blown over. In fact, Merkel’s refugee policy has actually reinforced her popularity among younger voters.
Toward the end of the twentieth century, former US Secretary of State Madeleine Albright defined the US as the “indispensable nation.” Now, almost 20 years later, The Economist magazine has deemed Merkel the “indispensable European.” But as Merkel herself has warned, it would be “grotesque and absurd” to expect that she could carry the standard of liberal internationalism.
Germany, owing to its history, is reticent about reclaiming a leading role on the world stage.

But at the European level, Merkel can and should use a fourth term to establish an international legacy that measures up to her political stature. With the election behind her, and with a in French President Emmanuel Macron, she will have a prime opportunity to pursue measures to rebalance and strengthen the European Union.
Meanwhile, Xi’s legacy is also at stake. In mid-October, China’s political elite will convene for the 19th National Congress of the Chinese Communist Party (CCP), an event that will inevitably center on Xi. As of last year, Xi has been officially declared the “core leader” of the CCP, a designation that his predecessor, Hu Jintao, never achieved.
At the Congress, CCP delegates will elect a new Central Committee, which will then fill the highest positions in the Party. Xi’s reelection as CCP General Secretary is seen as a fait accompli, and most analysts expect that he will continue to surround himself with faithful allies and oust potential rivals, as he has already done through a much-publicized anticorruption campaign.
In 2015, Wang Qishan, Xi’s right-hand man who has been leading the anticorruption campaign, raised the question of the CCP’s “legitimacy” in a statement that previously would have been taboo. With China’s economy slowing down in recent years, the CCP knows that it can no longer rely on growth alone to guarantee its political standing in the eyes of ordinary Chinese.
Xi’s anticorruption campaign is a central component of the CCP’s new legitimizing narrative.
So, too, is nationalism, which the CCP has been fostering through a highly visible and more assertive foreign policy. According to CCP tradition, Xi’s second five-year term should also be his last. But whether he will use his newly secured position to push for ambitious economic reforms remains to be seen. His role within China after 2022 is also not yet known.
On the foreign-policy front, Xi has signaled that he might be ready to fill the leadership vacuum created by Trump’s “America First” approach. But China cannot hope to replace the US unless it vastly increases its “” and cultivates alliances and partnerships that it currently lacks. The CCP’s stoking of Chinese nationalism does not make either of those tasks any easier.
The ongoing North Korea crisis implies that the US-China relationship during the Trump-Xi era will be one of intense strategic competition. Will other actors, such as Merkel’s Germany or the EU as a whole, step in to ensure that great-power cooperation does not deteriorate beyond a point of no return? The answer to that question will likely determine whether the international order retains any order to speak of in the years ahead.
Javier Solana was EU High Representative for Foreign and Security Policy, Secretary-General of NATO, and Foreign Minister of Spain. He is currently President of the ESADE Center for Global Economy and Geopolitics, Distinguished Fellow at the Brookings Institution, and a member of the World Economic Forum’s Global Agenda Council on Europe.

Sprott Precious Metals Watch, September 2017

Trey Reik, Senior Portfolio Manager

It's the Debt Stupid!
The investment climate of 2017 has been characterized by thematic crosscurrents. 
Communication from global central bankers has at times appeared more hawkish, yet global rates of QE have only accelerated.  Optimism for the Trump agenda initially levitated sentiment measures, but hard economic statistics failed to follow.   Despite almost continuous upheaval in global geopolitics, volatility measures and credit spreads have remained unfazed near historic lows.  Since economic fundamentals can never compete with the intoxication of fresh weekly highs for the S&P 500, investor consensus now routinely ignores troubling imbalances in the global financial system.  Indeed, investors and asset allocators with the temerity to have employed risk-mitigation and hedging strategies have only succeeded in impairing portfolio performance and career prospects.  In an investment world now dominated by monthly inflows into ETF’s and index funds, unconstrained by rational analysis of portfolio components, it has become somewhat passé to fret over underlying fundamentals.

Amid such fervor for U.S. financial assets, gold’s solid year-to-date gains have been somewhat counter-intuitive.  After trading in a tight $100-range for seven months, spot gold broke upwards through resistance at $1,300 in late August and touched an intraday high of $1,357.64 on 9/8/17 (up 17.8% year-to-date).  Most investors are unaware that gold’s performance during this span exceeded the total-return of the S&P 500 (+11.51%) by some 55%!  Conventional wisdom attributes gold’s recent strength to North Korean provocation and Mother Nature’s wrath, but this narrative ignores the fact that gold broke through $1,300 (on its third attempt in five months) before Chairman Kim’s 8/28 Hokkaido missile launch.  We believe gold’s unheralded price-performance in 2017 carries an important signal for investors.  Much to the Fed’s chagrin, economic and financial imbalances are bubbling to the surface (once again), placing consensus expectations for further FOMC tightening in jeopardy.

As precious-metal investors, we frequently encounter the refrain that global economic conditions, while somewhat lackluster, are a far cry from the negative extremes of the financial crisis.  The funny thing about this nearly ubiquitous view is how precisely misinformed it actually is—virtually every measure of domestic and global debt is significantly worse today than at its financial-crisis peak.  In this note, we seek to disabuse the popular notion of economic and balance sheet repair, through dispassionate review of relevant statistics.  We recognize rehashing structural debt issues is a tiresome exercise for equity bulls, but we believe gold’s recent breakout may be foreshadowing an imminent uptick in financial stress.  If we are correct in our analysis, reigning positioning in prominent asset classes is likely to be recalibrated to gold’s tangible benefit. 

Perhaps the greatest misconception among contemporary investors is the belief that the U.S. economy has been deleveraging since the financial crisis.  Nothing could be further from the truth.  The Fed’s quarterly Z.1 report discloses that domestic nonfinancial credit (including households, business, federal, state and local) has actually increased over 40% since Q1 2009, rising from $33.9 trillion to $47.5 trillion by Q1 2017.  Of course, this aggregate measure does not capture growth in the Fed’s own balance sheet, which has expanded from  $930 billion in August 2008 to its current level around $4.5 trillion.  Because we have always viewed the Fed’s QE programs as tacit admission that the Fed feels compelled to provide a liquidity bridge whenever U.S. nonfinancial credit growth is insufficient to stabilize the U.S. debt pyramid (now $66.5 trillion including financial debt), we find it highly implausible that the Fed can now reduce the size of its balance sheet meaningfully without straining liquidity conditions in the U.S. commercial banking system.

Our gold investment thesis rests on the gross over-issuance of paper claims (debt) against comparatively modest levels of productive output (GDP).  Total U.S. credit market debt of $66.5 trillion cannot be functionally serviced by a $19 trillion economy without annual creation of copious amounts of fresh nonfinancial credit to help amortize existing debt obligations.  Gold serves as a productive portfolio asset amid such “forced” credit growth for two important reasons.  First, the only options for rebalancing unsustainable debt levels back towards underlying productive output are default or debasement, and gold is an asset immune to both.  Second, gold is an effective protector of portfolio purchasing power during inevitable episodes of official policy response.

In Figure 1, below, we plot a simplistic illustration of how burdensome U.S. debt levels have become.  During the past four quarters, net economy-wide interest payments approximated $641 billion, or over 90% of coincident GDP growth of $708 billion.  This certainly does not leave much economic fuel to power capital formation!

Figure 1:  U.S. Annual Aggregate Net Interest Payments (1985-2017) [MacroMavens; BEA; U.S. Treasury]
Drilling down in the consumer segment of total U.S. debt, historically high debt levels are frequently discounted by the observation that debt-service ratios remain manageable in the context of today’s near-ZIRP environment.  We view debt-service ratios as a classic tool of cognitive dissonance.  While these ratios calibrate aggregate disposable income to aggregate debt service, they ignore the reality that the disposable income and the debt obligations are largely concentrated in different sub-sectors of the U.S. population, so netting them out is a pyrrhic exercise.  Further, in the current environment of soaring healthcare and housing costs, traditional disposable income statistics have become far less instructive in gauging consumer financial health than discretionary income measures (after basic needs are paid for).  Reflecting growing consumer stress, delinquencies are beginning to spike (from low levels) on a wide range of revolving and installment credits, from JP Morgan’s credit card portfolio to subprime auto loans, to everything in between.  Rapidly declining fundamentals in important industries such as retail, automobiles and restaurants only serve to reinforce the message of tapped and retrenching consumers.

Corporate balance sheets have been deteriorating for many years.  ZIRP fostered an epic decline in capex in favor of borrowing to finance share repurchase.  In essence, corporate income statements have been consuming corporate balance sheets at an alarming clip.  State and local governments are struggling with a $4 trillion funding shortfall in public pensions, due largely to the corrosive effects of seven years of ZIRP on the complexities of pension accounting. 

The recently negotiated three-month suspension of the federal debt ceiling paved the way for a single-day$318 billion boost in our national debt, to $20.162 trillion on 9/8/17.  Since the U.S. has not run a budget surplus in over two decades, it is no surprise that first breach of the $20-trillion-level generated scant coverage in financial press.  Quickly recognizing he now faces the awkward timing of a year-end debt-ceiling standoff, President Trump once again demonstrated his trademark flexibility with respect to longstanding convention by floating the concept of abandoning the ceiling altogether (9/7/17): 

For many years, people have been talking about getting rid of debt ceiling altogether, and there are a lot of good reasons to do that….It complicates things, it’s really not necessary.
Rounding out the surreal quality of contemporary U.S. governance, Treasury Secretary Mnuchin on 9/13/17 issued veiled threats towards China which we found disturbing.  Addressing an Andrew Sorkin question as to why the U.S. has been unable to “move the needle” in convincing China to pressure North Korea to change its behavior, Secretary Mnuchin responded:

I think we have absolutely moved the needle on China.  I think what they agreed to yesterday was historic.  I’d also say I put sanctions on a major Chinese bank.  That’s the first time that’s ever been done.  And if China doesn’t follow these sanctions, we will put additional sanctions on them and prevent them from accessing the U.S. and international dollar system And that’s quite meaningful.

As John McEnroe might protest, “You can’t be serious!”  The United States is the world’s largest debtor nation, running the world’s largest trade deficit, requiring more external capital than any other global nation.  Yet Treasury Secretary Mnuchin saw fit to threaten to deny China, both our largest creditor and our largest trading partner, access to the SWIFT interbank clearing network, which underpins the dollar-standard system and, therefore, the vast majority of global commerce.  Beyond almost inconceivable disrespect to China, Mnuchin’s comments demonstrate either ignorance of, or reckless disregard for, the critical role played by savings (domestic or foreign) in the capital formation process.  In the United States, we don’t even pretend that savings matter anymore.  It’s all about the printing press!

Amid cavalier U.S. attitudes regarding the dollar-standard system, the global trend towards de-dollarization continues apace.  In response to U.S. sanctions, Venezuela announced 9/14/17 that it will no longer accept U.S. dollars as payment for its crude oil exports.  Even more intriguing was disclosure in the Nikkei Asian Review on 9/3/17 that China is launching a crude oil futures contract denominated in yuan and fully convertible into gold on the Shanghai and Hong Kong exchanges (already beta-tested this past June and July).  Long-held global resentments over the petrodollar payment system are finally coalescing into tangible policies and products to reduce dollar hegemony.  These currency-diversification efforts only compound the dollar’s 2017 woes. 
As shown in Figure 2, below, 2017-year-to-date performance of the Fed’s Broad Trade-Weighted Dollar Index has been the worst since inception of the index in 1995.        


Figure 2:  Annual Performances of Fed’s Broad Trade-Weighted Dollar Index by Trading Days (1995-2017) [Bespoke Investment Group; Zero Hedge]
Pulling this all together, we attribute recent dollar weakness to growing speculation that the Fed is finished with its current tightening cycle.  As we have communicated in the past, we believe outstanding U.S. debt levels absolutely preclude normalization of interest rate structures (on both the short and the long end).  While it is still too early to cite definitive proof, we suspect the Fed’s three most recent rate hikes have already begun to weigh on U.S. economic performance in manners the Fed will not countenance (such as declining growth rates in commercial-bank lending).  On 9/5/17, Minneapolis Fed President (and 2017 FOMC voter) Neel Kashkari freely acknowledged his own apprehensions over recent Fed tightening:

Maybe our rate hikes are actually doing real harm to the economy.  It’s very possible that our rate hikes over the past 18 months are leading to slower job growth, leaving more people on the side-lines, leading to lower wage growth, and leading to lower inflation and inflation expectations.

Despite the Fed’s recent rate increases and occasional outbreaks of hawkish jawboning from global central bankers during 2017, the U.S. dollar’s extended decline, together with gold’s recent breakout, signal growing market skepticism that the era of central bank stimulus is truly coming to a close. 

Figure 3: Spot Gold vs. Aggregate Market Value of Global Negative-Yielding Sovereign Bonds (February 2017-September 2017) [Meridian Macro] 
Nowhere is this inflection in market expectations for central bank policy more evident than in the dramatic summer resurgence of sovereign bonds sporting negative yields.  Figure 3, above, demonstrates that the global stock of negative-yielding sovereigns exploded by 50% during the past three months, and now stands just $2.1 trillion shy of its June 2016 record-total.  Tight correlations in Figure 3 suggest gold has certainly taken notice.