Is the Bubble Economy Set to Burst?

The tug of war grows more fraught for investors

The IMF and World Bank meetings mixed optimism about the global economy with plenty of concerns

by Mohamed El-Erian
.

© Bloomberg


A “Yes, but” emerged from last week’s global gathering of policymakers that provides a comprehensive check-up for the global economy. In Washington for the 2017 Annual Meetings of the International Monetary Fund and World Bank, officials from almost 190 countries mixed excitement about the improving prospects for the global economy with caution about a list of actual and potential challenges.

And with both sides of this ledger having grown during the past few months, it is a configuration that amplifies the contradictions that traders and investors have to navigate down the road but, for now, are comfortable to profitably ignore.

Four factors underpin the “Yes”:·

- A pick up in economic growth that is becoming broader and more durable. The IMF now projects global growth to increase from 3.2 per cent last year to 3.6 per cent in 2017 and 3.7 per cent in 2018.

- Loose financial conditions that support consumption, and do so without a worrisome increase in inflation and inflationary expectations.

- Very low financial market volatility that, now common to virtually all market segments, allows the wave of higher valuations to reach far and deep.

- Hope that economic growth could be turbocharged by long-awaited progress in implementing more pro-growth policies, particularly in Europe and the US.

The “But” list includes:

- Limited understanding of key economic relationships in advanced countries (such as productivity, wage determination and inflation dynamics), as well as the impact of technological innovation.

- The “hot potato” dimension of today’s foreign exchange markets in which virtually no country is able and willing to live with a sustainably stronger currency.

Uncertainties about the impact of an eventual normalisation of monetary policy in more than one systemically-important central bank, together with those relating to trading arrangements in Europe and North America.

- Growing backlash against big tech in the context of a catchup, both by governments and the companies themselves, to the sector’s systemic importance.

- An international economic order facing greater probability of fragmentation along national and regional lines.

- The geopolitics of North Korea’s brazen nuclear threats.

- Persistent inequalities that fuel the politics of anger, social divisions and party polarisation.


While both sides of this ledger have increased over time, traders and investors have been profitably focusing elsewhere — that is, applying a “buy-the-dip” (any dip) strategy that has served them well. It involves ever greater exposures to credit, liquidity and volatility risks that, over the past few months, have spread from advanced countries’ stocks and bonds to virtually every corner of the public markets around the world. And it is a phenomenon that is being structurally embedded through the proliferation of a growing array of low-cost passive products, notably ETFs, that implicitly promise investors instantaneous liquidity at reasonable bid-offer spreads in asset classes that, in the past, have suffered numerous liquidity strains.

Over time, this confluence of factors sets the global economy and markets on course for a tug-of-war among dramatically opposing possible outcomes. If the “Yes” prevails, the result would include higher and more inclusive growth, a validation of elevated asset prices, the orderly normalisation of unconventional monetary policy, reduced cross-border tensions and an improved environment for national politics. However, a decisive tip towards the “But” would threaten recession and unsettling financial instability, increase the risks of a policy mistake, worsen trade and currency tensions, and fuel more divisive national politics.

It is very hard to predict with a high enough degree of confidence the timing and direction of the eventual resolution. In the meantime, only major disruptions are likely to dissuade traders and investors to abandon what most dream of — a strategy that reliably rewards them and even has some legitimate justification (that is, the ample availability of liquidity from central banks and the corporate sector). In the meantime, both sides of the ledger will continue to grow.


Mohamed El-Erian is chief economic adviser to Allianz and author of the book ‘The Only Game in Town’

Buttonwood

Higher taxes can lower inequality without denting economic growth

A new study by the IMF finds no strong correlation between lower taxes and higher growth



INEQUALITY is one of the big political issues of the 21st century, with many commentators citing it as a significant factor behind the rise of populism. After all, nothing could be more indicative of the triumph of the common man than the elevation of a property billionaire to the American presidency.

A new IMF report* looks at how fiscal policy can help tackle inequality. In advanced economies, taxation already has an impact. The Gini coefficient (a standard measure of income inequality) is around a third lower after taxes and transfers than it is before them. But whereas such policies offset around 60% of the change in market inequality between 1985 and 1995, they have had barely any impact since.

That is because of a change in policy direction. Across the West, taxes on higher incomes have generally fallen. This could be for a number of reasons, the IMF says. The tax take from high earners could have become more “elastic” (ie, sensitive to rate changes); in a mobile world, the elite will move countries to reduce their tax bills. But there is no sign that elasticity has increased in recent decades. A second possibility, easily dismissed, is that the share of income taken by the rich might have fallen; it has, of course, increased. A third option is that society reached a consensus that tax rates needed to be cut to help the rich. In fact, surveys show that people are more in favour of redistributive policies than they were in the 1980s.

Another reason that governments might have driven down top tax rates could be to create greater incentives to invest, thereby boosting economic growth. That certainly seems to be the rationale behind the cuts being proposed by President Donald Trump.

But the IMF, after analysing tax rates in OECD countries between 1981 and 2016, found no strong relationship between how progressive a tax system is and economic growth. Indeed the study adds that for countries wanting to redistribute wealth, there may be “scope for increasing the progressivity of income taxation without significantly hurting growth”.

The latter sentence will be seized on by politicians on the left. But the argument works better in some places than in others. The IMF reckons that the optimal tax rate on higher incomes, assuming the aim is revenue maximisation, is 44%. Britain’s highest rate is already 45%. So the IMF study does not really provide much ammunition for Jeremy Corbyn, the leader of the Labour Party, the main opposition, who wants to raise it to 50%. It is a better argument, perhaps, for Bernie Sanders, the Democrat, since the top American tax rate, before any Trump cuts, is only 39.6%.

Even here, a note of caution is needed. Companies are inclined to move in search of more favourable tax treatment—hence the success of Ireland in attracting business with its 12.5% corporate-tax rate, and the row about “inversions” where American companies move overseas to lower-tax jurisdictions. In response, countries have steadily lowered corporate-tax rates; since 1990 the average rate in advanced economies has fallen by more than 13 percentage points (see chart).

Many rich individuals can choose to shift the way they report their income to take advantage of lower corporate-tax rates. So it is difficult to push up the tax rate on individual incomes while simultaneously lowering the corporate rate. As the IMF report drily remarks: “International tax co-ordination could potentially address this problem but has proved very difficult to implement.” So are there other ways to reduce inequality via the tax system? Another option discussed by the IMF is taxing property, which is an immovable asset. Inheritance taxes are another possibility, although they are costly to administer, and no G7 country raises more than 1% of GDP through this route.

Given the political clout of the rich, it seems unlikely that an international consensus on reducing inequality through higher taxes is going to emerge. In the absence of such a consensus, few governments will take the risk of raising their own rates unilaterally. Step forward, however, a future Corbyn government, which plans to increase the tax rate on companies as well as on individuals—all in the context of Brexit, when companies might in any case be reconsidering their decision to invest in Britain. It will be an economic experiment closely watched by other countries, suggesting a new national slogan: “Britain—we try policies so you don’t have to.”

Don’t Bank on Bankruptcy for Banks

Mark Roe
 .

In China, a New Political Era Begins

By Matthew Massee

The world has changed since modern China was founded, and it seems that China, not for the first time, is changing with it. When Mao Zedong established the republic in 1949, having fought a civil war to claim it, China was poor and unstable. To reinstate stability he ruled absolutely, his government asserting itself into most other state institutions. Private property was outlawed, and industrialization was mandated, from the top down, in an otherwise agrarian society. The goal was to disrupt China’s feudal economic system that enriched landlords but left most of the rest of the country in poverty. Mao’s techniques ensured compliance with government policies, but they did little to improve the country’s underdeveloped economy. This is what we consider the first era of communist rule. When Mao died in 1976, his successor, Deng Xiaoping, made economic development his utmost priority. He liberalized some of Mao’s policies, allowing foreign trade in some areas and private ownership in others, and so ushered in the beginning of China’s economic miracle. The country prospered, but it did so unevenly. The coastal provinces became wealthy while the impoverished interior regions floundered. Liberalization meant less government control, but with less control, military and economic elites began to pursue their own interests, which sometimes ran counter to those of the party. Central leaders became comparatively less important. This is what we consider the second era of communist rule. Chinese President Xi Jinping delivers a speech at the opening session of the Chinese Communist Party’s Congress at the Great Hall of the People in Beijing on Oct. 18, 2017. WANG ZHAO/AFP/Getty Images   The third era of modern China may well have begun on Oct. 18, the first day of the 19th National Congress of the Communist Party. President Xi Jinping basically said as much in his opening speech, noting that he would raise his country’s influence abroad and lower its poverty rates at home. To do that, however, Xi believes he must blend the policies of Deng and Mao – in other words, he must liberalize with an iron fist. This explains why, over the past five years, he has steadily accrued more power than almost any other leader, using anti-corruption as pretext to purge his political enemies. He has disciplined several party figures and replaced them with officials loyal to him. He has implemented a variety of military reforms. And he has centralized economic management more than it already had been – something he believes is necessary to remove the biggest impediments to Chinese growth and stability: uncontrolled maritime territory and an imbalanced economy.   The Protection of Rights The Chinese economy depends heavily on exports, but the country’s geography is all but hostile to land-based trade. It therefore relies heavily on the world’s sea lanes to bring its wares to market. One of China’s geopolitical imperatives – something it must to do survive and thrive – is to guarantee trade through the East China Sea and South China Sea, areas to which Beijing has laid exclusive claim. (Nearly 40 percent of China’s total trade in 2016 transited through the South China Sea, according to the Center for Strategic and International Studies.) Put simply, these waters are so important to China’s economy that Beijing cannot afford to lose them. The government is aware of how vulnerable this dependence makes the country, and it is likewise aware that the United States, the world’s foremost naval power, could exploit it if a conflict between the two broke out.   (click to enlarge)   One way to overcome this weakness is to overhaul China’s navy and air force. This is why, in his Oct. 18 speech, Xi said China intends to fully modernize its military and enhance the nation’s defensive capabilities by 2035. The stated rationale is to protect maritime rights and to engage in counterterrorism, disaster relief, peacekeeping and humanitarian relief. But the tacit reason is to protect its own maritime rights. Some reforms are already underway. In 2014, for example, Xi reduced the number of military command regions from seven to five, and all armed forces were placed into joint groups to better coordinate their operations. Earlier this year, the People’s Liberation Army announced that it would cut 300,000 soldiers because modernization requires technological applications, not manpower. The central government is asserting dominance over the PLA and preventing alternative centers of power from arising. This, coupled with an increasing defense budget with a heavy focus on technological upgrades, will remake the armed forces into a more effective, modern fighting force.   Money to the Middle History tends to repeat itself in China. Over the centuries, when Beijing opened up its economy, it generated wealth that usually never made it in to the rural interior provinces. The disparity created enough of an economic imbalance between the rich coast and the poor interior that the government needed to turn inward to reunite the country. (click to enlarge)   For China, that moment approaches again. The Deng era helped China to become wealthy, but the coastal provinces have benefited far more than the interior. For Chinese leaders, this is palatable during times of prosperity, but when economic growth slows, as it has recently, it creates a problem for the Communist Party, the legitimacy of which depends on keeping people wealthy enough – or at least well-enough fed – to not rebel against it. After all, the party came to power in a revolution of the people, not of the elite. Xi sees the risk and knows what’s at stake. So far, his approach in mitigating the risk has been to centralize power by taking it away from the provinces and suppressing political and social dissent. Centralizing power, however, is just the first step in Xi’s plan to right the economy. The next step involves real measures to reduce economic inequality. (Xi’s government intends to eliminate rural poverty by 2020.) To that end, Beijing has directed infrastructure development to poor areas to help jumpstart growth. To encourage foreign capital inflows, China will create a more unified national investment environment. Instead of each foreign trade zone having its own “negative list” that determines which sectors foreign investors are allowed to participate in, Xi plans to make a national list, which would grant the central government more control over provincial and municipal economic managers, and allow it to incentivize investment outside of coastal provinces. The goal is to get money into the interior. Over the past two years, Beijing has also placed restrictions on capital outflows from domestic sources to encourage investment in the nation’s inner provinces and discourage capital flight. Until now, coastal firms and wealthy investors have tended to put their money into foreign assets such as sports teams and hotels, which increased capital scarcity and forced the People’s Bank of China to sell foreign assets to stabilize the yuan. Investments in foreign countries now require approval to ensure they are either to gain technology in strategic industries or to fund One Belt, One Road projects. Generally, it’s a mistake to overemphasize the importance of political speeches. But Xi’s was no ordinary speech. Over the past five years, he has instituted sweeping changes in a country resilient to change and has enhanced his power at the expense others. The people like him. Officials fear him. The military has been reorganized around him. And economic growth under him has declined slowly and steadily, not sharply or dramatically. In other words, his speech is notable, especially since it came during what is, by many accounts, the formalization of his power and policies.