How Democratic Is the Euro?

Dani Rodrik

Mario Draghi presents ECB report at EU Parliament

SAN SERVOLO, ITALY – When Italy’s president recently vetoed the appointment of the Euroskeptic Paolo Savona as finance minister in the government proposed by the Five Star Movement-League party alliance, did he safeguard or undermine his country’s democracy? Beyond constitutional strictures specific to the Italian context, the question goes to the heart of democratic legitimacy. The difficult issues it raises need to be addressed in a principled and appropriate manner if our liberal democracies are to be restored to their health.

The euro represents a treaty commitment from which there is no clear exit within prevailing rules of the game. President Sergio Mattarella and his defenders point out that an exit from the euro had not been subject to debate in the election campaign that brought the populist coalition to power, and that Savona’s appointment threatened a financial market meltdown and economic chaos. Mattarella’s detractors argue that he overstepped his authority and has allowed financial markets to veto the selection of a minister by a popularly elected government.

By joining the euro, Italy surrendered monetary sovereignty to an external, independent decision-maker, the European Central Bank. It also undertook specific commitments with respect to the conduct of its fiscal policy, though these constraints are not as “hard” as those framing monetary policy. These obligations place real limits on the Italian authorities’ macroeconomic policy choices. In particular, the absence of a domestic currency means Italians cannot choose their own inflation target or devalue their currency vis-à-vis foreign currencies. They also have to keep their fiscal deficits below certain ceilings.

Such external restraints on policy action need not conflict with democracy. Sometimes it makes sense for the electorate to tie its hands when doing so helps it achieve better outcomes. Hence the principle of “democratic delegation”: Democracies can enhance their performance by delegating aspects of decision-making to independent agencies.

The canonical case for democratic delegation arises when there is a paramount need for credible commitment to a particular course of action. Monetary policy is perhaps the clearest instance of this. Many economists subscribe to the view that central banks can generate output and employment gains through expansionary monetary policy only if they are able to produce surprise inflation in the short run. But, because expectations adjust to central bank behavior, discretionary monetary policy is futile: it yields higher inflation but no output or employment increases. Accordingly, it is far better to insulate monetary policy from political pressures by delegating it to technocratic, independent central banks that are charged with the singular objective of price stability.

Superficially, the euro and the ECB can be seen as the solution to this inflationary conundrum in the European context. They protect the Italian electorate from their politicians’ counterproductive inflationary tendencies. But there are peculiarities to the European situation that make the democratic delegation argument more suspect.

For one thing, the ECB is an international institution, bearing responsibility for monetary policy for the eurozone as a whole rather than Italy alone. As a result, it will be generally less responsive to Italian economic circumstances than a purely Italian, but equally independent central bank would have been. This problem is aggravated by the fact that the ECB chooses its own inflation target, which was last defined in 2003 as “below, but close to, 2% over the medium term.”

It is difficult to justify the delegation of the inflation target itself to unelected technocrats. When some countries in the eurozone are hit by adverse demand shocks, the target determines the extent of painful wage and price deflation these countries must undergo to readjust. The lower the target, the more deflation they must bear. There was a good economic argument for the ECB to have lifted its inflation target following the euro crisis to facilitate competitiveness adjustments in Southern Europe. Insulation from political accountability was probably a bad thing in this case.

As Paul Tucker, a former deputy governor of the Bank of England, discusses in his masterful recent book Unelected Power: The Quest for Legitimacy in Central Banking and the Administrative State, the argument for democratic delegation is a subtle one. The distinction between policy goals and how they are implemented needs to be clear. Insofar as they entail distributional consequences or tradeoffs between contending goals (employment versus price stability, for example), policy objectives have to be determined through politics. Delegation is warranted at best in the conduct of policy that serves politically determined objectives. Tucker argues, correctly, that few independent agencies are based on a careful application of principles that would pass the test of democratic legitimacy.

This shortcoming is far worse in the case of delegation to international agencies or treaties. Too often, international economic commitments serve not to fix democratic failures at home, but to privilege corporate or financial interests and undermine domestic social bargains. The European Union’s legitimacy deficit derives from the popular suspicion that its institutional arrangements have veered too far from the former to the latter. When Mattarella cited the reaction of financial markets in justifying his veto of Savona, he reinforced those suspicions.

If the euro – and indeed the EU itself – is to remain viable and democratic at the same time, policymakers will have to pay closer attention to the demanding requirements of delegating decisions to unelected bodies. This does not mean that they should resist surrendering sovereignty to supranational agencies at all costs. But they should recognize that economists’ and other technocrats’ policy preferences rarely endow policies with sufficient democratic legitimacy on their own. They should promote such a delegation of sovereignty only when it truly enhances the long-term performance of their democracies, not when it merely advances the interests of globalist elites.

Dani Rodrik is Professor of International Political Economy at Harvard University’s John F. Kennedy School of Government. He is the author of The Globalization Paradox: Democracy and the Future of the World Economy, Economics Rules: The Rights and Wrongs of the Dismal Science, and, most recently, Straight Talk on Trade: Ideas for a Sane World Economy.

Political tale-telling is splitting the eurozone apart

The biggest threat to the bloc is the toxic combination of mistrust and untruths

Wolfgang Münchau

Matteo Salvini, left, and Luigi Di Maio. Italy's populist government is not an electoral accident, as the country's moderate political commentators want us to believe © AFP

Narratives matter. A friend once warned me not to use the word “narrative” because it was a convoluted way of saying “stories”. But narratives are special kinds of stories. They are the tales we keep telling each other, until we believe them.

I have been following narratives on European integration in the largest member states of the EU with mounting disbelief. One of the causes of the vote for Brexit was the language of Euroscepticism and the lack of an intelligent counter-message. Similar stories are now driving the eurozone apart.

A well-known political columnist at Der Spiegel recently referred to Italians as beggars lacking the decency to say thank you. Behind this disgraceful insult stirs an all-too-widespread belief among Germans that they are bankrolling the EU — and Italy, in particular. But the truth is that Italy is a net contributor to the EU budget, runs surpluses in its primary fiscal balance and its current account, and has never been a recipient of German bailouts.

Another common line in Germany, but also in many English-speaking countries, is that France is an economic basket case. Few proponents of this idea seem aware of the fact that France’s economic performance has been similar to that of Germany since the creation of the eurozone almost 20 years ago.

What is particularly shocking about these spurious narratives is not only the contempt and ignorance they reflect, but the casual way in which they are cobbled together. They are part of common folklore and judged to be true because everybody has been saying the same kind of stuff for years.

This tendency could be seen in the UK during the run-up to the Brexit referendum. If people are told to associate the word “Brussels” with “bureaucrat” for two decades, why should we be shocked when they vote to cut loose from the hated bureaucracy?

The lesson I draw from Brexit is that narratives shape politics. Italy’s populist government is not an electoral accident, as moderate Italian political commentators want us to believe. It is what happens when a prolonged economic downturn drives the electorate against the establishment. Italy used to be one of the most pro-European countries. According to the latest Eurobarometer survey, it is now the most Eurosceptic.

Narratives also matter in policy analysis. Here we face a different crisis — one of self-censorship. At the height of the eurozone crisis, I was briefly drafted into an expert group to help come up with ideas. I remember well the opening statement by a German economist, who announced that the group should not even consider proposals which the German government had already rejected. This was a reference to a mutualised eurozone bond— the “He-Who-Must-Not-Be-Named” of discussions about eurozone policy. Reading a recent report by 14 French and German economists on the eurozone, which was astonishing for its lack of ambition, I had a sense of déjà vu.

I know many economists who agree privately with the assertion that the eurozone requires a mutualised safe asset. But when they put their names to reports on the subject, they begin to talk like politicians.

If realism is your guide, as it should be, then the reality of the eurozone should be all that matters. The argument in favour of mutualised bonds is that, without them, the eurozone’s financial system can never be stabilised. The eurozone is a monetary union in a semi-permanent state of crisis.

I understand the argument that political boundaries must be respected. Eurozone crisis resolution is about compromise and adopting second or third-best alternatives. But I shuddered when I heard political commentators gushing that Angela Merkel was to be congratulated when she finally gave her response to Emmanuel Macron on eurozone reform.

The German chancellor said no to almost everything the French president has proposed. The only meaningful concession is a short-term lending facility for countries in trouble — but on conditions likely to be unacceptable to Italy in particular. I have not heard anyone even trying to explain how this could help reduce instability.

The same goes for the idea by the 14 economists to create a synthetic eurobond through debt securitisation. This is the same method used to create the toxic financial instruments in the previous decade. The narrative is similar to what it was then. The risks are apparently not correlated, we are told. Except that the strong co-movement of Italian and Greek bond yields would suggest otherwise.

The only known antidote to misleading narratives such as these is truth-telling. The biggest threat to the eurozone now is the toxic combination of the preachers of hatred and those who dare not speak truth to power.

Inflation: Your Role as a Milk Cow

by Jeff Thomas

Traditionally, inflation has been defined as “an increase in the amount of currency in circulation.”

Such an increase almost always causes an increase in the cost of goods and services, since, more plentiful currency units lowers their rarity, as compared to the supply of goods and services, which remains roughly the same. Therefore, it shouldn’t be surprising if a 20% increase in the amount of currency units translates into a 20% increase in the price of goods and services.

Unfortunately, in recent decades, even dictionaries have been offering a revised definition of inflation, as “an increase in the price of goods and services.” This is a pity, as it makes an already confusing subject even more difficult to understand.

This is especially true for the average guy who has a minimal understanding of economics, but does realise that, even if his wages increase (which he regards as a good thing), he never seems to get ahead. In the end, he always seems to be worse off.

So, let’s see how simply we can break this down. And, let’s do it from the layman’s personal point of view.

Let’s say that you’re paid $4000 per month. You budget for housing, food, clothing, transportation, etc. Let’s say that that adds up to $3800 per month, and you’re hoping to put $200 per month into savings. Often that doesn’t happen, as unplanned expenses “pop up,” and must be paid for. So, in the end, you save little or nothing.

In the meantime, you’re daydreaming about buying a new car, but it can’t be bought, because you don’t have any money to allocate to it.

Then, your boss says that the recent prosperity has resulted in a big new contract for the company that allows him to give you a raise of $200 a month.

This is your big chance. You go to the car dealership, buy the car, and arrange for time payments of $200 per month to pay for it.

However, what’s rarely understood is that the theoretical “prosperity” is the result of governmentally induced inflation. What appears to be prosperity is merely a rise in costs and, along with it, a rise in your wages.

You appear to be “getting ahead,” but here’s what really happens…

The inflation that resulted in your pay rise also raises the prices on most or all other goods and services. So, instead of spending $3800 on expenses every month, your costs have risen to, say, $4200.

So, only months after your pay rise, you become aware that, not only are all your expenses higher (which you didn’t figure on when you bought the car), you now have the extra monthly obligation of the $200 car payment.

A year later, you look back and say to yourself, “Just when I was finally getting ahead, just when I was realizing my dream to have a new car, all those greedy businesspeople raised their prices because they just want to be rich, and I ended up a loser.”

Not so. The businesspeople raised their prices for the same reason everyone does during inflation—because their costs are also higher and they must either raise prices or go out of business.

So, in effect… no one got ahead.

But, worse, you got behind. Because, now, in addition to your monthly expenses, you have debt obligations, and buying on time is always more costly than paying as you go.

As time goes on, you run into emergencies of one type or another that dip into your meagre savings.

You must renegotiate your debt with the bank in order to keep your car and, of course, the bank demands a greater percentage than before, assuring that your economic situation will only get worse.

Ergo, inflation has not been a boon, but a curse.

And that, in fact, is exactly the idea. Banks figured out ages ago that, although people will only tolerate so much taxation, they’ll not only tolerate, but welcome the hidden tax of inflation. The illusion that they’re “getting ahead” gives them the false confidence to take on debt, which will, over time, cripple them.

The purpose of bank-created inflation is to extract wealth from the populace.

By regularly increasing the amount of currency in circulation, banks create an environment in which the concept of debt appears to be beneficial. As a result, virtually everyone in today’s society not only has debt; he actually believes that he couldn’t improve his life except through debt.

So, that’s essentially how inflation works. However, there’s a further knock-on effect from inflation that comes with retirement.

When retirement arrives, almost no one who is caught up in the system described above has found a way to get out of debt. Inflation always gobbles up whatever advances he feels he’s made, because inflation itself created those imagined advances.

Just before retirement, most people have their most expensive houses, cars, etc., and appear to have prospered, but they also have the greatest level of debt that they’ve ever carried.

If they’ve been careful, they may have savings and/or investments that they hope will carry them through their twilight years. But they quickly find that inflation continues after they retire. Savings in banks no longer earn money. In fact, they do the opposite. Inflation takes more than the paltry interest savings received, resulting in an annual loss on any money held in banks.

But, inflation continues to march on, assuring that the retiree’s costs will continue to rise, even as his savings decline.

In essence, the inflation concept was invented by banks as an invisible tax—a means by which they could extract wealth from the populace.

And, here we get back to the original complaint of the individual. As he tries to balance his chequebook or to plan for his retirement, he scratches his head and wonders, “How is it that no matter how much more money I make, I never seem to get ahead?”

In effect, the individual is used by the banking system as a milk cow. For his entire working life, inflation is carefully adjusted to extract as much monetary value from his labours as possible, whilst still leaving him capable of continued production.

Pretty grim… So, is that it, or is there a way out?

Well, to begin, it would be very helpful to exit any country where the dual monetary drains of taxation and inflation are prominent. (By leaving, you may take an initial step down, but, over the long haul, you’re more likely to prosper.)

An additional move would be to refuse to borrow money for any situation. Yes, it will mean that, as your friends show off their new cars, you’ll be driving an older model. They’ll also live in nicer houses than you and they’ll “own” their own house before you do. But, at some point, since you’re free from debt, you’ll pass them by and eventually retire well.

By understanding inflation, and acting on that understanding, the odds of living your life as a milk cow can be greatly diminished.

The Rhetorical Battle Over China’s Rise

By Phillip Orchard


Defense chiefs from more than 40 countries gathered at the annual Shangri-La Dialogue in Singapore last weekend. Such high-profile gatherings usually come and go without producing any meaningful outcomes, but two emerging realities were on display at this year’s event. The first: Beijing is losing the rhetorical battle over the nature of its rise. A dominant theme in Singapore was that China has little interest in preserving the established order, and it’s becoming less and less useful to pretend otherwise. The second: Indo-Pacific states aren’t waiting around for the U.S. to contain China on their behalf, but uncertainty about the U.S. is breeding reluctance to form a cohesive front.

In his keynote speech, for example, Indian Prime Minister Narendra Modi obliquely criticized China’s disregard for the rules-based order and said the U.S.-India relationship is becoming a pillar of regional stability, but he also decried the U.S. retreat into protectionism and warned against a return to great power competition. The U.S., Japan and Australia agreed on the need for greater international cooperation in the South China Sea but didn’t hint at a plan of action. France and the U.K. announced plans to conduct new freedom of navigation operations in the South China Sea, but these patrols do nothing to slow the Chinese advance in the disputed waters. Singapore said China’s military buildup and the U.S. retreat into protectionism were equal threats to the status quo. The recently revived Quadrilateral Security Dialogue – intended to lay the groundwork for a coalition between Japan, India, Australia and the U.S. – was barely mentioned. U.S. Defense Secretary James Mattis said China’s recent installations of missiles and bombers on its man-made islands would be met with consequences and insisted that the U.S. was in the region to stay, but he declined to elaborate on what any of that means in practice.

For China, which sent only a midlevel delegation to face the fire, this heralds a deeper retreat into diplomatic isolation from its Indo-Pacific counterparts. It has little choice but to double down on the strategy that got it to this point, however alienating it may prove to be. For everyone else, well, talk is cheap. Forging a consensus on the nature of the Chinese challenge is one thing. Forging a coherent response is quite another – though there are hints that the U.S. may be preparing to match word to deed.
The Tide Begins to Turn
Since the beginning of the year, the hints of a backlash against Beijing’s narrative – that its rise will be mutually beneficial to its neighbors – have been bubbling up across the Indo-Pacific. For example, there’s been a growing drumbeat of warnings that China’s One Belt, One Road initiative is luring poorer countries into “debt traps,” which Beijing could exploit to, say, secure naval access to the far-flung deep-water ports it is funding. Strategically important China-backed infrastructure projects in Malaysia, Myanmar, Indonesia, Nepal and elsewhere have since been put up for review by host governments. In Australia, China is fending off a backlash over purported influence operations targeting Australian civil society groups, universities and, according to Australia’s spy chief, “every level of government.” Recently, U.S. and Canadian intelligence warned that Chinese infiltration in both Australia and New Zealand is putting the intelligence-sharing pact among those countries (plus the U.K.) at risk.

Europe, meanwhile, has largely rebuffed China’s attempts to portray itself as a champion of free trade while the U.S. targets friends and foes alike with protectionist grenades. Europe has instead echoed U.S. warnings about nefarious Chinese investments and technology theft. Even the Philippine government, whose rhetoric about Chinese power has become markedly fatalistic, has begun to harden its position. Last week, Manila laid out three “red lines” in the South China Sea and warned of war if China crossed them. The Philippines also recently resumed construction on its largest holding in the Spratlys and, in April, finally broke ground on projects, implementing a landmark 2014 deal giving the U.S. rotational access to Philippine bases.

China’s boilerplate defenses – that suspicions about its infrastructure investments are unfounded and cynical, that the blowback to its efforts to win friends in Australia is hysterical, and that any country with its experience with foreign exploitation would build a protective buffer on its periphery – aren’t entirely groundless. It rightfully fears a Japan-U.S.-India-Australia coalition that could sever its access to critical trade routes through the first island chain or the Strait of Malacca. One Belt, One Road is more about keeping the Chinese economy humming and opening new trade outlets than bullying smaller states into serving as a network of naval bases. It is encircled by powers capable of bringing the economy to its knees. The Communist Party of China has staked its legitimacy with the public on a pledge to make the country a great power against even greater odds.

In other words, China’s behavior is largely a symptom of its enduring weakness. But this doesn’t change the reality that China’s historical memory and persistent vulnerabilities are compelling a degree of assertiveness that makes it difficult for its neighbors to put much faith in Beijing’s intentions.
A More Robust Response
Regional states certainly aren’t sitting on their hands. At the Shangri-La Dialogue, India announced new trilateral exercises with Singapore as well as plans to involve Association of Southeast Asian Nations members. This comes less than a week after India struck a deal with Indonesia that could give the Indian navy access to a deep-water port at the mouth of the Malacca, and two weeks after it launched its first-ever maritime drills with Vietnam. Australia, too, has begun poking around in the South China Sea and deepening defense ties with regional states. Japan has been the most active, ramping up security assistance and strategic aid in Southeast Asia, shedding internal constraints on its military, and spearheading efforts to revive the Quad and the Trans-Pacific Partnership.

To an extent, the mounting sense of urgency in Tokyo, New Delhi and Canberra to contain Chinese assertiveness stems from their shared anxieties about U.S. commitments. But only the U.S. can fill in the gaps in each of these states’ naval capabilities and transform the grouping from a loose coalition to a dynamic alliance in a conflict. This extends to the economic realm as well. Coordinated efforts to counter Chinese coercion in One Belt, One Road target states and shield each other from retaliation would be much more robust with the world’s largest consumer market and investment source on board. Mattis acknowledged as much in Singapore and in January’s National Defense Strategy.

More than anything, states fear committing to something that exposes them to Chinese retaliation and then being hung out to dry by the United States. This problem is particularly evident among Southeast Asian states, whose participation would be invaluable in an effort to contain China, but who have the most to lose to China and the least ability to do anything about it. Philippine President Rodrigo Duterte has a point when he says that U.S. disinterest in a war over Chinese-occupied reefs off the Philippine coast has given Manila – a U.S. treaty ally – little choice but to comply when Beijing dictates terms on fishing, resource extraction and so forth. Vietnam’s recent cancellation of two foreign-backed drilling projects on the fringes of China’s territorial claims, reportedly under threat from Beijing, spoke louder than words. The White House’s threats to sanction states for purchasing Russian arms – critical to military modernization among weaker Indo-Pacific states – certainly doesn’t build faith in U.S. motivations.

The U.S. is hinting that a more robust response is forthcoming. In mid-May, the U.S. pulled China’s invitation to the Rim of the Pacific exercise, the world’s largest annual multilateral naval exercise – a move Mattis called merely a small consequence for Chinese actions. Notably, Vietnam (which agreed to ramp up maritime cooperation with the U.S. on May 25), Malaysia and potentially Taiwan will participate for the first time in China’s stead. Last week, a top U.S. general talked openly about the U.S. ability to destroy Chinese military installations in the South China Sea, and Mattis said the U.S. is planning a “steady drumbeat” of naval exercises near Chinese holdings in the disputed waters. On June 5, Reuters reported that the U.S. is mulling sailing a carrier group through the Taiwan Strait for the first time since 2007. Also this week, the U.S. conducted a freedom of navigation operation involving two warships for the first time, sailing near Chinese holdings in the Paracels, and then flew two B-52s over the Spratlys. The Quad finally held its second meeting on June 7.

Chinese weapons on South China Sea islands may not threaten core U.S. interests, and they may be useless in a war with the U.S., but they are certainly undermining U.S. partnerships with littoral states. If the U.S. thinks preserving credibility is important enough to roll back Chinese encroachment in the South China Sea, it would be a lot easier to do so sooner rather than later. And if the North Korea standoff is soon settled in a manner the U.S. can live with, the U.S. would be better positioned to stomach a major collapse in relations with China.

This may be what’s behind the newfound willingness in exceedingly cautious countries like the Philippines, Vietnam and Indonesia to stick their necks out. Similarly, per new satellite imagery obtained by Fox News, China has at least temporarily removed some surface-to-air missile systems from Woody Island in the Paracels – suggesting it may think the U.S. is serious about giving its South China Sea policy some teeth. But as always, the devil will be in the details. Freedom of navigation operations are good PR, but they are not an actual deterrent and never were intended to be. The same goes for winning a rhetorical battle without any appetite for a risky fight over the facts on the ground.

Former Brazilian president: Revolutionary conditions are developing in Brazil

by Fernando Henrique Cardoso

An image of the Brazilian flag adorns the presidential palace in Brasilia, Brazil. (Eraldo Peres/AP)

SAO PAULO — Brazilians are confronted with a fateful choice in the upcoming general elections, including for the presidency, in October.

Either there must be a convergence of democratic leaders capable of bridging the gap between society and politics, rebuilding trust from the bottom up, or Brazil will join other disintegrating democracies, such as Venezuela, which have embraced false prophets and demagogues who persuade the population that the only solution to the crisis lies in the direct relationship of a strongman with the masses.

Should the latter be the outcome, representative democracy, freedom and the public interests will all be at risk.

Brazil’s structural challenges

Brazil faces a series of structural and short-term problems. The difficulty of a middle-income country in sustaining its level of prosperity is compounded by the fact that the country is industrialized but not yet fully integrated into the global networks of production and commercialization. A great part of Brazil’s economic dynamism in recent decades came from the deepening and expansion of the internal market. But it still lacks a strong capacity to export manufactured goods.

Despite steady growth from the end of World War II to the 1980s, and some sparse favorable periods later on, Brazil’s GDP growth rate in 2017 was only 1 percent, which pales in comparison with the global rate. The average productivity of the Brazilian economy remains inferior to that of developed economies and even that of some still developing ones. GDP per capita in Brazil was 13 percent of that of the United States in 1990; today it is 15 percent. By contrast, South Korea stood at 27 percent of U.S. levels in 1990, but it is now 48 percent.
In Brazil and elsewhere, the radical transformations in the means of communication (Internet and social media) and in the modes of production (automation and artificial intelligence) have profoundly changed society and the way people connect with each other and acquire information. One of the consequences of these tectonic shifts has been the generalized feeling that political institutions — the parties, Congress and the whole architecture of representative democracy — are no longer capable of responding to the demands of a connected and informed citizenry.

Misguided policies and a moral crisis

To these structural factors one must add two major hazards. First, the misguided economic policies implemented in the last years of former president Luiz Inácio “Lula” da Silva’s government and throughout the mandates of his successor, Dilma Vana Rousseff, have nearly bankrupted the state with fiscally reckless spending.

Second, Brazil’s political and economic systems are facing an appalling moral crisis. Investigations by the judiciary have brought to light a systemic web of corrupt collusion among the government, the political parties and private and public companies. Privilege and patronage replaced competition as the driver of both economic and political life.

Prosecutors and magistrates in the so-called Operation Car Wash scandal have revealed that the money used to illegally finance political parties came from overpriced contracts with public corporations, whose directors were nominated by the government to execute exactly this kind of deal. Far from a simple matter of covert campaign funds, what came to light was a system organized to divert public funds for the benefit of companies and parties, and more often than not, also for the pockets of individual politicians.

Moral crisis combined with relative economic stagnation — unemployment stands at 13 percent today — is a deadly mix for any society.

Confronted with the indignation of the public, and also with the crossfire of accusations among conflicting political groups, it became impossible to acknowledge that not all corruption cases are alike, that a given political leader did not misuse campaign funds for personal benefit, that another may have committed a crime but his party had not and so forth. To the eyes of an incensed public, all politicians looked like a bunch of crooks guilty of thievery. Both the political class and the government have lost credibility and legitimacy.

No revolution has occurred in Brazil. Yet we are witnessing the revolutionary conditions in which avengers are gearing up to cut off the heads of the high and the mighty and are cheered by the populace. If history is any guide, the endgame tends to be the arrival of a providential leader, the charismatic savior or strongman who comes to put an end to anarchy in the land. 
These are the risks hovering over the forthcoming elections. With Lula ineligible due to being jailed on corruption charges, the different segments of the left, bereft of their natural leader, feel electorally insecure. The right is calling for the restoration of order at any cost, including the curtailment of democratic freedoms. A far-right former military officer, Jair Bolsonaro, accused of racially charged language against Brazil’s Afro-Brazilian and indigenous communities, is currently leading in the polls.

A fragmented body politic that distrusts institutions

The remaining political sensibilities are fragmented, unable to coalesce around the disconnected parts of the political center, really only an amalgam of some with an archaic vision and others more liberal or vaguely social-democratic who value the institutions of democracy and know that inequality is the main threat.

The wide array of political groups is organized in no less than 26 political parties with representation in Congress, the majority of which hardly deserve to be called “parties.” They are rather conglomerates of individuals whose only objective is to loot the booty of the state. Understandably skeptical, the body politic at this stage does not know whether it is worthwhile to vote at all.

In this, Brazil is no exception. Our society, like others, has been splintered by the very advances of modernity: improved social mobility, the advent of the information age and the rise of race and gender identity politics. All have broken the cohesiveness of the old class divisions and of the parties and ideologies that represented them in an earlier era.

A dim prospect

Is there no way out? I am convinced that in situations like this, a common vision of the future is the only message that can unite society.

Social demands are linked to people’s basic needs: the search for jobs, the fight against inequality, and the complaints about the inability of the state to efficiently provide security, housing, transportation, health and, above all, education. In times of crisis, political leaders must translate a common set of values — the spirit of freedom, equality of opportunity and the respect for human dignity — into concrete ideas and proposals that touch people’s hearts and minds.

They must address themselves to persons who are no longer part of an amorphous mass. Each voter has access to information, is aware of his or her rights and wants the government to take care of his or her needs. This “re-enchantment” of public life has to go hand in hand with the effort to control public finances and promote productive investment, without which there is no employment creation.

Everyone who values democracy and freedom knows what has to be done. Yet, as elsewhere, the old mainstream is out of step with the new realities, and new political alliances have not yet found a cogent voice in common with the whole of the people.

The risk of regression coexists with the perspective of renewal. Brazilian society, driven by social and economic transformations and by new values, is on the move. This process of change is not as visible as the current political polarizations. In many fields, the pace of change in society is faster than in institutions. There is, thus, reason for hope – if we find the political will to transform our institutions in sync with public aspirations.

Fernando Henrique Cardoso was the president of Brazil from 1995 to 2002. He is a member of the Berggruen Institute’s 21st Century Council.

This was produced by The WorldPost, a partnership of the Berggruen Institute and The Washington Post.

What Is the Trade Deficit?

It’s not a scorecard, and reducing it won’t necessarily be good for jobs.

By Neil Irwin

Money has been flowing from China to the United States, the flip side of the U.S. trade deficit that President Trump has bemoaned. CreditThomas White/Reuters

This is an updated and expanded version of an article published in 2016.

A core idea that Donald J. Trump has embraced throughout his time in public life has been that the United States is losing in trade with the rest of the world, and that persistent trade deficits are evidence of this fact.

In this accounting, the $69 billion United States trade deficit with Mexico or $336 billion gap with China is something of a scorecard reflecting diminishing American greatness.

The vast majority of economists view it differently. In this mainstream view, trade deficits are not inherently good or bad. They can be either, depending on circumstances.

As the president’s emphasis on trade deficits puts the United States at odds with allies — in this case at the Group of 7 leaders meeting this weekend in Canada — the trade-offs in making this an overwhelming focus of economic diplomacy are becoming more clear. 
Trying to eliminate the trade deficit could mean giving up some of the key levers of power that allow the United States to get its way in international politics. The reasons have to do with the global reserve currency, economic diplomacy and something called the Triffin dilema.

What is the trade deficit?

Imagine a world with only two countries, and only two products. One country makes cars; the other grows bananas.

People in CarNation want bananas, so they buy $1 million worth from people in BananaLand. Residents of BananaLand want cars, so they buy $2 million of them from CarNation.

That difference is the trade deficit: BananaLand has a $1 million trade deficit; CarNation has a $1 million trade surplus.

But this does not mean that BananaLand is “losing” to CarNation. Cars are really useful, and BananaLanders got a lot of them in exchange for their money.

Similarly, it’s true that the United States has a large trade deficit with Mexico, for example. But it’s not as if Americans were just flinging money across the Rio Grande out of charity. Americans get a lot of good stuff for that: avocados, for example, and Cancún vacations.

If you want to think of it in terms of winners and losers, you could justifiably reverse Mr. Trump’s preferred framing: “Those losers in Mexico gave us $69 billion more stuff than we gave them last year. Ha, ha, ha. We’re winners.”

What does that have to do with savings and investment?

When a country runs a trade deficit, there is a countervailing force. Think back to our pretend countries. BananaLand has a $1 million trade deficit with CarNation. But that means that car producers in CarNation are sitting on an extra $1 million a year in income.

Something has to happen with that $1 million. If CarNation doesn’t want the value of its currency to rise, it has to take that $1 million trade surplus and plow it back into BananaLand. There are different ways it could do that. People in CarNation could buy stocks or bonds in BananaLand, or companies in CarNation could invest in factories in BananaLand, or the government of CarNation could buy assets directly.

In effect, the flow of capital is the reverse of the flow of goods. And the trade deficit will be shaped not just by the mechanics of what products people in the two countries buy, but also by unrelated investment and savings decisions. The cause and effect goes both directions.

So, for example, if a country enacts a giant tax cut that increases its budget deficit, it is effectively lowering its savings rate — which tends to increase its trade deficit. 
That, of course, is exactly the fiscal policy choice the United States has made, so the tax cut passed late last year will tend to increase the trade deficit relative to its level if tax rates had remained unchanged.

New Volkswagens in a delivery tower in Wolfsburg, Germany.CreditMichael Sohn/Associated Press

But don’t trade deficits mean fewer jobs?


It is true that a trade deficit subtracts from a country’s gross domestic product. G.D.P. measures the value of goods and services produced within a country’s borders, so when a country is selling less stuff abroad than it buys from abroad, the country is making less stuff, and as a result there are fewer jobs. This piece of the Trump theory of trade is true.

But the flow of capital into the country — the inverse of the trade deficit — creates benefits that can be good for jobs, by encouraging more domestic investment.

This isn’t just an abstraction. It’s what has happened between the United States and China for the last couple of decades. China has had consistent trade surpluses, but it did not want its currency to rise in a way that would undermine its exporters. So money has flowed from China into the United States — both from the Chinese government’s purchases of United States Treasury bonds and more recently in the form of direct investment from Chinese companies into the United States.

When you see a headline about a Chinese company buying American hotels or factories, you’re seeing the flip side of the trade deficit Mr. Trump bemoans. (The same when a citizen of China buys a luxury apartment in a Trump tower.) Money flowing into a country is usually considered a good thing. It makes borrowing money cheaper, drives up stock prices and can mean more investment in new businesses.

So does a trade deficit mean fewer jobs? It depends on which force is more economically powerful: fewer jobs creating exports or investment dollars flowing into the country.

So which is it?

It depends on what the country does with the investment that comes in.

In theory, that money could go toward long-lasting investments with positive economic returns: new factories and equipment; education for the work force; new roads and bridges, or repairs and improvements to existing ones. 

Unfortunately, how countries use these capital inflows is not always so fruitful. In the United States, the influx of foreign capital in the mid-2000s went in large part to fuel an unsustainable housing and mortgage bubble. Greece’s capital inflows in the same time period went to fund bloated public spending.
When the world is flinging money at you, it’s important to use it for something productive. It’s not that trade deficits (and the capital inflows that are their flip side) don’t matter — but just knowing the numbers doesn’t tell you much about whether they are good, bad or indifferent.

Wouldn’t it be better if the U.S. didn’t run a deficit?

It’s not clear that that’s even an option, because the dollar isn’t used just in trade between the United States and other countries.

The dollar is a global reserve currency, meaning that it is used around the world in transactions that have nothing to do with the United States. When a Malaysian company does business with a German company, in many cases it will do business in dollars; when wealthy people in Dubai or Singapore’s government investment fund want to sock away money, they do so in large part in dollar assets.

That creates upward pressure on the dollar for reasons unrelated to trade flows between the United States and its partners. That, in turn, makes the dollar stronger — and American exporters less competitive — than they would be in a world where nobody used the dollar for anything except commerce involving the United States.

The roughly $500 billion trade deficit that the United States runs each year isn’t just about poorly negotiated trade deals and currency manipulation by this or that country. It’s also, to some degree, a byproduct of the central role the United States plays in the global financial system.

There’s even a name for this: the Triffin dilemma. In the mid-20th century, the economist Robert Triffin warned that the provider of the global reserve currency would need to run perpetual trade deficits to keep the world financial system from freezing, with those trade deficits potentially fueling domestic booms and busts.

The key idea is that if Mr. Trump really wanted to reduce our trade deficits in a major way, he would have to have to rethink the very underpinnings of global finance.

If having the global reserve currency means bleeding jobs overseas, why keep it?

Be careful what you wish for.

There’s no doubt that maintaining the global reserve currency creates costs for the United States, namely a less competitive export industry.

But it also creates a lot of advantages. Lower interest rates and higher stock prices are among them (though they have the downside of also feeding debt-driven booms and busts). Even more important is what the dollar’s prominence in global finance does for America’s place in the world.

It helps ensure that the United States can afford to finance wars, and it gives the government greater ability to fight recessions and panics. A country experiencing a banking panic will see money sent out of the country, causing its currency to fall and its interest rates to rise. All that limits a government’s options for fixing the problem. In 2008, when the United States experienced a near collapse of the banking system, the opposite happened.

The centrality of the dollar to global finance gives the United States power on the global stage that no other country can match. It has enforced sanctions on Iran, Russia, North Korea and terrorist groups with the implicit threat of cutting off access to the dollar payments system for any bank in the world that does not cooperate with American foreign policy.

Part of what makes the United States powerful is the great importance of the dollar to global finance. And part of the price the United States pays for that status is a stronger currency and higher trade deficits than would be the case otherwise.

The debate over the trade deficit is about more than Mexico and China, cars and bananas, or winning and losing. It’s about what makes America great, and which of the country’s priorities should come first. 

Neil Irwin is a senior economics correspondent for The Upshot. He previously wrote for The Washington Post and is the author of “The Alchemists: Three Central Bankers and a World on Fire.”

Buttonwood: Ignore your instincts

A case for owning euro-zone shares

The contrarian wisdom of George Costanza

IN AN episode of “Seinfeld”, a 1990s television comedy, George Costanza, a serial failure played by Jason Alexander, decides that every instinct he has is wrong. So he resolves to do the opposite. He is soon squiring a new girlfriend and is up for a dream job. “It’s all happening because I’m completely ignoring every urge towards common sense and good judgment I’ve ever had,” he says.

Success in investing often means going against the grain—and your own feelings. To do otherwise is to be swept along by the general greed and fear. Still, fear is a useful emotion. It would be unwise, for instance, to ignore the recent turmoil in Italy, where bond yields spiked in response to concerns that the country might be on the road to leaving the euro. Though the worst fears have subsided, the coalition that was eventually given the president’s blessing to form a government looks capable of causing trouble.

A natural inclination in the circumstances is to turn away from euro-zone assets—not just bonds (where the rewards are notably scanty in relation to the risks) but equities, too. Yet such instincts can betray investors. There is an argument for buying euro-zone shares precisely because their defects have now become all too clear to everyone.

Among the shortcomings is that Europe is ageing. It is the place to find businesses ripe for disruption, rather than those doing the disrupting. Its bourses are heavy with the technologies of the second industrial revolution—mass-market cars, petrochemicals and machinery—but light on the digital firms that power stockmarkets in America (see chart). Its banks, a big weight in stockmarket indices, look leaden. Deutsche Bank is a target of short-sellers. Last year’s strong GDP growth has cooled. To cap it all, there are glaring holes in the euro area’s design. There is no continent-wide deposit or unemployment insurance, for instance. A nasty recession could plausibly break the zone apart.

So there is plenty not to like. The experience of owning European stocks over the long haul has been quite horrible. The Euro Stoxx 50 of big euro-zone shares is no higher now than it was 20 years ago. Its broader sibling, which contains 300-odd companies, is well below its peak in the summer of 2000. The inclination to steer clear is quite natural. But there is a strong case for doing exactly the opposite.

For a start, euro-zone equities look cheap. The earnings yield on the Euro Stoxx 50 is 6.4%. That compares with a 4.8% earnings yield on America’s S&P 500 index and is handsome for an economy where holding cash pays less than nothing and where the safest government bonds pay a negative yield after adjusting for inflation. Patience may be required. But over time the chances that a punt on euro-zone equities pays off are good.

What is more, there is room for earnings to improve. Take banks, for instance. Bad loans and the need for more capital had been a continuing drain on their profits. But now even Italy’s big banks are in decent shape. “If at any point interest rates turn positive, you could see huge earnings upside,” says Eric Lonergan, of M&G, a fund-management group. Similarly, other firms, which still had to fork out on wages and rents during the euro zone’s depressed years, could squeeze out more profits if the economy keeps growing. In America, by contrast, there is no comparable scope for earnings to accelerate, because the economic cycle is more mature.

To be sure, the euro is a rickety construct. Countries are also currency zones and they work tolerably well because of fiscal transfers from rich to poor regions. That is absent in the euro area—hence the fear of break-up. Even so, it is far from obvious that this should be ranked higher than any number of other uncertainties.

What investors choose to worry about changes. At the beginning of 2016, for instance, China’s debt mountain was a source of terror for financial markets. Now it elicits a yawn. Few have yet mapped out the implications for markets of President Donald Trump’s foreign policy in the way they have done for a break-up of the euro. Yet it might turn out to be of greater consequence. The risks to the euro are simply more salient. And when risks are more palpable, people tend to give them too much credence.

Instinct does not always serve investors well. The political tremors in Italy are more like a scare than a rerun of the crisis of 2012. In which case there is money to be made from European equities, says Mr Lonergan. So remember George Costanza. When every urge tells you to shy away, consider doing the opposite.

How Amazon Will Supercharge the Blockchain Revolution

By Jeff Brown, editor, The Near Future Report

Most investors missed it…
And the mainstream media, as far as I know, never even reported on it…

But while Wall Street remains fixated on the ups and downs of bitcoin, something unusual is playing out behind the scenes in the blockchain industry.

And it could have huge implications for cryptocurrencies… and even change how business is done… forever.

In short, I believe a major U.S. company is about to issue its very own cryptocurrency…


What I’m about to tell you may sound unbelievable. But I’ll show you all the proof. Then you can decide for yourself.

The company I alluded to is Amazon, the e-commerce and web-services giant. And I believe it is about to issue its very own cryptocurrency.

You likely know Amazon as an e-commerce company. Maybe you’re even an Amazon Prime member and use the company’s fast delivery services.

But investors who think that Amazon is in the business of just selling books, electronics, and dishwasher detergent online are unfortunately missing the big picture… unless you dig in and understand what’s happening behind the curtain, it’s easy to miss.

But there has been an interesting development with Amazon. And as an investor, it should be on your radar…

Strange Discovery

You see, something interesting popped up in the internet domain name registry recently. And it looked like this:

Amazon registered the new website address under the name “amazonethereum.”

And it registered another called “amazoncryptocurrency.”

And another: “amazoncryptocurrencies.”

And this was on top of the already registered “amazonbitcoin.”

Now, these websites will not lead to anything. They are not “live.”

But if history tells us anything, this is likely just the beginning of something exciting.

As I said, I think Amazon is getting ready to launch its own digital currency. And I can’t think of a better company traded on a U.S. stock exchange that could pull this off.

An Early Experiment

Now, before you think I’ve gone mad, have a look at this:

In 2013, Amazon started experimenting with issuing “coins” to be used on Amazon “Fire tablets, Fire TV, and on any Android device through the Amazon Appstore.”

These coins are kind of like frequent flyer points. They have a clear value and can be redeemed for Amazon applications or other services; but they cannot be transferred, sold, or converted back into a fiat currency like the U.S. dollar.

This was just the first step. For a company with annual revenues the size of a decent-sized country, it is in a position to issue a real currency, cryptocurrency, or digital token that is fully convertible into popular cryptocurrencies like bitcoin and ether.

And if a cryptocurrency or token is convertible into bitcoin or ether, it’s convertible into U.S. dollars or just about any other form of fiat currency.

And what’s the best way to guarantee such convertibility of an Amazon cryptocurrency? Simple: create a marketplace to do so. And that’s precisely why Amazon has locked up the domain names above.

How It Would Work

This is where the issuance of a digital token or cryptocurrency has significant advantages. Not only is it completely fungible, it is also divisible down to the smallest amounts desirable.

So… how would it work?

Amazon would either issue a finite number of Amazon-coins or employ a slightly inflationary monetary policy, something aligned with Amazon’s rate of growth over time. This might be something similar to Ethereum’s monetary policy.

It would likely do what is called an airdrop of Amazon-coins into Amazon Prime customers’ accounts. An airdrop simply means that it would distribute the crypto-assets to its ecosystem of customers and partners to get the system started.

Having its own currency would enable Amazon to:

• Give coins away to application developers to incentivize development on any of its technology platforms.

• Issue coins to facilitate in-application purchases.

• Potentially use the coins for in-game purchases of virtual items.

• Reward customers with more digital tokens if they purchase regularly from the Amazon online store.

And Amazon is the perfect company to do this. It has the ideal ecosystem of partners, retail customers, and business customers to leverage.

For starters, Amazon already has 300 million individual customer accounts worldwide. That’s roughly the population of the United States.

Amazon also has 100,000 sellers on its platforms with hundreds of millions of items for sale.

Also, nearly half of all shoppers use Amazon—not Google—as a search engine to find products when they go online.

This is the big difference between Amazon and these tiny four- or five-person teams that are writing white papers and having initial coin offerings (ICOs) to raise money.

There is a massive, vibrant economy taking place around the world that’s already linked to Amazon. And this Amazon ecosystem would be able to utilize Amazon-Coin as soon as it’s issued.

But there’s more to this story than just Amazon…

A Bigger Trend

The emergence of blockchain technology is an area of intense focus for me. Everything I’ve uncovered tells me that we are just at the beginning of a revolution in blockchain-related technologies and cryptocurrencies.

But nobody has really considered the impact of a multinational corporation like Amazon issuing its own digital currency.

For the reasons I laid out, I believe Amazon-Coin isn’t just possible, I believe it’s imminent. When this happens, it will signal the institutional adoption of blockchain technology.

And when Amazon issues its own cryptocurrency, what’s to stop other major companies from following suit? Perhaps one day, you’ll book your next flight using American Airlines-Coin, or pay for your trip to Disney World with Disney-Coin.

It may seem too far-fetched. But these companies have issued customer “reward points” for years. A company-backed cryptocurrency is not beyond the realms of possibility.

What that means is that blockchain and digital assets will no longer be a curiosity of the mainstream investing world, they’ll be adopted with open arms. As a result, high-quality blockchain projects like bitcoin and Ethereum will likely appreciate several times over in the years ahead.

So get ready. The blockchain revolution isn’t just imminent. It’s here.

The Pension Train Has No Seat Belts

By John Mauldin


In describing various economic train wrecks these last few weeks, I may have given the wrong impression about trains. I love riding the train on the East Coast or in Europe. They’re usually a safe and efficient way to travel. And I can sit and read and work, plus not deal with airport security. But in this series, I’m concerned about economic train wrecks, of which I foresee many coming before The Big One which I call The Great Reset, where all the debt, all over the world, will have to be “rationalized.” That probably won’t happen until the middle or end of the next decade. We have some time to plan, which is good because it’s all but inevitable now, without massive political will. And I don’t see that anywhere.
Unlike actual trains, we as individuals don’t have the option of choosing a different economy. We’re stuck with the one we have, and it’s barreling forward in a decidedly unsafe manner, on tracks designed and built a century ago. Today, we’ll review yet another way this train will probably veer off the tracks as we discuss the numerous public pension defaults I think are coming.

Last week, I described the massive global debt problem. As you read on, remember promises are a kind of debt, too. Public worker pension plans are massive promises. They don’t always show up on the state and local balance sheets correctly (or directly!), but they have a similar effect. Governments worldwide promised to pay certain workers certain benefits at certain times. That is debt, for all practical purposes.
If it’s debt, who are the lenders? The workers. They extended “credit” with their labor. The agreed-upon pension benefits are the interest they rightly expect to receive for lending years of their lives. Some were perhaps unwise loans (particularly from the taxpayers’ perspective), but they’re not illegitimate. As with any other debt, the borrower is obligated to pay. What if the borrower simply can’t repay? Then the choices narrow to default and bankruptcy.
As you will see below, the pension crisis alone has catastrophic potential damage, let alone all the other debt problems we’re discussing in this series. You are sadly mistaken if you think it will end in anything other than a train wreck. The only questions are how serious the damage will be, and who will pick up the bill.

Demographics and Destiny
It’s been a busy news year, but one under-the-radar story was a wave of public school teacher strikes around the US. It started in West Virginia and spread to Kentucky, Oklahoma, Arizona, and elsewhere. Pensions have been an issue in all of them.
An interesting aspect of this is that many younger teachers, who are a long way from retirement age, are very engaged in preserving their long-term futures. This disproves the belief that Millennial-generation Americans think only of the present. From one perspective, it’s nice to see, but they are unfortunately right to worry. Demographic and economic reality says they won’t get anything like the benefits they see current retirees receiving. And it’s not just teachers. The same is true for police, firefighters, and all other public-sector workers.
Thinking through this challenge, I’m struck by how many of our economic problems result from the steady aging of the world’s population. We are right now living through a combination unprecedented in human history.
  • Birth rates have plunged to near or below replacement level, and
  • Average life spans have increased to 80 and beyond.
Neither of these happened naturally. The first followed improvements in artificial birth control, and the second came from better nutrition and health care. Each is beneficial in its own way, but together they have serious consequences.
This happened quickly, as historic changes go. Here is the US fertility rate going back to 1960.

Source: St. Louis Fed

As you can see, in just 16 years (1960–1976), fertility in the US dropped from 3.65 births per woman to only 1.76. It’s gone sideways since then. This appears to be a permanent change. It’s even more pronounced in some other countries, but no one has figured out a way to reverse it.
Again, I’m not saying this is bad. I’m happy young women were freed to have careers if they wished. I’m also aware (though I disagree) that some think the planet has too many people anyway. If that’s your worry, then congratulations, because new-human production is set to fall pretty much everywhere, although at varying rates.
Breaking down the US population by age, here’s how it looked in 2015.


Source: US Census Bureau

Think of this as a python swallowing a pig. Those wider bars in the 50–54 and 55–59 zones are Baby Boomers who are moving upward and not dying as early as previous generations did. Meanwhile, birth rates remain low, so as time progresses, the top of the pyramid will get wider and the bottom narrower. (You can watch a good animation of the process here.)
This is the base challenge: How can a shrinking group of working-age people support a growing number of retirement-age people? The easy and quick illustration to this question is to talk about the number of workers supporting each Social Security recipient. In 1940, it was 160. By 1950 it was 16.5. By 1960 it was 5.1. I think you can see a trend here. As the chart below shows, it will be 2.3 by 2030.


Source: Peter G. Peterson Foundation

Similarly, states and local governments are asking current young workers to support those already in the pension system. The math is the same, though numbers vary from area to area. How can one worker support two or three retirees while still working and trying to raise a family with mortgage payments, food, healthcare, etc.? Obviously, they can’t, at least not forever. But no one wants to admit that, so we just ignore reality. We keep thinking that at some point in the future, taxpayers will pick up the difference. And nowhere is it more evident than in public pensions.
In a future letter, I will present some good news to go with this bad news. Several new studies will clearly demonstrate new treatments to significantly extend the health span of those currently over age 50 by an additional 10 or 15 years, and the same or more for future generations. It’s not yet the fountain of youth, but maybe the fountain of middle-age. (Right now, middle-age sounds pretty good to me.)
But wait, those who get longer lifespans will still get Social Security and pensions. That data isn’t in the unfunded projections we will discuss in a moment. So, whatever I say here will be significantly worse in five years.

Let me tell you, that’s a high order problem. Do you think I want to volunteer to die so that Social Security can be properly funded? Are we in a Soylent Green world? This will be a very serious question by the middle of the next decade.

Triple Threat

We have discussed the pension problem before in this letter—at least a half-dozen times. Most recently, I issued a rather dire Pension Storm Warning last September. I said in that letter that I expect more cities to go bankrupt, as Detroit did, not because they want to, but because they have no choice. You can’t get blood from a rock, which is what will be left after the top taxpayers move away and those who stay vote to not raise taxes.
This means city and school district retirees will take major haircuts on expected pension benefits. The citizens that vote not to pay the committed debt will be fed up with paying more taxes because they will be at the end of their tax rope. I am not arguing that is fair, but it is already happening and will happen more.
States are a larger and different problem because, under our federal system, they can’t go bankrupt. Lenders perversely see this as positive because it removes one potential default avenue. They forget that a state’s credit is only as good as its tax base, and the tax base is mobile.
Let me say this again because it’s critical. The federal government can (but shouldn’t) run perpetual deficits because it controls the currency. It also has a mostly captive tax base. People can migrate within the US, but escaping the IRS completely is a lot harder (another letter for another day). States don’t have those two advantages. They have tighter credit limits and their taxpayers can freely move to other states.
Many elected officials and civil servants seem not to grasp those differences.

They want something that can’t be done, except in Washington, DC. I think this has probably meant slower response by those who might be able to help. No one wants to admit they screwed up.
In theory, state pensions are stand-alone entities that collect contributions, invest them for growth, and then disburse benefits. Very simple. But in many places, all three of those components aren’t working.
  • Employers (governments) and/or workers haven’t contributed enough.
  • Investment returns have badly lagged the assumed levels.
  • Expenses are more than expected because they were often set too high in the first place, and workers lived longer.

Any real solution will have to solve all three challenges—difficult even if the political will exists. A few states are making tough choices, but most are not. This is not going to end well for taxpayers or retirees in those places.
Worse, it isn’t just a long-term problem. Some public pension systems will be in deep trouble when the next recession hits, which I think will happen in the next two years at most. Almost everyone involved is in deep denial about this. They think a miracle will save them, apparently. I don’t rule out anything, but I think bankruptcy and/or default is the more likely outcome in many cases.

Assumed Disaster

The good news is we’re starting to get data that might shake people out of their denial. A new Harvard study funded by Pew Charitable Trusts uses “stress test” analysis, similar to what the Federal Reserve does for large banks, to see how plans in ten selected states would behave in adverse conditions (hat tip to Eugene Berman of Cox Partners for showing me this study).
The Harvard scholars looked at two economic scenarios, neither of which is as stressful as I expect the next downturn to be. But relative to what pension trustees and legislators assume now, they’re devastating.

Scenario 1 assumes fixed 5% investment returns for the next 30 years.

Most plans now assume returns between 7% and 8%, so this is at least two percentage points lower. Over three decades, that makes a drastic difference.
Scenario 2 assumes an “asset shock” involving a 20% loss in year one, followed by a three-year recovery and then a 5% equity return for years five through year 30. So, no more recessions for the following 25 years.  

Exactly what fantasy world are we in?
Their models also include two plan funding assumptions. In the first, they assume states will offset market losses with higher funding. (Fat chance of that in most places. Seriously, where are Illinois, Kentucky, or others going to get the money?). The second assumes legislatures will limit contribution increases so they don’t have to cut other spending.
Admittedly, these models are just that—models. Like central banks models, they don’t capture every possible factor and can be completely wrong. They are somewhat useful because they at least show policymakers something besides fairytales and unicorns. Whether they really help or not remains to be seen.
Crunching the numbers, the Pew study found the New Jersey and Kentucky state pension systems have the highest insolvency risk. Both were fully-funded as recently as the year 2000 but are now at only 31% of where they should be.


Source: Harvard Kennedy School

Other states in shaky conditions include Illinois, Connecticut, Colorado, Hawaii, Pennsylvania, Minnesota, Rhode Island, and South Carolina. If you are a current or retired employee of one of those states, I highly suggest you have a backup retirement plan. If you aren’t a state worker but simply live in one of those states, plan on higher taxes in the next decade.
But that’s not all. Even if you are in one of the (few) states with stable pension plans, you’re still a federal taxpayer, and that’s who I think will end up bearing much of this debt. And as noted above, it is debt. The Pew study describes it as such in this chart showing state and local pension debt as a share of GDP.


Source: Harvard Kennedy School

For a few halcyon years in the late 1990s, pension debt was negative, with many plans overfunded. The early-2000s recession killed that happy situation. Then the Great Recession nailed the coffin shut. Now it is above 8% of GDP and has barely started to recover from the big 2008 jump.
Again, this is only state and local worker pensions. It doesn’t include federal or military retirees, or Social Security, or private sector pensions and 401Ks, and certainly not the millions of Americans with no retirement savings at all. All these people think someone owes them something. In many cases, they’re right. But what happens when the assets aren’t there?

The stock market boom helped everyone, right? Nope. States' pension funds have nearly $4 trillion of stock investments, but somehow haven't benefited from soaring stock prices.
A new report by the American Legislative Exchange Council (ALEC) shows why this is true. It notes that the unfunded liabilities of state and local pension plans jumped $433 billion in the last year to more than $6 trillion. That is nearly $50,000 for every household in America. The ALEC report is far more alarming than the report from Harvard. They believe that the underfunding is more than 67%.
There are several problems with this. First, there simply isn’t $6 trillion in any budget to properly fund state and local government pensions. Maybe a few can do it, but certainly not in the aggregate.
Second, we all know about the miracle of compound interest. But in this case, that miracle is a curse. When you compute unfunded liabilities, you assume a rate of return on the current assets, then come back to a net present value, so to speak, of how much it takes to properly fund the pension.
Any underfunded amount that isn’t immediately filled will begin to compound. By that I mean, if you assume a 6% discount rate (significantly less than most pensions assume), then the underfunded amount will rise 6% a year.
This means in six years, without the $6 trillion being somehow restored (magic beans?), pension underfunding will be at $8.4 trillion or thereabouts, even if nothing else goes wrong.
That gap can narrow if states and local governments (plus workers) begin contributing more, but it stretches credulity to say it can get fixed without some pain, either for beneficiaries or taxpayers or both.
I noted last week in Debt Clock Ticking that the total US debt-to-GDP ratio is now well over 300%. That’s government, corporate, financial, and household debt combined. What’s another 8% or 10%? In one sense, not much, but it aggravates the problem.
If you take the almost $22 trillion of federal debt, well over $3 trillion of state and local debt, and add in the $6 trillion debt of underfunded pensions, you find that the US governments from the top to bottom owe over $30 trillion, which is well over 150% of GDP. Technically, we have blown right past the Italian debt bubble. And that’s not even including unfunded Social Security and healthcare benefits, which some estimates have well over $100 trillion. Where is all that going to come from?
Connecticut, the state with the highest per-capita wealth, is only 51.9% funded according to the Wall Street Journal. The ALEC study mentioned above would rate it much worse. Your level of underfunding all depends on what you think your future returns will be, and almost none of the projections assume recessions.
The level of underfunding will rise dramatically during the next recession. Total US government debt from top to bottom will be more than $40 trillion only a few years after the start of the next recession. Again, not including unfunded liabilities.
I wrote last year that state and local pensions are The Crisis We Can’t Muddle Through. That’s still what I think. I’m glad officials are starting to wake up to the problem they and their predecessors created. There are things they can do to help, but I think we are beyond the point where we can solve this without serious pain on many innocent people. Like the doctor says before he cuts you, “This is going to hurt.”
We’ll stop there for now. Let me end by noting this is not simply a US problem.

Most developed countries have their own pension crises, particularly the southern Eurozone tier like Italy and Greece. We’ll look deeper at those next week.
This is not going to be the end of the world. We’ll figure out ways to get through it as a culture and a country. The rest of the world will, too, but it may not be much fun. Just ask Greece.

St. Louis and Trying to Stay Home

I haven’t done very well staying home in June so far. This week, I made last-minute trips to both New York and Houston. There is actually nothing on my calendar except for one day trip to St. Louis the week after next—until a busy August.
There are lots of good things happening in my business and personal life, but it’s too early to share. And in the spirit of trying to do shorter letters, let me just hit the send button and wish you a great summer week! (Unless, of course, you are in the southern hemisphere.)
Your trying to figure out how we will muddle through this debt train wreck analyst,

John Mauldin
Chairman, Mauldin Economics