Economy on a Roll

John Mauldin


In addition to popping champagne corks and black-eyed peas (at least in the South) on New Year’s Day, year-end brings something else for economists and portfolio managers: annual forecasts. People want to know what the coming year will bring. I would like to know, too. But since I’m on the other side of your monitor, I must give you my own forecast. Caveat emptor applies.

I don’t really think of myself as a forecaster. I talk about the future all the time, of course, and I tell you what I think is coming – but whether it will arrive next month, next year, or five years from now is a different question. Timing is hard.

So, when I write annual forecast letters like this one, I put some extra pressure on myself. In addition to identifying the macro forces in play, I try to anticipate when we will see their impact. That’s never been easy, and it seems to get tougher every year. But inquiring minds want to know, so here we go.


 
First, a brief message. If you missed my email on Thursday, I want to be sure you know that the Alpha Society is now accepting new members. The Alpha Society is one of my happiest achievements, and I’m excited to see it growing. When I started writing Thoughts from the Frontline almost two decades ago, little did I know that it would quickly garner a “tribe” of curious and thoughtful readers. Getting to know you has been an amazing honor.

The Alpha Society is really an extension of that relationship – it’s for those of you who simply want more. More intellectual stimulation, more communication with people who thoroughly enjoy debate and discussion, more opportunities to talk to me and the Mauldin Economics editors. The driving goal behind the Alpha Society is to enrich your world and the world at large.

Is that a lofty ambition? Yes. Is it achievable? Absolutely. If you have time today, please take a look at your invitation. It’s also worth mentioning that your membership fee may be tax deductible, so if you want to apply it to 2017’s return, now is your chance.

Objects in Motion

As you probably recall, I’ve long criticized the economics profession for its ambition to be a “hard science” like physics or chemistry. I think the global economy is far too complex and far too dependent on irrational human behavior for that ambition to be realized. However, there are some occasional similarities.

Think back to high school science. Remember Newton’s Laws? The first one is about inertia and motion:

An object at rest stays at rest, and an object in motion stays in motion, with the same speed and direction, unless some other force intervenes.


 
In similar fashion, an economy that is moving in a particular direction will probably continue in that direction until something makes it change – either the forces that put it in motion lose strength, or other forces counteract them. 

My friend Sam Rines gives us a wonderful illustration of that basic principle. The following is a graph of nominal GDP growth for the last six years. Normally, when we talk about GDP numbers, we talk in terms of real GDP, or GDP with inflation backed out. Even though there are various measures of inflation, real GDP growth measures the actual buying power of your dollars.


 
There is a great way to illustrate the difference between real and nominal GDP growth. If you bought the S&P 500 Index in 1966, it was 16 years, until 1982, before your nominal dollars recovered. But, taking account of inflation, it was 26 years later, or 1992, before you saw any increase in your buying power. Not exactly what your financial planner was forecasting for you in your retirement plan. Using the average market returns for the last 80 or 100 years to forecast your returns for the next 20 years, or until your retirement, is both foolish and dangerous. Forecasting what your portfolio will look like in a reasonable length of time, say 10 or 20 years, all depends on your starting point. If you happen to be part of the demographic that allowed you to start in 1982, you look brilliant. If you began in 1966 instead? Not so much.

But real personal income, while it has grown modestly over the last seven years, has begun once again to flatten. This chart courtesy of Jeff Snyder at Alhambra.


But I will lean on our law that objects in motion tend to stay in motion for my 2018 forecast. I think the US economy will maintain its current slow but steady growth, because no greater forces are likely to stop it. But of course I have to add an asterisk, which we will get to in a bit. I don’t mean to suggest that no other forces exist; they certainly do. But as we’ll see, they will either balance each other so that there is no net change, or they will come at us from outside in unpredictable fashion.

I am not, however, predicting smooth sailing for the stock market. The economy and the stock market are different animals. The equity markets face serious challenges and will endure a reckoning at some point, but I don’t think it will happen in 2018. In fact, 2018 could be our last calm year for some time, so we need to use it constructively.

Fed Pops Its Own Bubble

Before we get into 2018, let’s quickly review how we got here. In response to the 2008 financial crisis and the recession it sparked, the Federal Reserve and other central banks deployed zero or near-zero interest rates, quantitative easing, and assorted other interventions. These may have averted an even worse disaster, but their impacts were far from ideal. Nonetheless, the economy slowly lifted off as consumers rebuilt their balance sheets and asset values rose.

The asset values climbed in large part because the Fed practically forced everyone with money to invest it in risk assets: stocks, real estate, corporate bonds, etc. The resulting wealth effect theoretically enabled more spending, at least by those in the top income quintile. The recovery has been slow and ugly, and too many people still don’t feel the progress.

The Fed’s trickle-down monetary policy hasn’t really worked. (I note with some irony that the same economists who espoused what can only be called trickle-down monetary policy scoffed at Reagan’s trickle-down fiscal tax-cut policy. There is essentially no difference between the two, except the source of the funds.) Those who gripe about income inequality actually have points to make. Even if you filter out the top one half of 1% (the tech billionaires, Warren Buffett, et al.), there is still a large imbalance in how much the top and bottom earners have benefited from the Fed’s lopsided monetary policy.

The chart below, based on data from Zillow, shows that the share of unmarried adults in double-up households has increased in all age brackets, and especially among Millennials. Having a few Millennials in my own family, and even some young Gen Xers, the need to double up is readily apparent to me. Rents are just too high for the average person. Also notice that nearly one in three people between ages 50 and 59 is living with someone else in order to save on rent and other expenses..
 


 
Furthermore, nearly 5 million Americans are in default on student loans. Is it any wonder people are doubling up on their housing?

The economy and markets are growing, but the benefits of that growth are not evenly distributed. Supposedly a rising tide raises all boats, but it’s not working that way today.

Now the Fed is slowly reversing its stimulus measures, both by raising short-term rates and by letting its bond portfolio shrink as it matures. Both measures have a tightening effect on an economy that isn’t growing remotely as well as it has in past recoveries. So why is the Fed doing it? Because the FOMC members fear inflation will take hold if they do nothing. I think they are probably wrong there, but my opinion isn’t factored into their models.

In other words, my #1 risk factor for the US economy in 2018 is Federal Reserve overreach. I think there is a significant chance that their anticipated inflation will not appear and the Fed will tighten too much too soon. Frankly, the same risk applies to Europe as the ECB significantly reduces its quantitative easing.

Look at the graph below (hat tip my friend Tony Sagami), which shows the amount of quantitative easing that was pumped into the economy in the last few years. With 2½ trillion dollars of monetary stimulus from the world’s central banks, we still need tax cuts and boosted infrastructure spending to expand the US and global economy? Seriously?


 
Further, their quantitative tightening, which is what it really is, is going to reduce M2 money growth from its current 4% to less than 2%, as Lacy Hunt pointed out to me a few days ago. That slowdown is likely to affect the velocity of money, exerting further deflationary pressure on the economy.

It is monetary policy madness to raise rates and undertake quantitative tightening at the same time. Do I think the economy can actually stand three rate hikes next year? Without risking a recession? I think it’s likely that it can. But nobody has anything in any of their models, based on anything like real experience, that predicts what will occur if there is effective quantitative tightening at the same time. This is a real-time experiment.

In 2018 there will be almost $1 trillion less global QE than in 2017. What does that mean? We don’t know – and by we I mean you and I and all of our central bankers. I don’t much care what their models say, because their models have been continually, disastrously wrong. They create those models in order to give themselves excuses to do what they want to do, and then they conduct massive monetary experiments on economies to sees what happens. Sometimes everything works out. Sometimes it doesn’t.

Here is the US Treasuries yield curve as of December 5, from a graph on Seeking Alpha by Richard Turnill. The curve is slightly flatter today than it was then.


 
As I’m sure you know, an inverted yield curve happens when short-term rates are higher than long-term rates. I have used the yield curve to accurately predict the last two recessions. But let’s add a note here: A flattening yield curve does not mean there is a recession in our future. The yield curve has to be inverted for a period of time; and since World War II, when we have had an inverted yield curve for a protracted period, we have typically waded into a recession a year later. So even when we get an inverted yield curve, it doesn’t necessarily mean that we should immediately head for the storm shelter. In the last two cases of inversion, stocks continued rising (by over 20% in 2006!) before the general market rolled over and a recession ensued.

I recall an offstage debate David Rosenberg, David Zervos, and I had in Florida two or three years ago. They were arguing that the economy would not weaken until we had an inverted yield curve. And my question was, quite simply, “How can we have an inverted yield curve, since the Fed is going to hold rates down almost forever because of the risk of their rising and thereby making the economy worse?” And they assured me that the Fed would eventually get around to raising rates, probably by too much, and that we would then get an inverted yield curve and could start thinking about storm shelters. It looks like they were right.

The Fed can control the short end of the yield curve but has limited influence over the long end. Right now the federal funds rate is 1.5%. One-month US dollar LIBOR is 1.57%, and 12-month LIBOR is 2.1%. Do I think today’s economy can stand a 2.25% fed funds rate? Yes, I do.
 
The Trump Effect

Fortunately, I think another force will counteract the Fed’s actions, at least for 2018, and that’s what I will call (for lack of a better term) the “Trump effect.” Like him or not (and I know from the email I get that many of my readers don’t), the new administration is making some good things happen. I think the combined impact of deregulation, tax cuts, and (possibly) infrastructure spending will push back against the Fed’s monetary tightening and keep the economy on roughly the same course as in 2017.

If the Republican tax bill isn’t what you wanted, join the club – I was a charter member. I’ve met with my accountant, and the new law probably won’t help or hurt me very much, but it wasn’t intended to. It was about reducing corporate taxes to help US companies compete with the rest of the world. The headline stories tend to look at the publicly traded giants, but I think the real impact will be on small and mid-sized businesses – particularly exporters and everyone who competes with imports. The lower tax rates will help them expand and even cut prices.

Having said that, the tax cuts won’t perform magic. I don’t expect uninterrupted 3% growth for the next decade, as some of the bill’s cheerleaders predict. We will have another recession long before then, and it will probably be a deep one.

I have been talking about the new law with senior financial executives of large, privately held companies, my own accountant, and a number of friends. This is going to be like 1986, when everybody figured out how to game the system. You changed from being a C corp. to a sub-S corp. When you look at Thomas Piketty’s fudged and manipulated US income numbers in his laborious and ill-conceived book Capital in the 21st Century (which came out to massive academic acclaim – which says something about economic academia), you see this massive spike in US income in 1986. Did US citizens suddenly get rich? No, companies simply changed from being regular corporations to being pass-through corporations, which massively increased their reported income without actually increasing their real income. I did the same thing. You were an idiot not to. Today we all use LLCs, and it is rare to see a sub-S corporation created today. But I still have that 1986 sub-S corporation as an operating entity. Same difference as an LLC, just different tax reporting.

Now, you are going to see a lot of larger private pass-through corporations become regular C corporations again, because that’s how they can game the new tax system. In addition, blue-state politicians are already discussing ways to alter their tax systems so that their residents can get around the new SALT deduction limits. The tax revenue that Congress thinks it’s going to get is not all going to show up, so the deficit is actually going to be worse than projected. (Let’s come back in three years and see if this prediction was right.)

Goldman Sachs estimates the tax changes will boost GDP by an annualized 30 basis points in 2018–2019, then fade away. That seems as reasonable guess as any. The changes will help keep the mild expansion alive and push back against Fed tightening, and I think Trump-driven regulatory easing should help as well. Ask any CEO in practically any industry how much regulatory compliance costs – then stand well back. Now, if my friend GOP Rep. Jeb Hensarling can push through his reform of Dodd–Frank and ease regulations on small banks, we could see an even bigger boost. Regulatory costs are a major expense item, and companies would much rather spend that money on other things like worker training and maybe even pay raises.

These same factors will also let public companies distribute more capital to shareholders via stock buybacks and dividends. That should support stock prices at least at current levels and possibly push them higher still. It may not be another 2017-style record year, with numerous sectors gaining 20% or more, but it should be a decent year.

Notice that I said “should be.” Events could also conspire to derail that happy scenario. Let’s look at what could do it. Winter is coming, but not just yet.


What Could Go Wrong?

My more-of-the-same forecast presumes that monetary tightening and fiscal easing will roughly offset each other’s impacts. Of those two, I’m more confident on the fiscal side. I think any error will likely emanate from the Fed – namely, that it will tighten too far and/or too fast.

Predicting the Fed’s behavior is especially hard at this point, even with their dot plots, because the cast of characters will change significantly. We can also expect some transitional hiccups as Janet Yellen bows out and Jerome Powell sets his own sail.

What could happen that would make the Fed slow its present course of tightening? A sharp drop in inflation expectations should do it, but I’m not sure how that might happen. Energy prices are moving up, food and housing aren’t getting any cheaper, and out-of-pocket healthcare costs are hitting families hard. The low unemployment rate hasn’t yet created much wage pressure, though many economists think it’s coming. I have my doubts. I think we’ll see at least the three rate hikes in 2018, as the FOMC’s last set of dot plots indicated, and maybe more.

My friend Michael Lebowitz flagged some interesting rate data last week. Fed hikes to date have raised borrowing rates, just as you would expect, particularly for floating-rate loans and adjustable mortgages. That means additional cash outlays for debtors, i.e. most Americans, and less to spend on other goods and services.


 
Normally this added expense would be at least partially offset by higher rates earned by savers, but bank-deposit and money-market yields haven’t risen nearly as much as loan rates have. Current Fed policy is punishing debtors without helping savers.
 
That’s wonderful for bank profits, but the Fed’s tightening may have more deflationary impact than it expects. It raises the odds of a policy error.

Fed error is my top domestic policy risk factor for 2018, but it’s far from the only risk. Other central banks matter, too. If the European Central Bank and/or the Bank of Japan decide to follow the Fed’s lead and begin to exit from their own stimulus programs, global liquidity could fall faster than presently expected. The impact would depend on exactly how the policy shifts occur, but markets might shift quickly.

Other risks are out there, too. The debt crisis in China; US military action against North Korea; the Middle East conflict, which affects oil and gas production; dueling trade wars – you know the list. Add to it the newest bubble asset, Bitcoin, whose possible collapse would strip a lot of money from people who can’t afford to lose it. A lot could go wrong – but probably won’t; or if it does, the changes should remain manageable.

What to Do

 We’ll begin to see the market impact of the tax changes when 2018 trading opens this week. The typical Santa rally ends on the second trading day of the year. The Stock Trader’s Almanac tells us that if we end up on a high on January 3, an extraordinarily high percentage of the time we’ll be up for the year as well. That said, I continue to emphasize that if you have large open gains in some of your holdings and you’re a bit concerned about them, you might want to cash in and buy back at lower valuations. One way or another, I suspect we’ll see a significant correction at some point in 2018. It has been so long since we’ve had a correction that we are due one.

Corrections can happen anytime, not just in the midst of economic weakness. Frankly, I think it would be healthy for the Dow to back down by 10% or so. That kind of correction would skim off some of the froth and give new entrants a lesson in humility. I would treat any such weakness as a buying opportunity, especially for stable, dividend-paying companies. You might be able to lock in some good yields.

A correction or even a bear market (a 20% drop in the market indexes) that isn’t accompanied by a recession becomes a V-shaped recovery in the market prices.
 
Think 1987 or 1998. Bear markets during recessions are ugly in that their recovery periods are long.

The even bigger opportunity might be in high-yield bonds. They’ve not yet begun to retreat. If we get into a real fear-based market that thinks recession is coming, I think we’ll see 15% yields in the junk bond segment. They’ll get even better if recession actually appears. You see opportunities like this in the high-yield market only every 15 to 20 years. When they emerge, you have to put aside your fears and buy for the longer term. The technical charts show nothing but down when that pattern does happen. But a 15% yield and almost 50% capital gain can make that trade a meaningful addition to your portfolio.

If you’re holding stocks, investment real estate (as opposed to income real estate), or even more nebulous assets like Bitcoin, I would seriously consider taking some profits in early 2018, with an eye toward getting back in at lower prices when we get a decent-sized correction. That may not happen in 2018, but I suspect it’s not too far away.

All that said, consumer optimism is at an all-time high. For whatever reason, all the consumer polls are telling us that it’s “Happy Days Are Here Again.” Note that the song was written in 1929 and debuted in 1930 – just in time for the Great Depression. Consumer sentiment today is a real-time indicator, and as they say, it’s subject to change. But right now, the public is in a good mood, for a variety of reasons.

Bluntly, we are due for a correction in the markets, but we’ve been due for some time. And it’s not just the stock markets: Do you realize that the euro has not dropped more than 1% against the dollar for the entire year? Volatility is seemingly a thing of the past. Until, of course, it isn’t.

I’m going to close this first of my forecast issues at this point, to keep the letter from getting too long. Next week we’ll review the forecasts of other writers and friends, as I write to you from Hong Kong. The week after I will likely look at more specific markets, such as like energy, and offer additional comments on the tax reforms. But for now, let me wish you the very warmest and happiest of New Years.

Black-Eyed Peas, Hong Kong, Sarasota, and Boston

Shane and I will host close to 100 friends and neighbors on New Year’s Day for black-eyed peas, ham, and cornbread. And lots of mimosas. I think Shane is getting ready to cook about 8 gallons of black-eyed peas. Seriously. And while there will be a small quantity of them for the vegetarians among us, the bulk of them will have bacon, ham hocks, and smoked ham, plus a ton of seasonings; and one of those pots will have a healthy helping of jalapenos.

The next day we will fly with Lacy Hunt and his wife JK to Hong Kong, which, I have found out, is the longest flight in the American Airlines system: 17 hours and 15 minutes. It sounds like an opportunity to get some rest and catch up on some work.

When I get back, I am going to have to spend the day in Sarasota, looking at a new biotech company that my friend Patrick Cox thinks is extraordinarily promising. Honest to God, as skeptical as I am about government and central banks, I am extraordinarily optimistic about the human experiment. I think our world is going to be so much better in 20 years that the outcome exceeds our imagination.

I will have to get to Boston in mid-January to meet with new business partners and do a deep dive into the future of my business. Again, I’m extraordinarily optimistic about what I will be able to provide to you as investors and readers in terms of information, online services, and investment opportunities. More on that front in the future.

For now, let’s close out 2017. I am sincerely grateful to have been able to write this letter for 20+ years – and to have had so many of you join me for the ride. When I talk about my one million closest friends, it’s not just idle chit-chat, at least in my mind. When I sit down to write, I try to think of a person I want to talk to and share my latest thoughts with. Not a large audience, not the world, but you.

You give me the most valuable commodity in the world, your precious attention; and I try to deserve it by writing the best letter and giving you the most important information that I can. I thank you from the bottom of my heart. As one person who is overwhelmed by the information in his inbox, just as you are, I truly appreciate the value of your input.

My best wishes for 2018 – may it be your best year ever. I am ever optimistic this time of year, but I truly believe that 2018 will be my best year. I know that the “best plans of mice and men gang aft agley,” as the Scottish poet Robert Burns wryly observed; but as I have often pointed out, cautious optimism is the best strategy. Betting against humanity and our long-term success has always been a losing proposition. Betting against governments? That’s a different story. But nobody in 2038 will want to go back to the “good old days” of 2018. And as I will be writing in some of my future letters, your chances of making it to 2038 are a lot better than you think.

So let’s raise our champagne glasses high in a toast to the New Year and a great future. I look forward to exploring that future with you.

Your ever-optimistic and eating black-eyed peas for good luck analyst,

John Mauldin


Does Trickle-down Economics Add Up – or Is It a Drop in the Bucket?

water-droplet

An old term of questionable meaning is getting a new lease on life: Trickle-down economics.

And to many in media and liberal circles, it has once again emerged as the great hobgoblin of our time.

“Trump and conservatives in Congress are planning a big tax cut for millionaires and billionaires,” Robert Reich, who served as secretary of labor during the Clinton administration, wrote in Newsweek recently. “To justify it they’re using the oldest song in their playbook, claiming tax cuts on the rich will trickle down to working families in the form of stronger economic growth. Baloney. Trickle-down economics is a cruel joke.”

But what is trickle-down economics? The answer depends on who is saying it and what public opinion buttons they are trying to press. Kent Smetters, Wharton professor of business economics and public policy, says that trickle-down economics is a term created to disparage supply-side economics.

“It is just a clever negative sound bite,” says Smetters, faculty director of the Penn Wharton Budget Model (PWBM). “Detractors claim that supply-side economics is about giving tax breaks to the rich. The rich then engage in more economic behavior, such as buying more stuff or hiring more workers; that eventually ‘trickles down’ to the non-rich who get the crumbs that fall from the table.”

Many others have pointed out the folly of using the term — that no real economic model or serious school of thought stands behind what has long been a term of art at the intersection of politics and media. “I have a little bit of a hard time with the terminology and the idea of trickle-down economics,” says Wharton professor of finance Joao F. Gomes. “Although everyone in the popular press has a somewhat different characterization of what this means, this is not something we have tested or seriously theorized about as economists.”

But if there is no substance behind trickle-down — just pejorative intent — the Trump administration itself has curiously invoked the term in its zeal to sell its tax plan to the American public.

“I don’t believe that we’ve set out to create a tax cut for the wealthy. If someone’s getting a tax cut, I’m not upset that they’re getting a tax cut. I’m really not upset,” Gary Cohn, President Trump’s chief economic adviser, told CNBC recently. “We create wage inflation, which means the workers get paid more; the workers have more disposable income, the workers spend more. And we see the whole trickle-down through the economy, and that’s good for the economy.”
 
It’s not clear that most Americans believe that anything good will eventually trickle down to them from the still-unfinished overhaul. When asked who the Republican tax plan would help most, 76% of respondents to a December 2-5 CBS poll of 1,120 adults nationwide said it would be large corporations, with 69% saying wealthy Americans would benefit most. Just 31% named the middle class as winners, with “you and your family” trailing at 24%.

A Politically Infused Etymology

Oxford defines the particularly colorful phrase trickle down as the notion that wealth will “gradually benefit the poorest as a result of the increasing wealth of the richest.” The term’s popularization is often traced to a 1932 syndicated column by Will Rogers in which the humorist referred to money “appropriated for the top in the hopes that it would trickle down to the needy. Mr. Hoover was an engineer. He knew that water trickles down. Put it uphill and let it go and it will reach the driest little spot. But he didn’t know that money trickled up. Give it to the people at the bottom and the people at the top will have it before night, anyhow.”

“Favors for the few and prayers for the many” is what Adlai Stevenson II called it in an address to a 1954 Democratic Party rally in Detroit while stumping nationally for candidates.

A 1971 New York Times editorial referred to organized labor’s view that President Nixon was embracing “old-line ‘trickle down’ economics in the conventional Republican mold” by suggesting that “workers will benefit most by large-scale tax concessions to industry designed to spur investment in modernized plants and thus strengthen the competitive position of American business.”

And when President Ford proposed a tax overhaul in 1974, Sen. Edward M. Kennedy dismissed it as “a throwback to the trickle-down economics the nation has traditionally had to suffer under Republican Presidents.”

The phrase’s resonance today, of course, emanates from the Reagan era, and while it may have stood the test of time, longevity has not conferred clarity. Part of the problem is that “trickle down” lacks a universally understood meaning. Smetters says the idea of tax breaks for the rich eventually producing benefits to the poor has never been part of supply-side economics.

“Supply-siders believe — correctly or not — that lower taxes lifts all boats together,” he says. “Growth is not a flow of resources that cascade from rich to non-rich. In fact, many supply-siders argue that lower taxes benefit workers more than capital owners through international capital flows. Whether this argument is right or wrong is a legitimate issue. But describing this view as ‘trickle-down economics’ would be akin to supply-siders describing their detractors as communists, a label that would certainly be rejected as well.”
 
Semantics aside, most agree that the right kind of stimulus can be efficacious to growth. “The term ‘trickle-down economics’ doesn’t really represent a cohesive economic theory,” says Wharton professor of business economics and public policy Benjamin Lockwood. “It’s a term used, often negatively, to characterize the view that reducing taxes on the rich will benefit the non-rich.”

There are a number of reasons why tax cuts for high earners could theoretically make others better off, he says. “Economists have long emphasized that taxes don’t necessarily ‘stick’ where you levy them — for example, a tax cut on corporate profits could raise workers’ wages. And if taxes are very high, reducing them can theoretically spur economic activity enough that tax revenues actually increase, which may have been the case in the 1950s, when top income tax rates exceeded 90%.”

However, he says, there’s little evidence to suggest that this would be the case for the current GOP proposal. “Most recent estimates suggest that the majority of corporate income taxes fall on business owners and shareholders, with only a minority falling on wages. And the fiscal crisis generated by Kansas’s recent tax cuts suggests today’s tax rates aren’t high enough for such cuts to be revenue-generating.”

“How much growth will we get from this plan? It depends on final details and things we truly don’t know much about.”–Joao Gomes

The current tax bill is still a moving target, but the Penn Wharton Budget Model finds that the boost to GDP produced by the tax cuts would not be enough to pay for the tax cuts.

Lower taxes will probably add to growth. “Almost all economists accept that,” says Gomes. “How much and for how long is another question, and that’s where we disagree. There are several reasons for that. Some of us will say it is because lower taxes encourage people to work more and maybe corporations to invest more. If the tax cuts are long lived, this will raise national income for a long time. Republicans tend to start from this point.” Others will say it is because lower taxes will put money in people’s pockets and encourage spending which in turn creates jobs for a short time, even when the tax cuts are also temporary, Gomes adds. “Democrats tend to start from here. Indeed, this was the rationale for temporary cuts under President Obama. As I said, most economists agree that each of these arguments has merit. However, long-term cuts that stimulate work and investment cost more money and tend to benefit people who pay higher rates and/or capital gains taxes. These tend to be higher-income individuals.”

Do tax cuts pay for themselves, as some like to suggest?

“Almost surely not,” says Gomes. “But it is also important to say, to be absolutely fair, neither does spending on infrastructure, and that has not stopped left-wing economists from proposing it with the same fuzzy math that right-wingers support with these cuts. For an unbiased observer, there really is very little to choose between the fiscal probity of Democrats and Republicans.

“How much growth will we get from this plan? It depends on final details and things we truly don’t know much about,” Gomes continues. “Will it encourage people to work more? I would estimate yes, maybe a little but not very much. Will it encourage investment? Absolutely. Will it encourage corporations to relocate operations to the U.S.? Maybe, but the details are going to matter a lot.”

Looking for Growth in All the Right Places

The details of the tax plan are still opaque. One key unknown is the extent to which tax savings might be applied in ways that produce growth.

“Under the current tax proposal, the trickle-down economics becomes: ‘we’ll give a big cut in the corporate tax rate with the hope that those workers will benefit from the resulting new investment.’ It’s not surprising that if you tax returns on investments less there will be more investments,” says Robert P. Inman, Wharton professor of finance. “The real question becomes: How big of an effect on investment will there be, and if there is new investment in capital, will it benefit workers?

“For example, if businesses invest that in existing real estate or share buy-backs,” Inman continues, “there is probably not going to be much of an impact on employment or worker wages. However, investing in a new building or in new capital equipment will employ people and potentially increase worker productivity. In that case there will be a positive effect on employment and on worker wages.”

But how many jobs? And wages of what kind?

“I suspect most of the new machinery will be very sophisticated, high-tech, investment. If so, the trickle down, the wage premium for those at the lower ends of the income distribution, will be rather modest. The trickle-down will probably stop at [jobs paying] about $50,000.”

Inman recalls the effects of President George W. Bush’s 2004-2005 overseas corporate profits repatriation program. “The idea was that it would lead to a big influx of cash on the investment side, but what corporations ended up doing was buying back shares. That was an investment, but an investment that didn’t create any jobs.”

Of the new tax plan’s repatriation of earnings — about $2.5 trillion sitting offshore — that would be automatically brought home and taxed at a special rate, Smetters says it’s likely that some of it will translate into higher dividends, some into stock repurchases and some of it will be invested. “We don’t think the investment channel is going to be nearly as big as some people will say, and the reason why is that there are already some ways of clever financing,” he recently said in a separate Knowledge@Wharton interview.

Inman does believe that lowering the corporate tax rate makes sense, but that it needs to happen along with closing loopholes. “Close the loopholes, then see how much money you have and lower the tax rate accordingly,” he suggests.

On the question of whether the GOP’s plan will increase income and wealth inequality, a lot depends on what the exact changes to the estate tax end up being, says Gomes. “Still, from an inequality standpoint it would be great to see the elimination of the state and local tax and home mortgage deductions, which are mostly gifts to the top 20% of the income distribution. Eliminating these deductions while cutting tax rates is also the sort of ‘revenue neutral’ change that most economists would applaud.”

One aspect of this debate that is under-emphasized, says Lockwood, is the potential for other types of targeted tax cuts to generate beneficial spillovers. These are benefits that could bubble up from low earners, or flow sideways from middle earners, rather than trickling down from the top.

“In fact, there is evidence that cutting taxes, or targeting spending, on specific middle-class professions, including teaching and basic research, would have quite large beneficial spillovers,” he says. In a recent paper co-authored with Charles G. Nathanson of Northwestern University and E. Glen Weyl of Microsoft Research and Yale University, Lockwood writes that some professions have “spillovers” — that the social value of an individual’s work can be much higher, or much lower, than that individual’s compensation.

“Some spillovers are quite large,” they write in a Harvard Business Review piece about the paper “Taxation and the Allocation of Talent,” published in the Journal of Political Economy.

“Given how much good teachers raise the eventual incomes of their students, we calculate that spillovers from teachers are twice as large as the salaries teachers are paid. The benefits from medical research are even larger, amounting to over one-fifth of total income in the U.S. “On the other hand, some sectors involve ‘zero sum’ endeavors, in which profits come at the expense of other market participants. Examples include excessive litigation or financial traders trying to beat the market.”

They examine two potential types of tax policies. In one, raising top tax rates would, in theory, encourage workers to choose lower-paying jobs, compelling some to gravitate toward more socially valuable professions. In the other, the government would tax or subsidize some professions more than others.

The first approach would do little to spur economic growth, they conclude. The second could boost growth dramatically. Rather than advocating a rewrite of tax code with different rates for different jobs, the authors recommend a rewards system that would raise salaries and award merit pay.

Of growth stimulators in the current GOP tax proposal, Gomes says one aspect that is appealing is the expensing of investment. Firms will be allowed to deduct all investment expenses from their corporate taxes immediately, instead of slowly over time. “This change more than any others should encourage them to invest and boost our economy in the short and long runs. It’s a clever idea that economists have been advocating for years on the left and the right,” he says.

What he likes least: The fact that the plan is unlikely to pay for itself. “We should be raising revenues elsewhere to offset the cost of [many] good ideas. We are adding to the burden of the federal debt when we should be reducing it. Admittedly it’s not a lot relative to GDP, and the bond market is not concerned about the government’s ability to repay higher debt. But it goes in the wrong direction.”

Gomes says “there are several good ideas in the plan. The main problems might be the overall cost and the lack of phase-in for some of the changes that are likely to be very disruptive.”

It is, however, a complex plan, he says, and “obviously Republicans exaggerate its virtues and Democrats the defects. The truth is in the middle.”

Fluidic imagery aside, change is coming. Says Inman: “There is no economist who doesn’t agree that if you give somebody money, it’s going to have effects elsewhere in the economy. The only issue is how do those effects play out, and who are the beneficiaries?

For conservatives, he notes, “trickle-down is a flood, and for liberals it’s a drip.”


Fake Tax Reform

By: Peter Schiff


After supposedly chomping on the bit for years to pass meaningful tax reform, Republicans are now set to blow an historic opportunity. Whatever version of the Bill that emerges from the House and Senate Conference Committee (which will be signed by President Trump faster than he can down a Filet o’Fish), will be far less than the Republicans envisioned when they finally captured the White House and both Congressional Chambers in 2016. But from what I have seen of the particulars, the revisions to the tax code will offer a marginal, although temporary, win for low income individuals, a major slap for moderately successful wage earners and home owners, (especially in the high tax Blue States) and a huge victory for the extremely wealthy and certain categories of business owners. While it is certain that the plan will add to the growing deficit, its immediate economic and political impact is hard to predict.

For generations, taxpayers and politicians alike lambasted our overly complex tax code for its myriad of economic distorting loopholes that seemed to produce nothing except employment for legions of accountants and tax lawyers adept at gaming the system. As a result, talk about tax reform has always included proposals to make the system simpler, fairer, and more transparent. But on that front, the Republican proposals fail miserably. Trump and Congress will hail this achievement as being a major victory for the American people. But the true winner will be the swamp that Trump promised to drain.

Unlike Ronald Reagan, who passed tax reform in 1986 by striking a deal with Democrat House Speaker Tip O'Neill, Trump and Congressional Republicans faced no particular need to compromise. If Reagan had the benefits enjoyed by Trump, Ryan and McConnell, his tax cuts would have been paired with significant spending cuts and perhaps a balanced budget. But to get O’Neill (and his whopping 71 seat House majority) to go along, Reagan's ideals of fiscal prudence and smaller government had to be set aside. But Trump is no Reagan, and today’s Republican Party has about as much commitment to shrinking the size of government as did the Democrats in the 1980s.

Taxes are the price we pay for government. If Republicans want to reduce the tax burden, they need to make government less expensive. Tax cuts without spending cuts is the Republican version of a free lunch. But if government spending is not paid for with tax revenue, alternate sources must be found that will ultimately prove more costly than the forgone tax revenue.

Despite endless campaign rhetoric to the contrary, the Republican Party is no longer the party of limited government, fiscal responsibility, Federalism, the Constitution, sound money, or any of the principals that they typically espouse while stumping for office or raising money. Instead of reducing the size of government, thereby lightening the burden on taxpayers and limiting the economic drag caused by government, Republicans have chosen the easy course of tax cuts, replete with overly optimistic assumptions and gimmicks meant to disguise their true impact on future deficits. Adding insult to injury, they leave in place an even more complex tax code, replete with even more loopholes, that limits individual freedom and undermines economic growth.

True reform would have eliminated the income tax completely, or at a minimum, replaced it with a flat tax. It would have abolished the corporate income tax, payroll taxes, and the estate and gift taxes, and replaced them with a tax system based on consumption rather than production. Such a system would encourage savings rather than debt accumulation, and would restore some semblance of sanity to a system increasingly dependent on borrowing. Real reform would have included entitlement reform, as well as across the board reductions in government spending. Entire agencies and departments would have been eliminated, making government smaller and less expensive. These are the types of changes that are needed to head off a possible looming debt crisis and put the country back on a path to achieve real economic growth, not the phony financial gains we have seen in the past generation.

But instead, Republicans crafted a plan that would cut taxes for some while raising taxes for others.

The political genius of the plan can be found in the elimination of state and local tax deductions that will raise taxes predominantly on higher wage earners in Democrat controlled states with high taxes.

This move was a political freebie for Republicans, as it largely spares their constituents from tax hikes, but prevents Democrats from protecting theirs because to do so would require them to argue against raising taxes on the "wealthy." It may also trigger a fiscal crisis in largely Democrat states as high earners, who provide an outsize share of state tax revenue, consider pulling up stakes for lower tax jurisdictions.  But Republicans did not leave well enough alone.

The taxes raised on rich Democrats will not nearly be enough to pay for the cuts they offer business owners, passive investors, and corporations. The balance will be "paid for" by borrowing. In addition, high tax states may be forced to scramble to adjust their tax policies in an attempt to forestall defections of the wealthy. To do so, they may shift taxes to businesses (for which state taxes will still be deductible from federal taxes). The businesses in turn, can pass these costs onto their employees in the form of lower wages and their customers in the form of higher prices.

Republicans, of course, argue that the economic growth that will be generated by lowering the corporate tax rate from 35% to 20% will generate enough new tax revenue to offset what is lost.

While that idea is sound in theory, nothing about our current situation would suggest that a growth surge is around the corner, with or without corporate tax cuts.

We are already in the ninth year of a supposed economic expansion. Over the last century, these expansions (the time between recessions) have lasted, on average, about five and a quarter years. So, already our current “expansion” has lasted nearly twice the average. Also, this expansion has been extraordinarily weak, with growth averaging around 2% since 2009. This is far below the 3% to 4% rate seen in prior recoveries. (data from the National Bureau of Economic Research and Bureau of Labor Statistics) It is also clear that this tepid number has relied heavily on surging asset prices in stocks, real estate, and bonds. But all three of those markets could easily reverse course.

The stock market has surged to all-time highs based on the expected likelihood that tax reform would be passed early in the Trump Administration. When this hope becomes reality, it may be that we will get a “buy the rumor, sell the fact” decline, especially if the final package is not all that investors hoped it would be. The real estate market may actually suffer under the new rules as high-end properties become more expensive to own and less attractive to buy given the limits on property tax and mortgage deductions. On the lower end of the market, the expansion of the standard deduction could mean far fewer will receive a tax benefit from buying modestly priced homes, thereby mitigating the advantages of buying over renting. (It is no accident that some of the biggest objections to the new proposals have come from real estate industry groups). And lastly, the bond market faces no shortage of headwinds. With the Fed threatening to sell much of its $4.5 Trillion holdings of Treasury and Mortgage bonds, the likelihood of falling bond prices and rising yields looms large. (In the past three months, 10-year Treasury yields have increased 30 basis points). Even the tax bill’s supporters acknowledge that it will increase the deficit significantly in the near term, thereby requiring the Treasury to sell more bonds to fill the gap. The extra supply could put downward pressure on bond prices and raise yields on the long end, creating losses in the bond market and raising borrowing costs for government, businesses and consumers.

For these reasons, it is logical to assume that the current tax proposals will have a more modest economic impact than the Tax Cuts of 1986 or even the Bush tax cuts of 2001. It is important to note that the Bush tax cuts occurred while the economy was already in recession, a time where economists could at least plausibly argue that fiscal stimulus was needed. But by putting these cuts through now, while the economy is still expanding (at least on paper), by the time the next recession arrives, the fiscal bullets will have already been fired.

Assuming that the hoped for economic growth does not materialize, the money borrowed now must eventually be repaid. Deficit spending means that today’s tax cuts merely sow the seeds for tomorrow’s tax hikes. But since taxpayers will not only be on the hook for the money borrowed, but the added interest associated with that debt, the future tax hikes could be larger than today’s cuts.

Of course, instead of raising future taxes to repay the money borrowed to fund today’s cuts, a cooperative Federal Reserve could simply print the money needed to buy the additional Treasury debt. But this does not mean we get all this government for free. The cost will come in the form of higher consumer prices as a new round of monetary expansion could cause a continuing drop in the dollar. So Americans may end up with more after tax dollars in their paychecks, but the reduced value of those dollars means they will actually be able to afford to buy less stuff. Just because it appears consumers dodged this bullet during the first three phases of Quantitative Easing does not mean that we will be as lucky with additional rounds.


Two Myths About Automation

BARRY EICHENGREEN

 An inside view of the 'AknRobotics'

BERKELEY – Robots, machine learning, and artificial intelligence promise to change fundamentally the nature of work. Everyone knows this. Or at least they think they do.

Specifically, they think they know two things. First, more jobs than ever are threatened. “Forrester Predicts that AI-enabled Automation will Eliminate 9% of US Jobs in 2018,” declares one headline. “McKinsey: One-third of US workers could be jobless by 2030 due to automation,” seconds another.

Reports like these leave the impression that technological progress and job destruction are accelerating dramatically. But there is no evidence of either trend. In reality, total factor productivity, the best summary measure of the pace of technical change, has been stagnating since 2005 in the United States and across the advanced-country world.

Moreover, as the economist Timothy Taylor recently pointed out, the rate of change of the occupational structure, defined as the absolute value of jobs added in growing occupations and jobs lost in declining occupations, has been slowing, not accelerating, since the 1980s. This is not to deny that the occupational structure is changing. But it calls into question the widely held view that the pace of change is quickening.

The second thing everyone thinks they know is that previously safe jobs are now at risk. Once upon a time, it was possible to argue that robots would displace workers engaged in routine tasks, but not the highly skilled and educated – not the doctors, lawyers and, dare one say, professors. In particular, machines, it was said, are not capable of tasks in which empathy, compassion, intuition, interpersonal interaction, and communication are central.

Now, however, these distinctions are breaking down. Amazon’s Alexa can communicate.

Crowd-sourcing, together with one’s digital history, can intuit buying habits. Artificial intelligence can be used to read x-rays and diagnose medical conditions. As a result, all jobs, even those of doctors, lawyers, and professors, are being transformed.

But transformed is not the same as threatened. Machines, it is true, are already more efficient than legal associates at searching for precedents. But an attorney attuned to the personality of her client still plays an indispensable role in advising someone contemplating a messy divorce whether to negotiate, mediate, or go to court. Likewise, an attorney’s knowledge of the personalities of the principals in a civil suit or a criminal case can be combined with big data and analytics when the time comes for jury selection. The job is changing, not disappearing.

These observations point to what is really happening in the labor market. It’s not that nurses’ aides are being replaced by health-care robots; rather, what nurses’ aides do is being redefined.

And what they do will continue to be redefined as those robots’ capabilities evolve from getting patients out of bed to giving physical therapy sessions and providing emotional succor to the depressed and disabled.

At one level, this is good news for those concerned about the prospects of incumbent workers: there will continue to be demand for workers in existing occupations. Not all nurses’ aides will have to become software engineers. The knowledge they acquire on the job – of how one interacts with patients, how one recognizes their moods, and how one acknowledges their needs – will remain pertinent and valued. They will use that knowledge to guide and cooperate with their robotic colleagues.

Thus, the coming technological transformation won’t entail occupational shifts on the scale of the Industrial Revolution, with its wholesale redistribution of labor between the agricultural and industrial sectors. After all, the vast majority of Americans already work in the service sector. But it will be more important than ever for people of all ages to update their skills and renew their training continuously, given how their occupations will continue to be reshaped by technology.

In countries like Germany, workers in a variety of sectors receive training as apprentices and then over the course of their working lives. Companies invest and reinvest in their workers, because the latter can insist on it, possessing as they do a seat in the boardroom as a result of the 1951 Codetermination Law. Employers’ associations join with strong trade unions to organize and run training schemes at the sectoral level. The schemes are effective, in part, because the federal government sets standards for training programs and issues uniform curricula for trainees.

In the US, board membership for workers’ representatives, strong unions, and government regulation of private-sector training are not part of the prevailing institutional formula. As a result firms treat their workers as disposable parts, rather than investing in them. And government does nothing about it.

So here’s an idea. Instead of a “tax reform” that allows firms to expense their capital outlays immediately, why not give companies tax credits for the cost of providing lifelong learning to their employees?


Barry Eichengreen is Professor of Economics at the University of California, Berkeley, and a former senior policy adviser at the International Monetary Fund. His latest book is Hall of Mirrors:The Great Depression, the Great Recession, and the Uses – and Misuses – of History.


2007 All Over Again, Part 7: Borrowers Start Scamming Desperate Lenders

One of the hallmarks of late-stage bubbles is a shift of power from lenders to borrowers. As asset prices soar and interest rates plunge it becomes harder to generate a decent yield on bonds and other fixed income securities, so people with money to lend (like pension funds and bond mutual funds) are forced to accept ever-less-favorable and therefore far-more-risky terms.

Recall the liar loans that were popular towards the end of the 2000s housing bubble and you get the idea. Lenders were so desperate for paper to feed the securitization machine that they literally stopped asking mortgage borrowers to prove that they could cover the interest.

Here we go again, but this time in the market for leveraged buyout loans: 
Yield-Starved Investors Giving In to the Demands of Bond Sellers 
(Wall Street Journal) – Demand for leveraged loans is allowing private-equity firms to water down legal safeguards for investors Hellman & Friedman LLC and other investors sought last month to borrow money in the bond market to finance a takeover.  
The U.S. private-equity firm offered a yield of about 3%, but few of the protections once considered routine. 
Still, the investors bought. 
Rampant demand for leveraged loans is allowing private-equity firms to water down legal safeguards for investors. Many lawyers and bankers increasingly worry that such changes could result in higher losses for investors during the next downturn, as creditors find themselves with less protection. 
Terms on loans from Hellman & Friedman’s takeover of Denmark’s Nets A/S allowed greater flexibility for the borrower to take on more debt, extract cash from the company and even restrict who owns the loans. That, though, is no longer unusual in the loan market.

 
In the financing of a previous takeover of Nets in 2014, a separate group of private equity borrowers had to prove that debt at the Danish payments company wasn’t rising too quickly. Such a requirement wasn’t present this time. 
The move to more borrower-friendly terms has come in both the U.S. and Europe.  
But the most dramatic shift has been in Europe, where the imbalance between loan supply and demand is most acute. 
Investors are clamoring for leveraged loans as years of low interest rates and central banks’ bond buying have pushed down returns elsewhere. Trillions of dollars of sovereign debt, primarily in Europe, continue to sport negative yields, meaning investors pay to lend governments money. 
With “far too much cash trying to find too few homes,” private-equity firms “can be more aggressive and lenders will take it,” said Adam Freeman, a partner at Linklaters LLP. 

Some of the year’s largest leveraged buyouts in Europe have either removed covenants and legal protections, or allowed the borrower to control who buys its debt. 
That included Bain Capital and Cinven’s takeover of German drugmaker Stada Arzneimittel AG, Lone Star LP’s acquisition of German building materials maker Xella Group, as well as the takeover of Nets A/S. 
Analysts say that along with low borrowing costs, the weakening of deal terms has helped boost the appeal of loans to private-equity firms. In Europe, around 88% of the debt funding for leveraged buyouts came from loans this year, according to S&P Global Market Intelligence’s LCD unit, up from 73% in 2015. Meanwhile, 81% of loans in Europe this year have been “covenant-lite,” meaning they lack many standard investor protections, up from 21% in 2013, according to LCD. 
Among the first changes was the stripping out of so-called financial-maintenance covenants, which are investors’ main defense against borrowers taking on too much debt. They require quarterly tests of a company’s leverage level, allowing lenders to force the firm into default if it rises too high. 
Other borrower-friendly terms include stringent loan-to-own clauses, which limit investors’ ability to sell to distressed debt funds. Recent loans have placed restrictions against such firms as Elliot Capital Management, Apollo Global Management and Cerberus Capital Management. 
Bankers warn that such provisions, along with so-called white lists that detail which funds can buy the loan, could hurt liquidity if investors can’t unload loans in troubled companies to the sort of funds that specialize in taking on this risk. 
This is just what happens when central banks push interest rates way down while flooding the market with new currency. Lenders find themselves with too much money to lend and borrowers can, as a result, can write their own tickets. With eventually disastrous results.  
When things get tough, as they always do after a long debt binge, the private equity borrowers will suck as much money out of their captive companies as possible, while layering on new debt at unfavorable terms. Then they’ll let those companies default and hand off the near-worthless carcasses to creditors.  
You have to feel sorry (and, yes, a bit of disgust) for the victims of this recurring scam. Pension funds, for instance, are saddled by their political masters with unrealistically high return assumptions of 7% – 8%, which are unattainable in a world where long-term bonds yield next to nothing. So the prospect of even an extra percentage point of yield is tantalizing for pension fund managers whose jobs are on the line if they can’t do the impossible.  
A personal aside: My first serious finance job was as a junk bond analyst with a high-yield mutual fund, and my days boiled down to reading bond covenants and answering the question, “how can they screw us?” The assumption was that if the borrowers could screw us they would, and we wanted to see it coming.  
But with bubbles of today’s magnitude, seeing it coming isn’t much help for either the owners of this increasingly toxic paper or the economy as a whole. 


For India and China, Southeast Asia Is a Battleground

By Kamran Bokhari

 

Power is inflationary. As countries become stronger, their interests expand beyond their borders, where they must find new ways to protect those interests. India is no exception. Its expansion, though, brings it into contact with China, a much more formidable country that competes with India for land-based and maritime trade routes in the Pacific. China and India have protocols in place for dealing with neighbors such as Nepal and Bhutan, which they border by land. But they have less established rules of engagement for dealing with Southeast Asian nations, which, as coastal, peninsular and island nations, require different strategies. 

India is putting its expansion efforts on display this week, hosting the first ASEAN-India Connectivity Summit, aimed at supporting infrastructure development and trade partnerships between India and the members of the Association of Southeast Asian Nations. It is part of India’s Act East policy, an initiative to strengthen economic and security ties with Southeast Asia. India hopes that this policy will help it meet its objectives both on the domestic and international fronts. Domestically, Act East will encourage economic development in India’s Northeast region, an area poorly connected to the rest of the country. Internationally, this policy aims to expand India’s presence in Southeast Asia so that it can serve as a counterweight to China. 

India’s attempt to gain a foothold in the region isn’t new. India and ASEAN countries have been holding summits for the past 15 years. They signed a free trade agreement in 2009, and trade between them totaled $71 billion in 2016-17.
 
In fact, the Act East policy started as the Look East policy in the early 1990s. 
 
Since then, every Indian government has pursued the initiative but made little headway, in part because all development and infrastructure initiatives are long-term projects. But it’s also because these governments faced serious domestic divisions. The lack of internal coherence made it difficult for India to exert power abroad. But the government of Prime Minister Narendra Modi has been able to centralize power by implementing new tax systems, new bankruptcy rules, a national demonetization drive, income tax reform, real estate reform and a national infrastructure stimulus program. These moves could help Modi finally pursue a more proactive foreign policy and make inroads in Southeast Asia.
India ASEAN Southeast Asia
Leaders from ASEAN member states pose with Indian Prime Minister Narendra Modi during the 15th ASEAN-India Summit on the sidelines of the 31st ASEAN Summit in Manila on Nov. 14, 2017. MANAN VATSYAYANA/AFP/Getty Images
 
India is now using the Act East policy as a counter to China’s own ambitious One Belt, One Road initiative, a vast network of infrastructure projects that promises to build connections throughout Asia and into Europe. This week’s summit is part of India’s efforts to respond to OBOR. Representatives from all 10 ASEAN member states as well as Japan are in attendance. India’s road transport minister already announced that India has proposed a $1 billion line of credit to promote land, sea and air connectivity projects with the ASEAN bloc. Some projects, like the India-Myanmar-Thailand trilateral highway, are already in the works. Indeed, $1 billion is a lot of money, but not nearly enough to fully fund all of these initiatives. 

Yet, what makes the ASEAN-India summit significant is that it demonstrates India’s intention to help fund major infrastructure projects in Southeast Asia. China has promoted itself as the leading source of infrastructure funding and assistance in Southeast Asia, but now India is positioning itself as China’s direct competitor. 

OBOR poses a major challenge and potential threat to India. India has already objected to one important component of OBOR, the China-Pakistan Economic Corridor, partly because it passes through the disputed Kashmir region. Earlier this year, China also tried to expand a road onto land that Bhutan claimed was its territory. A strong ally of Bhutan, India got involved in the border dispute and tensions escalated before a diplomatic settlement was reached. Though these developments do not mean China is about to gain a major foothold in South Asia, India cannot wait for that to happen to respond. 

In addition to its land-based infrastructure projects, China has been working on its maritime-focused String of Pearls initiative, which will connect China to North Africa and the Middle East through a series of ports along the Indian Ocean. To successfully contain and counter Beijing’s maritime expansion, New Delhi will need to partner with other countries. India is building up its navy, but it currently does not have the capabilities to patrol sea lanes alone. 

This is where Japan comes in. Japan also fears China’s growing power in East Asia and wants to limit it. Tokyo has helped coordinate the ASEAN-India summit, and last week, Japan and India held their own Act East Forum. The forum aimed to expand cooperation between Japan and India’s Northeast region, an area of particular importance for anti-China efforts because it shares a border with China. Japan has been described as a linchpin in India’s Act East policy, and its cooperation with India will help both countries increase their influence over ASEAN members, offering alternative sources of investment and support for these countries. 

Notably, Cambodia, Myanmar and Vietnam – all of which are ASEAN members and are attending the summit this week – historically have close ties with China.
 
They understand well the rivalry between India and China, and they are aware that Beijing opposes India’s move to expand its reach into the Pacific. They chose to attend the summit anyway. This could be a sign that countries in the region are genuinely tiring of China’s demands and its claims to territory in the South China Sea. It could also be a sign that these countries are adopting a strategy similar to that of the Philippines, which plays two powers – China and the U.S. – off one another to extract better trade, security and investment deals. 

It will take far more than a $1 billion credit line for India to fully counter China’s influence in Southeast Asia. But with ties between Japan and India growing, the ASEAN-India summit might be a sign that an anti-China bloc in Southeast Asia is emerging.