Pacifist Germany defies Europe’s nationalist tide

Berlin has not shrunk from the darkest chapters of continental history


There was a time when Europe thought it had made its peace with history. The nations of East Asia — Japan, China, Korea — might nurture the embers of conflicts past, but Europe had liberated itself with the creation of the EU. You did not have to be an ardent Europhile to see that economic integration served as the midwife for postwar reconciliation.

All this was before Poland’s authoritarian government reopened a claim for war reparations against its neighbour Germany, and Hungary’s prime minister Viktor Orban sought to rehabilitate the reputation of his country’s fascist wartime leader Miklos Horthy. The ruling Law and Justice party (PiS) in Warsaw now wants to criminalise any suggestion that some Poles were complicit in the operation of Nazi concentration camps.

Nations mostly celebrate history by marking triumphs over adversity or, sometimes, bathing in the nostalgia of past glories. In its moment of denial, Brexit Britain cannot get enough of Churchillian reminiscence about standing alone. The new nationalism is rooted in mostly imagined grievance.

Mr Orban has never quite reconciled himself to the loss of Hungarian territory under the Treaty of Trianon in 1920. Jaroslaw Kaczynski, the leader of PiS, sees a German or Russian plot around every corner.

The nationalist right has a keen eye for enemies. Jews have always been a favourite target. Now they are joined among adversaries of old by Muslim refugees arriving from the Middle East. Nor is Mr Orban alone in his revisionist take on 1930s dictators. In far-right Italian circles you often hear that history has “misunderstood” the fascist leader Benito Mussolini.

Harder to comprehend have been angry demonstrations in Athens against suggestions that the former Yugoslav Republic of Macedonia might more simply be called Macedonia. The tiny Balkan state stands accused of seeking to appropriate Greek heritage. But is Greece’s identity really quite so fragile? Surely after the tribulations of recent years the nationalists could find more recent grudges than an argument about the lineage of Philip of Macedon?

There is one European nation that has never sought to forget the history of the continent during the first half of the 20th century. Germans remain at once uncomfortable about talking about the past, but determined to confront it. This way they can legitimise the present.

Walk the streets of Berlin and there is no escape from Hitler’s calumnies — from the small, gold memorial plaques studded in the pavement to mark places where individual Jews were seized, to the grim but inspiring Holocaust memorial next to the Brandenburg gate and the bleak account of the rise of Nazism in the museum of German history.

Next week foreign and defence policy chiefs from across the advanced western democracies will gather for the annual Munich Security Conference. Two of the conclusions of their deliberations can be written in advance. Donald Trump’s disavowal of global leadership in favour of “America first” nationalism leaves Europe to do more to safeguard its own security. And the nation most able to shoulder more of the defence burden? Germany.

The hosts cannot complain. It was in Munich that chancellor Angela Merkel last summer offered a caustic assessment of Mr Trump as an unreliable partner. Only last month in Davos she called for Europe to “take its destiny into its own hands”. Talk to policymakers in Berlin and you get the same message: as Europe’s most powerful nation, Germany will play its part.

I wonder. Ms Merkel may tell international audiences that Germany will pay up for defence and security, but the draft coalition agreement her Christian Democrats have negotiated with the Social Democrats tells a rather different story. Beyond a few bromides — “German foreign policy is dedicated to peace” — the draft says nothing about Germany’s role in preserving an open international order. As for defence, well, “the Bundeswehr remains an indispensable element of German security policy”.

Critics call this freeriding. And there is something of that. Germany is a stable, prosperous society and its citizens have grown wealthy as others paid for Europe’s security. But no one should underestimate the weight of history.

Berlin’s Invaliden cemetery was built more than 250 years ago on the orders of Frederick the Great to memorialise Prussia’s war heroes. Among the graves is the tomb of the warrior Gerhard von Scharnhorst. But do not expect grandeur — the monuments sit on a small scrap of ill-tended land hemmed in by apartment blocks and the canal behind the city’s main railway station.

Scharnhorst shares the ground with the authors of Operation Valkyrie, the abortive attempt by military officers to assassinate Hitler. Somewhere, in an unmarked grave, lies Reinhard Heydrich, the SS officer who chaired the infamous Wannsee conference.

This is our “Arlington”, a former German foreign minister told me laconically. Another way of putting it would be to say that Germany’s stubborn pacifism keeps clear sight of history. That is inconvenient for those of us who believe that Europe does indeed need to do more to defend itself. But Germany at least has held on to a true account of events that angry nationalists pretend to have forgotten.

The Era of Fiscal Austerity Is Over. Here’s What Big Deficits Mean for the Economy.

It depends on whether you look at the short, medium or long term.

By Neil Irwin

When he was running as a Republican vice-presidential candidate in 2012, Paul Ryan spoke in front of a national debt clock.CreditBrian Snyder/Reuters

The last seven weeks amount to a sea change in United States economic policy. The era of fiscal austerity is over, and the era of big deficits is back. The trillion dollar question is how it will affect the economy.

In the short run, expect some of the strongest economic growth the country has experienced in years, and some subtle but real benefits from a higher supply of Treasury bonds in a world that is thirsty for them.

In the medium run, there is now more risk of surging inflation and higher interest rates — fears that were behind a steep stock market sell-off in the last two weeks.

In the long run, the United States risks two grave problems. It may find itself with less flexibility to combat the next recession or unexpected crisis. And higher interest payments could prove a burden on the federal Treasury and on economic growth. This is particularly true given that the ballooning debt comes at a time when the economy is already strong and the costs of paying retirement benefits for baby boomers are starting to mount.

It’s hard to overstate how abrupt the shift has been.

When the Congressional Budget Office last forecast the nation’s fiscal future in June, it projected a $689 billion budget deficit in the fiscal year that begins this coming fall. Analysts now think it will turn out to be about $1.2 trillion.

One major reason is the tax law that passed on Dec. 20, which is estimated to reduce federal revenue by about $1.5 trillion over the next decade, or $1 trillion when pro-growth economic effects modeled by the congressional Joint Committee on Taxation are factored in. A budget deal passed in the early hours of Friday morning includes $300 billion in new spending over the next two years for all sorts of government programs and $90 billion in disaster relief, without corresponding cuts elsewhere in the budget.

It is a stark reversal from 2010 to 2016, when congressional Republicans insisted upon spending cuts and the Obama administration insisted on raising taxes (or, more precisely, allowing some of the Bush administration’s tax cuts to expire). Those steps, combined with an improving economy, cut the budget deficit from around 9 percent of G.D.P. in 2010 to 3 percent in 2016.

The Near Term: Strong Growth in 2018

In almost any economic model you choose, the new era of fiscal profligacy will create a near-term economic boost. For example, Evercore ISI, the research arm of the investment bank Evercore, estimates that the combination of tax cuts and spending increases will contribute an extra 0.7 to 0.8 percentage points to the growth rate in 2018, compared with the policy path the nation was on previously.

Economists generally think that these policies will have a lower “multiplier” than these policies would have if they took place during a recession, when there is more spare capacity in the economy. But that doesn’t mean the multiplier becomes zero.

“Some people assume that because this was a bad process and the tax bill is really regressive that it won’t have a short-term growth impact, but I think that’s wrong,” said Adam Posen, president of the Peterson Institute for International Economics. “We shouldn’t confuse whatever distaste one has for the composition of the package for totally overwhelming the multiplier effects.”

Put a different way, it would be very hard for the government to pump an extra half-trillion dollars into the economy in a single year without getting some extra economic activity out of it.

Another potential near-term positive for the global financial system could be the effect of billions of dollars in bonds issued by the Treasury. For years the world has experienced what some analysts call a “safe asset shortage,” too few government bonds and other investments viewed as reliable relative to demand.

This has arguably been a factor in depressed interest rates and sluggish growth across much of the advanced world. More Treasury bonds floating around might reduce those pressures.

The Medium Term: Depends on Economic Slack, and the Fed

Over the next two or three years, things get more murky. What happens will depend on how the economy responds to the additional fiscal stimulus, and how the Fed responds to that.

The big question is whether the economy has the room to keep growing without higher inflation emerging. The unemployment rate is already low at 4.1 percent, so there aren’t exactly hordes of jobless people available to be put back to work. That means there is a chance that all this extra money flooding into the economy doesn’t go toward more economic output but just bids up wages and ultimately consumer prices.

If that happens, the Federal Reserve would almost certainly raise interest rates more than it now plans, essentially engineering an economic slowdown to try to keep inflation from accelerating. In that scenario, the apparent benefits of tax cuts and spending increases would be short-lived.

But there’s no certainty that will happen. It may be that the United States has more growth potential than standard models suggest. Perhaps corporate income tax cuts and looser regulation on business will unleash more capital investment and higher productivity, as conservatives argue. Maybe some of the millions of prime-age adults who have dropped out of the labor force in recent years will come back in, creating more economic potential.

“The really big question mark we have is how much slack there really is in the economy,” said Donald Marron, a scholar at the Urban Institute who was once acting director of the Congressional Budget Office. “If you look at conventional measures, unemployment looks really low, but on the other hand if you look back to what we used to think of the potential of the economy a few years ago, we may have some room to grow.”

The Long Run: Higher Debt-Service Costs and Less Room to Maneuver

The public debt was already on track to rise relative to the size of the economy before the new tax and spending deals; now it will probably rise faster. The Congressional Budget Office projected last June that the nation’s debt-to-G.D.P. ratio would rise to 91 percent in 2027, from 77 percent in 2017.

The C.B.O. hasn’t updated those numbers to reflect the new tax and spending legislation, but the Committee for a Responsible Federal Budget estimates that it will turn out to be between 99 and 109 percent, depending on whether provisions of the tax law are allowed to expire as they are scheduled to.

But those numbers are just an abstraction. The question is what effects higher debt loads might have for Americans in 2027 and beyond.

Higher debt service costs are one big one. Taxpayers in 2027 were forecast to pay $818 billion a year in interest costs even before the tax cuts and spending increases, or 2.4 percent of G.D.P.

That will presumably be higher, because taxpayers will be paying interest costs on more debt, and probably at higher interest rates.

And there is probably some point at which the amount of debt the government takes on crowds out private investment; to the degree that the supply of funds to borrow is finite, every dollar the government borrows is not available to be lent to a homeowner taking out a mortgage or a business looking to expand. That said, in practice, the supply of loanable funds is not finite — households may save more with higher interest rates, for example, and foreign capital might flow in.

The bigger costs of a high national debt may come in how much flexibility policymakers have to respond to a future recession or crisis. If the United States finds itself in a major war or a deep recession, its starting point in terms of debt load will be much higher than it was at the onset of the Iraq War or the 2008 financial crisis.

“It’s about risk management,” Mr. Posen said. “We may need that fiscal capacity for something else.”

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.” 

Beware The Inflation Trap

by: Eric Parnell, CFA


- Sustained inflation pressures are on the rise.

 - Or are they?

- Putting the latest widely accepted mainstream financial media narrative to the test.

- What's really going on.

- Implications for your portfolio and how to capitalize.

- This idea was discussed in more depth with members of my private investing community, The Universal

It is the mainstream financial media narrative du jour. After years of relatively benign pricing pressures during the post crisis period, we are now entering a phase of sustainably higher inflation.

This notion has raised the specter that the U.S. Federal Reserve will need to raise interest rates more quickly than expected, has sent U.S. Treasury yields higher, and has shaken the U.S. stock market to the core over the past two weeks. But while the narrative certainly makes good sense, a key question remains critically important to ask. Are we really seeing any signs of the rise in inflation that so many have already assumed as given? And what does the true answer to this question mean for our stock and bond allocations?
From The Top
Let’s take this discussion from the top. Here’s how the story goes:
Lower corporate tax rates will be driving a substantial increase in corporate earnings over the coming year, which in turn will feed through to increased economic activity and an acceleration in real GDP growth. Given that the labor market is already tight, this will also bring with it increased wage pressures and will have too much money chasing too few goods in general, thus resulting in sustainably higher inflation pressures going forward. Bond yields will rise as a result, while the ultimate fate for stocks will depend on whether companies can grow earnings to more than compensate for the rise in inflation. Assuming the right companies will be able to do so, favor stocks over bonds in a diversified portfolio strategy, and bias toward growth and cyclical names over defensive allocations within the stock allocation.
This narrative makes completely good sense. And a close monitoring of the news flow from the mainstream financial media provides confirmation for this outlook.
But relying on qualitative confirmation leaves us exposed to the risk of error in our analysis and conclusions. Thus, it is worthwhile to consider the following. Is the underlying quantitative data actually confirming this is the case?
Why is this question important? Because throughout the post crisis period, we have heard that sustainably higher inflationary pressures were looming right around the corner. Yet after nine years, they never actually materialized. In fact, the same narrative was being told throughout the years following the bursting of the technology bubble leading up to the onset of the financial crisis. This included gasoline prices cresting at over $4.10 per gallon in the summer of 2008, which equates to $4.62 per gallon in today’s dollars. Yet sustainably higher inflation pressures never materialized then either. In fact, the exact opposite has been taking place ever since.
Taking A Walk
Corporate Earnings

Let’s take a quantitative walk through the widely accepted narrative outlined above.
We will begin with the increase in corporate earnings. Now over the last three years, annual GAAP earnings on a nominal basis have been flat. After peaking in 2014 Q3, we entered into an earnings recession thanks in large part to the collapse in oil prices. But we have emerged from this earnings recession over the past year and in 2017 Q3 corporations on the S&P 500 Index (SPY) managed to set a new all-time high in annual GAAP earnings at $107.08 per share (the latest reading is still more than -2% below the previous highs on an inflation adjusted basis, but this is a needling observation given as we are likely to clear this hurdle once and for all either in 2017 Q4 or 2018 Q1). So from a realized, in the books perspective, corporate earnings are still effectively no higher today than they were three years ago.
Of course, history is not the story when it comes to corporate earnings. Instead, it is in the forecast, as annual corporate earnings are forecasted to increase at a robust pace over the coming year as the effects of the corporate tax cuts passed by Congress at the end of 2017 increasingly make their way into the numbers. For example, by 2018 Q4, annual GAAP earnings are currently forecasted to be $145.67 per share, which if realized would be a remarkable +40% increase in corporate earnings over the coming year.

So while trailing corporate earnings over the past few years may not necessarily fit the narrative, the forecasts for the coming year certainly do. The only problem here is that forecasts are predictions and not yet fact. And the possibility remains that corporate earnings could end up coming in well below what is currently being forecasted today. After all, such an outcome certainly would not be unheard of when it comes to corporate earnings. Moreover, the 2018 Q4 earnings season is still a long way away in the future from February 2017 and A LOT can happen between now and then.
GDP Growth
OK. Let’s take the leap and assume corporate earnings growth is going to be robust over the coming year. This strong earnings growth should presumably be working its way through to GDP forecasts. In short, as corporate earnings forecasts accelerate, so too should expectations for expected GDP growth.

But what is notable that, at least so far, the forecasts for GDP growth remain relatively subdued. Projections for 2018 Q1 from the New York Fed’s Nowcast has not budged since tax cut legislation was officially passed. In fact, it has modestly tailed off in recent weeks. As for the Atlanta Fed’s GDP Now forecast, it popped a few weeks ago but has since faded back lower.

Nonetheless, the GDP growth forecasts in the 3% to 4% range are still solid. But are they sustainable?
According to the Economic Forecasting Survey from The Wall Street Journal, the consensus view at least to date is that they are not. Derived from a survey of more than 60 economists on more than 10 major economic indicators on a monthly basis, not only is the consensus view for 2018 Q1 coming in below the Fed bank forecasted range currently at a more pedestrian 2.85%, but the forecasts for future GDP growth in coming quarters is for the pace of growth to fade toward the 2.5% range or below, not accelerate. We have had GDP growth running in this range throughout much of the post financial crisis period, and inflationary pressures have largely remained in check throughout.
So on this second point, this feels much less consistent with the mainstream financial media narrative and not so inflationary. But you know what they say about economist predictions, right?
Jobs And Wage Growth
Let’s for the sake of argument take the leap of faith (the antithesis of relying on quantitative proof, of course) that economists are flat wrong on their GDP forecasts and growth actually ends up accelerating instead of fading. This leads to the next question. Does our current place in the economic cycle support such an acceleration? Put more simply, where are all of the workers going to come from to fill the new jobs to increase output and drive the economy higher.
When looking at the current unemployment rate, we see that at 4.1% we are approaching the lowest levels in joblessness in the United States in nearly the last half century. Only once before since 1971 was the unemployment rate lower than it is today, and that was in 2000 at the end of the longest economic expansion in U.S. history. And the last time that the unemployment rate was even close to the current low in May 2007, a recession also soon followed. Thus, the current unemployment rate alone suggests we might be much closer to the end of an economic expansion, not the start of a new acceleration phase. And the onset of recessions are more often than not disinflationary to deflationary, not inflationary.

But wait a second. If the unemployment rate is already low and the high octane juice of corporate tax cuts have just been injected into the economy, couldn’t we see a scenario where already tight labor markets lead to increased wage growth pressures, thus sparking an inflation outbreak. Certainly, but if this were the case, and this was what has indeed been unfolding over the past several months that has contributed the rise in Treasury yields, it is not showing up in any meaningful way in the actual wage growth data. At least not yet.

If anything, the current data on jobs and wage growth is less reassuring. For not only, would the unemployment rate have to fall to unprecedentedly low levels over the last half century to keep the economic expansion going, but the wage growth pressures that still remain latent today despite all of the new found economic optimism would finally have to ignite. Perhaps they will, but they have not yet. And perhaps corporates have a machine or two that they might seek to install instead with their next capital budgeting decision. And last I checked, I haven’t seen too much money in the hands of a machine chasing too few goods at the store.

So the narrative that we outlined at the beginning of the article is not so cut and dry when taking a walk through the data. But maybe some of these factors do not matter. Maybe we don’t even need GDP growth and wage increases to spark inflationary pressures. After all, the U.S. government is expanding the deficit and the debt like we are already deep in recession, and many of us can still remember the stagflationary 1970s when falling economic growth, rising unemployment, and falling corporate earnings still resulted in higher inflation. Maybe we could be having inflation pressures simply brewing on their own.
With this in mind, let’s just get right to the bottom line and look at the data that would typically be signaling a sustained rise in inflation.
Let’s begin with a headline reading most of us know best, which is the Consumer Price Index from the U.S. Bureau of Labor Statistics. The following chart shows current inflation on a year over year basis.

What we see is that at least through the latest reading from December 2017, the core inflation rate less food and energy is only at 1.76%. This is well below the readings from this time last year when the inflation rate was running at a relatively hotter 2.22%. And it is even further below the recent peak readings over 2.3% in both April 2012 and February 2016.

Not a core CPI person? The headline CPI number is telling an even more definitive disinflation trend story. For not only is the current headline number at 2.21% well below the peak readings of less than a year ago at 2.79% in February 2017, but they are still meaningfully below the peak readings of 3.81% back in September 2011.
OK. So inflation is not yet showing up in the headline numbers. But we all know that CPI is a lagging indicator for the economy. After all, by the time inflation shows up in the CPI data, the horse is already out of the barn and galloping down the road from a portfolio management standpoint.
Thus, let’s consider some leading inflation indicators to see if they are showing signs of inflation heating up in the coming months.
First, we will consider a proprietary indicator from the Economic Cycle Research Institute (ECRI) in the U.S. Future Inflation Gauge. This is an indicator that is designed to move in advance of a change in inflation. Put simply, this reading should be rising well in advance of an increase in actual inflation pressures. So where is this reading at present? After peaking all the way back in 2016, it has been flat to fading ever since. And over the last few months, it actually shrank by -1.5% in December 2017 and -0.2% in January 2018. And while it rose marginally in February 2018, it is still measurably below the readings from nearly two years ago.

OK. But this is a proprietary index that could be subject to error. So let’s just go with the numbers in their simplest form. Lex parsimoniae, right? What are the simplest and straightforward leading inflation indicators telling us?
We begin with the five year breakeven inflation rate, which is a measure of expected inflation over the next five years based on Treasury (TLT) data. Yes, inflation expectations have risen since last summer, but they also remain below levels from this same exact time last year.

Moreover, they remain well below the peak inflation expectations from a few years back in the post crisis period from 2011 to 2013. Put simply, if investors are worried about inflation now, they were even more worried about it a year ago, five years ago, and seven years ago versus today. And during past instances of even greater worry, their concerns turned out to be unfounded.

We continue on by taking a look at the yield curve. A common story I have repeatedly heard on the mainstream financial news is that the yield curve has been steepening lately, thus confirming the rising inflation narrative. Sure, it might have steepened a few basis points in recent days, but it is still as flat as a pancake compared to where it was six months ago, a year ago, or five years ago. This alone is definitively disinflationary if not deflationary and certainly not inflationary – after all, why would an investor be willing to accept an increasingly diminishing and generally minimal maturity risk and inflation risk premiums for lending money to the U.S. Treasury for an extra 25 years if they thought a meaningful inflation outbreak was nigh?

High yield bonds (HYG) provide added confirmation to this story. For if inflation was really set to sustainably climb going forward, we would almost certainly be seeing high yield bonds (JNK) getting crushed, as spreads relative to U.S. Treasuries are already at historical tights.

And while high yield bonds have sold off as of late during the recent correction, they are still trading above on an unadjusted price basis versus the levels reached in late 2016 when inflation was also assumed to be right around the corner but never actually materialized.

Commodities prices (DJP) also do not suggest that inflation pressures are building in any meaningful way. Instead, they continue to linger not far above their post crisis lows.

Even copper (JJC) and oil (USO), which have seen solid increases in price over the past two years, are still below the much higher levels from the first half of the decade.
The Bottom Line
Putting this all together, inflation pressures remain largely benign today. And a variety of economic and market indicators suggest that inflation may continue to remain benign and potentially even weaken into the forecast outlook.
It is very possible that we may ultimately see an outbreak of real sustained inflationary pressures going forward. But while the qualitative narrative of why this should be the case certainly makes sense, it is simply still not showing up in the quantitative data in any meaningful way.
So what then explains the steady sharp rise in bond yields in general and U.S. Treasury yields in particular? If it’s not the expected inflation that everyone is assuming, exactly what is it? The likely answer? The same answer it has been every other time in recent history. And the same answer that is likely behind the recent liquidation cycle sweeping through the U.S. stock market. What is this likely answer? One word. China. And this will be the topic of a follow up article on Seeking Alpha on this same topic.
But aren’t investors selling bonds? No. In fact, investors have poured inflows of more than +$60 billion net into bond mutual funds and ETFs since the start of 2018 according to the Investment Company Institute. And if U.S. retail and institutional investors are not selling bonds right now, then such selling is likely coming from faraway lands that own a good chunk of U.S. debt. Such selling influences are not driven by fears of inflation. Instead, they are driven by a variety of other mechanical factors. And they have often proven to be not sustaining over time.

What about the Fed? Won’t the fact that they are raising interest rates cause bond yields to continue to rise? On the short end of the curve, sure. But a variety of other factors other than what the Fed is doing with short-term interest rates are determinants for intermediate-term to long-term bond prices.
And if it turns out that the pace of Fed tightening is faster than the pace of economic growth in the coming quarters, current long-term rates may actually appear attractive at some point in the not too distant future.
What about the Fed’s quantitative tightening (QT)? Doesn’t the fact that the Fed is now selling bonds (BND) from their balance sheet mean that bond yields are going higher? Possibly, but remember that the Fed selling bonds (AGG) is just one market participant in a vast and deep bond marketplace. For as long as the volume of buyers exceeds whatever the Fed has to sell at any given point in time, prices can certainly rise. Do not forget that bond yields consistently rose during all three implementations of quantitative easing (QE) when the Fed was actively buying bonds on a daily basis. Thus, it is not outside of the realm of possibility that bond yields could consistently fall the more the Fed is selling into the marketplace as a result of QT.
If it indeed the case that the rise in bond yields have little to do with inflation expectations and much more to do with spillover effects from China (NYSEARCA:FXI), this implies the following.
First, stay long bonds. This does not mean that you need to overweight or back up the truck in owning bonds. But it also does not mean that you should throw them overboard from your portfolio either. Stay long, strategic and selective with your bond allocations.
Second, remain patient and seek opportunities. The current sell off in bonds is potentially setting up for good buying opportunities. Just recognize that you may be buying these bonds against a steady media narrative wave against this idea. Such is where the best opportunities can be derived, however.

Third, do not overlook related stock market opportunities. Selected quality defensive stocks (NYSEARCA:DIA) with high and growing dividends are trading at increasingly interesting valuations as the current market pullback continues to unfold. These may present some of the best upside opportunities in the years ahead depending on how economic events play out in the coming quarters.
Lastly, look beyond the narratives being put forth by the mainstream financial media as to why asset prices are moving in any given direction on any given trading day. For more often than not, what is actually taking place is something entirely different from what it may seem.
Remain watchful and diligent, avoid becoming dogmatic in any particular view, do your own homework, and formulate your own conclusions as to what is taking place in capital markets at any given point in time. Then act accordingly. For it is through this process that some of the best long-term investment opportunities can be generated.
And when it comes to inflation, beware falling into the inflation trap.

India’s Path From Crony Socialism to Stigmatized Capitalism

Arvind Subramanian  

Union budget session displayed on billboard In Mumbai

NEW DEHLI – Is India about to get its mojo back? As the country’s exports accelerate on the back of today’s synchronous global economic expansion, the negative effects of the November 2016 demonetization of high-value bank notes and the enactment last July of a new goods and services tax (GST) are receding. Provided that macroeconomic pressures from high oil prices are contained, and sharp corrections to elevated asset prices are managed, India is poised to regain its status as the world’s fastest-growing major economy.

But ongoing efforts by the government will be key to reviving private investment and sustaining medium-term growth. Specifically, economic policymakers must address the long-standing problem of over-indebted firms and under-capitalized public-sector banks – the so-called “twin-balance-sheet problem.”

To that end, many distressed companies have been forced to clean up their balance sheets under a new bankruptcy code that was adopted in December 2016, and more companies are likely to follow suit this year. Meanwhile, the government has also announced a large recapitalization package (about 1.2% of GDP) to shore up public-sector banks, so that they can write down their stressed assets.

As these reforms take hold, Indian firms should finally be able to resume spending, and banks will once again be able to lend to the critical but currently indebted infrastructure and manufacturing sectors. India’s economic reforms have taken a long time to implement. But if they continue to be a success, they will provide valuable lessons for future leaders about the proper role of the private sector not just in India, but around the world.

In India, the private sector – and capitalism generally – evokes feelings of deep ambivalence. This is for good reason, given that India’s private sector still bears the stigma of having been midwifed under the pre-1990s “License Raj” – an era remembered for its red tape and corruption. To this day, some of India’s legendary entrepreneurs are believed to have built an empire simply by mastering the minutiae of India’s tariff and tax codes, and then manipulating them brazenly to their advantage.

Some of the private sector’s stigma was cleansed by the boom in information and communications technology that started in the 1990s. The ICT sector had developed by virtue of its distance from, rather than proximity to, government. Indian ICT firms adopted exemplary governance standards, were listed on international stock exchanges, and thrived in the global marketplace. And, by extension, they improved the standing of Indian capital.

But after that era of good capitalism, the stigma returned. During the infrastructure boom of the mid-to-late 2000s, public resources were captured under a “Rent Raj,” which put terrestrial rents (land and environmental permits), sub-terrestrial rents (coal), and even ethereal rents (spectrum) up for grabs. Moreover, the infrastructure investments of this period were funded by reckless and imprudent lending by public-sector banks, which often funneled resources to high-risk, politically connected borrowers.

As a result, the Indian public concluded that majority equity holders (“promoters”) had little skin in the game, and that “limited liability” really meant no liability at all. And now that rapid technological change is threatening the ICT sector’s business model – providing low-cost programming services to foreign clients – even India’s “cleanest” capitalist industry is confronting governance challenges.

More broadly, one could say that India has moved from “crony socialism” to “stigmatized capitalism.” And under stigmatized capitalism, the prevailing zeitgeist has hobbled policymakers’ efforts to address the legacy of the twin-balance-sheet problem, which, in turn, has constrained growth.

Indeed, the mere thought that major shareholders’ debts would be forgiven at taxpayers’ expense has created political paralysis for years. After all, why should ordinary people bear the burden of fat cats who are laughing all the way to the bank?

Seen against this background, it is easier to understand why India’s economic reforms have taken so long to adopt, and why they have been so difficult to implement. At the same time that the government has had to resolve the twin-balance-sheet problem, it has had to ensure that promoters cannot regain access to their assets, driving up fiscal costs.

India’s early-stage experience with capitalism has lessons that other countries should heed in an age of rising tech giants. The Indian model, whereby public-sector-banks lent to private firms, proved so toxic and difficult to replace that public-sector bank ownership itself has lost much of its traditional socialist appeal. The irony is that after a long and bruising experience with crony capitalism, the best thing for India now might be more capitalism, starting in the financial sector.

Arvind Subramanian is Chief Economic Adviser to the Government of India.