There Will Be No Economic Boom - Part II

by: Lance Robert

On Tuesday, I presented at the Financial Planning Association (FPA) Conference in Houston at which I discussed the issues surrounding financial planning in an environment of high valuations and low forward returns. After my presentation, a few CFPs approached me to discuss the premise that recent "tax cuts/reforms" will lead to a resurgence of economic growth which will boost earnings and, therefore, negate the overvaluation problema.
This is unlikely to be the case and something that I discussed recently in "There Will Be No Economic Boom." However, that article focused on the impact of the passage of the 2-year "Continuing Resolution" which will lead to a surge in the national deficit as unconstrained spending negates the effect of "tax reform" on the U.S. economy.
But there is more to this story.
When the "tax cut" bill was being passed, everyone from Congress to the mainstream media and, even the CFPs I spoke with yesterday, regurgitated the same "storyline:"
"Tax cuts will lead to an economic boom as corporations increase wages, hire and produce more and consumers have extra money in their pockets to spend."
As I have written many times previously, this was always more "hope" than "reality."
Let me explain.
The economy, as we currently calculate it, is roughly 70% driven by what you and I consume or "personal consumption expenditures (PCE)." The chart below shows the history of real, inflation-adjusted, PCE as a percent of real GDP.
If "tax cuts" are going to substantially increase the growth rate of the U.S. economy, as touted by the current Administration, then PCE has to be directly targeted.
However, while the majority of consumers will receive an "average" of $1,182 in the form of a tax reduction, (or $98.50 a month), the increase in take-home pay has already been offset by surging healthcare cost, rent, energy and higher debt service payments. As shown in the table below - the biggest constituents of the "non-discretionary family budget" are rising the most.
So, since tax cuts, by themselves, are unlikely to offset rising prices of essential goods and services, it's hard to see how they fuel a significant surge in consumer spending.

"No problem. The 'windfall' to corporations (since that is where the bulk of the tax-reform legislation was focused) will lead to a surge in employment, higher wages and increased production. 
After all, since corporations can now repatriate those 'trillions of dollars' sitting overseas they will surely be magnanimous of enough to 'share the wealth' with the workers. Right?
Maybe. But anyone who has watched corporate behavior since the "financial crisis" should know that such a belief is heavily flawed.
However, now that we are a couple of months into the New Year, the data is in, and we can see exactly what "corporations" are doing with their dollars.
Wage Increases
Immediately after the passage of the tax reform bill, companies lined up to garner "political favor" by issuing out $1,000 bonus checks to employees. While the mainstream media, and the White House, gushed over the "immediate success" of tax reform, the bigger picture was entirely missed.
A $1000 bonus to an employee is a one-time "feel good" event. Wage increases are "permanent and costly."
The reality is that companies are NOT increasing wages because higher wages increase tax liability, benefit costs, etc. Higher payroll costs erode bottom line profitability. In an economy with very weak top-line revenue growth, companies are extremely protective of profitability to meet Wall Street estimates and support their share price which directly impacts executive compensation.
So, while companies are gaining media attention, and political favor, by issuing one-time bonus checks; the bottom 80% of workers are falling woefully behind the top 20%.
Wages are failing to keep up with even historically low rates of "reported" inflation. Again, we point out that it is likely that your inflation, if it includes the non-discretionary items listed above, is higher than "reported" inflation, and the graph below is actually worse than it appears.
But this is nothing new as corporations have failed to "share the wealth" for the last couple of decades.


The conundrum from "corporate executives" is that if consumers don't have more money to spend, they can't buy the goods and services offered which drives corporate revenue. If revenue does not substantially rise at the top line, profits will be impacted at the bottom line ultimately threatening "executive compensation."
Not surprisingly, the easiest cure for that little problem has been, and remains, share buybacks.
As I discussed previously:
"The use of 'share buybacks' to win the 'beat the estimate' game should not be readily dismissed by investors. One of the primary tools used by businesses to increase profitability has been through the heavy use of stock buybacks. The chart below shows outstanding shares as compared to the difference between operating earnings on a per/share basis before and after buybacks."
I want to draw your attention to the bottom part of the graph Since 2009, the TOTAL growth in sales per share has only been 39% or roughly 3.9% a year, and yet earnings grew at 253% or roughly 25.3% a year. The 21.4% differential has been heavily driven by the reduction in shares outstanding.
The important point here is that 70% of the economy is driven by consumption and the very weak rates of sales (or consumption) show why economic growth remains weak.
So, are companies using their newfound wealth to boost wages? Not so much. As Jesse Colombo recently showed:
"The passing of President Donald Trump's tax reform plan was the primary catalyst that encouraged corporations to dramatically ramp up their share buyback plans."


Of course, corporate executives (who tend to own a LOT of company stock and options) can also reward themselves through increases in the dividend payout. Not surprisingly, as noted by Political Calculations, corporate boards have used the recent tax reform to their advantage.
"When it comes to the number of dividend increases declared during a single month, the U.S. stock market just recorded its best February ever."
This issue of whether tax cuts lead to economic growth was examined in a 2014 study by William Gale and Andrew Samwick:

"The argument that income tax cuts raise growth is repeated so often that it is sometimes taken as gospel. However, theory, evidence, and simulation studies tell a different and more complicated story. Tax cuts offer the potential to raise economic growth by improving incentives to work, save, and invest. But they also create income effects that reduce the need to engage in productive economic activity, and they may subsidize old capital, which provides windfall gains to asset holders that undermine incentives for new activity. 
In addition, tax cuts as a stand-alone policy (that is, not accompanied by spending cuts) will typically raise the federal budget deficit. The increase in the deficit will reduce national saving - and with it, the capital stock owned by Americans and future national income - and raise interest rates, which will negatively affect investment. The net effect of the tax cuts on growth is thus theoretically uncertain and depends on both the structure of the tax cut itself and the timing and structure of its financing."
While tax cuts CAN be pro-growth, they have to focused on the 80% of Americans that make up the majority of the consumption in the economy. With the benefits of tax cuts being hoarded by the top 20%, which already consume at capacity, there is little propensity to substantially increase consumption as opposed to the accumulation of further wealth.
Furthermore, tax reform does little to address the major structural challenges which provide the greatest headwinds for the economy in the future:
  • Demographics
  • Structural employment shifts
  • Technological innovations
  • Globalization
  • Pensions
  • Financialization
  • Debt
These challenges have permanently changed the financial underpinnings of the economy as a whole. This would suggest that the current state of slow economic growth is likely to be with us for far longer than most anticipate. It also puts into question just how much room the Fed has to extract its monetary support before the cracks in the economic foundation begin to widen.

Simply, until you can substantially increase the consumptive capability of the bottom 80%, there will be no "economic boom."

Jean-Claude Juncker’s Dangerous Defense Strategy

Ana Palacio

MADRID – These days, there are just three events that bring together all of the main actors in international politics: the annual General Debate of the United Nations General Assembly, G20 summits, and the Munich Security Conference. That makes it all the more disappointing that the latest MSC, which took place in mid-February, brought only one big idea – and not a good one.

The MSC has long been a place not just to see and be seen, but also to hear and be heard. Yet, at this year’s meeting, what was not said seemed to speak louder than what was. Post-mortems of the gathering amounted to something of an indictment of the increasingly rudderless global order. Observers largely focused on how little in the way of new ideas or innovative solutions there was, despite much handwringing about the state of the world.

This stands in stark contrast to years past. In 2015, the MSC helped to generate momentum for the subsequent deal on Iran’s nuclear program. Last year, it was at the MSC that key members of US President Donald Trump’s administration first met their global counterparts. In 2007, Russian President Vladimir Putin famously used the MSC to present his stark worldview, in a speech that presaged Russia’s interventions in Georgia and Ukraine.

At this year’s conference, the one big idea was European Commission President Jean-Claude Juncker’s call to shift authority over foreign and defense policymaking in the European Union from the member states to the Commission. But, while Juncker is right to assert that the EU should take steps to ensure that it can act effectively in world politics, his approach is deeply flawed.

To assume a leading role in the world, the EU needs a culture and incentives that support genuine cohesion and cooperative action. Rather than take the time to achieve that, Juncker wants to take a short cut, arguing that, when it comes to foreign and defense policies, the EU cannot be required always to achieve unanimity.

And yet the EU is founded on an agreement that, in exchange for membership, states relinquish a certain degree of sovereignty in some areas. But foreign and defense policy are areas where states are supposed to retain authority. Flippantly attempting to change that bargain eschews political realities and threatens to set the European project on a dangerous course.

Juncker’s proposal at the MSC echoes similar recommendations on the single market, which he floated in his 2017 State of the Union address. Both are part of a broader effort to shift power from the European Council to the Commission – an effort that Juncker buttressed by recently appointing his Svengali, Martin Selmayr, as the Commission’s secretary-general, the body’s top civil-service job.

Now, Selmayr – who, as Juncker’s chief of staff, has been compared to figures like Machiavelli and Rasputin – will have far greater influence, including over the selection of a new Commission president next year. The way the appointment was carried out – shrouded in secrecy, in order to avoid the involvement of member states – should do more than raise eyebrows.

But such machinations are merely a symptom of a deeper problem with Juncker’s approach. The problem is not that his approach may succeed – a functioning United States of Europe would achieve a lot – but rather that it cannot. Europeans are simply not prepared to cede more sovereignty to the EU.

Since the global financial crisis erupted a decade ago, Europe has been firmly in inter-governmental mode. The last thing it needs is another grand-sounding scheme that it is not in a position to carry out. Between the Economic and Monetary Union, the Banking Union, and the Energy Union – each of which was launched with great fanfare and is now adrift – the EU already has plenty of those.

Rather than politely applauding castles in the sky, EU officials and member governments need to work, with a frank and realistic mindset, to build consensus on foreign and security issues. This means not changing the rules at the top, but rather building cohesion from below.

To ensure that this effort does not end up being dragged out interminably, as so many EU discussions do, we should begin with concrete objectives. The Permanent Structured Cooperation in the field of defense – agreed by the European Council last December – is a good place to start, with countries increasing, for example, joint strategic planning at the European level. Inspired by German Chancellor Angela Merkel’s recent proposal to tie EU funding to the acceptance of migrants, member states should also work to create stronger incentives for cooperation.

There is no question that it is difficult for 27 sovereign countries to act as one. But, as tempting as it may be, trying to paper over differences or avoid dissent – let alone destroying the compact at the core of the European project – will not make matters any easier. The only way to get where Europe needs to go is through a realistic and gradual effort to build unity. For Europe, it is this that should be the key lesson of the MSC.

Ana Palacio, a former Spanish foreign minister and former Senior Vice President of the World Bank, is a member of the Spanish Council of State, a visiting lecturer at Georgetown University, and a member of the World Economic Forum's Global Agenda Council on the United States.

Saudi Arabia on the Sidelines

By Jacob L. Shapiro

No region has been as active thus far in 2018 as the Middle East. The action has been driven by Iran, which is seeking to fill the vacuum left by the Islamic State’s defeat in Syria and Iraq.

Amid the fighting and diplomatic horse-trading, one actor has been conspicuously silent for the past two months, the last major Sunni Arab power still standing in Iran’s way: Saudi Arabia.

That silence ended this week. On Feb. 26, Saudi Arabia reshuffled its top military commanders, and on Feb. 28, it hosted Lebanon’s prime minister in Riyadh for a friendly visit. Neither event bodes well for Saudi Arabia’s future, which is looking more uncertain every day.

Saudi Arabia’s occultation was particularly notable because of its suddenness. In November 2017, it seemed like events in Saudi Arabia might be the most important in the region after the Islamic State’s defeat. That was the month when Saudi Arabia removed the economy minister and the head of the National Guard, set up a new anti-corruption agency, held numerous Saudi princes in a Ritz-Carlton hotel for ransom and threatened to declare war on Lebanon. The November political reshuffles suggested that Crown Prince Mohammed bin Salman was quelling a potential threat to his newly confirmed succession to the throne. The Lebanon affair became an embarrassment because it showed that Riyadh was out of touch with the limits of its own power.

Relegated to the Sidelines

Since these developments, Saudi Arabia has been relegated to the sidelines. At the beginning of the Syrian civil war, Saudi Arabia was a major sponsor of anti-Assad rebel groups. Now, Saudi Arabia is a spectator watching Iran, Turkey, Israel, Russia and the U.S. compete to reshape the region. Saudi Arabia’s benching is not for lack of interest; it’s for lack of ability. The kingdom is mired in a protracted conflict in Yemen and, up until November, was burning through its foreign reserves. (An increase in the price of oil has helped matters in recent months, but it’s a temporary state of affairs, and Saudi Arabia continues to run a budget deficit.)

Suffice to say, there is not much Saudi Arabia can do now in Syria. Instead, Saudi Arabia has been focusing on internal affairs. The most important of these has been extorting money from princes and other officials picked up in the anti-corruption drive to replenish state coffers. But there have been other notable, albeit small, developments. In January, the kingdom ended a 35-year ban on the public screening of movies when “The Emoji Movie” was shown on a projector in a tent. Last week, Saudi Arabia’s General Entertainment Authority chief announced that $64 billion would be spent in the next 10 years on entertainment projects such as movie theaters and an opera house.

Those may seem like frivolous developments, but they aren’t. They speak to the depths of Saudi Arabia’s challenges: $64 billion is about 10 percent of Saudi Arabia’s 2017 gross domestic product – a luxurious sum for a government in dire financial straits. But of course, the issue here isn’t just entertainment. It’s keeping the Saudi population pliant as the new crown prince reshapes the kingdom’s economic and political structure away from government handouts to an ever-expanding circle of royalty and oil payoffs to keep tribes invested in the system. Bread and circuses helped maintain the Roman Empire for centuries after its prime. The crown prince believes he just has to get to 2030, by which point his “Vision 2030” will have fixed all of Saudi Arabia’s problems.

That is all nice in theory, but it is much harder in practice. Even were we to grant that his plans could fix what ails Saudi Arabia (hint: we think it’s a pipe dream), every move he makes creates new enemies among the more conservative and religious parts of Saudi society, or simply among the princes who have been on the losing end of the anti-corruption drive. If the prince is to survive his reform drive, he will need the Saudi military on his side, which is exactly what the most recent reshuffling is designed to ensure. On Feb. 26, the Saudi Press Agency issued a short release that announced the termination and retirement of the chairman of the Joint Chiefs of Staff, the commander of the Air Defense Forces, and the commander of the land forces. Nearly all were replaced by relatively unknown officers whose main qualification is likely loyalty to the new crown prince.

Dangerous Foreign Threats

Serious though Saudi Arabia’s internal issues are, its foreign threats are even more dangerous. 2017 was a disastrous year for the kingdom’s foreign policy. Saudi Arabia tried to prevent Qatar from deepening its relationship with Iran – it failed. Saudi Arabia tried to get its allies in Lebanon to declare war on Hezbollah, and instead revealed how little the Saudis’ desires matter on the ground in Beirut. Saudi Arabia made little headway in the Yemeni civil war, and watched Iranian-backed Shiite militias, legitimized in Iraq in 2016, win important victories on the ground in Syria. Even the Islamic State’s defeat, which Saudi Arabia greatly wanted, did not come without its own attendant threats: Saudi Arabia is an enticing target for future IS operations.

It is not a surprise, then, that Saudi Arabia has decided to rethink its strategy. It replaced threats to the Lebanese prime minister with an invitation to come to Riyadh, and no doubt promised to deliver large sums of what Saudi Arabia has always purchased its allies with: money. When Iraq recently asked for money to help finance its reconstruction after the war against IS, Saudi Arabia pledged $1.5 billion, and would likely pledge much more if it meant Iranian influence in Iraq could be reduced. Money is ultimately all Saudi Arabia has to offer, and this explains why Saudi Arabia is collecting funds from its own princes even while it still retains more than about $500 billion in foreign reserves. Saudi Arabia sees the domestic and foreign challenges it faces and knows that even a sum as large as $500 billion isn’t going to be enough to solve them.

The irony about Saudi Arabia is that besides Israel, it has the region’s best-equipped military, but few forces. Having the equipment, however, isn’t enough – someone has to use it. Until Saudi Arabia can solve that problem, it is not going to be a major player because, while Saudi Arabia is looking for proxies to take its money, Turkey and Iran are providing their proxies with armor and artillery support. That’s why it doesn’t matter if Saudi Arabia develops a military-industrial complex (which it is trying to do) or that Saudi Arabia increased its defense budget by 9 percent in 2017 and will increase it by a projected 12 percent in 2018. At this point, the best-case scenario for Saudi Arabia is to break out the popcorn, root for Turkey and hope Crown Prince Mohammed bin Salman’s reforms work. The worst-case scenario is a Saudi civil war. Hope is never a good policy. Replacing military commanders is a better one, but it doesn’t fix the underlying problem. It only buys the crown prince time – and the clock is ticking.

The Legal Case for Striking North Korea First

Does the necessity of self-defense leave ‘no choice of means, and no moment of deliberation’?

By John Bolton

An intercontinental ballistic missile on display at a North Korean military parade in Pyongyang on Feb. 2. Photo: Yonhap News/Zuma Press

The Winter Olympics’ closing ceremonies also concluded North Korea’s propaganda effort to divert attention from its nuclear-weapons and ballistic-missile programs. And although President Trump announced more economic sanctions against Pyongyang last week, he also bluntly presaged “Phase Two” of U.S. action against the Kim regime, which “may be a very rough thing.”

CIA Director Mike Pompeo said in January that Pyongyang was within “a handful of months” of being able to deliver nuclear warheads to the U.S. How long must America wait before it acts to eliminate that threat?

Pre-emption opponents argue that action is not justified because Pyongyang does not constitute an “imminent threat.” They are wrong. The threat is imminent, and the case against pre-emption rests on the misinterpretation of a standard that derives from prenuclear, pre-ballistic-missile times. Given the gaps in U.S. intelligence about North Korea, we should not wait until the very last minute. That would risk striking after the North has deliverable nuclear weapons, a much more dangerous situation.

In assessing the timing of pre-emptive attacks, the classic formulation is Daniel Webster’s test of “necessity.” British forces in 1837 invaded U.S. territory to destroy the steamboat Caroline, which Canadian rebels had used to transport weapons into Ontario.

Webster asserted that Britain failed to show that “the necessity of self-defense was instant, overwhelming, leaving no choice of means, and no moment of deliberation.” Pre-emption opponents would argue that Britain should have waited until the Caroline reached Canada before attacking.

Would an American strike today against North Korea’s nuclear-weapons program violate Webster’s necessity test? Clearly not. Necessity in the nuclear and ballistic-missile age is simply different than in the age of steam. What was once remote is now, as a practical matter, near; what was previously time-consuming to deliver can now arrive in minutes; and the level of destructiveness of nuclear, chemical and biological weapons is infinitely greater than that of the steamship Caroline’s weapons cargo.

Timing and distance have long been recognized as surrogate measures defining the seriousness of military threats, thereby serving as criteria to justify pre-emptive political or military actions. In the days of sail, maritime states were recognized as controlling territorial waters (above and below the surface) for three nautical miles out to sea. In the early 18th century, that was the farthest distance cannonballs could reach, hence defining a state’s outer defense perimeter. While some states asserted broader maritime claims, the three-mile limit was widely accepted in Europe.

Technological developments inevitably challenged maritime-state defenses. Over time, many nations extended their territorial claims, but the U.S. adhered to the three-mile limit until World War II. After proclaiming U.S. neutrality in 1939, in large measure to limit the activities of belligerent-power warships and submarines in our waters, President Franklin D. Roosevelt quickly realized the three-mile limit was an invitation for aggression. German submarines were sinking ships off the coast within sight of Boston and New York.

In May 1941, Roosevelt told the Pan-American Union that “if the Axis Powers fail to gain control of the seas, then they are certainly defeated.” He explained that our defenses had “to relate . . . to the lightning speed of modern warfare.” He scoffed at those waiting “until bombs actually drop in the streets” of U.S. cities: “Our Bunker Hill of tomorrow may be several thousand miles from Boston.” Accordingly, over time, Roosevelt vastly extended America’s “waters of self defense” to include Greenland, Iceland and even parts of West Africa.

Similarly in 1988, President Reagan unilaterally extended U.S. territorial waters from three to 12 miles. Reagan’s executive order cited U.S. national security and other significant interests in this expansion, and administration officials underlined that a major rationale was making it harder for Soviet spy ships to gather information.

In short, both Roosevelt and Reagan acted unilaterally to adjust to new realities. They did not reify time and distance, or confuse the concrete for the existential. They adjusted the measures to reality, not the reverse.

Although the Caroline criteria are often cited in pre-emption debates, they are merely customary international law, which is interpreted and modified in light of changing state practice. In contemporary times, Israel has already twice struck nuclear-weapons programs in hostile states: destroying the Osirak reactor outside Baghdad in 1981 and a Syrian reactor being built by North Koreans in 2007.

This is how we should think today about the threat of nuclear warheads delivered by ballistic missiles. In 1837 Britain unleashed pre-emptive “fire and fury” against a wooden steamboat. It is perfectly legitimate for the United States to respond to the current “necessity” posed by North Korea’s nuclear weapons by striking first.

Mr. Bolton is a senior fellow at the American Enterprise Institute and author of “Surrender Is Not an Option: Defending America at the United Nations and Abroad” (Simon & Schuster, 2007).

 Consumers In Surprising Places Are Borrowing Like Crazy 

The Money Bubble is inflating at different speeds in different places. But apparently no culture is immune:

Household Debt Sees Quiet Boom Across the Globe

(Wall Street Journal) – A decade after the global financial crisis, household debts are considered by many to be a problem of the past after having come down in the U.S., U.K. and many parts of the euro área. 
But in some corners of the globe—including Switzerland, Australia, Norway and Canada—large and rising household debt is percolating as an economic problem.  
Each of those four nations has more household debt—including mortgages, credit cards and car loans—today than the U.S. did at the height of last decade’s housing bubble. 
At the top of the heap is Switzerland, where household debt has climbed to 127.5% of gross domestic product, according to data from Oxford Economics and the Bank for International Settlements. The International Monetary Fund has identified a 65% household debt-to-GDP ratio as a warning sign. 
In all, 10 economies have debts above that threshold and rising fast, with the others including New Zealand, South Korea, Sweden, Thailand, Hong Kong and Finland. 
In Switzerland, Australia, New Zealand and Canada, the household debt-to-GDP ratio has risen between five and 10 percentage points over the past three years, paces comparable to the U.S. in the run-up to the housing bubble. In Norway and South Korea they’re rising even faster. 
The IMF says a five percentage-point increase in household debt over a three-year period is associated with a hit to GDP growth of 1.25 percentage points three years down the road. The historical record suggests that large debts lead to a short-term economic boost but long-term struggles, as a greater share of the economy’s resources go to servicing the spending binge associated with high debts. The IMF also finds rising household debts are associated with greater risks of banking crashes and financial crisis. 
“When household credit goes up too fast, the fact is, it doesn’t end well,” said Guillermo Tolosa, an economist at Oxford Economics. 
The disparate economies on this debt list, though far apart geographically, actually have much in common. They are mostly wealthy with well-developed financial systems and avoided the worst of last decade’s global financial crisis. Their housing markets didn’t collapse dramatically. They weren’t the focus of fiscal debt crises. When nearly the entire world was in recession in 2009, Australia, New Zealand and South Korea managed to keep growing. 

Compared with the euro area, the U.S., or Japan they looked like little outposts of stability. 
But as economist Hyman Minsky once said, stability can be destabilizing. They attracted capital and their interest rates followed the rest of the world’s rates lower, sparking housing booms that are now a source of risk. 
During the U.S. housing bubble, home prices nearly doubled from 2000 to their peak in 2006, according to the Case-Shiller home price index. In Canada, Australia, New Zealand and Sweden home prices have more than tripled by some measures. 
Collectively, those 10 economies have $7.4 trillion in total economic output and a household debt stock about the same size. Taken as a whole, that’s more than the output of Germany or Japan. Moreover, many of them have a large stock of adjustable-rate mortgages that could suddenly become more costly to service should global interest rates rise. 

Note that this article’s first sentence — “A decade after the global financial crisis, household debts are considered by many to be a problem of the past after having come down in the U.S., U.K. and many parts of the euro area.” — was outdated before it was written. As the chart below illustrates, US consumers are back to borrowing like it’s 2006. November was a credit card orgy and December was about twice the year ago level.  

And has there ever been a case of a country’s house prices tripling in a decade without causing a crisis? That kind of data doesn’t seem to be available but it’s a safe bet that the answer is either “rarely” or “never.”