George Friedman’s Thoughts: China and a Global Economic Contraction

The protests in Hong Kong must be understood in the context of a global economic slowdown.

By George Friedman

There has been much talk recently about economic problems in key economies around the world. Early Wednesday morning, for example, I spoke on Bloomberg Surveillance about the situation in China. Before I went on air, Bloomberg News was covering multiple stories on the decline in bond yields and its effect on the U.S. economy, weakness in the German economy, and so on. I then realized how closely this issue is linked to the protests in Hong Kong.

It has been about 10 years since the last U.S. recession, and we would expect to see another one soon. Since the United States is the world’s leading importer, an American recession always leads to a weakening of the global economy. Massive exporters like Germany and China are particularly vulnerable to such downturns. China’s economy was significantly weakened by the 2008 financial crisis. It has, until recently, managed to stave off U.S. attempts to try to level the imbalance between Chinese exports to the U.S. and U.S. exports to China. But it has now lost the ability to manage the United States. And at the same time, Hong Kong is rising.

The uprising occurred because China was increasing its control over Hong Kong, including taking much greater control of the criminal justice system. In 1997, when the United Kingdom relinquished control of Hong Kong to China, Beijing was willing to allow Hong Kong to have a high degree of independence because Hong Kong was the financial interface between China and the world. China could not afford to undermine Hong Kong’s dynamism.

But China is in a very different position today, and it can no longer accept a strong and independent Hong Kong. Even before the U.S. trade actions, the Chinese economy was in serious trouble, and its banking system was nearly in shambles. The introduction of new tariffs by its largest customer has created deeper problems in the economy, which are seen in industrial production data and other sector statistics. The accuracy of these statistics is always uncertain to me, but that China is publicly revealing its economic weakness is significant. When it admits that it has problems, it likely means the problems are serious indeed.

Today’s China was built on economic growth and the promise of prosperity. Maoism still exists, but it is on the margins. Chinese elites, like elites everywhere, expect greater wealth and, at minimum, that the wealth they have already accumulated will be protected. And the public expects a better life for themselves and especially their children. The Communist Party of China, therefore, now derives its legitimacy not from communist ideology but rather from the promise to deliver prosperity to the people, coupled with national pride. But as the economy weakened, China engaged in major international initiatives to try to encourage pride in its global standing, from exaggerating its military power, to lending money to other countries, to building a route to Europe. The more concerned China was about delivering prosperity, the more it leaned on pride in Chinese power and the idea that the U.S. would be bypassed by the Chinese in every way possible.

But the Chinese realize that their relationship with the United States has gotten out of control. On one hand, they depend on the U.S. to buy their goods. On the other hand, they want to show that they are pushing back against the United States. In the end, national pride goes only so far in a country that is divided into many social classes, with millions left out of the economic boom and others having benefited but remaining resentful of the avariciousness of the elite. The foundation of China is prosperity; national pride is just a substitute.

Right now, that prosperity is threatened not only by U.S. demands to redefine economic relations between the two countries, but also by the last thing China needs: a global economic slowdown. It is always the exporters who are hurt the most by such downturns.

China tried to dramatically increase its control of Hong Kong, not out of confidence but out of fear. If the Chinese economy contracts, Hong Kong doesn’t want to be taken down with it. But the people of Hong Kong couldn’t predict how far they would be able to separate the island from China’s problems, so they wanted to ensure their security apparatus had control of Hong Kong. The Chinese resistance to these steps was what really led to the uprising. From my point of view, it also points to a critical Chinese weakness. China relies on its internal intelligence system to maintain order, but it failed to anticipate the uprising in Hong Kong. That raises the question of whether a pillar of the Chinese system, its internal controls, is weakening.

Another major concern for Beijing is that the unrest in Hong Kong may spread to the rest of the country. People in other Chinese cities might sense Beijing’s weakness and, facing tough economic conditions, take their concerns and resentments into the streets. This is why Beijing cannot appear to have lost control of Hong Kong. If it does, China’s global image as a confident, leading power would be transformed into one of a brutal and repressive regime, fighting its own people.

Hong Kong has not triggered a reaction on the mainland, but Chinese President Xi Jinping has been wrong on several fronts, so the Central Committee may not be in the mood to let him handle this problem. But it is caught between its need to suppress the protests in Hong Kong and its fear of the consequences if it does. When decisive action becomes a threat, it’s a sign that a regime is in trouble. China has tried to appear patient, but it is increasingly appearing impotent to its own people. And that is the one thing it can’t tolerate.

Economic downturns have a tendency to trigger political responses. Consider 2008 and how the political landscape changed in many countries in the following years. While 2019 may not be as intense as 2008, many countries’ economies are struggling, having never fully recovered from the global financial crisis. It is in this context that I am beginning to think of China. It’s easy for an exporter to prosper in a robust global economy. It’s much harder to sell to a world facing an economic downturn. Such exporters are battening down the hatches – China’s approach to Hong Kong is one example. Having encountered resistance, it fears the consequences of decisive action. And it fears not acting. China doesn’t know quite what to do, and that is not the behavior of a formidable rising power.

In office but not in power

Are Western democracies becoming ungovernable?

Politicians sometimes say so, but mean different things in different countries

ASPECTRE IS haunting the rich world. It is the spectre of ungovernability. “Ungovernability in Italy is a great risk,” averred its former prime minister, Matteo Renzi, in 2017. “It will be impossible to govern Spain until they face the political problem in Catalonia,” predicted the spokeswoman of the Catalan regional government in February (just before that government was closed down). Emmanuel Macron, for whom to govern is to reform, warned that “France is not a reformable country”, evoking the spirit of General de Gaulle who once asked how anyone could govern a nation with 246 kinds of cheese.

When you survey the political landscape of rich countries, you see an unusual amount of chaos and upheaval. Prague has seen the largest demonstrations since the overthrow of communism. More than a quarter of the current parliaments in Europe were elected in polls that were called early. In Britain the mother of parliaments has been at the gin bottle and opinion polls everywhere show increasing numbers of people losing patience with democratic niceties and hankering after a strongman.

But experiencing protests or having weak governments does not make a country ungovernable. Moreover, as Tolstoy might have written, each ungovernable country is ungovernable in its own way. The problems of Italy, Spain and Britain are all different. So what, if anything, does ungovernability mean when applied to democracies? And if it is a problem, is it worse now than in the recent past?

Ungovernability can be thought of in four ways. No Western country is ungovernable in every one. But there are a few features that exist in more than one country and a few countries that look ungovernable in more than one sense.

First, some countries cannot form a stable government either because (in first-past-the-post systems) the largest party does not command a majority in parliament, or because (in countries with coalitions) parties cannot organise a stable alliance on the basis of election results. Spain has had three elections since the end of 2015 and may have to call a fourth following its failure to negotiate a new coalition. In Britain an election in 2017 stripped the ruling Conservatives of their majority and their subsequent period in office has been tumultuous. In both countries, stable two-party systems have given way to wobbly four- or five-party ones. (And both, incidentally, have seen the collapse of large regional governments, in Catalonia and Northern Ireland.)

In the 28 European Union countries, eight of the most recent legislative elections were snap polls, called before the end of the normal parliamentary term. This is not a trivial share, though it does not suggest widespread chaos, either.

Joining up is hard to do

More common, countries with coalition governments have suffered unusually protracted negotiations. Sweden’s lasted four months ending in January 2019; the country now has an ineffective minority government. Finland held an election in April and it took until the end of May to create a left-right coalition. These cases pale in comparison with the eight months that it took to produce a Czech government in 2018, to say nothing of the record 535 days that Belgium endured without a government in 2010-11. After its vote in 2018, Italy did manage to cobble together a coalition between populist right and populist left, though they cannot stand one another. These countries should probably be called precarious, rather than ungovernable.

Next, ungovernability can mean that governments fail to pass basic laws on which the operations of the state depend. Spain’s could not pass a budget this year, triggering the election in April. Italy did pass its budget for 2019, but by busting the financial limits imposed by the EU, though confrontation has so far been avoided.

Broken by Brexit

Britain has seen an unprecedented failure: a thrice-repeated defeat by huge margins in the House of Commons on the most important issue of the day, Brexit. Had this happened at any other time, the government would have resigned, precipitating an election. As it was, the defeats triggered a contest for leadership of the Conservative Party, resulting in a government which expects to crash out of the EU without an agreement, pitted against a parliament determined to prevent such a thing happening (see Britain section). This is an extraordinary turn of events in a system which is not supposed to permit divided government. If Britain is sliding towards ungovernability will depend on whether it does crash out and what happens at the expected early election. At the moment, with a one- or two-seat majority, the government is running on fumes.

But the home of failure to pass meaningful laws is the United States, where both Republicans and Democrats have given up on passing legislation until after the presidential election of 2020. This continues a long-standing failure. Appropriation (budget) bills routinely fail to be approved on time. Between 2016 and 2018, Republicans controlled both branches of government but failed in their main legislative goal, to repeal the Affordable Care Act (“Obamacare”), and did not try to win approval for a promised deal to improve America’s crumbling infrastructure. America is not ungovernable in most senses of the term but its legislature and executive are locked into paralysis.

A third aspect of ungovernability is the systematic corruption of constitutional norms, making political processes haphazard or arbitrary. This does not always make countries ungovernable. Sometimes, as recently in Hungary, for example, it does the opposite, increasing state power at the expense of democratic checks and balances. But the undermining of norms can also hamper decision-making, as in Britain. There, cabinet responsibility and party discipline have broken down, ministers break the ministerial code of conduct and traditions of parliamentary procedure, such as holding a Queen’s Speech to outline legislative proposals, are ignored.

America is not quite as bad. But President Donald Trump shut down the federal government twice in a year—compared with once in Barack Obama’s eight years. The second Trump shutdown, in 2018-19, was the longest in history. Mr Trump has flouted Congress over a tax law and urged his administration to resist Congressional requests for information. The former British ambassador to Washington called his administration dysfunctional, unpredictable, faction-riven, diplomatically clumsy and inept. And that is the view of America’s friends. America’s political system is not designed to operate smoothly. But it is becoming dysfunctional in ways the framers never envisaged.

Western countries are not ungovernable in the sense of paralysed by riots or crises. They have not lost control of the streets. Nor are they Congo. But their governments are riven by disputes and are too weak to implement big reforms—to pensions, say, or social care. They are not impossible to govern in the sense of chaotic or anarchic but more than a few are ungovernable in the sense that their governments cannot do anything of importance.

Lastly, the past year has seen a return to the streets of mass demonstrations. In France, the gilets jaunes (yellow jackets), a populist grassroots movement, have blocked roads and staged some of the most violent demonstrations the country has seen since 1968. In Britain campaigners against Brexit claimed 1m people joined a demonstration in London in March 2019, which would make it one of Britain’s largest-ever rallies. Prague has seen the largest demonstrations since the Velvet revolution of 1989. And there have been smaller anti-government rallies in Spain, Serbia, Hungary and Slovakia in 2018-19.

The nature of these demonstrations, however, is a reminder of what today’s ungovernability is not. It is not mob rule. No one is burning down the presidential palace or executing the king. Protests in Western capitals have mostly been placid compared with the 1960s and 1970s. During riots after the assassination of Martin Luther King in 1968, machineguns were posted on the steps of the Capitol.

That point of comparison suggests an odd feature of contemporary politics: it turns the experience of the 1970s upside down. Then, inflation was rampant, unemployment high and strikes common. There were riots and assassinations and, in America, conscription into an unpopular war. Yet, with exceptions such as the Watergate scandal, the business of government continued to rumble along. Within a couple of years of the riots in 1968, Richard Nixon had set up the Environmental Protection Agency; de Gaulle won a legislative election just after the Paris événements. Paul Keating, later Australia’s prime minister, said of his country’s government in the 1980s that “the dogs may bark but the caravan moves on” (ie, the government kept going, critics notwithstanding). Now, matters seem to be reversed. Inflation is tamed, unemployment is low and wages are inching up. But governments are stalemated. Compared with the 1970s, societies are less disorderly but politics is more so.

Perhaps this will prove short-lived. Maybe politicians are just facing a temporary double-whammy of unpopularity. Voters are not giving them credit for economic recovery and are angry about the costs of austerity. If so, governments might one day reap electoral rewards and normal governance will resume.

The party’s over

But longer-term trends seem against that, notably the secular decline of large political parties which has gone furthest in Europe (see chart). At their height, the two largest parties in Britain, Spain and Germany were winning 80-90% of the vote. Now, they are down to two-thirds or less.

In 1960, 15% of electorates in western Europe were affiliated with a party. Now the share is below 5%. Britain’s two big parties were once the largest civic organisations in the country.
Now their combined membership is less than that of the Royal Society for the Protection of Birds.

Membership of unions and churches has fallen, marginalising the institutions that buttressed the centre-left and centre-right, respectively. And, except in America, voters are more fickle. Alessandro Chiaramonte of the University of Florence and Vincenzo Emanuele of Luiss University in Rome found that 8% of European voters changed their votes between national elections in 1946-68; in 1969-91, 9% did so; in 1992-2015, 13% changed their minds.

Everywhere, parties are finding it harder to recruit and retain members and to mobilise voters. Parties are the organising forces of parliamentary democracy. They pick candidates, approve manifestos and get out the vote. Coalitions usually revolve around one large party. If parties continue to decline, political systems are likely to become at least more fluid, and at worst harder to govern.

Challenges for New ECB Head

Will Christine Lagarde Pursue Tighter Monetary Policy?

By Tim Bartz, Martin Hesse and Christian Reiermann

Christine Lagarde, current head of the IMF, is moving to the European Central Bank in November.

As Christine Lagarde prepares to head the European Central Bank, the ECB's critics are urging her to stop the flow of cheap money. At stake is the economic stability of eurozone member states -- and the savings of millions of ordinary people.

If there's one thing Christine Lagarde can't complain about as she prepares to take over the presidency of the European Central Bank on Nov. 1, it's that there has been a lack of care on the part of her predecessor. There are only three months left before Mario Draghi vacates his office in the imposing double towers in Frankfurt's Ostend neighborhood, and until then, his goal is to provide his successor with as smooth a start as possible.

And so it was on Thursday, after the meeting of the Governing Council, that Draghi did everything in his power to prepare the European public for the further loosening of monetary policy. "A significant degree of monetary stimulus" continues to be necessary, he announced. The ECB didn't mention any concrete measures, but in view of the bleak economic outlook, Draghi indicated that he wanted to lower interest rates again in the autumn. He would also like to relaunch the purchasing program for government bonds, which the Germans are particularly suspicious of. In short, Draghi is plotting a course to maintain the status quo.

The latest figures provide him with useful fodder: The International Monetary Fund (IMF) expects growth of only 1.3 percent in the eurozone this year, with Italy and Germany delivering especially weak performances. Meanwhile, inflation in the currency area is stuck at 1.3 percent, far below the ECB's target.

Flooding the Markets With Money

In view of the weak forecasts, it seems appropriate to boost growth with cheap money. But Draghi's radical easing course harbors risks and side effects. At the same time, there is growing concern that the ECB, under the leadership of the ex-politician Lagarde, may be tempted to yield to growing pressure from governments to provide cheap money on a permanent basis, making it easier for them to service their debts. But the Fed, the central bank in the United States, is currently experiencing just how difficult this can be. It will likely yield to the constant pressure from U.S. President Donald Trump and lower interest rates soon.

Banks and depositors are already feeling the downside of the ECB's low-interest policy. Fixed deposit and overnight money accounts are barely yielding any interest anymore -- and that is unlikely to change anytime soon. In addition, now depositors are threatened with penalty fees for having too much money in their accounts, fees that in past have been directed largely at credit institutions or big companies. Life insurers, pension funds and financial institutions are already suffering from the fact that it is growing increasingly difficult to invest in profitable ways.

Lagarde will likely maintain Draghi's course for the foreseeable future. As the head of the IMF in Washington, she has earned a reputation for viewing central banks as a kind of all-purpose weapon for all sorts of problems. Under her aegis, the IMF regularly urged central bankers to flood the markets with money. As head of the ECB, she'll likely tone down her rhetoric, but her election is a further sign that the German central bank's time as a role model for the ECB has come to an end. When the ECB was founded 20 years ago, the Bundesbank provided both organizational and conceptual inspiration. The Germans, in particular, were skeptical and needed to be convinced of the stability of the euro. To this day, the Bundesbank is regarded as the seat of the monetary policy hawks, as those who advocate a strict course geared toward price stability are called.

Hawks vs. Doves

Under Draghi's patronage, however, the so-called doves -- the supporters of monetary easing measures by the ECB -- have gained the upper hand. Draghi is the first ECB president who did not raise interest rates a single time during his entire term in office. Of course, this largely had to do with the fact that the sovereign debt crisis threatened to completely destroy the eurozone.

At the same time, Draghi has also refrained from bringing the key interest rate back up from zero as the economy has recovered. The interest rate turnaround that was announced months ago has so far failed to materialize. And Draghi has continued to buy bonds. As a result, the ECB is poorly equipped for the impending economic downturn.

And now, of all times, the Executive Board, which heads the ECB and prepares the decisions of the Governing Council, is struggling with a brain drain of sorts. Chief Economist Peter Praet left in May, while Vice President Vitor Constancio said his goodbyes a year ago. Benoit Coeure, another board member, is also planning to leave this year.

Experienced monetary policymakers and seasoned economists are increasingly being replaced by former government ministers without any real monetary policy experience. Lagarde's deputy, Luis de Guindos, left the Spanish government directly for the ECB's Executive Board. Lagarde, for her part, used to be France's finance minister. The ECB's new chief economist, Philip Lane, who was previously the head of Ireland's central bank and a university professor, is the only economist with academic merits on the board.

"The danger of a politicization of monetary policy is clear," warns Clemens Fuest, the head of the Ifo Institute, a Munich-based economic think tank. Low inflation apparently gives politicians the idea that monetary policy can be a panacea without costs or risks. "It's seductive and it pressures central banks to justify themselves, and at the same time, it's very dangerous," Fuest says.

He views Lagarde's appointment favorably, "but she should make it clear to the public as soon as possible that she stands for an independent monetary policy and for an ECB that is limited to its mandate," Fuest says.

Back-Door Remedies

Ansgar Belke, an economics professor at the University of Duisburg-Essen, sees the recruitment of ex-politicians as an attempt by euro member states to remedy a fundamental error in the currency union through the back door. The eurozone's central monetary policy lacks a fiscal counterweight. "The appointment of former finance ministers to the Executive Board of the ECB has indirectly brought fiscal policy interests on board at the central European level," Belke says. Many finance ministers in the member states seem to be OK with this at a time when the lines between monetary and fiscal policy are blurred and when the ECB is involved in bailouts for cash-strapped states, handles banking supervision and, by buying government bonds, ensures that governments have access to cheap money.

When the ECB purchases government bonds, the price of those bonds rises and interest rates fall as a result. Higher inflation would also take some of the pressure off eurozone countries, including those currently facing high debt loads like Greece and Italy, but also Lagarde's home country France.

Since 2008, the average interest rate on Italy's national debt has fallen from 4.9 to 2.8 percent, saving the country 260 billion euros ($289 billion). For all countries in the eurozone, interest savings over the past 10 years came out to 1.4 trillion euros, according to the Bundesbank's calculations. Germany, too, has benefitted: From 2008 to 2018, federal, state and municipal governments have saved almost 370 billion euros in interest payments.

The ECB has increasingly become a lender to the euro member states. Its balance sheet contains more than 2.6 trillion euros worth of government bonds. This corresponds to 22 percent of the eurozone's economic output. The hawks on the ECB Governing Council fear Lagarde could now begin seeking debt relief for highly indebted states, such as Italy, by printing money.

German Reservations

Resistance within the central bank is unlikely. When he was in the running for the ECB's top job, Bundesbank President Jens Weidmann, abandoned his previous criticism of the European Central Bank's bond-buying programs in what many observers saw as an effort to make the candidate more palatable to other eurozone countries. Now that he has come away empty-handed, those reservations could well return. Otherwise, Lagarde is striking a chord in the ECB's Governing Council, according to insiders at the bank. "There's a broad majority among the doves," says one German central banker.

This does not bode well for depositors in Germany. The future looks bleak for the financial sector, too. Commercial banks can borrow money inexpensively on the capital market, but they have trouble lending it at higher interest rates the way they did before.

Although meager interest rates are a global phenomenon, for which there are myriad reasons, Germans are particularly angry about them. "With its glut of money, the ECB is laying the foundations for a new financial crisis," says Florian Toncar, financial policy spokesman for Germany's business-friendly Free Democratic Party (FDP) in the German parliament. "The more unconventional measures the ECB takes on, the less incentive there is for reform," he believes, with a view to Europe's southern countries.

"If the ECB mutates into a perpetual interest rate brake, it is risking the next crisis," says Andreas Jung, deputy leader of the conservative Christian Democrats in parliament. "Cheap money causes a flash in the pan -- and all that remains after a flash in the pan is ashes." Behind the fierce middle-class criticism is not only concern about the savings of Germans, but also fears that the ECB's cheap money policy could drive new voters to the euroskeptic and right-wing populist Alternative for Germany (AfD) party.

Helmut Schleweis, the president of the German Savings Banks Association (DSGV), points to Japan as a warning. Interest rates there have remained at extremely low levels for more than 20 years, which has contributed to a banking crisis in the country, without the economy regaining its momentum. "If the negative interest rate phase continues or is even further aggravated, this will be clearly noticeable for the economy and for everyone in this country. Given the experience in Japan, we can only warn against underestimating these long-term negative effects," says Schleweis.

Debatable Impact

More than anything, Schleweis is worried about the business model of the banks whose interests he represents. On Thursday, Draghi hinted that he could further reduce the deposit rate that banks have to pay if they park surplus money at the ECB. Currently, that rate is at -0.4 percent, but it could fall even lower in the future.

Draghis' penalty interest, or negative interest, is intended to ensure that banks lend money to boost the economy rather than bunker it at considerable expense. That sounds logical, but it is still controversial today, even within the ECB.

The authors of a working paper issued by the central bank in August 2018 concluded that banks issue even fewer loans and instead tend to invest surplus deposits in riskier ways that offer potentially higher returns. As such, the positive impact on the economy is limited and the policy instead creates considerable uncertainty on the financial markets. It's an astonishing finding that makes the justification for the penalty interest seem absurd.

The authors also have some prominent backers.

"I don't believe that the higher penalty interest is going to lead banks to issue more loans," says IFO head Fuest. "It might lead banks to make investments that could backfire and destabilize the system."

A Growing Problem

German banks, in particular, are suffering as a result of Draghi's penalty interest. It cost them a total of 2.4 billion euros in 2018. And they cost all banks across the euro zone a combined total of 7.5 billion euros. It is true that the penalty interest on German banks is miniscule and manageable when you consider the 85.5 billion euros that domestic banks and savings banks earned in 2017 alone as net interest income, their primary source of revenue.

But the problem is growing, because even as penalty interest rates are rising, banks' net interest income has been shrinking for years. This is particularly problematic for institutions to which customers entrust a great deal of money: savings banks and credit unions.

"They still profit from the fact that they have invested money in high interest-bearing investments and granted long-term loans at higher interest rates," says Oliver Mihm, founder and head of the consulting firm Investors Marketing. But many of these securities and loans are set to expire soon. "In 2020 and 2021, the dangerous interest rate confluence will have full impact on the banks' interest results and will reduce net interest income by 20 percent or more in the next three years -- even at the current interest rate level."

If the ECB were to lower the deposit rate further, the effect would be even more pronounced, Mihm predicts. So far, many financial institutions assumed in their calculations that the interest rate may soon be raised slightly. But that illusion is now being shattered.

In addition, during the economic upswing of the past 10 years, many banks have dramatically reduced their risk provisions for loan defaults in order to increase their profits. If the economy falters, that could also change abruptly.

Passing Costs Down to Customers

What does seem clear is that financial institutions want to recover the penalty interest in the easiest possible way: through their customers. For some time now, account fees have been rising almost across the board. In some places, banks have introduced penalty interest for particularly wealthy people, a legally delicate step. For example, the Nassauische Sparkasse (Naspa) based on the prosperous city of Wiesbaden, collects 0.4 percent of the deposited sum as negative interest from private customers who have parked more than 500,000 euros in current and money market accounts.

Alternatively, like many other institutions, Naspa is increasingly talking to customers in an effort to convince them to invest their money in shares or funds, for which the banks collect commissions. Germans have always been notoriously wary of stocks and securities, and they display some pretty bizarre behavior when it comes to investing: They're risk averse, preferring to hold on to their cash and spurn opportunities for the kinds of returns the stock market can deliver.

So what's to be done? It's unlikely financial institutions will also introduce penalty interest for small-scale depositors, because doing so would trigger a wave of lawsuits, says Niels Nauhauser of the Baden-Württemberg Consumer Advice Center. He says only borrowers can be required to pay interest. "The Civil Code does not contain negative interest rates for financial investments," he says.

That may sound reassuring, but there is another term that is creeping into the debate that could prove to be extremely explosive: a "custody fee." Banks already collect custody and storage fees when they hold securities, jewelry or gold, but in the future the same trick could also be applied to deposits.

'ECB Policy Has Reached Its Limits'

Larger savings banks and banks have already been charging such custody fees to corporate customers and institutional depositors such as pension funds for some time now. The Stadtsparkasse München savings bank, for example, charges 0.4 percent for balances starting at over 250,000 euro and offers the justification that this is the market standard today. Legally, such fees could also be agreed in the private customer sector, but on an individual basis and not simply by changing the terms and conditions, says Nauhauser.

Peter Schneider, president of the Savings Banks Association of Baden-Württemberg (SVBW), recently made clear where the journey may be heading. If the ECB were to cut interest rates even further and not take countermeasures, there would be no way around a broad front of banks demanding money for the custody of account balances. If the savings banks are preempted by the competition, he says, they will have no choice but to follow suit.

But even if it were possible to pass on at least the full penalty interest burden to consumers, the situation would still remain fragile. "The ECB's negative interest rates are like a bacteria attacking the immune system of more and more banks," says bank consultant Mihm. Still, officials in Brussels are unlikely to pay much heed to these complaints from German banks and savings banks. "The EU Commission would like to see a market shakeout in the fragmented banking market, anyway," he says.

In view of the growing side effects of the ECB's policy, the question arises all the more as to whether it is achieving its objectives.

Ifo President Fuest has his doubts. "The ECB policy has reached the limits of its effectiveness."

And that's not good news for Christine Lagarde.

China’s Power to Boost Global Economy Is Fading

Americans for years have been concerned about Beijing’s power, but the new worry is its inability to stimulate the world’s economies

By Jon Sindreu

A bridge under construction in China’s Guangdong Province in 2017. China’s spending at home doesn’t boost economies elsewhere as much as it once did. Photo: Lu Hanxin/Zuma Press 

Americans have gotten used to worrying about China’s power. They may need to start worrying about its powerlessness.

Central banks have been widely credited with helping the global economy escape major pitfalls since the financial crisis over a decade ago. Now, the Federal Reserve is cutting rates again to forestall the next downturn. But all along, China has played a bigger role: Whenever global growth faltered, Beijing splurged on roads, airports and housing developments that fed companies and their employees across the globe.

Worryingly, this secret weapon seems to be losing its force.

The Asian giant is grappling with a structural slowdown. Moreover, data suggests that economic growth isn’t transmitted across borders as effectively as before.

China recently reported its slowest growth since 1992 in the second quarter, attracting headlines. The knock-on effect has been less well documented. Trade is now acting as a drag on the U.S. economy, second-quarter data show. In the eurozone, services remain robust but manufacturing activity—which depends more on exports—has fallen to its lowest level in almost seven years.

This isn’t a problem that will swiftly go away, even if fresh trade talks between the U.S. and China yield results. China’s problems long preceded President Trump’s tariffs. Maintaining the breakneck growth of yesteryear—at a point when the country already has caught up with most of the developed world’s technology—was always a monumental task.

It is made even more formidable by Beijing’s attempts to bring down a massive debt pile. Every round of stimulus has pushed new forms of leverage into opaque corners of China’s financial system, including local-authority debt and wealth products held by so-called shadow banks.

The latest slowdown has left officials with no choice but to restart fiscal policy.

The stimulus package launched at the end of last year amounts to about 5.6% of Chinese gross domestic product, according to analysts at JPMorgan Chase .This is about half the size of the gargantuan 4 trillion yuan ($580 billion) program launched after 2008, but similar to the 2015 stimulus, which worked out at 5.4% of GDP.

The economy has been slow to react. Part of the problem is that the central government has been reluctant to get too involved. It has avoided amassing more debt itself and has prioritized tax cuts over direct job creation.

The main concern for the rest of the world, however, is that the share of this stimulus that reaches other countries is shrinking.

Bhanu Baweja, an economist at UBS ,has long been warning that the ratio of world import growth to GDP growth has been falling back to its pre-1980s norm—so one country’s success doesn’t benefit its trading partners as much as it used to. Globalization is in retreat and so is the halo effect of China’s growth.

Between 2011 and 2018, each extra point of world GDP growth boosted imports by 1.4%, UBS data shows, compared with 2.2% in the period of accelerated globalization between 1986 and 2008, when China emerged as an economic superpower. The ratio keeps diminishing: In the past 12 months, it was 0.6%.

This is partly due to the shale revolution, which has made the U.S. far less dependent on foreign energy. There are broader reasons too, such as manufacturers tiring of long supply chains and moving production closer to their customers.

But China’s propensity to import has also dropped over the last 15 years as the country’s domestic production has become increasingly sophisticated and it has needed less foreign steel and machinery. This process seems entrenched. Chinese technology giant Huawei has responded to President Trump’s restrictions on its use of U.S. suppliers with plans to roll out its own operating system to replace Google’s Android, for instance.

Without rocketing exports to China, it is unclear where Western economies will find their next big source of economic demand.

After the 1970s, many nations around the world kept inflation in check by limiting wage growth. Debt, often funded by house-price growth, picked up the slack in the consumer economy. When the debt bubble popped in 2008, Chinese growth and central-bank stimulus became the engines that kept the world economy chugging along.

But low interest rates have proven largely ineffective in reviving spending and China won’t be the safety net that it once was. At some point, policy makers may need to look back to a previous era of wage growth and active fiscal policy for inspiration.

To be sure, a recession still isn’t on the horizon. The U.S. in particular has been protected from China’s slowdown by its more domestically focused economy.

When the global economy does start misfiring, though, investors will need a new benefactor.

Economic Growth and the US Presidential Election

Slowing US economic growth poses a problem for President Donald Trump, who promised repeatedly that growth would accelerate under his administration and always remain above 3% per year. But will the Democrats prove capable of coalescing around the kind of policies that would really make a difference?

Simon Johnson


WASHINGTON, DC – Economic growth in the United States was just 2.5% in 2018 and, according to the latest “advance” estimate, may have slowed to only 2.1% in the second quarter of 2019. The economy is growing at roughly the same pace as it did during Barack Obama’s second term as president (GDP growth was 2.5% in 2014 and 2.9% in 2015, before slowing to 1.6% in 2016 – perhaps related to election-induced uncertainty).

Such growth rates pose a problem for President Donald Trump, who promised repeatedly that economic growth would accelerate under his administration and always remain above 3% per year. It is therefore an opportunity for the Democratic presidential contenders. But will the Democrats prove capable of coalescing around the kind of policies that would really make a difference?

The problem to be solved, of course, is not only – or even especially – the headline growth numbers. Several profound imbalances have emerged in the structure of the US economy.

Smaller towns and rural areas are experiencing an outflow of working-age people. College-educated people are moving to where the opportunities are, while those with only a high school education, for example, are increasingly stuck in areas with weak economic prospects. And while the superstar cities on the coasts (Seattle, the San Francisco Bay area, Los Angeles, Boston, New York City, and the Washington DC area) are attracting a disproportionate share of the country’s tech talent and risk-taking capital, they are burdened by very high real estate prices and extreme congestion.

So, how can the US boost productivity growth, in a sustainable fashion, while also sharing the benefits of that growth much more broadly across the income scale and all geographic regions?

There are two important strands of ideas currently under development which should help. Some versions of them may appear during and after the next round of Democratic candidate debates.

The first idea is that the US can strengthen its national manufacturing capabilities through public investments in “translational innovation” – meaning the ability to turn scientific ideas into practical engineering applications and, crucially, scale them up and launch domestic commercial production. This general idea has attracted bipartisan support, both in terms of the 14 advanced manufacturing institutes that have been developed during the last decade and – potentially – the next-generation version (bigger and better) being put forward by Sridhar Kota of the University of Michigan and his colleagues at MForesight: Alliance for Manufacturing Foresight.

As Jonathan Gruber and I argue in our book Jump-Starting America, there is a strong case for public investment in research and development when there are sufficiently strong spillover effects – for example, through the creation of new knowledge and techniques. Potential spillovers can be extremely valuable, but they tend to discourage private sector investment – people who raise capital, after all, are rightly focused on the return their investors will receive. And that means the private sector, left to its own devices, underinvests in developing engineering talent, building the ability to scale up manufacturing, and strengthening America’s ability to compete with China, South Korea, and other manufacturing powerhouses.

What exactly should our priorities be? The 2018 “Manufacturing Prosperity” report by Kota and Tom Mahoney of MForesight has some fascinating suggestions, including nanotechnology and flexible electronics, and smart (“digitized”) manufacturing. Our view, in Jump-Starting America, is simple: do it all, because creating new sectors is precisely what will create the good jobs of the future – and in all corners of the country. Every state, as far as we can determine, has the potential to participate constructively in this kind of initiative.

But faster productivity growth and even good job creation is only one part of the puzzle. What ensures that everyone has a chance to benefit from the prosperity and opportunities that result?

For this second dimension, we now have an appealing overarching framework, provided by Ganesh Sitaraman and Anne L. Alstott in their new book The Public Option: How to Expand Freedom, Increase Opportunity, and Promote Equality. Their proposal is not that the public sector should displace the private sector, but rather that offering a publicly-run alternative would expand everyone’s choices and ensure that no one is left too far behind.

Leading historical examples include the post office, libraries, swimming pools, and national parks. In each instance, the availability of a public option at least ensures access to a basic service at reasonable cost. Well-run public options also put pressure on the private sector to perform better.

Just think of all that people need and the private sector does not provide, at least not currently in an affordable, effective form that is widely available: health insurance, retirement funds, basic financial services, and childcare. In all these instances, Sitaraman and Alstott have simple proposals which, at the very least, would move America’s policy debates in the right direction – toward ensuring broader participation in future prosperity. Let us hope that the Democratic presidential contenders champion these and other ideas for achieving that goal.

Simon Johnson, a former chief economist of the IMF, is a professor at MIT Sloan, a senior fellow at the Peterson Institute for International Economics, and co-founder of a leading economics blog, The Baseline Scenario. He is the co-author, with Jonathan Gruber, of Jump-Starting America: How Breakthrough Science Can Revive Economic Growth and the American Dream.

What I Learned at Camp Kotok

By John Mauldin

I am back from my 14th annual Maine fishing camp and the mood was decidedly different this year. The private event at Leen’s Lodge is generally called Camp Kotok in honor of David Kotok of Cumberland Advisors who started these outings many years ago. CNBC and others began calling it the “Shadow Fed” but it is really just a meeting of wickedly smart people focused on economics and markets. (I am allowed to attend for comic relief.) Throw in a little fishing, more fabulous food and wine than anyone should consume, formal debates and informal Q&A, and it really is one of the highlights of my year.

All this happens at a fishing lodge without many luxuries except for the food which is off the charts in the evenings. For lunch, all the boats meet at one spot and the guides cook what we catch in a 2+ hour experience. (Only the hardcore go out fishing afterwards.) The lunch conversations are simply fascinating.

I am still absorbing what I learned, but for me the general mood stood out more. We will get to that below. First, a point of personal privilege.

I first started writing Thoughts from the Frontline in August 2000. That makes this the beginning of my 20th year. I started with 2,000 email addresses from an earlier writing incarnation. I was still writing a print publication which I sold through the mail and thought I would just stick my letter on the internet for free and see what happened. Within two years I had canceled the print letter as the free publication’s growth went through the roof. Even now, I meet people all the time who say they read it from the beginning (or shortly thereafter).

Words cannot express my genuine gratitude that so many of you have read these letters for so long and continue doing so. Simply saying “thank you” doesn’t adequately express how truly, profoundly thankful I am you give me the single most important part of your life—your attention—when we are all so inundated with emails, TV, podcasts, Twitter, Facebook, and other ways to spend our time. The fact that you give some of that precious time to me and my humble musings is emotionally overwhelming.

I sometimes humorously say that each reader is one of my million closest friends, but it’s the truth. I feel you are indeed my friend as you spend your time with me. And my pledge for the next 20 years is the same as the last 20: to give you my unvarnished and true opinion, whatever it may be, as we try to make our way in an ever more volatile, changing world. And while it can’t fully express my feelings, still I say with a full heart (and maybe some moist eyes), “Thank you.”
“Don’t Look Back. Something Might Be Gaining on You.”

That quote is from Satchel Paige (whom my dad played against in Paige’s barnstorming days in the 1930s). It expresses how I felt as I left Leen’s Lodge on Sunday. We discussed the world’s problems and the general mood was that many of those problems are beginning to catch up. Looking back at them simply underscored the frustration and dread.

I missed the Thursday night discussions due to travel “inconveniences,” but thankfully you can read three exceptionally well done takeaways from the meetings, which I shamelessly borrow from David Kotok, Brent Donnelly and Dave Nadig.

This year’s conversations focused on three key long-term themes which were discussed one by one.

1.   A future where global interest rates remain permanently near zero

2.   Modern Monetary Theory (MMT) and US fiscal strategy

3.   A fundamental change in the US/China relationship

Kotok offers a quick introduction:

The 50-person gathering at Leen’s Lodge encompassed diverse political views, financial and economic specialties, and asset classes focused from cannabis to currency trading, real estate to debt of all types, stock markets and ETFs, derivatives and futures, and more. Over $1 trillion in managed assets was represented as we gathered for each informal meal. No lectern, no PowerPoint. The China Panel and the MMT panel are public and in the social media domain and the press and public are free to use the video footage and quote the speakers. Other discussions were conducted under the Chatham House Rule.

Photo: David Kotok

I was not around for the Thursday night survey, when 40 people were asked their opinion of Peter Navarro. One person supported him, three had no opinion, and 36 disapproved. It would have been 37 had I been there. I have said many times that Peter Navarro is the single most dangerous man in the Trump administration. He understands neither trade policy nor trade deficits and yet seems to have a Svengali relationship with the president. I missed that part of the discussion but Kotok summarized:

The damage incurred by Navarro’s advice and Trump’s policy was cataloged in detail, and it is ugly. It is spreading and appearing in more and more evidence and anecdotes.

Border and immigration policies were discussed in detail and with data. The group’s outlook is bleak. Nearly all fault a dysfunctional Congress for its repeated failures. Here the group leaps over partisanship. Democrats and Republicans are guilty.

Mauldin observation: A big majority of a diverse group generally agreed the tariffs were having a global impact, slowing growth elsewhere in ways that will come back to haunt our own shores. Nearly everyone was glad Trump is pushing back on China, but most thought he should do it in another way. (As my friend Gary Halbert asks, why does China still have Most Favored Nation status?) Tariffs hurt Americans. If you want to draw a line, get together with our allies and tell Beijing it needs to stop the intellectual property theft and allow competitors a level playing field or the rest of the world will move on without them. Now that’s getting tough. Hardball? Yes, but I think we are all beginning to realize Chinese leaders are not our friends.

MMT or the Magic Money Tree

There was an open “debate” about MMT or Modern Monetary Theory. Brilliant young man economist Sam Rines took the difficult position of being pro-MMT for the sake of debate. He thinks it would be a disaster but is truly afraid we will actually pursue such a policy. There was the usual pushback, which I’ve written about more than once, but I have to admit that I was struck by the private conversations after the debate. Many smart, well-informed thinkers were almost resigned to seeing MMT actually attempted in the next decade.

Mauldin take away: If we attempt MMT it will end the US dollar’s reserve currency status, produce out-of-control inflation that will essentially destroy the Boomer generation’s ability to retire with anything like most envision today. I can’t say it any stronger. If I really see MMT coming I will reposition my portfolio to heavily weight gold, real estate, and a few biotech companies. I simply can’t imagine a more dire economic scenario.

Honestly, though, I don’t think we will go there. Are there politicians that would like to do it? Absolutely, and they have less economic understanding than God gave a goose. Even economists with whom I strongly disagree on many topics think MMT is not something to be trifled with.

Many participants had read my analysis of the potential for $45 trillion worth of US debt by the end of the 2020s. When I started talking about the potential for $20 trillion of additional quantitative easing, it was clear the question made some uncomfortable.

There was general agreement that neither political party can balance the budget. The latest “deal” between Trump and Congress raised spending $320 billion over the next two years. The previous “sequester” deal that at least tried to limit spending is out the window. With it will go any control on the spending process. Current deficit projections will seem mild compared to what we actually get.

As I said a few weeks ago, using CBO projections from earlier this year and assuming one recession, the national debt would rise to almost $45 trillion by the end of the 2020s. This new deal will add at least another $1.5 to $2 trillion to that amount. If there is a second recession, we would be looking at north of $50 trillion.

We don’t have $40 trillion, let alone $50 trillion, to put into federal debt. It would crowd out all funding for productive private enterprises and sharply reduce GDP growth. Which is why I expect to see massive, currently inconceivable amounts of quantitative easing.

The 2020s will force us to continually think the unthinkable. No, that is probably too mild. We are going to find ourselves having to continually DO the unthinkable.

Doom and gloom? Not really. The math is from the Congressional Budget Office. It is politically impossible for them to project a recession, so they don’t. I would also admit that it is also statistically impossible to predict a recession so they don’t. I don’t have such a restriction.

These are the charts that I’ve printed in part four of the discussion with Ray Dalio a few weeks back, assuming recession in either 2020 or 2022. You can see what happens to the deficits and revenues.

This first graph assumes a recession in 2020. Note that revenues fall below mandatory spending by the middle of the decade, then never get back above mandatory spending plus defense spending. Then by the end of the 2020s mandatory spending will again rise to consume all tax revenue. And again, these don’t include significant off-budget spending.

This next graph assumes recession in 2022 instead of 2020. The pattern is basically the same, except that the $2-trillion deficits don’t begin until 2023. Again, this uses actual CBO projections and adjusts revenues by the same percentage they fell in 2008–2009, and recovered thereafter.

I asked one person after another what they thought would happen. How can we avoid this? I got no good answers. Others were clearly just as frustrated as I am. Let me tell you, I am way past frustration. I am seriously worried for the future of the Republic and our children and retirees.

I asked at least a dozen attendees (and maybe more) this question: If we introduce MMT and the result is what we all think it will be, I think there is a 50–50 chance some states will want to secede from the union. Do you agree or disagree?

I got literally no pushback on that admittedly outrageous idea. When you undertake policies that will destroy the very fabric of society in the name of “justice and equality for all,” those damaged in the process will push back.

The debate on MMT had some lighter moments. Everyone chuckled when one panelist called MMT the “Magic Money Tree.” After someone said MMT could be used to fund universal health care and Space Force investments, Jim Bianco (channeling John F. Kennedy) said: “We choose to go to Mars, not because it’s easy, but because it’s free.”

A Fundamental Change in the US/China Relationship

We talked quite a lot about China. Brent Donnelly said this in his Camp Kotok wrap-up:

It was interesting to hear how it now seems to be almost universally accepted that the United States is in a multi-year, multi-front (so far, non-military) war for global supremacy against China. No trade agreement is going to change that. The first challenge to US hegemony since the USSR. Attendees at Camp Kotok run the entire political spectrum but this issue seems almost totally non-partisan.

It was notable how even while many did not agree with the US escalation strategy against China, there was broad agreement that China should be challenged. The China/US long-term decoupling is an issue that will continue post 2020, whoever wins. A rare bipartisan issue.

A good part of the discussion centered around the book “China’s Vision of Victory,” written by Jonathan Ward, one of the attendees. Ward, a US citizen, told remarkable stories of boarding container ships, learning Cantonese and pidgin Indonesian, living in rural and urban China for several years and translating every document publicly released by the Chinese Communist Party to better understand China’s motivations as it rebounds from the Century of Humiliation.

(Sidebar: I personally invited Jonathan Ward at the last minute with Kotok’s permission. He was a big hit at the camp. Read his book.)

Dave Nadig wrote about his question-asking experience:

This year, my question was: "What’s one thing—a risk, a concern, a data point, a situation—that’s really important, that the rest of the econo-finance sphere isn’t paying attention to?”

The answers here were dizzying. While there were a few somewhat predictable answers like, “We’re in a corporate earnings recession and nobody’s talking about it,” there were also some big surprises for me, such as:

·         The entire global maritime fleet has to change fuel types in five months, and it’s going to cost a ton.

·         The New York PMI (producers manufacturing index) is flashing red lights about the service-based economy.

·         Geopolitics is being swept under the rug, leaving us open to a “hot war” while we focus on all the economic wars.

·         The risk from Chinese corporates like Huawei is enormous.

·         The degradation of the National Weather Service is going to destroy US agriculture.

The list of terrifying one-liners goes on and on.

Nadig and I, along with others, noticed the, for lack of a better term, political fatigue in the room. Normally there would be some passionate discussion, especially when under Chatham House Rules you can’t be quoted. Here’s Nadig again:

This year, the political discussions petered out quite quickly. It wasn’t disinterest that defused things, it was bone-penetrating exhaustion. Even folks I would’ve pegged as the most die-hard partisans seemed to have a hard time mounting a fervent defense of any politician or appointee. The opinions were still there, but the will seemed to have faded.

I feel the same way. Any thinking about policy for the last few years has been waylaid by a discussion of the people behind the policy.

Bone-Penetrating Exhaustion

That is as good a way as any to describe the mood in the room at the end of Saturday night. Bone-Penetrating Exhaustion. It is like we are staring into an abyss, it’s a long way down, and we simply don’t know what to do. Oh, there were ideas tossed around: infrastructure bonds to stimulate the economy funded by the Federal Reserve, different ways to fund the deficits that everybody can see coming. But we all agree that there is no political will to stop them.

I spent a long time talking with one of my favorite philosophical economists, Dr. Ben Hunt of Epsilon Theory fame. While we have some minor disagreements, we share the sheer frustration, the sheer worry about the policies our current government has been pursuing and what they will do to the retirement hopes of the Boomer generation, let alone the growth potential to fund the hopes and dreams of the Millennials. We talked about how to help people get through what is going to be a very volatile and difficult time. I will share more on that in future letters.

I know this has been a little bit of a Debbie Downer letter. When the consensus is that we are going back to the zero bound on interest rates, we’re literally screwing an entire generation. People who have saved and worked and bled will be rewarded with zero interest rates and the need to take more risk in retirement, exactly the wrong time in their lives to be taking risk.

I promise in future letters I will write more about how to avoid the consequences I’ve mentioned above. Stick with me, we’ll get through this together.

Montana and Back to Puerto Rico

Shane and I are in Montana staying with Darrell Cain at his compound. He graciously invited Pat and Cheryl Cox to join us. Pat and I are working on several of the chapters in my book on what the world will look like in 20 years, which are kind of the rainbow and unicorn chapters. The world really is going to be a better place. We just have to get there.

Last night Howie Long was sitting next to us at the restaurant and I asked to take a picture with him. I reminded him that he, Roger Staubach, and Walter Payton were in New York for a Super Bowl party hosted by Société Générale where I won first place for trading futures and options on the Super Bowl score during the game. I got all sorts of fabulous prizes, including a football signed by these three famous Hall of Famers. I told Howie I would put this picture next to the original. I swear, he doesn’t look any older today than he did 20+ years ago. What a gracious gentleman.

Speaking of winning, my prediction for the gold price from last year at Camp Kotok was literally pennies from the actual price. Talk about fooled by randomness. And with that I will hit the send button and wish you a great week.

Your working on a plan that gets us through the 20s together analyst,

John Mauldin
Chairman, Mauldin Economics