The Rules Will Change but That’s (Probably) OK

By John Mauldin

 
“But the emperor has nothing at all on!” said a little child.


“Listen to the voice of innocence!” exclaimed his father; and what the child had said was whispered from one to another.

“But he has nothing at all on!” at last cried out all the people. The emperor was suddenly embarrassed, for he knew that the people were right; but he thought the procession must go on now! And the lords of the bedchamber took greater pains than ever, to appear holding up the robes although, in reality, there were no robes at all.

—“The Emperor’s New Clothes” by Hans Christian Andersen


When you write about controversial topics for hundreds of thousands of readers for 20 years, you develop a thick skin. Virtually anything I say will upset someone.

So, when people say something like, “John Mauldin wakes up sucking lemons and then moves onto something sour,” as happened after last week’s letter, it doesn’t bother me. (It actually made me smile.) I write what I believe is correct. Those opinions change over time as I get new information.

I’m not the only one who changes. Laws and policies that may seem etched in stone are often more flexible than generally thought. In last week’s Japanification letter, I described how no one anticipated the various extreme measures taken in the last crisis, from TARP to QE to NIRP. Yet once those ideas were in play, they happened quickly.

I think the next crisis will bring similarly radical, sudden changes. We will think the unthinkable because we will see no other choices. That means the range of possible scenarios may be wider than you think.

To think this may be so is not necessarily bearish.

Fiscal Insanity

As of now, my best guess is the US will enter recession sometime in 2020. I may be off (early) by a year or two, but it’s coming. We know two things will happen.

  • Tax revenues will fall as people’s income drops.

  • Federal spending will rise as safety-net entitlement claims go up.

The result will be higher deficits. Keynesian economics advocated running deficits during recessionary and economically difficult times and surpluses the rest of the time. That’s not what we did.

Last year (fiscal 2018) the “official” budget deficit was $779 billion. The national debt went up $1.2 trillion. The “small” $421-billion difference was more than half the official budget deficit. That is the off-budget spending that Congress doesn’t count. It includes the revenue and spending of certain federal entities that Congress wants to isolate from the normal budget process. Lately it has run in the multiple hundreds of billions of dollars, every year.

Below is a graph showing the projected budget deficits for 2019 and 2020 from a website called The Balance. You can find similar numbers all over the internet. I’m using the US but the situation is similar in most developed countries (though hopefully not yours).



Now, add another $400 million to each of those numbers. What is called the “unified budget” is now $1.5 trillion.

Next, let’s go to a very handy website called The US Debt Clock. (Scrolling around you can find the debt for your own country and state and other useful data.) We see that halfway through fiscal year 2019, the debt is already well over $22 trillion. It will be $23 trillion before the end of this year. By the end of 2020, Trump’s first term, it will be approaching $25 trillion. And that doesn’t include state and local debt of $3 trillion plus their $6 trillion unfunded pension liabilities.

And as I pointed out before, all that is without a recession. The unified deficit will easily hit $2 trillion and approach $2.5 trillion in the next recession. Within 2 to 3 years later, the total US debt will be at least $30 trillion. Not including state and local debt or unfunded pension obligations (more on those later).

Recognizing that simple arithmetic is not being bearish. It’s recognizing reality.

There are calls for a 70% tax rate on incomes over $10 million. Experts quoted in The Washington Post estimated it would produce about $72 billion a year. And you can guarantee that people will work their income statements to get below that. And in the face of a $2.5-trillion deficit? It doesn’t do very much, let alone pay for any new programs.

The simple fact is that raising income taxes on whatever we think of as the wealthy doesn’t get us close to a balanced budget. But what about actually doing a wealth tax? Like 1% of total net worth on the 1% wealthiest in America? Helpfully, The Washington Post article calculates that for us (my emphasis):

Slemrod, of the University of Michigan, said in an email that the wealthiest 1 percent of Americans own roughly one-third of the $107 trillion in wealth in America. This group collectively holds about $20 trillion in wealth above $10 million per household.

From there the calculation of wealth tax is simple: a 1 percent wealth tax on the wealthiest 1 percent of households above $10 million could raise about $200 billion a year, or $2 trillion over 10 years. Tedeschi, the former Obama official, found a 0.5 percent wealth tax on the top 1 percent could raise at most $3 trillion over 10 years.

But this, too, would probably change Americans' behavior and perhaps lead them to try shifting their wealth overseas, and the economists say the actual amount of revenue is likely lower than their estimates suggest. And this is assuming there are no exemptions to what is considered wealth, such as housing assets.


Again, a few hundred billion a year is nothing to sneeze at, but at the rate we’re going would make only a small dent in the deficit.

The real problem? Unfunded entitlement spending. The CBO is projecting literally trillion-dollar deficits in the latter part of this next decade simply because of unfunded entitlement spending. And then there’s the pesky little fact that we spent $500+ billion last year on interest payments.

In a recession and bear market, the $6 trillion of unfunded pension liability on state and local balance sheets could easily rise to $9 trillion, a number most cannot meet. Either firefighters, police officers, teachers, former government workers, etc., would not get their agreed-upon pensions or state and local taxes would have to rise precipitously, or the federal government will have to step in.

All of this will happen in an environment in which the Federal Reserve will be fighting a recession and a slow-growth economy, trying to move those asset prices back up to help the pension funds. So for me to suggest that the balance sheet of the Federal Reserve could grow to $10 trillion by the middle of the next decade and $20 trillion by the end of the decade is not entirely outrageous. And we haven’t really approached Japanese territory yet.

This analysis is not “bearish.” It is simply looking at the numbers, doing the arithmetic, and observing that we’ll have to borrow a great deal of money to meet our obligations.

I might be wrong if politicians from either party run and win with a platform of “I’m going to cut your Social Security and Medicare, slash the defense budget, and zero out a lot of little other pesky expenditures that you probably like.” I feel sure that won’t happen.

Avoiding the Windshield

The Emperor isn’t wearing any clothes. Maybe I’m that naïve little boy who isn’t smart enough to see the beautiful cloth in which our national budgets are arrayed, and how easily we can raise more taxes from invisible sources.

And like the Emperor in the above story, we just keep walking and telling ourselves that nobody will notice.

The bulk of that debt will end up on the Federal Reserve’s balance sheet, just like the bulk of European debt will end up on the balance sheet of the European Central Bank, the Bank of England, and so on.

Exactly the path the Bank of Japan has already gone.

Let’s examine how that worked for them. From one perspective, it has done quite well. From another, they have paid a cost. Is it worth it? I think many Japanese, likely a big majority, would say yes.

The Bank of Japan has more than 140% of Japanese GDP on its balance sheet. Its laws let it buy equities not just in Japan but all over the world and it has. Yet the currency is roughly the same value as it was when the Bank of Japan got busy with that project.

I am personally well aware of that because I was the one who called Japan “a bug in search of the windshield.” Just like I am predicting that much of the US deficit will end up on the balance sheet of the Federal Reserve, I said the same thing would happen to the Japanese. I also said it would devalue their currency. I actually put real personal money, not just token money, on the prediction. I bought a 10-year yen put option. That trade has not worked out so well. I don’t even want to open the envelopes from J.P. Morgan containing that information.

But I learned a lesson and I had a great deal of company. Many hedge fund managers and other investors made the same bet. In essence, we said that Japan is going to print money and the same thing will happen to it that happened to every other country in the same situation: The currency will lose value.

Instead, it brought one of the most surprising macroeconomic outcomes that I could imagine. Talk about thinking the unthinkable back in 2008. What happened is unthinkable to me, and to a lot of other people.

First, let’s realize that Japanese debt-to-GDP has risen to 253%. Notice in the graph below that the increases are much smaller each year. That is a (surprising!!!) point I’m going to make next.


 
For the last two decades, the Japanese have been promising they would balance their budget in 7 to 10 years—and they’re actually beginning to make progress. Their fiscal deficit is in fact smaller every year in terms of GDP and actual numbers of dollars. Good for them.


 
The deficit should fall even further as they have a small sales tax increase kicking in the fall of this year. It is, of course, controversial whether they will actually implement the tax, but I expect them to eventually do so. And sometime in the next decade, it is entirely possible that Japan will actually have a balanced budget, and then a surplus that lets the government begin paying down that debt.

Of course, they have to navigate global recessions, and all the sturm und drang and vicissitudes of life, but they are clearly trying to move in the correct direction. Kudos to Abe and Kuroda-san.

The Cost of High Debt

All this has not been without cost. It brought severe financial repression on savers. If you could somehow buy a new Japanese government bond, which is almost impossible because the BOJ buys everything that isn’t nailed down, you would get negative yield. That’s one reason Japanese savers are not selling their bonds. Even 1–2% on bonds bought “back in the day” is a lot more than they can get now.

The Japanese government bond market was once one of the world’s most liquid. Now it trades by appointment. Here is the JGB yield curve right now. Notice it is negative out to 10 years. So if somehow you had bought a 20-year bond 10 years ago, which makes your Japanese bond now a 10-year bond (effectively), you would have a nice capital gain. But then where would you put the proceeds if you sold? That’s why there are very few actual sales in the Japanese bond market.


 
As Lacy Hunt will demonstrate to us at the SIC (get your virtual Pass here), massively increasing debt actually reduces interest rates, productivity, and GDP growth, exactly as we see in Japan. They ran massive government debt, bringing future consumption into the then-present, and now must live in a world where that future consumption doesn’t happen, GDP growth is negligible if not negative, and investors have to live by new rules.

To some degree, we already see the first evidence of that in the US. My good friend Ben Hunt notes that the S&P 500 companies have the highest earnings relative to sales in history.


Source: Ben Hunt

Quoting Ben:

This is a 30-year chart of total S&P 500 earnings divided by total S&P 500 sales. It’s how many pennies of earnings S&P 500 companies get from a dollar of sales… earnings margin, essentially, at a high level of aggregation. So at the lows of 1991, $1 in sales generated a bit more than $0.03 in earnings for the S&P 500. Today in 2019, we are at an all-time high of a bit more than $0.11 in earnings from $1 in sales.

It’s a marvelously steady progression up and to the right, temporarily marred by a recession here and there, but really quite awe-inspiring in its consistency. Yay, capitalism!

 
Ben goes on to say many people think that is because of technology. He argues it is the financialization of our economy and the Fed’s loose policies. I agree 100%. If you think they haven’t changed the rules since the 1980s and 1990s, you aren’t paying attention, boys and girls!

It goes without saying that those profits are not going to labor, and the same monetary policies that were supposed to enhance the economy have contributed mightily to wealth and income disparity. When you muck around with the markets, don’t be surprised if you get unintended consequences. We have them in spades, and everybody wants to blame “the rich” rather than the incentives the government and Federal Reserve created.

New Rules, or Moving the Goalpost

I don’t think it is bearish to notice the political and arithmetic implications of our budget process. I want to help my readers understand that the rules are going to change. That is not necessarily a bad thing. It is just what it is.

The massive increase in debt, huge quantitative easing programs, and increased financialization of the investment process are going to change the rules of investing we have lived under for the last 50 years.

It is going to be difficult, more difficult than now, to get a positive return on your bonds without taking significant risk. And your returns are going to be lower. Think Japan. Think Europe. For that matter, think the US.

If somehow the gods of American football changed the rules so you needed 12 yards for a first down, the field was now 120 yards long, and gave a few advantages to receivers, the nature of the game would change. It would still be recognizable as football but it wouldn’t be the game we know.

That’s not unprecedented. Football in my father’s day was significantly different from now. I’m sure there are people nostalgic for the way it was. I just want to watch the game as it is today. And when it comes to investing, if I have to change my style and look for different opportunities, it is just acknowledging a rule change.

I am not being bearish when I say there is the potential for future rule changes. I am simply pointing out what I see.

I think I am truly the most optimistic man in the room. Everywhere I turn I see opportunities. But then, I’m looking beyond my Bloomberg or business TV.

The world is changing around us and we have to adapt. Many won’t notice the changes and end up like the dinosaurs. That is very sad. What will happen to people who are counting on pension funds is also going to be very sad. Or we taxpayers are going to have to step in and bail them out. As a taxpayer, that is also sad.

Is there a way out of all of this? Absolutely. We can overhaul the tax system like I wrote two years ago, actually balance the budget, fund all the entitlement spending, and watch GDP growth once again become part of our national conversation.

But it will take a crisis before we consider that. In the meantime, let’s pay attention to how the rules are changing and adapt.

Now, how is that bearish?

The rules really are changing and past performance is not, and will not be, indicative of future results.

Dallas, Cleveland, Chicago, Puerto Rico, and Washington DC

Travel just seems to happen to me. I have to go back to Dallas to have my root canal checked and get a new cap, then run to the airport to get to Cleveland to have my eyes checked because of the cataract surgery (which seems to have gone well), then run to another airport to get to Chicago for a speech, some meetings, and a dinner the next night, then back to Puerto Rico and finish next week’s letter before flying off to Washington DC to do a video with my friend Neil Howe.

Almost every day I have one if not two conference calls with speakers who will appear at the Strategic Investment Conference, going over what they will say and how the panels will interact. It is hard for me to curb my enthusiasm. There will be so much important information conveyed that will help you understand the changes that are coming. We will discuss China, Europe, geopolitics, debt, central bank policy, all sorts of market and market opportunities, real investment ideas, and much more. And hopefully have a lot of fun while we are doing it. If you can’t make it (get on the waiting list if you think you might be able to change your schedule), then you really should get the Virtual Pass. It’s the best deal out there.

One of the best things about going to Dallas is that I will get to see some of my kids. Maybe even catch an action movie with the boys. And a few friends have time slotted as well. Sunday will be a full day. You have a great week!

Your calling it as I see it analyst,



John Mauldin
Chairman, Mauldin Economics

Precious Metals Give Traders Another Opportunity

Chris Vermeulen


We know many of you follow our research posts and have been waiting for the Gold/Silver setup we predicted would happen near April 21~24, 2019 back in January 2019. Well, it looks like our predictions were accurate and the current downward price rotation in Gold/Silver are the opportunities of a lifetime for precious metals traders.

Our original research regarding the predicted Gold price rotation and breakout initially posted in October 2018 and was updated in January 2019. You can read our updated post here.

This research suggested, back in October 2018, that gold would rally above $1300, then stall and setup a momentum base near April 21~24, 2019. Currently, we are actively seeking entry positions in Gold, Silver and many other stock market sectors related to the metals and miners.

We’ll start by highlighting the Gold to Silver price ratio. When this ration moves well above 80, it is generally considered a long term buy trigger. The reason for this is that this ratio attempt to reflect the price of Silver to the price of Gold. When this level reaches above 80, it traditionally reflects an extremely cheap price ratio for both Gold and Silver and usually prompts a big price advance in the near future.



Taking a look at historical price moves for both Gold and Silver, we fall back to the big upward price advance that began after the 2009 market crash. One thing that all traders and investors must understand is that, currently, Silver presents an incredible opportunity for bigger returns than Gold. Yes, Gold will likely rally higher and provide an incredible opportunity for upside gains. Yet, historically, Silver begins to move a bit later than Gold does and the upside potential of Silver tends to be 40~70% greater than the upside potential for Gold.

Take a look at this comparison chart, below, of the 2009 to 2011 price move. Gold shot up nearly 100% – as shown on the chart. Silver shot up over 150% when the breakout move happened a bit after the Gold move started. We expect the same type of price advance pattern in the near future. We expect Gold to begin the move higher and Silver to lag behind this upside move a bit – possibly for a few months. Eventually, Silver will break to new multi-year highs and could rally 130% to 220% above current levels – possibly higher.



Over the next few months, we believe increased volatility in the US stock market may drive prices a bit lower as price rotates near all-time highs. We believe this rotation, coupled with foreign market concerns (think Brexit, Europe, China, South America) as well as the US Election cycle may cause the markets to enter a period of stagnation and sideways trading. These impulses may become a catalyst for precious metals to break recent highs and begin an upward price advance as a general increase in FEAR settles into the global markets.

We do believe Gold and Silver will likely move a bit higher over the next 30+ days as the US stock markets continue to push higher towards new all-time highs. Yet, if the volatility increases, as we expect, and a bigger price rotation takes place (see the chart below), we believe Gold and Silver may experience another price drop to near or below current levels before a massive upside breakout move begins. Historically, the price of Gold contracts throughout the initial price correction phase of the S&P500 and begins to accelerate upward near the end of a correction phase. This is because investors and traders are typically shocked to see the correction take place and move into a protective mode as true fear sets in. When fear subsides, traders move out of precious metals and back into stocks.



Our current expectations are that Gold will continue to push lower, below $1275, in an attempt to establish our April 21~24 momentum base. This base should be at or near ultimate lows for the price of Gold and we would expect a pennant or sideways price channel to complete this bottoming formation. Ideally, any price move below $1250 is a gift for skilled traders. We’ll just have to wait to see where this bottom sets up before we know just how low Gold will fall before the next leg higher.

We believe the next upside price leg in Gold will push prices above $1400 initially, likely in May or June 2019. After that peak is reached, we believe a period of rotation and a potential for a price decline is very real. We believe this next leg higher will really to levels above $1400, then price will stall and retrace – possibly retracing back to levels below $1300 again. It would be at that point that skilled traders should consider this the last opportunity for long entries before the bigger move to the upside.



Our research into this move, which initiated back in October 2018, has called these rotations almost perfectly. If our newest research is correct, you will have at least two opportunities to enter fantastic long trades in Gold and Silver, one setup hitting between April 21 and April 28 and another setup after the initial upside price rally retraces (likely in June or July 2019). After that last retracement, we believe the bigger upside rally will begin and both Gold and Silver will initiate a rally that could be an opportunity of a lifetime for skilled traders.


Bello

The wisdom of José Carlos Mariátegui

The Latin American left should rediscover the Peruvian thinker’s pluralism and creativity



HE DIED AGED just 35, disabled for his last six years by the amputation of a leg. But in his short life José Carlos Mariátegui managed to become Latin America’s most influential Marxist thinker, at least until Che Guevara came along.

Barely known today outside Peru, he also played a significant role in Latin American culture in the late 1920s, a period when artists and writers were trying to establish national identities based on the recognition of mestizaje (racial mixing) and of workers and peasants. An exhibition, currently at the Reina Sofia museum in Madrid and then bound for Lima, Mexico City and Austin, Texas, introduces Mariátegui to a broader audience while establishing him as a cosmopolitan figure at the hinge of revolutionary politics and artistic vanguards. It offers lessons for the region today.

The child of a mestiza mother and an absent aristocratic father, Mariátegui was an autodidact who became a journalist and writer. Exiled by Peru’s authoritarian regime, he lived in Europe from 1919 to 1923, mainly in Italy and Berlin. He attended the first congress of the Italian Communist Party and was influenced by its founder, Antonio Gramsci, whose thought was a bridge between liberalism and Marxism and who stressed the importance of culture. Mariátegui was introduced to a profusion of European artistic movements, including Italian futurism, Dada and surrealism.
He returned to Peru “with the idea of founding a magazine”, he wrote. That idea came to fruition in 1926 with Amauta (“wise one” in Quechua), a political and cultural journal. Mariátegui was never dogmatic or narrow in his interests, and he wanted Amauta to analyse the problems of Peru “in the world panorama”. The first issue contained articles by Sigmund Freud and George Grosz, a German artist, as well as reports on political developments in Spain and Mexico. It included illustrations by Emilio Pettoruti, an Argentine cubist, and José Sabogal, a Peruvian artist who created Amauta’s modernist design.

In his writings, Mariátegui developed a distinctive revolutionary vision, which he briefly tried to put into practice when he founded the Peruvian Socialist (ie, communist) Party in 1928. Peruvian (and Latin American) socialism should not blindly copy European models, he thought. Rather, it should put the “problem of the Indian”, and thus land reform, at its heart. He believed that the Amerindian peasant communities of the Andes contained the germ of socialism.

This romantic view set him on a collision course with the apparatchiks from Moscow, who took over Latin American communist parties shortly after his death. But Mariátegui was right in stressing indigenous peoples, popular religiosity and culture in Latin America’s political identity. He was unusual, too, in counting many women among his collaborators.

The exhibition highlights the loose continental network, with ties to Mexico and Argentina, to which Amauta belonged. It includes art by Diego Rivera and other Mexican muralists. But the visual highlight is the work of Peruvian “indigenist” artists, such as Sabogal and Julia Codesido, who painted portraits of Amerindian elders and scenes of Andean community life. Indigenism was seen as archaic compared with the revolutionary commitment of Rivera. But it endowed its subjects with dignity, and Mariátegui defended it. “The emergence of indigenism represented a radical upheaval that is hard to imagine today,” writes Natalia Majluf, the exhibition’s co-curator and the outgoing director of Lima’s Museum of Art.

Mariátegui was wrong about big things. It is capitalism, not communism, that has freed billions from poverty. But in the aftermath of the first world war and of the Russian and Mexican revolutions, and having seen the failure of liberalism to prevent Italian fascism, he was not to know that. What he saw was that in Peru a century of political independence and creole capitalism had not freed the Indian from near-serfdom.

Mariátegui was a committed socialist who also managed to be a free thinker. That makes him valuable today. Much of the Latin American left is blindly obedient to the failed models of Cuba and Venezuela, or still beguiled by populist caudillos (for whom Mariátegui had no time). It desperately needs some of the original thinking of the 1920s. For the right, “Gramscian cultural Marxism” is a new bugbear. They should recognise that Latin America suffers unacceptable inequalities based on sex and race, and needs more tolerance.


Look for Gray Rhinos, Not Black Swans, in China’s Financial Zoo

The main risk to the country’s financial system is the threats everyone knows about

By Mike Bird



Widely known flaws such as excessive leverage and mispriced risk are thundering toward policy makers.
Widely known flaws such as excessive leverage and mispriced risk are thundering toward policy makers. Photo: biju boro/Agence France-Presse/Getty Images 


Rhinoceroses are getting rarer everywhere in the wild—everywhere, that is, except in the wilds of China’s financial system.

Wang Jingwu, the Chinese central bank’s financial stability chief, listed this week a number of “gray rhinos” threatening the country, including the large pile of local government debt, more bond market defaults and banks’ high level of exposure to the shaky real estate sector.

Unlike Nassim Nicholas Taleb’s black swans, gray rhinos aren’t unpredictable events with catastrophic consequences. The term, popularized by American author Michele Wucker in a 2016 book, refers to highly visible and potentially devastating challenges that policy makers often elect to ignore, rather than dodge.

Mr. Wang is using the right framework to communicate what ails China’s state-led financial system, where highly unpredictable events aren’t the real threat. Rather, it is widely known flaws such as excessive leverage and mispriced risk that are thundering toward policy makers.



Not that black-swan events don’t happen. The 2015 blowup in the equity market and the collapse of several Chinese peer-to-peer lending platforms in 2018 are good examples of surprise shocks to the system.

But China’s core problems, as adumbrated by Mr. Wang, are well understood by analysts.

With far more control over the financial system than most Western countries exert, Beijing has shown that it can keep periodic eruptions under control, for instance by clamping down on capital flows out of the country.

But keeping that control comes at a price: the gray rhinos get larger and larger. Facing little external pressure, policy makers find it hard to resist the temptation to keep the economy afloat simply by increasing the country’s debt—even if each round of stimulus sparks less growth than the last.

So if Chinese policy makers are well aware of the underlying problems that cause such events, why don’t they act?

Easier said than done. This week, the Chinese Academy of Social Sciences noted that debt in the real economy fell from 244% of GDP in 2017 to 243.7% in 2018. For all the discussion of the deleveraging campaign and the economic pain it brought, the needle barely budged.

Neither aggressive stimulus, nor paring down debt levels are attractive options for Chinese policy makers. As long as that remains the case, expect those gray rhinos to keep piling on the pounds.


Can Amazon Reinvent the Traditional Supermarket?



Wharton's Barbara Kahn and Columbia's Mark Cohen analyze Amazon's plans to open supermarkets in major U.S. cities.



Amazon’s plans to launch physical grocery stores this year is just the latest affirmation that, ironically, bricks-and-mortar stores are crucial to the e-commerce giant’s future growth. Amazon may launch as many as 2,000 supermarkets in major U.S. cities, according to a recent report in The Wall Street Journal. It will be Amazon’s sixth physical retail format after Whole Foods, Amazon Books, Amazon Go, Amazon 4-Star and Amazon Pop-Up.

Amazon’s plans are likely to rattle major grocery purveyors such as Kroger’s and Walmart, whose shares fell on the news. But the expectation is that Amazon will introduce a different business model — one that merges bricks-and-mortar and online experiences, then powering it with data analytics, according to experts at Wharton and Columbia University who spoke about Amazon’s grocery-store strategy on the Knowledge@Wharton radio show on SiriusXM. (Listen to the podcast at the top of this page.)

“It was a natural next step,” said Wharton marketing professor Barbara Kahn. Opening supermarkets makes sense for Amazon because its business model is to offer low prices and convenience, which is what shoppers look for when getting groceries. “If you look at their bookstores or Amazon Go (fully automated convenience stores), they’re fine stores, but they’re not beautiful stores. They’re the kind of stores where you can get what you want at a cheap price, fast and convenient,” she said.

Amazon’s expansion of its grocery business — it already has Prime Pantry, AmazonFresh and Whole Foods — also lets it collect consumer data more frequently since people shop for food regularly and prefer to do it in person. “Their game is data and they need to have frequency. What’s really attractive about grocery is not really the margin; it’s the traffic,” Kahn said. “When you go into an Amazon store, you have to log in with your app and everything you do in that store is then connected with everything online.”

The Journal said Amazon’s supermarkets will take up about 35,000 square feet compared to 60,000 square feet for a typical grocery. Talks reportedly are underway to open stores in Seattle, Philadelphia, San Francisco, Chicago and Washington, D.C.

It’s About Data

Whatever retail store format Amazon uses, it “would be built upon this tremendous capacity they have to gather, analyze, understand and use what customers are saying to them every day,” said Mark Cohen, director of retail studies at Columbia University who had been CEO of Sears Canada. “Amazon is proof-positive of the value of big data and the way in which you collect it and the way in which you examine it and use it.”

Cohen cited the smart use of data by 7-Eleven, the convenience store chain. “7-Eleven has enterprise-wide systems that enable it to manipulate, modify or not modify its assortments to be extremely relevant and also extremely efficient so that not only is the right brand on the right shelf at the right depth, but it’s in a place in the store where customers expect to find it.”
Amazon’s opening of physical grocery stores also could solve some hurdles to growth. “Amazon has a fundamental barrier to its organic growth, and that is that there are may be millions of customers who can’t participate in e-commerce either outright or who find it inconvenient,” said Cohen. “That’s largely because they don’t have a place a package can be delivered because no one’s home and they’re not comfortable or in any way or willing to have something left on a doorstep.”

Physical locations are helpful also for folks who cannot buy online because they don’t have or cannot get credit cards — or don’t want to use them. “Having a network of locally convenient places with which to interact with those customers like an Amazon grocery convenience store that will accept cash would give them access to an enormous number of customers who very well might want to do business with Amazon but who can’t at the moment.”

Testing Bricks-and-Mortar

Amazon’s supermarket plans follow other forays into physical stores, the biggest of which thus far was its June 2017 purchase of Whole Foods for $13.7 billion. It gave Amazon nearly 470 stores, including about 20 in Canada and in the U.K. Six months ago, the company launched Amazon 4-star stores that carry the most popular products from its online store, including consumer electronics, devices, toys, books and home items.

In January 2018, it opened Amazon Go convenience stores where consumers take what items they want and leave without seeing a cashier or checkout counter. Sensors track their purchases, which are automatically charged to their Amazon accounts. There are now 10 Amazon Go stores with more to open soon. In addition, the company has opened 17 Amazon Books locations. Amazon also has Pop-Up stores in malls, Whole Foods and Kohl’s, but it is closing all 87 of them because the format didn’t work out.

As for its coming supermarkets, Amazon could redesign the traditional grocery format. Typically, staples like milk purposely are placed in the back so shoppers will spend more time in the store. Kahn said Amazon CEO Jeff Bezos could have a different design in mind. He could say, “Let us design the store so you can find what you want as fast as you need to find it and get in and out of there,” she said. “I bet once they start working on it and use their data, they will change things that make sense from the customer perspective. So that’s going to be pretty cool to see.”

The Journal said Amazon’s supermarket concept strongly resembles ideas from a 2013 report by former Deloitte consultant Brittain Ladd, who now works for AmazonFresh. That report sees Amazon’s supermarkets combining its discounting strategy with online capabilities, adding drive-through grocery pick-up and placing Amazon Lockers inside. The goal is to create “an ecosystem of channels centered on food and groceries capable of meeting the needs of all customers through all available channels,” he wrote.

As for concerns that Amazon is entering a low-margin business, Cohen said it doesn’t have to be problematic. “They view that as an opportunity in many cases,” he said. “At the end of the day, I think this is [about] creating more and more of an efficient connection to customers, especially those who they’re not doing business with, who would like to do business with them.”

Dynamic Pricing

Kahn said one of Amazon’s dilemmas in selling groceries is how to manage the costly effort of delivering to each home and business, the so-called ‘last mile.’ Amazon has to deliver because until it purchased Whole Foods, it didn’t have a lot of stores where people can shop, unlike traditional supermarkets. Walmart got into the grocery business and handled the industry’s thin margins by focusing on “operational excellence” to lower its costs. “They are a low-cost supply chain master,” she said.
Amazon’s priority is customer convenience. But deliveries can be quite costly because they’re inefficient, Kahn said. Therefore, opening more physical grocery stores could work so there will be more places for customers to pick up their orders. “They need it because their model is so different from a typical operationally-excellent grocery business,” Kahn added.

Moreover, Amazon will find it tough to convince competing bricks-and-mortar retailers to let it open one of its Lockers in their stores. Amazon has been “aggressive in trying to place those lockers throughout the realm. Many stores just don’t have room for them and some don’t really want Amazon delivering through a locker [the same products] they’re trying to sell,” Cohen said. “Amazon is not likely to convince Target to install Amazon Lockers, unless some incredible combination occurs.”

By opening its own stores, Amazon also gets control over pricing and margins. Kahn pointed out that it already uses “dynamic” pricing. At Amazon 4-star stores, prices are in digital form and match the ones on its website. However, the prices “can change as things happen,” she said.

Similarly, at Amazon Books, no prices are displayed. Instead, customers have to open up the Amazon app to find how much the books cost. This way, Amazon could play with the pricing too, perhaps setting different prices for Prime and non-Prime members. “In both of those ways — with ‘price’ and ‘place’ — Amazon is redefining the model,” Kahn said


Toward a New Global Charter

Whereas the failure to forge a lasting world order at Versailles resulted in the catastrophe of World War II, the establishment of shared principles under the 1941 Atlantic Charter led to eight decades of prosperity and relative stability. With the world undergoing another geopolitical sea change, a new global charter is needed.

Carl Bildt

gavel map


STOCKHOLM – In August 1941, even before the United States had entered World War II, British Prime Minister Winston Churchill and US President Franklin D. Roosevelt met secretly off the coast of Newfoundland to discuss how the world could be organized after the war. A similar feat had been attempted at Versailles just over two decades earlier, but it had clearly failed.

Churchill and FDR’s assignation resulted in the Atlantic Charter, which established a set of shared principles and institutions that still define the international order eight decades later. In 1944, the Bretton Woods conference laid the groundwork for the International Monetary Fund, the World Bank, and other global financial institutions; the establishment of the United Nations soon followed. The defeated Axis powers were transformed into dynamic democracies with market economies, and were integrated into the new global system, while stability was maintained through cooperative security structures spanning the transatlantic and Pacific theaters.

Then came China’s economic reforms, starting in the late 1970s, and the collapse of the Soviet Union in 1991, whereupon the dream of truly global multilateral governance as envisioned in the Atlantic Charter could start to be realized. In 1995, the Bretton Woods-era General Agreement on Tariffs and Trade was replaced with the World Trade Organization, and in under two decades, trade as a share of global GDP has grown from around 40% to over 70% (owing in no small part to China’s accession to the WTO in December 2001).

During this golden age of multilateralism, globalization, and social and economic development, more than one billion people were lifted out of extreme poverty, and democracy became the global norm. But it is clear that the second decade of the twenty-first century has marked the advent of a different era. Memories of the international order’s formative years, and of the tragedies that made it necessary, have faded with the passing of generations. New powers have emerged to challenge Western dominance within an increasingly multipolar context. And the recent proliferation of authoritarian regimes has raised questions about the future of democracy.

Though the basic structures of the post-war order remain in place, they are being hollowed out in the face of Russian revisionism, Chinese assertiveness, US disruption, and European uncertainty. With the goal of revising the principles of the Atlantic Charter for this dangerous new world, two prominent think tanks, the Atlantic Council in the US and the Centre for International Governance Innovation in Canada, recently convened policymakers and thinkers, including me, from 19 different countries.

When attempting to draft a new set of shared principles, the biggest challenge is in deciding whether to make them applicable just to the world’s democracies, or also to the likes of Russia, China, and Saudi Arabia. Obviously, democracy is by far the best way to ensure that individual rights are respected; but the debate also should be open to those advocating different values and interests. In our case, we wanted to produce a document that would resonate both in the “classical West” as well as in Brazil, Algeria, Iran, India, Indonesia, and Vietnam.

Our deliberations resulted in a Declaration of Principles that we issued at the Munich Security Conference last month. “Inspired by the inalienable rights derived from our ethics, traditions, and faiths,” the declaration reads, “we commit ourselves to seek a better future for our citizens and our nations. We will defend our values, overcome past failures with new ideas, answer lies with truth, confront aggression with strength, and go forward with the confidence that our principles will prevail.”

The full declaration comprises seven statements under the headings of “freedom and justice,” “democracy and self-determination,” “peace and security,” “free markets and equal opportunity,” “an open and healthy planet,” “the right of assistance,” and “collective action.” In each area, our goal was to set down principles that might serve as the tenets of a new consensus after an inclusive global debate.

The declaration is not merely a restatement of previously held beliefs. Environmental issues clearly have become more prominent than they were before, and questions of sovereignty must be reframed for an increasingly interconnected and interdependent world. Concerns about how prosperity is shared both within and between countries have gained significant currency.

But basic values such as respect for individual rights remain fundamentally important, as does the belief that “governments that answer to their citizens and respect the rule of law can best address inequity, correct injustice, and serve the good of all.” Indeed, governments ignore this proviso at their peril.

As the fruit of a year’s worth of discussions and revisions, the declaration has received broad support from different corners of the world. But our goal is to start a larger debate, not to have the final word. We are under no illusions that it will rival the Atlantic Charter in terms of its historical impact. But nor do we have any doubts as to the urgency and necessity of a new discussion about the basic principles of global governance. Without such a debate, the old order will continue to decay, to be replaced by a Hobbesian jungle ruled by sheer power and narrow self-interest. We all know how that turned out last time.


Carl Bildt was Sweden’s foreign minister from 2006 to October 2014 and Prime Minister from 1991 to 1994, when he negotiated Sweden’s EU accession. A renowned international diplomat, he served as EU Special Envoy to the Former Yugoslavia, High Representative for Bosnia and Herzegovina, UN Special Envoy to the Balkans, and Co-Chairman of the Dayton Peace Conference. He is Chair of the Global Commission on Internet Governance and a member of the World Economic Forum’s Global Agenda Council on Europe.


American Universities Are in Crisis

Elite universities are once again looking for social conformists rather than disrupters.

By George Friedman

 

Last week, dozens of wealthy parents were charged for allegedly paying a firm to cheat on college entrance exams or bribe officials to get their children accepted into elite colleges. The number of people involved in the scam is small, so the case itself has proved little except that all human institutions can be corrupted. But there’s a broader point that must be considered. This case is an indicator of a profound crisis at American universities. I know that profound crises have become a dime a dozen, manufactured by people like me with writing deadlines, but I ask you to bear with me.

We live in a knowledge-based economy. Our universities are the social institutions designed to produce and educate the next generation that will participate in that economy. But the best universities do more than this. They teach those outside elite circles the manners and customs of power. They allow them to meet others who will form the networks of authority that are indispensable to society. If you go to Harvard, you likely won’t learn any more about biology in your freshman year than you would at a state school. But you will learn something that isn’t taught by professors but is still vitally important: how to fit into the structure and customs of influence.

Harvard is blunt about this, though it might be unaware how blunt it is. The school’s website lists several factors considered in the admissions process. One is particularly striking: “Would other students want to room with you, share a meal, be in a seminar together, be teammates, or collaborate in a closely knit extracurricular group?” In other words, the school wants to know if an applicant will conform to the social order. Eccentrics and non-conformists – people who have radically different views that might be offensive to some – are not really welcome. There is, of course, always the socially acceptable oddity, but the real outlanders, the ones who have beliefs or interests that would cause them not to attract roommates, are screened out.

According to the Harvard Crimson student newspaper, about 12 percent of Harvard’s student body is Republican. But it’s unlikely students with conservative views would, for example, wear MAGA hats or organize pro-life rallies because most students likely wouldn’t want to room with them if they did, and that would make them a bad fit for Harvard. What’s missing in all this is the idea that you should be required to work and learn with people who you profoundly disagree with and face the fact that those who disagree with you may be not only reasonable but even right.

Many will leap on the political imbalance in the student body, but the more important issue is that Harvard bases its admissions policy on social conformity. And in doing so, it undermines one of its most important claims: that it promotes social diversity. As in the 1920s, elite schools now are looking for students who would fit in, not those who have different or uncomfortable perspectives on life. It should be the role of a university to, as H.L. Mencken and others said about newspapers, “comfort the afflicted and afflict the comfortable.”

The American university system was transformed after World War II by the GI Bill, which provided educational assistance to veterans. They flooded the nation’s universities and were admitted into some of its top schools. They did superbly and created the mass professional class that powered the nation through the 1970s. The GIs were mostly men, many of whom faced the abyss and saw it smile back at them. Many others had not been in combat but understood discipline and knew that life did not have to be pleasant, but had to be lived. They had to live with strangers they may not have liked. They never expected to be surrounded only by people who had similar views and experiences as they did. They understood diversity in a personal way and were there to learn the skills they would need in the next phase of life.

During this time, money flowed into universities from the federal government. The Manhattan Project, the U.S.-led effort to develop an atomic bomb, turned universities into centers for national security research. They were an integral part of American life and, in the 1950s and 1960s, included the best of Europe’s emigre scholars. While teaching for a short time at Louisiana State University in the mid-1990s, I remember discovering that the legacy of German political philosopher Eric Voegelin, who fled Germany in the 1930s and taught as LSU, was still alive and well.

When I went to college, candidates were still judged on their merits, but the ideological battle had already surfaced at Cornell and was developing into a discussion of what was and wasn’t socially acceptable at Harvard. Having the wrong point of view (and I always seemed to have the wrong point of view) could get you barred from grad school parties, and debates on the Vietnam War began redrawing the lines of propriety as they had been before the war.

Today, that divide seems even deeper. According to a study cosponsored by the College Board, there are 800,000 veterans or family members of veterans enrolled in U.S. colleges under the Post-9/11 GI Bill. Only 722, however, are enrolled at the country’s 36 most selective universities. That’s a stunning reversal of the numbers under the previous GI Bill. What that bill broke open more than 70 years ago is now closed.

This is part of the nation’s upward mobility problem. The lower-middle class has an average annual income of about $35,000. That leaves a take-home pay of about $2,500 a month, barely enough to rent an apartment, much less buy a house. I grew up in a lower-middle-class family. We had a small house and a car, but these days, that would be nearly impossible. For families facing such circumstances, getting a university education gives some hope that they’ll be able to improve their lot in life. Some of these students may even have the qualifications to get into an elite college, but the question remains whether they would be accepted in such schools. Would, say, a devout Catholic from a lower-middle-class home in Michigan be welcomed at Harvard? Would the university support such diversity?

Here’s a radical idea. I taught political philosophy for many years, and I noted that my students were less than thrilled to prowl through Plato. At 19 years old, a student’s hormones are raging and the desire to be liked by others is at its peak. Plato has little to do with any of this. The idea of going to university at this age originated in the Middle Ages when the university was created and life expectancy was in the mid-30s. Now, life expectancy is about 80, and a 40-year-old would be far more willing to learn about Plato than a 19-year-old. A 40-year-old student can understand the importance of justice; a 19-year-old can understand only that class will be over shortly.

Universities are failing in two ways. First, they have slipped back into the role of gatekeeper for the conformists. Second, they seem incapable of playing their historic role in not just promoting upward mobility but integrating the brightest of the poor with the existing elite. That was a vital function, and as everyone knows, unrest begins when the most intelligent youngsters have no hope left.

The university has become the major bar to the kind of social ferment the United States has always enjoyed. The problem started when universities stopped focusing on achievement and tried to admit students based on personal characteristics that were impossible to verify. The result was inevitable. They recruited students who were intelligent, likeable and liked. Plato wrote about Socrates, who was put to death for being an ass. I guess he wouldn’t have been accepted into Harvard either.


Full Capitulation

Doug Nolan


April 16 – Bloomberg (Rich Miller and Craig Torres): “Federal Reserve Chairman Jerome Powell and his colleagues have made an important shift in their strategy for dealing with inflation in a prelude to what could be a more radical change next year. The central bank has backed off the interest-rate hikes it had been delivering to avoid a potentially dangerous rise in inflation that economic theory says could result from the hot jobs market. Instead, Powell & Co. have put policy on hold until sub-par inflation rises convincingly.”

April 15 – CNBC (Thomas Franck): “Chicago Federal Reserve President Charles Evans said on Monday that he’d be comfortable leaving interest rates alone until autumn 2020 to help ensure sustained inflation in the U.S. ‘I can see the funds rate being flat and unchanged into the fall of 2020. For me, that’s to help support the inflation outlook and make sure it’s sustainable,’ Evans told CNBC’s Steve Liesman.”

April 15 – Reuters (Trevor Hunnicutt): “The U.S. Federal Reserve should embrace inflation above its target half the time and consider cutting rates if prices do not rise as fast as expected, a top policymaker at the central bank said… ‘While policy has been successful in achieving our maximum employment mandate, it has been less successful with regard to our inflation objective,’ Federal Reserve Bank of Chicago President Charles Evans said… ‘To fix this problem, I think the Fed must be willing to embrace inflation modestly above 2% 50% of the time. Indeed, I would communicate comfort with core inflation rates of 2-1/2%, as long as there is no obvious upward momentum and the path back toward 2% can be well managed.”

It's stunning how dramatically the Fed’s perspective has shifted since the fourth quarter.

There’s now a chorus of Fed governors and Federal Reserve Bank Presidents calling for the central bank to accommodate higher inflation. Watching the inflation data (March CPI up 1.9% y-o-y), it’s not readily apparent what has them in such a tizzy. And with crude prices surging 40% to start 2019, it takes some imagining to see deflationary pressures in the pipeline.

The Fed’s (and global central banks’) dovish U-turn was clearly in response to December’s global market instability. Quickly, the global system was lurching toward the precipice. Acute fragility revealed – and central bankers were left shaken. And witnessing the speculative fervor that has accompanied central bankers change of heart, the backdrop is increasingly reminiscent of Bubble Dynamics following the 1998 LTCM bailout. A Bloomberg headline from earlier in the week caught my attention: “Evans Sees Lessons From 1998 Rate Cuts for Fed Policy This Year.” It said, “For the Chicago Fed president Charles Evans the situation recalls the Asian financial crisis of 1998. According to Evans, ‘The risk-management approach taken by the Fed is not unusual. It served us well in similar situations in the past.’”

Historical revisionism. For starters, the Asian crisis was in 1997. The Fed aggressively reduced rates from 5.50% to 4.75% in the Autumn of 1998 in response to the simultaneous Russia and Long-Term Capital Management (LTCM) collapses.

From Evans’ April 15, 2019 speech, “Risk Management and the Credibility of Monetary Policy:”

“Later, in the autumn of 1998, the fallout on domestic financial conditions from the Russian default led to a downgrading of the economic outlook and an aggressive 75 basis point easing in the funds rate over a two-month period. When making the first of those cuts, the FOMC noted that easing would ‘provide added insurance against the risk of a further worsening in financial conditions and a related curtailment in the availability of credit to many borrowers.’”

Clearly many borrowers – and the system more generally - should have faced much tighter Credit Availability by late-1998 – certainly including those aggressively partaking in leveraged speculation (equities, fixed-income and derivatives) and debt gluttons in the real economy - including the highly levered telecom companies (i.e. WorldCom, Global Crossing, XO Communications and a long list) and others (i.e. Enron, Conseco, PG&E, etc.).

Evans, not surprisingly, skips over LTCM. That the Fed orchestrated a bailout of this renowned hedge fund sent a very clear message that the Federal Reserve and global central banks were there to backstop the new financial infrastructure that was taking control of global finance (Wall Street firms, derivatives, the leveraged speculating community, Wall Street structured finance and securitizations). If the Fed had allowed the system take the harsh medicine in 1998 the world would be a much safer place today.

Evans: “How did this risk-management strategy turn out? In the end, the economy weathered the situation well. Productivity accelerated sharply, and by early 1999 growth was on a firm footing. Subsequently, the FOMC raised rates by a cumulative 175 basis points by May of 2000.”

Evans leaves out the near doubling of Nasdaq in 1999, along with what I refer to as “terminal phase” Bubble excess. The bottom line is the Fed aggressively loosened policy while the system was in the late-stage of a significant Bubble, and then failed to remove this accommodation until mid-November 1999.

And let’s not forget that the subsequent bursting of the so-called “tech bubble” led to what was, at the time, unprecedented monetary stimulus – including Dr. Bernanke’s speeches extolling the virtues of the “government printing press” and “helicopter money.” These measures were instrumental in fueling the mortgage finance bubble that burst in 2008. That collapse then led to a decade-long – and ongoing - global experiment in zero rates, open-ended money-printing and yield curve manipulation.

This whole fixation on deflation risk and CPI running (slightly) below target gets tiring - after a few decades. Clearly, the evolution to globalized market-based finance has profoundly altered the nature of inflation. CPI is no longer a paramount issue – especially with the proliferation of new technologies, the digitization of so much “output,” the move to services-based economies and, of course, globalization. There is today a virtual endless supply of goods and services – certainly including digital downloads, electronic devices and pharmaceuticals – that exert downward pressure on aggregate consumer prices. Importantly, consumer price indices are no longer a reliable indicator of price stability, general monetary stability or the appropriateness of central bank policies.

Central bank officials today lack credibility when they direct so much attention to consumer price inflation while disregarding the overarching risks associated with unrelenting global debt growth, highly speculative and leveraged global financial markets, and deep global economic structural maladjustment. In the grand scheme of things, consumer prices running just below target seems rather trivial. What’s not trivial are central bankers that now appear to have accepted that they will accommodate financial excess and worsening structural impairment. At this point, it appears Full Capitulation.

In the same vein (and same day) as Evans’ speech, former President of the Federal Reserve Bank of Minneapolis, Narayana Kocherlakota, posted a Bloomberg editorial: “The Fed Needs to Fight the Next Recession Now. Its tools are limited, so the central bank must compensate by being aggressive.”

“Almost 10 years after the Great Recession ended, the growing threat of a new economic slowdown raises a troubling question: When the next recession strikes, what can the world’s central banks do? With interest rates low and their balance sheets still loaded with assets bought to fight the 2008 crisis, do they have the tools to respond? ‘What, then, can the Fed do?’ In my view, it needs to be much more aggressive in using the limited tools that it has. For one, if your medicine chest is nearly empty, you want to keep your patient as healthy as possible. That means cutting interest rates now to lower the unemployment rate even further. Doing so could also boost demand during any recession: If people come to expect stronger recoveries, they will be more likely to keep spending even in downturns. A pre-commitment to strong growth could also help. In the last recession and ensuing slow recovery, the Fed treated its low-interest-rate policy largely as an emergency step that would be removed within the next year or two. Instead, the Fed should publicly commit now to maintain maximum stimulus after a recession until the unemployment rate falls below 3%, as long as the year-over-year core inflation rate remains below 2.5%. Such a promise, much stronger than any used or even suggested during the last recovery, would help minimize the damage and speed up the rebound.”

It’s simply difficult to believe such analysis resonates – yet it sure does. These are strange and dangerous times. Kocherlakota: “If your medicine chest is nearly empty, you want to keep your patient as healthy as possible.” Noland: If you’re running short of medicine, you better not encourage your patient to live a reckless lifestyle. You certainly don’t want to convince the foolhardy that you possess an elixir that will cure whatever ails them. These central bankers have really lost their minds: What they administer is anything but medicine.

Such central bank crazy talk should have longer-term bonds beginning to sweat. But, then again, bond markets are confident that central bankers from across the globe will be buying plenty of bonds over the coming months and years. When central bankers talk about accommodating higher inflation, bonds hear “more QE”. And while safe haven bonds may not be overjoyed at the thought of CPI creeping higher, they remain more than fine with bubbling risk markets – prospective bursting Bubbles ensuring only more expansive QE programs. The so-called U-turn marked an inflection point from a meek attempt to return central banking to sounder principles - to a decisive breakdown in any semblance of responsible monetary management.

I was convinced in ‘98 the Fed was committing a major policy error. Like today, the Fed and global central bankers were afraid of global fragilities. Yet markets and economies do turn progressively fragile after years of excess. These days, I worry about what central bankers have unleashed with their ultra-dovishness in the face of historic late-stage global Bubble “terminal excess.”