The Rate Cut the Economy Doesn’t Need — but the Markets Do

By Randall W. Forsyth

Photograph by Andrew Harrer/Bloomberg

“Who are you going to believe, me or your own eyes?” That is a quote at the core of Marxist ideology from the most eminent of its authors, Groucho.

And that is a question that the Federal Open Market Committee must confront when it gathers on Tuesday and Wednesday for its highly anticipated meeting. Expectations run high that the Federal Reserve’s policy-setting panel will signal it is ready to lower its key policy interest rate, if not at this gathering, then at the next one, at the end of July.

What seems out of sync with the rising calls for rate reductions is that the U.S. economy and stock market both seem to be doing better than OK, thank you, as the expansion and bull market celebrate their 10th anniversaries. Unemployment is around the lowest level in a half-century. The worst thing seems to be that inflation continues to run slightly below the Fed’s 2% target, a problem that might strike some as similar to being too rich or too thin.

Nevertheless, the federal-funds futures market is pricing in three 25-basis-point reductions in the central bank’s target, from the current 2.25% to 2.50% range, by as soon as year end. (A basis point is 1/100th of a percentage point.) A move is unlikely at this coming week’s confab, although the futures market puts a nontrivial 25.8% chance for a reduction. In contrast, there’s an overwhelming 86.4% probability of a cut at the July 30-31 FOMC meeting, according to CME Group’s FedWatch site. Futures traders have priced in additional 25-basis-point decreases at the Sept. 17-18 and Dec. 10-11 meetings.

Yet these potential Fed rate drops would come while the economy is growing at roughly its long-term trend, which admittedly is a downshift from last year’s tax-cut-boosted 2.9% pace. That said, global growth does face a clear and present danger from tariffs and trade wars, which already are exerting a drag on corporate outlooks. But how much can reductions in already-low interest rates do to offset the contractionary forces on trade?

Those arguing for more monetary accommodation contend that the economic data provide a rear-view mirror image of what has happened. Forward-looking indicators, notably the yield curve, are flashing warning lights that have signaled past slowdowns and should be heeded. Too-low inflation also can become embedded in consumer and business expectations, which then persistently hurt growth, as Japan has demonstrated.

The Fed insists that its policy decisions are data-dependent. The data look good, even if some recent numbers don’t look great, including the disappointing 75,000 increase in nonfarm payrolls in May, about 100,000 shy of forecasts. But a stronger-than-expected rise in May retail sales of 0.5%, plus upward revisions in previous months, has gross domestic product on track to expand at a 2.1% annual clip in the current quarter, according to the Atlanta Fed’s GDPNow tracker, up sharply from its previous estimate of 1.4%, made on June 7.

That would be below the first quarter’s preliminary GDP growth of 3.1%, but the underlying components of the data actually seem to be improving.

Real personal-consumption expenditures, which account for more than two-thirds of the economy, are climbing at a 3.9% annual pace in the current quarter, the Atlanta Fed estimates, an upward revision from 3.2% previously and triple the 1.3% in the supposedly sterling first quarter.

In its previous Summary of Economic Projections, released at the March 19-20 FOMC meeting, the panel’s central forecast for GDP growth this year was 1.9% to 2.2%, a shade above its longer-run estimate of 1.8% to 2%. So the economy would appear to be expanding in line with the Fed’s expectations.

The job market doesn’t seem to be laboring. Despite the smaller gain in payrolls, the 3.6% unemployment rate harkens back to the glory days of the Apollo moon landing and Woodstock. The jobless rate is a lagging indicator, but new claims for unemployment insurance, a leading indicator, also hover near half-century lows. Other surveys find more job openings than applicants, and small businesses having trouble finding qualified employees. Average hourly earnings are growing at a better-than-3% pace. And that might understate wage gains, as prime-age workers make up a higher proportion of the workforce and higher-paid baby boomers retire.

Inflation seems to be the Fed’s main bugaboo, as it remains persistently below the 2% the solons view as the right number. Their favorite measure, the “core” personal consumption deflator, which excludes volatile food and energy prices, is running at just 1.5%. But “trimmed mean” measures of inflation—which throw out aberrant inputs that Fed Chairman Jerome Powell has called “transitory”—are trending much closer to the 2% target.

The Fed also has emphasized the trimmed-mean personal-consumption expenditures indicator lately, which J.P. Morgan economists find useful in predicting PCE inflation over the course of an economic cycle. And those expenditures are remaining around 2%, suggesting no great shortfall in inflation. That has been corroborated by other measures that attempt to reduce the influence of outlier prices. The Cleveland Fed’s mean consumer-price index has shown no easing in inflation, while its median consumer-price index suggests an upward trend, in contrast to the core CPI’s deceleration.

That contrasts with early 2017, when all three CPI measures fell sharply.

One alternative measure of inflation that has shown distinct moderation is the Economic Cycle Research Institute’s U.S. Future Inflation Gauge, which this column highlighted last year to suggest that the Fed might be overdoing rate increases. The institute suggests this has turned down before rate cuts were begun in past cycles.

But the most widely cited indicator pointing to Fed rate cuts has been the bond market, and the yield curve, in particular. The three-month Treasury bill’s yield has remained above that of the 10-year note for five weeks—historically a harbinger of economic downturns. The decline in bond yields has been global and might largely be attributable to factors outside the Fed’s control, notably trade frictions. 

Indeed, nearly $12 trillion in negative-yielding bonds is outstanding, according to Deutsche Bank, with the 10-year German Bund (the benchmark for European bonds) trading at a record minus 25 basis points. That surely exerts a gravitational pull on U.S. bond yields. They stand out globally among top-grade securities, with the 10-year Treasury at 2.08%.

That’s below the 2.18% from a three-month T-bill and even further from the 2.25% low end of the Fed’s target range for overnight fed funds. The implication is that the central bank is holding up the fed-funds rate in the face of market forces pulling down other rates. (For more on this, see this week’s Economy column.)

But there might be another factor behind the near-unanimous calls for the central bank to trim rates. Almost every asset class—stock, bonds, and real estate—is richly priced, compared with rates on cash equivalents. Lowering money-market rates would make asset prices seem less inflated. And that’s the one sort of inflation nobody seems worried about being too high.

There seems to be a lot of confidence—or possibly complacency—that the Fed will fulfill market expectations and signal the rate reductions predicted by fed-funds futures. Those sentiments are borne out in another corner of the derivatives market, futures on the VIX index, the so-called fear gauge measuring volatility on the S&P 500index.

There is a high speculative short position in VIX futures, according to the J.P. Morgan global markets strategy group, led by Nikolaos Panigirtzoglou. Those are bets on continued low volatility; in other words, wagers that nothing will go wrong. The last times such bullish sentiment was apparent were in January and September 2018, when the best-laid plans of low-volatility bettors went spectacularly awry.

As a result, the equity market could be vulnerable to a “more cautious and patient Fed,” which could trigger a correction, the bank’s strategists write in a client note. Even a truce in the U.S.-China trade war would be viewed as only a neutral outcome at the next big market event, the Group of 20 meeting in Japan on June 28 and 29, while a breakdown in trade talks would be a negative, they add.

Complacency is evident elsewhere in the equity market, which the JPM team figures is pricing in a mere 6% chance of a recession, in contrast to the 60% probability that they reckon is implied by the five-year Treasury note’s yield of just 1.83%, well below the three-month T-bill’s 2.18%.

The consensus earnings estimate of $167 for the S&P 500 companies is far from the contraction likely in a recession, they add, and 3% above the benchmark index’s tax-cut inflated profits last year.

The markets are likely to be caught in a tug of war between the positives from falling bond yields and the negatives from sliding earnings estimates, says Cliff Noreen, head of global investment strategy at MassMutual, the big insurer. Look for trade and tariff issues to come up in earnings warnings, as it has at Broadcom(ticker: AVGO), which slashed 2019 revenue guidance, owing to a broad-based slowdown in chip demand and export restrictions.

Strategists with year-end S&P 500 targets of 3000 or higher (just a 4% gain from Friday’s close of 2886.96) are implying a relatively rich 18 price/earnings ratio, facilitated by low bond yields. 

Meanwhile, initial public offerings are partying like it’s 1999 (see Tech Trader). No wonder Wall Street hopes that the Fed spikes the punch bowl.

A Greek Canary in a Global Goldmine

After 2008, Greece came to symbolize global capitalism’s failure to balance credit and trade flows. Today, as the global mismatch between economic reality and financial returns grows, there is clear danger that, once again, the country is foreshadowing a new phase of the global crisis.

Yanis Varoufakis


ATHENS – The eurozone country that has become synonymous with insolvency is today proving to be a treasure-trove for some. Traders who bought Greek assets a few years ago have good reason to celebrate, having banked returns that no other market could have provided. But, as is often the case, an opportunity that seems too good to be true probably is. And this one could portend the next phase of our global crisis.

An investor who bought German government bonds in 2013 has, by now, gained a 7% return, whereas a buyer of a Greek government bond issued at the height of the country’s debt crisis in 2012 would have earned a colossal 231% return. Two months ago, the price of the first ten-year bond issued since Greece’s bailout in 2010 surged for seven consecutive days, rising by 2.8% in a week – a better performance than any other government bond issue worldwide. That bond rally created a psychological slipstream, which, in recent months, pulled the Athens Stock Exchange 26% higher, against the background of a European asset market inexorably bleeding capital.

On the strength of these impressive numbers, it is as tempting as it would be false to herald the end of Greece’s crisis. The Greek bond and equity rally is obscuring a growing chasm between a gloomy economic reality and an unsustainably buoyant financial climate. Rather than reflecting Greece’s recovery, the traders’ high profit margins mirror continued deflationary pressures and fragmentation in Europe within a global environment of decreasing debt sustainability. The numbers from Greece, so exciting to investors far and wide, may well prove a harbinger of fresh troubles for Europe’s economy, and perhaps for the world.

Given the gaping gap between Greece’s nominal national income and its public debt, how is it possible that Greek bonds are soaring? Why is the Athens Stock Exchange rising while business remains hampered by punitive taxation, banks labor under a mountain of non-performing loans, declining unemployment reflects only emigration and some precarious jobs, net public investment is negative, and private investment in production of high value-added tradable goods is absent?

One reason is the proverbial dead-cat-bounce. Given how thin Greece’s equity market is – total capitalization is €52 billion ($58 billion) – the modest influx of capital that came in the wake of the bond rally was enough to drive the 26% rise in its index. But, despite this surge, the Greek market remains 81% below its 2009 level. As for the bond rally itself, the paradox quickly disappears once we recall how the first two bailouts shifted Greek public debt from the private sector to the shoulders of Europe’s taxpayers.

With 85% of Greece’s debt outside the markets, repayments deferred until after 2032, and another €30 billion of official loans extended to the Greek government to cover its repayments to all comers, investors can focus on the small slice of Greece debt that remains in private hands. As long as the Greek government is subservient to Europe’s authorities, traders cannot lose money on bonds it issues at interest rates of more than 3%, at a time when German bund yields are hovering near zero.

Determined to remain upbeat, most commentators point out, for example, that average Greek debt maturity is 26 years, in sharp contrast to seven years for Italy and Spain or ten years for Portugal, giving Greece’s economy the chance to recover properly. What they neglect to mention are the impossible austerity conditions that Greece’s creditors attached to that extension: a permanent primary budget surplus (excluding debt repayment) of 2.2-3.5% of GDP until 2060. In other words, Greek businesses will have to continue paying 75% of their profits to the government (including social security contributions), on average, while the total tax burden in neighboring Bulgaria is no more than 22%.

In short, Greece has gone from being Ground Zero of the eurozone crisis, and the best example of its mismanagement by the EU authorities, to a perfect example of how financial exuberance can ride on the back of economic misery. This disparity’s most worrying aspect is that profit-driven traders are not wrong to snap up the paper assets of a sinking country. From their short-term perspective, it’s an irresistible play – and their bottom line confirms this. But it is wrong, even reckless, to conclude that, because traders are making a mint with Greek assets, the underlying reality must be improving.

The rest of the world would benefit from viewing this disconnect as a symptom of a global predicament. In June 2017, Argentina issued a 100-year bond worth $2.75 billion that sold like hot cakes on the strength of great, and greatly mistaken, expectations of the Argentine economy’s prospects under a new neoliberal administration. While those trades have already proved foolhardy, there is hard evidence that average total returns to investors are higher when they buy the debt of countries that default more frequently. But financiers’ penchant for investing in low-quality debt and talking up non-existent opportunities is most dangerous when applied to private, as opposed to public, debt.

During the first three months of this year, a stupendous 40% of all loans to highly indebted companies in the United States went to the least solvent. According to the Federal Reserve, this over-leveraged lending increased 20.1% in 2018, while other sources report a deterioration in underwriting standards. Credit is being channeled to low-rated, heavily indebted companies, overshadowing the safer high-yield bond market as a source of financing. According to LCD, a division of S&P Global Market Intelligence, the leveraged loan market has now exceeded $1.2 trillion, overtaking traditional junk bonds and undermining less risky covered bonds.

Greece is in the vanguard of this trend, attracting fair-weather, shallow, speculative trades, while patient investment in its economic recovery is nowhere to be seen. After 2008, Greece came to symbolize global capitalism’s failure to balance credit and trade flows. Today, as the global mismatch between economic reality and financial returns grows, there is clear danger that, once again, the country is foreshadowing a new phase of the global crisis. When vultures grow fat on a corpse, they do not revive it.

Yanis Varoufakis, a former finance minister of Greece, is Professor of Economics at the University of Athens.

Studies Show

How Much Alcohol Can You Drink Safely?

By Kim Tingley

Credit Illustration by Celia Jacobs

Humans have been drinking fermented concoctions since the beginning of recorded time. But despite that long relationship with alcohol, we still don’t know what exactly the molecule does to our brains to create a feeling of intoxication. Likewise, though the health harms of heavy drinking are fairly obvious, scientists have struggled to identify what negative impacts lesser volumes may lead to. Last September, the prestigious peer-reviewed British medical journal The Lancet published a study that is thought to be the most comprehensive global analysis of the risks of alcohol consumption. Its conclusion, which the media widely reported, sounded unequivocal: “The safest level of drinking is none.”

Sorting through the latest research on how to optimize your well-being is a constant and confounding feature of modern life. A scientific study becomes a press release becomes a news alert, shedding context at each stage. Often, it’s a steady stream of resulting headlines that seem to contradict one another, which makes it easy to justify ignoring them. “There’s so much information on chocolate, coffee, alcohol,” says Nicholas Steneck, a former consultant to the Office of Research Integrity for the U.S. Department of Health and Human Services. “You basically believe what you want to believe unless people are dropping dead all over the place.”

Scientific studies are written primarily for other scientists. But to make informed decisions, members of the general public have to engage with them, too. Does our current method of doing so — study by study, conclusion by conclusion — make us more informed as readers or simply more mistrustful? As Steneck asks: “If we turn our back on all research results, how do we make decisions? How do you know what research to trust?” It’s a question this new monthly column aims to explore: What can, and can’t, studies tell us when it comes to our health?

The truth is, putting alcohol research in context is tricky even for scientists. The Lancet study is epidemiological, which means it looks for patterns in data related to the health of entire populations. That data might come from surveys or public records that describe how people behave in their everyday environments, settings that scientists cannot absolutely control.

Epidemiological studies are a crucial means of discovering possible relationships between variables and how they change over time. (Hippocrates founded the field when he posited an environmental rather than a supernatural cause for malaria, which, he noted, occurred most often in swampy areas.) They can include millions of people, far more than could be entered into a randomized-control trial. And they are an ethical way to study risky behaviors: You can’t experiment by randomly assigning groups of people to drive drunk or sober for a year.

But because epidemiologists can only observe — not control — the conditions in which their subjects behave, there are also a vast and an unknown number of variables acting on those subjects, which means such studies can’t say for certain that one variable causes another.

CreditIllustration by Celia Jacobs

Modern epidemiology took off in the 1950s and ’60s, when public-health researchers in the United States and Britain began long-term studies tracking a wide variety of health factors in thousands of people over decades and surveying them about their behavior to try to identify risks. What they found when they looked at alcohol consumption in particular was puzzling: People who reported being moderate drinkers tended to have a lower risk of mortality and many specific health problems than abstainers did. Did this mean that a certain amount of alcohol offered a “protective” effect? And if so, how much? In 1992, an influential study in The Lancet observed that the French had a much lower risk of death from coronary heart disease than people in other developed countries, even though they all consumed high levels of saturated fat. The reason, the authors proposed, was partly that the French drank significantly more wine.

The notion that alcohol may improve heart health has persisted ever since, even as further research has revealed that it can cause cancer and other health problems and increase the risk of injury and death. But equally plausible counterhypotheses also emerged to explain why teetotalers fared worse than moderate drinkers. For instance, people might abstain from alcohol because they are already in poor health, and most studies can’t distinguish between people who have never had a drink and those who drank heavily earlier in their lives and then quit. Indeed, over the years, compared with abstinence, moderate drinking has been associated with conditions it couldn’t logically protect against: a lower risk of deafness, hip fractures, the common cold and even alcoholic liver cirrhosis. All of which advances a conclusion that health determines drinking rather than the other way around. If that’s the case, and abstainers are predisposed toward ill health, then comparing drinkers to them will underestimate any negative effects that alcohol has. “This problem of the reference group in alcohol epidemiology affects everything,” says Tim Stockwell, director of the Canadian Institute for Substance Use Research at the University of Victoria in British Columbia. “It’s urgent to establish, What is the comparison point? All we know is that risk goes up the more you drink for all of these conditions.” But without a reliable comparison group, it is impossible to say precisely how dire those risks are.

The authors of the recent study in The Lancet endeavored to address this problem, at least in part, by removing former drinkers from their reference group, leaving only never-drinkers. To do so, they spent two years searching for every epidemiological study of alcohol ever done that met certain criteria and then extracting the original data. They marked those that already excluded former drinkers, which they thought would make the comparison group more accurate; to those that didn’t, they applied a mathematical model that would control for differences between their comparison group and that of the preferred studies.

The results — which are broken down by age, sex, 195 geographical locations and 23 health problems previously associated with alcohol — show that over all, compared with having zero drinks per day, having one drink per day increases the risk of developing most of those health problems. They include infections like tuberculosis, chronic conditions like diabetes, eight kinds of cancer, accidents and self-harm. (The more you drank, the higher those risks became.) This suggests that, on the whole, the benefits of abstaining actually outweigh the loss of any health improvements moderate drinking has to offer. The results, however, also show that a serving of alcohol every day slightly lowers the risk of certain types of heart disease — especially in developed countries, where people are much more likely to live long enough to get it. So, theoretically, if you are a daily drinker who survives the increased risk of accidents or cancers that are more likely to strike young to middle-aged people, by 80, when heart disease becomes a major cause of death, your moderate drinking could prolong your life. Then again, it might be your innate biological resilience that kept you healthy enough to drink. The data still can’t say.

Keep in mind that population studies like these are not meant to directly change individual behavior.

They offer generalizations — in the case of the Lancet study, that alcohol consumption is probably riskier and less potentially beneficial than we thought — that may eventually influence policies, like higher taxes on alcohol or warning labels on bottles. Paradoxically, only if those policies, in turn, reduce the amount that millions of individuals drink will we know whether doing so improved their overall health.

In the immediate term, a better way of understanding the value of scientific studies might be to think of each as a slight adjustment of an eyeglass-lens prescription. Each one answers the question “Is it clearer like this, or like this?” and in doing so, brings our view of reality — our understanding of ourselves and the world around us — into sharper focus. If we dwell too much on the conclusions studies seem to offer, instead of also considering how they were reached, we risk missing out on one of the great benefits of the scientific process: its ability to reveal all that we don’t know.

Kim Tingley is a contributing writer for the magazine.

Ray Dalio Is Kinda, Sorta, Really Wrong, Part 2

By John Mauldin

Last week we started a mini-series in the form of an open letter responding to a series of essays by Ray Dalio, the founder of Bridgewater Associates. I wrote that he was kinda, sorta wrong in Why and How Capitalism Needs to Be Reformed, Parts 1 and 2 but really, really wrong in It’s Time to Look More Carefully at ‘Monetary Policy 3 (MP3)’ and ‘Modern Monetary Theory,’ in which he basically endorsed MMT. Today I continue my response.

As I noted, Ray has done us all a service by pointing out some rarely-mentioned elephants in the room (some tinged with pink). We discuss various parts but seldom the entire creature. By that, I mean the rapidly growing potential for “progressive” control of both Congress and the White House. This stems from frustration over differences between haves and have nots, between the protected and unprotected, combined with a fascination for government solutions to our society’s perceived ills.

Last week, I basically agreed with Ray’s analysis of US income and wealth disparity. It obviously exists. The question is what, if anything, can we do about it? I think this is an important conversation, not just between two people but throughout the entire nation. The answers will make a huge difference to both our society and our children’s futures. Not to mention our own futures.

And if the response from my readers is any indication, you are also passionate about this conversation. Last week’s letter generated many long, thoughtful reader comments. Clearly, it is not just Ray and I who are worried about the country’s future direction. I find that encouraging. A national conversation is precisely what we need in these serious times.

So let’s pick up where we left off last week.

Dear Ray,

…As you can see, I really agreed with almost all of Part 1of your essay. In Part 2, I begin to see things a little differently, especially your suggested actions.

I am going to quote somewhat liberally from Part 2, primarily some portions you put in bold thus highlighting those points. They are worth repeating before we jump into the discussion.

Contrary to what populists of the left and populists of the right are saying, these unacceptable outcomes [income and wealth inequality, and ideological partisanship/populism] aren’t due to either a) evil rich people doing bad things to poor people or b) lazy poor people and bureaucratic inefficiencies, as much as they are due to how the capitalist system is now working.

I believe that all good things taken to an extreme become self-destructive and everything must evolve or die, and that these principles now apply to capitalism. While the pursuit of profit is usually an effective motivator and resource allocator for creating productivity and for providing those who are productive with buying power, it is now producing a self-reinforcing feedback loop that widens the income/wealth/opportunity gap to the point that capitalism and the American Dream are in jeopardy. That is because capitalism is now working in a way in which people and companies find it profitable to have policies and make technologies that lessen their people costs, which lessens a large percentage of the population’s share of society’s resources.

Those companies and people who are richer have greater buying power, which motivates those who seek profit to shift their resources to produce what the haves want relative to what the have-nots want, which includes fundamentally required things like good care and education for the have-not children. We just saw this exemplified in the college admissions cheating scandal.

As a result of this dynamic, the system is producing self-reinforcing spirals up for the haves and down for the have-nots, which are leading to harmful excesses at the top and harmful deprivations at the bottom. More specifically, I believe that:

1.   The pursuit of profit and greater efficiencies has led to the invention of new technologies that replace people, which has made companies run more efficiently, rewarded those who invented these technologies, and hurt those who were replaced by them. This force will accelerate over the next several years, and there is no plan to deal with it well.

2.   The pursuit of greater profits and greater company efficiencies has also led companies to produce in other countries and to replace American workers with cost-effective foreign workers, which was good for these companies’ profits and efficiencies but bad for the American workers’ incomes.

That brings several thoughts to mind.

First, I agree technology and globalization are clearly impacting jobs in the US but it isn’t a recent thing. It has been happening since the First Industrial Revolution. At one point, almost 80% of the population was organized around some form of agricultural activity. Today it is less than 2%.

Obviously, that has been a dramatic change but it also happened over at least 10 generations. And while we romanticize the family farm, it was damn hard work. It was also wrenching for people to go from working on a farm to an urban factory. There was plenty of political turmoil and pushback over those changes.

Globalization also started long ago, prior to 1930, and Republicans of that time dealt with it inadequately passing Smoot-Hawley and beginning a trade war that led to the Great Depression. They also misunderstood and misused Federal Reserve policy.

As you note, the pace of technological change is only going to accelerate.

Within 10 to 15 years, a significant portion, if not a majority, of the people who currently earn their living as truck or taxi drivers will find themselves replaced by self-driving trucks and cars. That is just one of many technologies which will reduce the need for direct human employment. Our own money management and investment industry won’t escape, either. Many of our customers may be unable to justify the cost of our expensive personal services when software can do it faster, better, and cheaper.

Few industries will be untouched. And there is no point in trying to be King Canute and hold back the tide. Any country that tries to save “their” jobs from technological change will soon find itself a backwater, struggling to compete as the world moves forward ever faster.

Financial Repression

While you correctly note that quantitative easing and easy money simply boosted asset prices and increased wealth and income inequality, you later argue that we need better-coordinated monetary and fiscal policies. I think monetary policy run amok bears a significant, if not primary, responsibility for the financial disparity (along with crony capitalism, but more on that later…)

Beginning with Greenspan, we have now had 30+ years of ever-looser monetary policy accompanied by lower rates. This created a series of asset bubbles whose demises wreaked economic havoc. Artificially low rates created the housing bubble, exacerbated by regulatory failure and reinforced by a morally bankrupt financial system.

And with the system completely aflame, we asked the arsonist to put out the fire, with very few observers acknowledging the irony. Yes, we did indeed need the Federal Reserve to provide liquidity during the initial crisis. But after that, the Fed kept rates too low for too long, reinforcing the wealth and income disparities and creating new bubbles we will have to deal with in the not-too-distant future.

This wasn’t a “beautiful deleveraging” as you call it. It was the ugly creation of bubbles and misallocation of capital. The Fed shouldn’t have blown these bubbles in the first place.

The simple conceit that 12 men and women sitting around the table can decide the most important price in the world (short-term interest rates) better than the market itself is beginning to wear thin. Keeping rates too low for too long in the current cycle brought massive capital misallocation. It resulted in the financialization of a significant part of the business world, in the US and elsewhere. The rules now reward management, not for generating revenue, but to drive up the price of the share price, thus making their options and stock grants more valuable.

Coordinated monetary policy is the problem, not the solution. And while I have little hope for change in that regard, I have no hope that monetary policy will rescue us from the next crisis.

Further, this financial repression that keeps rates far below their natural level punishes savers and rewards borrowers. This makes it especially hard for those in the lower- and middle-income brackets, not to mention retirees, to earn a return from their savings without having to take unhedged market risk.

The Referees Suck

Michael Lewis has just finished a seven-part podcast called Against the Rules. He begins by talking about referees, specifically the referees who toil at NBA games. Later episodes deal with the “referees” in financial markets, courts of law, civil society, and government.

The first podcast discusses how the NBA has completely reformed the entire process of refereeing NBA games. Every play in every game is reviewed real-time from an NBA studio with 110 screens that sees every play from many different angles. When a referee in any NBA game asks for a replay, other referees in Secaucus, New Jersey call up the play, revisit it in slow motion and from different perspectives, and then make a final call within 30 seconds. Sometimes the ruling on the floor stands, sometimes it is overturned—in either case accompanied by loud crowd reactions.

Because every play is now reviewed and referees after the game get to see where they made mistakes, the game has improved significantly. Referees now see their own biases and learn how to deal with them. The game has never been judged more accurately than it has been the last few seasons.

The interesting thing is that there has been almost no recognition of this improvement by fans or players. The elite players are frustrated they no longer get away with what they had in the past or what other great players did in decades gone by. Think Larry Bird and the extra step or two he took on his drives to the basket. It doesn’t happen today. Today’s players are generally held to a clear standard, whether rookie or all-star, and the all-stars don’t like it. They think they deserve that extra step or a little grace in the judgment call. Not happening anymore.

But the tone of the fans is also increasingly negative. To listen to the roar in the arenas around the country, you would think we are at an all-time low in the judgment of referees.

Small confession: Before I recently moved to Puerto Rico, I had been a 35-year Dallas Mavericks season ticket holder. I have done more than my fair share of yelling at refs. Sometimes, sitting next to minority owners for the team, I was encouraged to yell at the refs. They cited research showing part of the home-court advantage came from abusing the refs. More than a few of us were delighted by Mark Cuban turning red faced as he yelled at the refs from the floor. It was just part of the game.

And yet, Michael Lewis says this is part of the increasing coarsening of the culture. It is not just in sports that we yell, “Refs, you suck!” There is a general feeling that the system is rigged and the referees no longer fair. It’s not just in sports but also in the law, government, markets, in all the areas of life where we need outside judges to level the playing field. Nearly all of us have had our children angrily tell us, “That’s not fair!” Ref, you suck.

We resort to lawyers at the drop of a hat, looking for arcane rules to solve problems that used to be solved in more civil and less expensive ways. We take to the streets condemning those who disagree with our sense of fairness and justice as part of a system that needs to be changed, if not brought down. Ref, you suck.

Donald Trump and Bernie Sanders both said in the last election that the system was rigged. Trump clearly struck a sympathetic chord in enough voters to become president. Sanders is still arguing that the tax system or the electoral system is rigged. So are many of his fellow candidates. Ref, you suck.

One of the things you and I can agree on is that populist sentiments are not designed to produce compromise and solutions. Trump, and many of his associates, see problems in immigration or globalization or China or big government while the left increasingly sees income and wealth disparity as a core problem, along with climate change, racism, and a host of other issues.

But the overarching theme on both left and right is that the “referees” are no longer fair or impartial. There is a general distrust of those who are protected by circumstances and wealth by those who consider themselves unprotected. More and more of our fellow citizens feel that they are in the unprotected category and that the referees suck. They no longer trust the leaders of either party to solve problems. They increasingly prefer to throw a wrench in the system rather than look for a solution or compromise.

Ray, I have read and reread your Part 2, and especially your recommendations about what to do. I admire your optimistic, idealistic outlook. Even though I consider myself one of the most optimistic people I know, compared to your recommendations it seems I am cynical if not (sadly) skeptical.

You talk about the need for bipartisan commissions and solutions. Obama appointed Simpson and Bowles to lead a bipartisan commission on fiscal reform back in 2010. The commission couldn’t even pass its own findings because those on the left thought it unfairly reduced Social Security and Medicare and those on the right were against raising taxes.

That was in 2010. Congress is far more partisan today. The national debt is also $10 trillion more.

While a bipartisan commission sounds evenhanded and thoughtful, in today’s climate, where so few people trust the leadership and the elites, any bipartisan compromise would be shot down either from the left or the right or both. Likely both. If Trump were to propose a bipartisan commission to deal with the national deficit and entitlement spending, do you seriously think it could get any cooperation or trust from the left? Or that the right-wing members could convince their fellow partisans that a compromise was fair?

Margaret Thatcher once famously said, “First you win the argument, then you win the vote.” Putting together a working majority to deal with the problems we have is going to be a long, arduous process of winning the argument. And sadly, I am afraid it may take a full-blown crisis or series of crises to resolve the argument. I would very much prefer that not to be the case. But the cynical realist in me says the country is not ready for compromise and bipartisan stewardship.

Next week will be part three of this series. We still have the rest of Ray’s suggested solutions to deal with, before we get to the problems of using Modern Monetary Theory as part of the solution. But we will get there.

Boston, New York, and ???

I am enjoying the beautiful weather here in Puerto Rico. At the end of the month, Shane and I will fly to Boston to be with our good friends Steve Cucchiaro and (his future bride) Jama to help celebrate their wedding. Then Shane goes to California for a week while I meet with my Mauldin Economics partners in Boston, and then take the train down to New York for a few days of meetings and media. Then on July 4 I fly to…? Well, I’m not sure. The next destination is up in the air as no meetings have been confirmed. Hopefully I will know by this time next week. Then I will meet up with Shane and we will go back to Puerto Rico.

People often ask me for book recommendations, so here’s one I really liked. The Art of Currency Trading is a comprehensive, one-stop guide for anyone who seeks to master foreign exchange markets and achieve sustained trading success. Fellow Maine fisherman Brent Donnelly is one of the smartest currency traders anywhere. He is the king of cross currency trades. He writes a 1-2 page letter every morning explaining what is happening. I don’t trade currencies, but I’ve found that understanding them gives me better insight into global macro trends. This is a must-read for those who anyone who does anything with currencies. It will likely become the new go to book on currencies.

And with that I’ll hit the send button. Let me wish you a great week. And apologize to all of the NBA referees who I have screamed at over the years. Oh well…

Your thinking about our collective future analyst,


John Mauldin
Chairman, Mauldin Economics

China v America

A new kind of cold war

How to manage the growing rivalry between America and a rising China

FIGHTING OVER trade is not the half of it. The United States and China are contesting every domain, from semiconductors to submarines and from blockbuster films to lunar exploration. The two superpowers used to seek a win-win world. Today winning seems to involve the other lot’s defeat—a collapse that permanently subordinates China to the American order; or a humbled America that retreats from the western Pacific. It is a new kind of cold war that could leave no winners at all.

As our special report in this week’s issue explains, superpower relations have soured. America complains that China is cheating its way to the top by stealing technology, and that by muscling into the South China Sea and bullying democracies like Canada and Sweden it is becoming a threat to global peace. China is caught between the dream of regaining its rightful place in Asia and the fear that tired, jealous America will block its rise because it cannot accept its own decline.

The potential for catastrophe looms. Under the Kaiser, Germany dragged the world into war; America and the Soviet Union flirted with nuclear Armageddon. Even if China and America stop short of conflict, the world will bear the cost as growth slows and problems are left to fester for lack of co-operation.

Both sides need to feel more secure, but also to learn to live together in a low-trust world. Nobody should think that achieving this will be easy or quick.

The temptation is to shut China out, as America successfully shut out the Soviet Union—not just Huawei, which supplies 5G telecoms kit and was this week blocked by a pair of orders, but almost all Chinese technology. Yet, with China, that risks bringing about the very ruin policymakers are seeking to avoid. Global supply chains can be made to bypass China, but only at huge cost. In nominal terms Soviet-American trade in the late 1980s was $2bn a year; trade between America and China is now $2bn a day. In crucial technologies such as chipmaking and 5G, it is hard to say where commerce ends and national security begins. The economies of America’s allies in Asia and Europe depend on trade with China. Only an unambiguous threat could persuade them to cut their links with it.

It would be just as unwise for America to sit back. No law of physics says that quantum computing, artificial intelligence and other technologies must be cracked by scientists who are free to vote. Even if dictatorships tend to be more brittle than democracies, President Xi Jinping has reasserted party control and begun to project Chinese power around the world. Partly because of this, one of the very few beliefs which unite Republicans and Democrats is that America must act against China. But how?

For a start America needs to stop undermining its own strengths and build on them instead. Given that migrants are vital to innovation, the Trump administration’s hurdles to legal immigration are self-defeating. So are its frequent denigration of any science that does not suit its agenda and its attempts to cut science funding (reversed by Congress, fortunately).

Another of those strengths lies in America’s alliances and the institutions and norms it set up after the second world war. Team Trump has rubbished norms instead of buttressing institutions and attacked the European Union and Japan over trade rather than working with them to press China to change. American hard power in Asia reassures its allies, but President Donald Trump tends to ignore how soft power cements alliances, too. Rather than cast doubt on the rule of law at home and bargain over the extradition of a Huawei executive from Canada, he should be pointing to the surveillance state China has erected against the Uighur minority in the western province of Xinjiang.

As well as focusing on its strengths, America needs to shore up its defences. This involves hard power as China arms itself, including in novel domains such as space and cyberspace. But it also means striking a balance between protecting intellectual property and sustaining the flow of ideas, people, capital and goods. When universities and Silicon Valley geeks scoff at national-security restrictions they are being naive or disingenuous. But when defence hawks over-zealously call for shutting out Chinese nationals and investment they forget that American innovation depends on a global network.

America and its allies have broad powers to assess who is buying what. However, the West knows too little about Chinese investors and joint-venture partners and their links to the state. Deeper thought about what industries count as sensitive should suppress the impulse to ban everything.

Dealing with China also means finding ways to create trust. Actions that America intends as defensive may appear to Chinese eyes as aggression that is designed to contain it. If China feels that it must fight back, a naval collision in the South China Sea could escalate. Or war might follow an invasion of Taiwan by an angry, hypernationalist China.

A stronger defence thus needs an agenda that fosters the habit of working together, as America and the USSR talked about arms-reduction while threatening mutually assured destruction. China and America do not have to agree for them to conclude it is in their interest to live within norms. There is no shortage of projects to work on together, including North Korea, rules for space and cyberwar and, if Mr Trump faced up to it, climate change.

Such an agenda demands statesmanship and vision. Just now these are in short supply. Mr Trump sneers at the global good, and his base is tired of America acting as the world’s policeman. China, meanwhile, has a president who wants to harness the dream of national greatness as a way to justify the Communist Party’s total control. He sits at the apex of a system that saw engagement by America’s former president, Barack Obama, as something to exploit. Future leaders may be more open to enlightened collaboration, but there is no guarantee.

Three decades after the fall of the Soviet Union, the unipolar moment is over. In China, America faces a vast rival that confidently aspires to be number one. Business ties and profits, which used to cement the relationship, have become one more matter to fight over. China and America desperately need to create rules to help manage the rapidly evolving era of superpower competition. Just now, both see rules as things to break.

Monetary policy

The market believes the Fed will cut rates by September. Should it?

The case for and against responding to investors’ tantrums

THE FEDERAL RESERVE is changing direction. In December it predicted that it would raise the federal funds rate twice in 2019, to 2.75-3.0%. In March it thought it would hold rates steady instead. Investors now think there is a one-in-five chance that it will cut rates at its meeting on June 19th, and a 95% chance that it will do so by September (see chart). Jerome Powell, the Fed’s chairman, has said it is “ready to act”.

The reason for the change is a darkening world economy, caused primarily by the failure of America and China to strike a deal to bring their trade war to an end. Yet for all the ructions, the visible impact on America’s hard economic data has so far been relatively small. True, American firms hired only 75,000 workers in May, on first estimate, well below the recent monthly average. But jobs data are volatile, and the unemployment rate is a very low 3.6%.

Where the pain of the trade war has shown up is mainly in financial markets. The ten-year Treasury yield, for instance, was 2.5% in early May but has since fallen to 2.1% as investors have rushed to safety and anticipated rate cuts. Large moves like these raise an uncomfortable question for the Fed. Should it yield to the market, thereby risking the appearance that monetary policy is set by traders? Or should it consider only backward-looking economic data, which move slowly?

Markets provide the aggregated wisdom of a crowd of individuals with money on the line. In most contexts their forecasts will outperform those of a financially disinterested committee, even one made up of experts. But there are other reasons why an apparent discrepancy between the two may endure.

The first is that there is not really a discrepancy at all. Suppose the Fed and the market make the same judgment about the risk of an economic shock such as a trade war. “The Fed has the luxury of more time,” says Torsten Slok, an economist at Deutsche Bank. It can wait to see what happens before changing policy, whereas investors must hedge their bets immediately to account for even unlikely events.

The second is that markets agree with the central bank about the economic outlook, but are confused about how it will act. “The Fed might have failed to communicate well,” says Frederic Mishkin, a former rate-setter.

Only if these possibilities can be ruled out can central bankers conclude that markets are telling them something they need to hear about growth and inflation. Discerning this signal becomes trickier the more the Fed appears to respond to the market. To see why, suppose that the Fed ignores market movements completely, and instead sets policy in an entirely predictable way, responding only to hard data on growth and inflation. Any change in market expectations about Fed policy would then reflect only changes in investors’ perception of the outlook for those variables. “If Fed policy is clear and systematic,” says Charles Calomiris of Columbia University, “policymakers can glean useful information from markets.” The more the Fed responds to the market, however, the more it is “looking in the mirror”, as Alan Greenspan, a former Fed chairman, supposedly once quipped.

If monetary policy were entirely automated, however, the information embodied in markets would be useful but unused. What is more, reacting only to real data is like driving while looking only in the rear-view mirror. Central bankers often say that monetary policy works only with a lag of 18 months or two years. Many economists believe that flat-footedness at the Fed has been to blame for numerous post-war American recessions.

If the Fed wants to glean useful information from markets, it cannot pander to them. “The Fed needs to be the dog that wags the tail,” says Mr Mishkin. But when market movements have a fairly clear cause—in today’s case, the trade war—and the reaction is severe, it is likely that a rate cut will eventually be necessary. The short-term risk of moving in anticipation of events is that the outlook brightens and the rate cut then sparks inflation. Yet to the extent that economic data are telling a clear story, it is that inflation is contained. Consumer-price inflation, for example, slowed to 1.8% in May. That suggests it would be better for the Fed to get on with the rate cuts that the market expects.

Hong Kong’s Retreat Chips Away at Xi Jinping’s Iron Image

BEIJING — China’s leader, Xi Jinping, was in Tajikistan on Saturday, celebrating his 66th birthday with the Russian president, Vladimir V. Putin, when the political crisis in Hong Kong took a dramatic turn with an unexpected retreat in the face of mass protests.
Mr. Xi’s trip fortuitously gave him some distance from the events in Hong Kong, where the leadership on Saturday suspended its push for legislation to allow extraditions to mainland China. But the measure had been backed by Beijing, and there was no mistaking that the reversal was a stinging setback for him.
The move, the biggest concession to public pressure during Mr. Xi’s nearly seven years as China’s paramount leader, suggests that there are still limits to his power, especially involving events outside the mainland, even as he has governed with an increasingly authoritarian grip.
“This is a defeat for Xi, even if Beijing frames this as a tactical retreat,” said Jude Blanchette, a consultant and the author of a new book on the revival of revolutionary ideology in the country, “China’s New Red Guards.”

The Hong Kong police used tear gas against protesters on Wednesday.CreditLam Yik Fei for The New York Times


On Sunday, hundreds of thousands of people marched again in Hong Kong despite the government’s concession a day before, insisting that the legislation be withdrawn while making new demands, including for an investigation into the use of excessive force by the police in clashes with protesters.
The large turnout was a surprise, and it means the crisis is not over for Mr. Xi. Given how he has consolidated power in China, he may find it increasingly difficult to avoid blame.
The risk for Mr. Xi is not limited to Hong Kong. Though he has no visible rivals, he may face criticism in the leadership. And the mainland government’s censors, at least, are clearly concerned that the extraordinary events might inspire Mr. Xi’s beleaguered critics in mainland China, and they have been working vigorously to block the news from spreading.
“This further chips away at the image of Xi as an all-powerful, omnicompetent and visionary leader,” Mr. Blanchette added.
The demonstrations also made clear that after 22 years, Beijing has had minimal success in weaving Hong Kong into the country’s central political, economic and security systems, all dominated by the Communist Party. But if Mr. Xi and his cadres want to proceed more forcefully to bind Hong Kong to the mainland, they must also see how that could invite new waves of protest.
“This is an important time to see whether Xi is a rigid ideologue like Mao or the pragmatist that previous Chinese leaders like Deng, Jiang and Hu were,” said Susan L. Shirk, the chairwoman of the 21st Century China Program at the University of California, San Diego, referring to Mr. Xi’s predecessors.
Hong Kong’s chief executive, Carrie Lam, announcing the shelving of an extradition bill on Saturday.CreditAnthony Wallace/Agence France-Presse — Getty Images

As evidence of a pragmatic tinge, she cited recent adjustments that Mr. Xi made — at least cosmetically — to his signature “One Belt, One Road” international infrastructure initiative following criticism that it was ensnaring countries in indebtedness to Beijing.
“Pragmatic leaders adjust their policies when they become too costly,” she said.
Still, the controversy over the legislation has hardened views around the world toward Mr. Xi’s China, particularly regarding the lack of judicial independence or basic rights for defendants plunged into the Chinese judicial system.
The idea of a law that would allow transfers of criminal suspects into the Communist Party-controlled system provoked fear among Hong Kong’s seven million residents, including business executives, consultants and investors who have made the city a global hub of finance, trade and transportation.
“The proposed law, the protests and the Hong Kong government’s response has heightened international awareness of the repressive policies of the Xi era,” said Anne-Marie Brady, a professor at the University of Canterbury in Christchurch, New Zealand, adding that China was not living up to its pledge to honor Hong Kong’s autonomy for 50 years after the 1997 takeover.
During Mr. Xi’s four-day trip for previously scheduled summit meetings in Kyrgyzstan and Tajikistan, the events in Hong Kong were portrayed in China’s state media not as a retreat but as a well-considered move receiving Beijing’s full support.
“Sometimes we have to be on duty on our birthday,” Mr. Putin told Mr. Xi in a carefully choreographed exchange at a hotel in the Tajik capital, Dushanbe, even as Hong Kong’s chief executive, Carrie Lam, prepared to announce the suspension of the legislation.
Mass protests continued in Hong Kong on Sunday.CreditLam Yik Fei for The New York Times

Mr. Putin presented the man he has taken to calling a dear friend with a decorative vase, a cake and an entire box of ice cream that Mr. Xi had previously pronounced as the most delicious in the world.
Mr. Putin’s party for Mr. Xi was broadcast on China’s state television network, which had not even mentioned the protests in Hong Kong — some of the largest since Britain handed over the territory in 1997 — until Friday night. It described them as riots sponsored by foreign actors.
Both men are of similar age and temperament, sharing an abiding fear of foreign efforts to undermine their rule. Both have experienced the simmering fury of constituents nonetheless, suggesting that popular sentiment still plays a role in the era of strongman leaders. Mr. Putin, too, had to bow to public pressure last week following protests over a false arrest of a prominent investigative journalist, Ivan Golunov.
In the end, Beijing and Hong Kong decided that they already faced enough challenges with the economic headwinds and trade tensions with the United States heading into the Group of 20 summit meeting in Japan this month, according to a person in Hong Kong with a detailed knowledge of local policymaking, speaking on the condition of anonymity because of the political sensitivities inflamed by the protests.
Mr. Putin presented Mr. Xi with a cake on Friday, a day before the Chinese leader’s birthday. CreditPool photo by Alexei Druzhinin

President Trump and Mr. Xi are expected to meet in less than two weeks at the summit, in Osaka, although formal trade talks between them have not yet been confirmed.
Mr. Xi has never publicly commented on the Hong Kong matter, but two of the seven members of the governing Politburo Standing Committee that he presides over — Wang Yang and Han Zheng — expressed their support for the legislation.
On Friday, a vice foreign minister in Beijing summoned the deputy chief of mission at the American Embassy to complain about a congressional bill, drawn up in support of the protesters, that called for a broad review of Washington’s relationship with Hong Kong.
The suspension of the legislation — which stopped short of dropping it altogether — has fueled concerns that Mrs. Lam’s retreat was a tactical one, probably endorsed at least tacitly by Beijing. She met with senior Chinese officials on Friday before announcing her decision the following day, a person with knowledge of the government’s policymaking said. She declined to comment on Saturday on any private meetings she might have had.
Mr. Xi is not prone to concession or compromise, especially when under threat, as Mr. Trump has learned during his public efforts to negotiate an end to the trade war. This latest setback, analysts said, could be merely temporary.
“Postponement is not withdrawal,” Ryan Hass, a fellow at the Brookings Institution who served as the director for China at the National Security Council during the Obama administration, wrote in an email. “Beijing likely will be willing to let Lam take heat for mismanaging the process of securing passage of the bill, bide its time, and wait for the next opportunity to advance the legislation.”