Germany’s economic model is not the problem

Political leadership in addressing regional inequality and social polarisation is lacking

Marcel Fratzscher


Cars under construction at the Porsche factory in Leipzig. Germany’s export companies are increasingly investing abroad and less at home, threatening the country’s attractiveness as an investment hub © Bloomberg


The German economic model has received some unusually harsh criticism of late, notably from French president Emmanuel Macron, who said in April that it “has perhaps run its course”. Yet the problem for Germany today is not its economic model, but rather inadequate economic policies and two deep-seated illusions.

The German economy has slowed sharply, its dependence on industry is high and its automotive sector is slow to embrace new technologies. Germany’s dependence on exports makes it vulnerable to a slowdown in global growth.

Yet the problem is not the country’s economic model, which has been key to its success since the end of the second world war. The openness of the German economy and high degree of geographic and sectoral diversification of German exports which helped it to prosper for decades will be even more important for income growth and stability as the population ages and emerging markets catch up.

Mr Macron’s criticism of the German model for not being compatible with his vision of a social Europe is misplaced. A particular strength of that model is the Mittelstand — midsized, often family-run companies, with hundreds of unsung champions. These are often flexible, highly innovative and specialised firms with solid balance sheets and stable global market shares.

Another traditional strength has been the social partnership between employers and unions and a strong social welfare state.

The real problem for Germany is that its political elite is in the grip of two dangerous illusions. The first is the widespread assumption that it is not Germany that needs to change, but other European countries who need to follow the virtuous German path. But Germany has implemented hardly any meaningful economic reforms during the past decade, despite mounting imbalances and vulnerabilities.

Low levels of public and private investment contribute to anaemic productivity in the non-tradable sectors and a current account surplus of 8 per cent of gross domestic product in 2017. Germany’s export companies are increasingly investing abroad and less at home, threatening the country’s attractiveness as an investment hub.

Low productivity and weakening social partnerships have contributed to the enormous expansion of the low-wage sector. Meanwhile, instead of implementing reforms — such as lowering labour taxes, simplifying the tax code, deregulating services, modernising an inefficient bureaucracy and raising public investment in infrastructure, education and innovation — the past three governments have tried to appease vested interests through misguided handouts.

Popular frustration with the political elite and the rise of the far-right Alternative for Germany party are not the result of economic weakness, the migrant crisis or an overreaching EU, but of a political failure to address some legitimate concerns about rising regional inequality and social polarisation. Germany failed to use the boom years to renew its economic model.

The second illusion is that Germany does not need Europe and that the EU and eurozone are effectively a transfer union with a German paymaster. This attitude explains why many Germans are deeply suspicious of Mr Macron’s proposals for reforming the eurozone. Ironically, however, Germany would be one of the greatest beneficiaries of some of the changes Mr Macron envisages: the completion of monetary union and the strengthening of European institutions. Yet for years, Berlin resisted such reforms. Worse, it is showing increasingly protectionist tendencies, with proposals for the state to intervene much more directly in the economy and pursue the creation of “national champions”.

Global trade tension and rising nationalism in the US and elsewhere mean the continued success of Germany’s economic and social model will hinge on its ability to help create a strong, united Europe. The extent of political support in Berlin for further EU integration will be crucial in determining whether Europe can be a third partner at the geopolitical table alongside the US and China.

So it is not Germany’s economic model, but the reluctance of its political elite to pursue economic and social reforms, domestically and in the EU, that is the main risk that Europe faces today. But it is not too late to change course — Germany’s economic and political strengths mean it still has a chance to bring about change together with its European partners.


The writer is president of DIW Berlin, a think-tank, and professor of macroeconomics and finance at Humboldt-University Berlin

Working

American life is improving for the lowest paid

Come back capitalism, all is forgiven



BRAD HOOPER quit his previous job at a grocery in Madison because his boss was “a little crazy”. The manager threatened to sack him and other cashiers for refusing orders to work longer than their agreed hours. Not long ago, Mr Hooper’s decision to walk out might have looked foolhardy. A long-haired navy veteran, he suffers from recurrent ill-health, including insomnia. He has no education beyond high school. Early this decade he was jobless for a year and recalls how back then, there were “a thousand people applying for every McDonald’s job”.

This time he struck lucky, finding much better work. Today he sells tobacco and cigarettes in a chain store for 32 hours a week. That leaves plenty of time for his passion, reading science fiction. And after years of low earnings he collects $13.90 an hour, almost double the state’s minimum rate and better than the grocer’s pay. His new employer has already bumped up his wages twice in 18 months. “It’s pretty good,” he says with a grin. What’s really rare, he adds, is his annual week of paid holiday. The firm also offers help with health insurance.

His improving fortunes reflect recent gains for many of America’s lowest-paid. Handwritten “help wanted” signs adorn windows of many cafés and shops in Madison. A few steps on from the cigarette shop is the city’s job centre, where a manager with little else to do points to a screen that tallies 98,678 unfilled vacancies across Wisconsin. In five years, he says, he has never seen such demand for labour. He says some employers now recruit from a vocational training centre for the disabled. Others tour prisons, signing up inmates to work immediately on their release.

Unemployment in Wisconsin is below 3%, which is a record. Across America it was last this low, at 3.6%, half a century ago. A tight labour market has been pushing up median pay for some time. Fewer unauthorised immigrants arriving in America may contribute to the squeeze, though this is disputed. Official figures show average hourly earnings rising by 3.2% on an annual basis. “Right now, part time, it seems like everyone is hiring. Every American who wants a job right now can get a job,” says another shop worker in Merrillville, in northern Indiana.

In any economic upturn the last group of workers to prosper are typically the poorest earners, such as low-skilled shopstaff, food preparers, care-givers and temps. Their pay was walloped in the Great Recession a decade ago, and the recovery since has been unusually slow. Pay has leapt recently—with the lowest-paid enjoying faster gains than the better-off.



The benefits are not equally spread. In Wisconsin, as in much of the country, more jobs are being created in urban areas and in services. Laura Dresser, a labour economist, points to a “very big racial inequality among workers”. Wages have been rising fastest for African-Americans, but poorer blacks, especially those with felony convictions, are also likelier to have fallen out of the formal labour market, so are not counted in unemployment figures.

The wage recovery is not only about markets. Policy matters too. Some states, typically Republican-run, have been reluctant to lift minimum wages above the federal level of $7.25 an hour. In Merrillville, a worker in a petshop carries a Husky puppy to be inspected by a group of teenage girls. Staff are paid “a dollar or two above the minimum wage”, says his manager. Despite his 13 years’ employment, and over 40 hours’ toil each week, his pay and benefits amount to little. He calls occasional bonuses a “carrot at the end of the road”.

He could munch on bigger carrots in other states. Lawmakers in some states are more willing to lift minimum wages. Where they do, the incomes of the lowest-paid rise particularly fast. Thirteen states and the District of Columbia raised the minimum wage last year. (Some cities, like Chicago and New York, occasionally raise it too). Elise Gould of the Economic Policy Institute told Congress in March that, in states which put up minimum wages at least once in the five years to 2018, incomes for the poorest rose by an average of 13%. In the remaining states, by contrast, the poorest got a rise of 8.6% over the same period.

In neither case, however, do the increases amount to much better long-term prospects for the worst-off. By last year, the poorest 10% were still earning only a miserly 4.1% more per hour than they did (in real wages) 40 years ago. Median hourly pay for America’s workers was up a little more, by 14%.

One study in Wisconsin suggests that caretakers, for example, took home over $12 an hour by last year, so were only just getting back to their (real) average earnings achieved in 2010. Expansion at the bottom of the labour market “is finally pulling some wages up. But it’s certainly been much slower in this boom than any other,” argues Tim Smeeding, a poverty expert at the University of Wisconsin, in Madison. He describes “capital winning over labour” for several decades, and expects the trend to continue, given weak unions, more automation and other trends.

The poorest get some hard-to-measure benefits in addition to higher hourly pay. Mr Hooper is not alone in daring to walk away from an exploitative boss. More of the low-paid get a bit more say on how and when they toil. Many crave a reduction in the income volatility that afflicts them, since sudden swings in earnings are associated with poor mental health, high stress and worry over losing access to financial assistance or food stamps.

One study of 7,000 households, by Pew, found in 2015 that 92% of them would opt for lower average incomes, if earnings were predictable. Follow-up research late last year suggested the same trends are still present. Low- and middle-income households remain anxious about volatile earnings. Most have almost no savings. Many would struggle with a financial shock of just a few hundred dollars.

Lots of jobs that are being created are in or near flourishing cities like Madison, where low-paid workers are squeezed by high housing costs. Pew has estimated that 38% of all tenant households spend at least 30% of their income on rent. Living in more affordable places, such as Janesville, an hour south of Madison, may be an option for the lower-paid. But that means commuting to the city, or taking local jobs with less pay and fewer benefits. Few workers earning less than $12 an hour get health insurance from their employer, whereas most do so above that threshold.

Katherine Cramer, who studies the long-standing causes of simmering anger among poorer, rural Americans, says “resentment is worse than before”, despite the recent better wages.

Rural folk complain that “it’s been like this for decades”, she says. A year or two catching up has not yet been enough to change their minds.

ECB faces crucial test of credibility

Markets demand forceful action from central bank which has been failed by politicians

Frederik Ducrozet


Ever since Mario Draghi took office 8 years ago, he has dealt with the consequences of other policymakers’ mistakes, incompetence or inertia © Reuters


As markets seem prepared to call the European Central Bank’s bluff, we are left with fear and hope — that Mario Draghi and his successor will rise to the challenge.

Story of his life, as they say. Ever since the ECB president took office eight years ago, he has dealt with the consequences of other policymakers’ mistakes, incompetence or inertia. As he nears the end of his term in October, we have lost count of the number of times Mr Draghi has been under pressure to act, having already done the right thing.

On his first day in office in November 2011, Mr Draghi cut interest rates in response to his predecessor’s premature tightening of monetary policy. He then followed up with the first series of long-term refinancing operations (LTRO) for banks, which proved decisive in stemming the widening in sovereign debt spreads. When the euro’s existential crisis later led to a rapid rise in the so-called redenomination term premium (a measure of euro break-up risk), Mr Draghi responded with the three most powerful words a central banker has ever said: that he was ready to do “whatever it takes”, within his mandate, to preserve the single currency.

When front-loaded, synchronised fiscal austerity led to a double-dip recession, the ECB eased again, with forward guidance in July 2013 and negative rates in June 2014. When financial fragmentation threatened the transmission of monetary policy, the ECB doubled down on credit easing, including a “targeted” LTRO. Finally, when a global slowdown and a collapse in oil prices led to deflation fears, the answer was bond purchases — quantitative easing — culminating in over €2.5tn in asset purchases by the end of 2018.

It is not the failure of its monetary stimulus that has forced the ECB to ease again and again over the past eight years. Rather, national governments continued making promises they never delivered on, while failing to move beyond their differences to make the monetary union more resilient and efficient. It is the failure of politicians to take over that has left the ECB on the hook.

Faced with “pervasive uncertainty” and persistently low inflation, the ECB stands ready to act again today. Market-based inflation expectations are falling like a stone as ECB members meet for their annual conference in Sintra this week. Crucially, Mr Draghi has ruled out nothing for the June meeting, meaning rate cuts and new asset purchases are all on the table.

For markets, the devil will be in the details of any new stimulus. Cutting rates could be the path of least resistance, especially if aggressive monetary easing from the US leads to a stronger euro and an unwarranted tightening of financial conditions in Europe. In that case, the broader market reaction would largely depend on the implementation of mitigation measures for banks, as negative policy rates get closer to levels where their counterproductive effects outweigh the benefits. An even bolder move would include a cut in the ECB’s main refinancing rate, currently set at zero per cent.

Forward guidance is likely to be adjusted again, whether the ECB cuts rates or not. A proposal from Finnish central bank chief Olli Rehn to link the timing of the first rate rise to a sustained adjustment in (core) inflation using state-contingent forward guidance may be appealing to the Governing Council, eventually.

But, in a more adverse scenario, the ECB would have to resume bond purchases to address the risk of de-anchoring inflation expectations. It could do so by either adjusting limits on purchases to 33 per cent of member countries’ debt, or by tilting debt purchases toward corporates, supranational entities and/or the most indebted governments. In the former case, German Bund yields could fall even further into negative territory; in the latter, Bund yields could jump back above zero and the yield curve would steepen.

One option could be for the ECB to engineer a form of “insurance QE” in a similar spirit as potential insurance rate cuts from the Fed. That could take the form of a front-loaded programme with no predefined quantity of monthly purchases, but a total envelope to be spread over time with greater flexibility, depending on macro and market conditions.

The bigger picture boils down to the ECB’s credibility — its greatest asset under Mr Draghi’s presidency. If conditions deteriorate sharply, markets will demand another grand statement of intent. The hope could be to talk the QE talk without walking the walk, given all the institutional, political and technical hurdles embedded in a new QE programme. Inflation expectations, equity markets and the euro will rise if, and only if, the policy response proves credible.

Credibility inevitably raises the question of Mr Draghi’s successor. The biggest challenge he or she will face may not be to ease or to normalise monetary policy, but to maintain trust in the euro’s most important institution.


Frederik Ducrozet is a global strategist with Pictet Wealth Management, based in Geneva

When commodities get hooked on derivatives

The distortions will damage the welfare of market participants and society at large

Ruslan Kharlamov and Heiner Flassbeck


Pick up marketing materials of any commodity exchange and it’s all about “risk management”. 

For many bourses, however, a real business lies elsewhere. It needs no advertising and shuns public scrutiny. 

This is the business of making markets: a licence to set prices for raw materials. As these markets went global, so did the function of their pricing and benefits for those controlling this function.

Over the years, both commodity exchanges and derivatives traded on them came a long way from their original purpose. There were three forces behind this development.

First was the wave of mergers and buyouts in the 2000s, which turned western exchanges from not for profit utilities into large corporations. Today, CME Group and Intercontinental Exchange (ICE), the two bourses reining in energy and agricultural markets, are owned by institutional investors. In 2012, London Metal Exchange was acquired by Hong Kong Exchanges and Clearing for $2.2bn.

Exchange-traded derivatives (futures, options, swaps) were invented to help supply chains mitigate market risk through harvesting and economic cycles and were largely used for this purpose since the 19th century. The situation changed in the 1990s when investment funds noticed that commodity prices moved asymmetrically to financial markets and started trading raw materials as a store of value and a source of speculative income from price fluctuations. 

The derivatives enable such trading without physical possession. This was the second factor.

For exchanges and brokers that facilitate these transactions, it was a gold mine. Commodity risk management is limited by production, trade, and consumption; speculative trading is not. 

Since revenues depend on trading volumes and services, such as clearing, the more derivatives are traded, the more money flows to investors, exchanges and brokers, creating a whole new ecosystem. In this brave new world, nobody knows the size of derivative markets and understands the interplay with their physical cousins. 

Figure 1: Oil physical and derivative markets





Finally, China. As the world’s largest consumer and producer of many commodities, it wants a say in their pricing. But how to break into exchange “franchises” that had existed for decades? 

The answer is maximum liberalisation of domestic derivative markets to boost their size and impact, largely by dint of retail investors.

In the west, even though the business model of exchanges has changed, investors still assume that a commodity future should first be used for price hedging. 

Chinese futures were ostensibly launched with a financial community in mind irrespective of industrial needs and reception. The results are startling: last year eight of the top 10 metal and agricultural futures were traded on Chinese bourses. Energy is next in line.

These forces have fuelled an unprecedented surge of speculation in commodity markets. In a race for global dominance, derivatives turn into market-making instruments for investors and governments; laissez-faire meets co-ordinated policy; and risk management becomes a Trojan horse to justify financial intermediation and speculation. While regulators don’t keep up with the pace of change, commodities are overtaking equities to become the second-most traded derivative category (Figure 2).


Figure 2: Global futures and options trading (millions of contracts)



Once a commodity is hooked on derivatives, producers lose a right to set prices — and there’s no way back.

Derivative markets are not the efficient markets from economics textbooks. Centralisation and focus on trading expectations and interpretations rather than real things make them prone to behavioural biases and manipulation. Worse, they make commodities an integral part of financial markets.

The more commodities become investable assets, the more their pricing gets intertwined with financial market dynamics and phenomena unrelated to supply and demand. This is manifested by inverted correlations between commodity prices and financial markets, among other things (Figures 3 and 4). Quantifying these effects deserves a thorough scientific study based on meaningful data.

Markets so “financialised” fail in price discovery and the efficient allocation of economic resources. Such distortions may destabilise not only markets — consider, for example, renewable energy transition — but also entire commodity-dependent nations. They damage the long-term welfare of market participants and society at large.Figure 3: Crude oil financialization

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To tackle commodities financialisation some policymakers think of curbing “excessive” speculation. This is hard to quantify and implement, especially in international markets. 

Innovation offers a better approach, shifting the onus from regulation to self-governance. By connecting suppliers, buyers and service providers directly, it will keep price formation in the real economy and enable risk management without financial intermediation.

As Milton Friedman observed: “One of the great mistakes is to judge policies by their intentions rather than results.” It’s time to follow his advice instead of financial marketing.


Ruslan Kharlamov is the chief executive of SteelHedge, and Heiner Flassbeck is an honorary professor at the University of Hamburg and a former chief economist of the United Nations Conference on Trade and Development

Is America Tired of Losing Yet?

In the two years since US President Donald Trump abandoned the Trans-Pacific Partnership, Japan and the other TPP signatories have forged ahead with new trade deals. As a result, US exporters are increasingly feeling the pinch – and probably wondering what happened to "the art of the deal."

Anne O. Krueger

krueger15_NICHOLASKAMMAFPGetty Images_trumphuggingflag


WASHINGTON, DC – Not content with its trade war against China, US President Donald Trump’s administration has also opened bilateral trade negotiations with Japan. Yet whatever Trump hopes to achieve with Japan, it will be far less than what he threw away when he abandoned the Trans-Pacific Partnership (TPP) in early 2017.

During the 2016 US presidential campaign, Trump promised Americans that he would negotiate so many great deals on their behalf that they would get “tired of winning.” Now that he has imposed heavy costs on US farmers, consumers, and the overall economy through tariffs on Chinese imports, Americans are probably growing quite tired indeed.

Trump’s withdrawal from the TPP is the canonical example of his trade-policy recklessness. Signed in 2016 by the United States and 11 other Pacific Rim countries, the treaty would have governed around 40% of all trade covered by World Trade Organization rules. It was a “twenty-first-century agreement” that included not just tariff reductions, but also provisions to liberalize retail, communications, entertainment, and financial services. It would have strengthened labor and environmental standards, established a new dispute-resolution mechanism, and created a framework for managing e-commerce, cyber security, intellectual-property rights, data mobility, and more.

When the US withdrew from the TPP, many assumed the agreement was dead. But the remaining signatories, led by Japanese Prime Minister Shinzo Abe, quickly agreed on a replacement, the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP), which retains around 200 of the TPP’s 220-odd provisions. The 20 that were left out were those for which the US pushed, and can be reinstated should the country wish to join the pact at a later date.

Now that the CPTPP has entered into force, Australia, Brunei, Canada, Chile, Japan, Malaysia, Mexico, New Zealand, Peru, Singapore, and Vietnam enjoy preferential access to each other’s markets. As tariffs are phased out, US suppliers in those markets are finding themselves at a growing disadvantage. While the Japanese tariff on American beef imports has remained at 38.5%, the levy on beef from fellow CPTPP countries has fallen to 27.5% and eventually will reach just 9%. As a result, American beef (and wheat) entering Japan (or any other CPTPP country) now face a higher tariff than beef and wheat from Australia, Canada, or New Zealand.

Still, Abe has worked hard to maintain good relations with the US, taking much political heat at home for it. Japan was one of the few US trading partners not to retaliate when the Trump administration imposed tariffs on steel and aluminum. And while affirming Japan’s preference for regional and multilateral arrangements, Abe has nonetheless agreed to bilateral bargaining with the US.
With a Japanese parliamentary election coming this summer, bilateral talks aren’t likely to go anywhere until later in the year. When they do happen, Japan will benefit from having already entered into a free-trade agreement (FTA) with the European Union. As of this past February, more than 90% (soon to be 97%) of EU exports to Japan are duty-free; and, after a brief phase-out period, the same will apply to 85% of agri-food products. While wine from the US faces a 15% tariff, wine from the EU – as well as from CPTPP countries such as Chile – now enters Japan duty-free, as do European cars, which are subject to common safety standards. Not for nothing did Abe tout the EU deal as proof of “the unshaken political will of Japan and the EU to lead the world as the champions of free trade at a time when protectionism has spread.”

For its part, the Trump administration wants Japan to remove barriers to US agricultural and auto exports and reduce its bilateral trade surplus, which stood at $58 billion (in goods) in 2018. But while Trump often complains that US goods face trade discrimination in Japan, he has only himself to blame. It is only natural that US exporters would lose market share to their counterparts in Europe and the CPTPP countries. With Japan’s new FTAs in place, the US trade deficit with Japan is likely to grow even wider.

So much for Trump’s “art of the deal.” The supposedly brilliant negotiator has left US exporters at a severe disadvantage in markets spanning the Pacific Rim and Europe. Worse, China is now pushing for a mega-FTA among 16 countries under the Regional Comprehensive Economic Partnership (RCEP), negotiations for which are ongoing (although many China experts do not expect an agreement to be reached anytime soon).

Here, it is worth remembering that the TPP would have excluded China and locked in a US-led trade bloc in Asia for the long term. No deal that the Trump administration makes with Japan can possibly make up for what the US would have had under the TPP. At best, the US will salvage the TPP terms concerning Japan alone, rather than all 11 original signatories. Though Abe has declared his willingness to negotiate bilaterally with Trump, he cannot possibly grant the US better terms than those given to Japan’s CPTPP partners.

We’ve seen this movie before. With each Trumpian “negotiation,” the US issues its demands, offers little in return, and threatens “punishment” through tariffs if it doesn’t get its way. Like the thief who says “your money or your life,” there is no actual negotiation to speak of. By acting like an insecure bully, Trump has left the US increasingly isolated in the global economy. American producers and consumers are already paying the price. The only question is how much more “winning” they are willing to bear. 

Anne O. Krueger, a former World Bank chief economist and former first deputy managing director of the International Monetary Fund, is Senior Research Professor of International Economics at the School of Advanced International Studies, Johns Hopkins University, and Senior Fellow at the Center for International Development, Stanford University.




















Trump Is Turning Out To Be A Consequential President

The Donald’s personal failings make it hard to say nice things about his presidency.

Yet contrary to most inside-the-Beltway expectations, he’s having an impact.

Let’s start with abortion, something that divides the country in a visceral way, with one side seeing it as murder and the other side viewing its prohibition as the subjugation of poor women.

The Supreme Court’s 1973 Roe v Wade ruling — which legalized abortion from the top down – took the issue off the legislative agenda.

But early on, Trump got the chance to name two new Justices and picked relatively young, relatively conservative men who are seen as possible votes for overturning Roe v Wade. So abortion is back in play. From today’s Wall Street Journal:
States’ Abortion Curbs Put Supreme Court to the Test
Sweeping state-level abortion restrictions present a direct test of whether the newly constituted Supreme Court is willing to revisit Roe v. Wade, the landmark abortion-rights precedent that has spurred deep divisions for nearly 50 years. 
States with antiabortion legislative majorities have long been weighing how to prompt a Supreme Court review of the 1973 ruling, but generally have preferred a strategy aimed at reducing the procedure’s availability through incremental restrictions that hamper providers, or by forbidding late-term abortions. 
But following last year’s retirement of Justice Anthony Kennedy, the key fifth vote on a nine-member court for preserving Roe’s central guarantee, that attitude has shifted. Since President Trump took office, he has appointed Justices Neil Gorsuch and Brett Kavanaugh, and had vowed as part of his 2016 campaign to appoint jurists who would overturn the Roe decision, though neither of the new justices has committed to do so. 
During this state legislative season, lawmakers in several conservative-led states have proposed bills that are designed to challenge Roe in court, and governors have been more willing to sign them than ever before. The most dramatic example came this week in Alabama, which enacted a near-total ban on abortion, with an exception only when a woman faces a serious health risk; the Legislature rejected exceptions for victims of rape or incest. On Thursday, the Missouri Senate passed a ban on abortion after eight weeks of pregnancy. 
Several states—Georgia, Kentucky, Mississippi and Ohio—recently passed bans on abortion once a fetal heartbeat is detected, which can be as early as six weeks.


One or more of these cases will reach the Supreme Court before the 2020 presidential election, and it’s now at least conceivable that the Court will have something interesting to say.

And then there’s China. The developed world really, really wanted China’s billion people with their history of political instability and ideological insanity to morph into a peaceful quasi-capitalist country. So the US and Europe looked the other way as China developed at all costs – with those costs being born mostly by its trading partners.

Among the many ways China has been cheating are:

Extreme protectionism. China keeps foreign goods out with high tariffs and impenetrable regulations. And it subsidizes domestic industries with cheap energy, low-cost loans and lax environmental regulations.

Debt imperialism. It lends money to developing countries, then seizes collateral assets like mines and infrastructure when the loans aren’t repaid.
 
Forced technology transfer. If a foreign company wants to operate in China, Beijing requires it to take a majority local partner and transfer its technology to that partner – which then forwards it to the government.

Cyber- theft. The Chinese military runs an army of hackers who break into foreign networks and steal whatever business and military IP they find. This has allowed Chinese companies to produce copycat versions of major products, and its military to produce next-generation weapons, without all the expensive R&D.

This cheating — and the resulting hollowing out of American manufacturing — was just accepted as the price of having China inside rather than outside of the global trading system. Trump, as an obnoxious outsider himself, doesn’t seem to be constrained by this vision and is trying to force China to play by the same rules as Japan and France. He may or may not succeed, but he’s already shifted the debate, forcing mainstream pundits to preface their opinions with, “of course China cheats and of course we should do something about it…”

That’s pretty consequential right there.

Immigration. Pre-Trump, elites on both right and the left loved open borders, the former because of all the cheap labor that couldn’t complain about bad working conditions, and the latter because new arrivals tend to vote for Democrat.

But of course open borders are a disaster for pretty much the entire taxpaying mainstream, so Trump is finding fertile ground here and might just engineer an immigration system that controls the border and lets in only the most valuable immigrants. In any event, as with China, he’s changed the terms of debate by forcing opponents to begin with “of course border security is important…”

War. This is the ultimate in “consequential.” And there’s a lot of it going around. See ‘Potentially imminent threat’ from Iran grips Washington.

Most of the above (with the exception of war) would not even be discussed under President Hillary Clinton, illustrating the impact, for better or worse, that Trump is having. Much of it will endure long after he’s gone.

What Does It Take to Trigger a Stock-Market Selloff, Anyway?

By Ben Levisohn


Photograph by Mandel Ngan/AFP/Getty Images

 
Boy, that escalated quickly.

Investors ended the previous week hopeful for a quick resolution to the trade dispute between the U.S. and China. Those hopes were dashed after China said it would raise tariffs on U.S. goods and President Donald Trump signed an executive order banning telecommunications equipment built by “foreign adversaries.” Further talks between the U.S. and China seem to be off the table for now.

The stock market, however, didn’t seem to mind all that much. Yes, the S&P 500 index dropped 2.5% on Monday, as investors realized that the trade war would not end quietly, but it spent the rest of the week trying to make back its losses. It closed this past week down 0.8%, to 2859.53, while the Dow Jones Industrial Average declined 178.37 points, or 0.7%, to 25,764.00, and the Nasdaq Composite dropped 1.3%, to 7816.28.

The worst of the damage, perhaps unsurprisingly, was sustained by companies with the most overseas business. Goldman Sachs ’ sector-neutral basket of stocks with the most international exposure has dropped 5.5% in May, while a similar basket of domestically focused stocks has declined just 2%. (The S&P 500 has fallen 3% this month.) That’s a sure sign that investors have started paring back their exposure to companies that could be disproportionately affected by an escalating trade war.

That’s also how the situation played out in the fourth quarter of 2018. From Oct. 2 through Oct. 10, the stocks in the S&P 500 with the most overseas pretax income underperformed the ones with the least

That’s also how the situation played out in the fourth quarter of 2018. From Oct. 2 through Oct. 10, the stocks in the S&P 500 with the most overseas pretax income underperformed the ones with the least by about three percentage points. From Oct. 10 through the end of the year, the stocks with the most overseas exposure outperformed slightly as everything else played catch-up, observes Ed Clissold, chief U.S. strategist at Ned Davis Research.

“If the selling widens to other areas, it would be a sign that the pullback is taking on a life of its own,” he writes.

Still, the market drop has been rather muted, considering the risks. That China announced higher tariffs on U.S. goods was predictable—from the beginning, tariffs have been viewed as bargaining chips on the way to a trade deal between the two nations.

The decision to limit Huawei Technologies’ access to U.S. goods and markets, however, is something more, because it has the potential to disrupt China’s plans during a year when the People’s Republic is celebrating its 70th anniversary, says Carmel Wellso, director of research at Janus Henderson. “People don’t understand how important this is to the population of China,” she says. “We’re striking at something more fundamental.”

Some chalk up the market’s calm to investors’ ability to ignore what’s happening overseas. “In our view, the reason markets haven’t budged much on worsening China headlines is because America is happy right now and simply doesn’t get it yet,” explains Richard Farr, chief market strategist at Merion Capital Group.

The fact that the University of Michigan’s consumer sentiment index jumped to a 15-year high in May suggests as much, even if the survey was taken before the latest headlines.

Others suggest that a broader battle between the U.S. and China might not be that bad for stocks, at least in the short term. Higher tariffs will probably mean a slight pickup in inflation, while interest rates will almost certainly stay low. In fact, the futures market is predicting a 75% chance that the Federal Reserve will cut rates in 2019. “Low interest rates typically mean good stock markets,” says Janus Henderson’s Wellso.

But what if something has fundamentally changed in the market? Investors have become accustomed to central banks stepping in to bail out the market, as the Fed did in both February 2016 and this past January, explains Macquarie strategist Viktor Shvets, who notes that damage was quickly undone in both cases “as if by magic.”

There’s no reason to expect that to change, he says, and monetary policy could soon be joined by government spending of epic proportions to keep the economic cycle going. “Investors are complacent because they no longer believe in free markets, and expect any damage from trade wars or politics would be offset by fiscal or monetary tools,” Shvets writes.

The scary part is he might be right.


Triangulation

The ECB presidency is distinct but not immune from backroom deals

Europe works in strange ways





“THE LONGEST lunch in history” is how Jonathan Powell, an adviser to Tony Blair, a former British prime minister, has described the appointment of the first head of the European Central Bank (ECB) in 1998. The French, keen to have their man in the job, had convinced the Germans that Wim Duisenberg, a Dutchman, should serve only half of his eight-year term before making way for a Frenchman. Mr Duisenberg resisted, giving in only after midnight.

The choice in 2011 of the third and current president, Mario Draghi, an Italian, involved less drama. Even so, France and Italy fell out after Lorenzo Bini Smaghi, another Italian on the bank’s six-strong executive board, initially refused to give way to a French national. “What can I do? Shall I kill him?” Silvio Berlusconi, then Italy’s prime minister, asked Nicolas Sarkozy when his French counterpart complained.

Mr Draghi departs in October. What tales will be told of his successor’s selection? The scope for theatrics is greater than ever. The choice is always political: national leaders make nominations and eventually agree on a name. But Mr Draghi’s term ends in the wake of European elections, as they are also deciding other top jobs. At a summit on June 20th-21st the European Council of leaders aspires to pull off a package deal covering the key roles. Succeed or no, the next few months will be a test of whether the process for choosing the next ECB leader has become any more sensible.

No one knows precisely who is in the running: there is no formal nomination process. Among the five leading contenders, pictured above, is Jens Weidmann, the hawkish chief of the Bundesbank. As a former adviser to Angela Merkel he helped form her hard line on Greece during its sovereign-debt troubles. Olli Rehn, the head of the Bank of Finland and a former EU commissioner, is also seen as a candidate.

Erkki Liikanen, Mr Rehn’s well-liked predecessor in Helsinki and also a former commissioner in Brussels, is in contention, as is François Villeroy de Galhau, the governor of the Banque de France. So is Benoît Cœuré, a Frenchman already on the ECB’s executive board, though the ECB’s rules seem unlikely to permit him a second term as a member. Klaas Knot, the Dutch central-bank head, Klaus Regling, the head of the EU’s bail-out fund, and Sylvie Goulard, deputy head at the Banque de France, are also mentioned.

Officials in Berlin and Paris claim that they see the ECB presidency as distinct from the three more political jobs of the heads of the commission and European Council and the high representative, or the EU’s foreign-policy chief. They describe their approach as “3+1”, says Mujtaba Rahman of Eurasia Group, a consultancy. Perhaps Mr Draghi’s crucial role in keeping the currency union together during the sovereign-debt crises in 2010-12 has taught everyone that the bank’s president needs more than a modicum of competence.

Looming economic threats should remind them why their decision matters. A trade slowdown is hammering the euro area’s economy. A row between Rome and Brussels over public debt risks unnerving investors. Market expectations of euro-zone inflation in five years’ time have drifted below the bank’s 2% target. On June 6th Mr Draghi said the bank would keep interest rates low for the next year, and raised the possibility of further asset purchases.

Mr Weidmann is the most contentious candidate. His vocal opposition to ECB asset-purchase programmes was reportedly derided by Mr Draghi as “Nein zu allem”(“No to everything”). Appointing him would be a mistake, says Christian Odendahl of the Centre for European Reform, a think-tank: the bank would be less activist in downturns and less supportive of fiscal easing. That prospect could lose him the support of countries keen on further integration, such as France and Spain, in which case Germany might instead plump for another northerner, perhaps one of the Finns.

But the decision cannot be divorced entirely from the EU’s tiresome preoccupation with balance of various sorts. Despite their noble talk about “3+1”, leaders still want national balance on the bank’s six-strong executive board, which, together with the 19 governors of national central banks, constitutes its policymaking body. Having had an Italian at its helm for eight years, and a Spanish vice-president, the received wisdom is that the ECB presidency now belongs to a northerner—if not to Germany, which has yet to hold the post.

Such calculations, surprisingly, are the reason Mr Weidmann seems to have support from Italy, even though it is the country most likely to benefit from the unconventional policies he has spoken against so forcefully. Its finance minister, Giovanni Tria, has said that he would be “open” to Mr Weidmann as president. The reason seems to be that once the top job is allocated, any compatriots already on the board tend to step down. If the job goes to a Frenchman or German, that would leave a gap for Italy to claim. Italian economists suspect further Machiavellian plotting: if the ruling populists were to elevate an official at the Bank of Italy to the ECB, that in turn gives them a chance to install one of their own at the bank in Rome, realising their ambition to gain influence over it.

The obsession with balance extends across European institutions. Leaders want to ensure that nationalities, genders and party affiliations are well-represented across the top jobs. Emmanuel Macron, France’s president, sees the commission presidency as the prize, says Mr Rahman. The price could be a German at the ECB.

All this means that expertise is not the sole criterion for replacing Mr Draghi. And until the commission presidency is decided, there are plenty of permutations. A drawn-out process raises the risk that the job is traded for other positions. Other names could emerge. A fudge, with the 68-year-old Mr Liikanen doing half a term and giving way for someone else, is not impossible. Just as a break with the past cannot yet be ruled out, nor can a reversion to it.


US sets course for its next Middle Eastern war of choice

Dick Cheney’s heirs are laying the groundwork for an Iran conflict

Edward Luce


Skilled insiders: John Bolton and Mike Pompeo © Getty


Dick Cheney, the former US vice-president, said that if there was a 1 per cent threat of something happening, America should act as if it were a certainty. By that yardstick, the chances of a US war with Iran are now flashing red. Any such conflict could induce a geopolitical earthquake to exceed what followed the US-led invasion of Iraq.

That war unleashed Isis, empowered Russia and China, and left a bitterly divided America roughly $3tn worse off. In the first Gulf war in 1991, the US led a broad international coalition. By the second one in 2003, the “coalition of the willing” had shrunk to Britain, Spain, Australia, Poland and a handful of Pacific islands. This time, the US would be fighting without any non-Middle Eastern allies.

In the spirit of Mr Cheney, the US should bear in mind parallels between the build up to the Iraq war in 2003 and what is happening today. Much like then, today’s case is led by two highly skilled insiders. John Bolton, the national security adviser, and Mike Pompeo, the secretary of state, are worthy heirs to Donald Rumsfeld and Dick Cheney. They know how to marshal intelligence for their ends.

Each claims that Iran is stoking its proxies in Iraq, Syria, Yemen and Lebanon for imminent attacks on the US and its allies. They have withdrawn non-essential US personnel from Baghdad and ordered the USS Abraham Lincoln aircraft carrier and a bunch of B52 bombers to the region. America would respond with “unrelenting force” to any Iranian attack, said Mr Bolton. US retaliation would be “swift and decisive” says Mr Pompeo.

All that is lacking is clear intelligence to back them up. Chris Ghika, the British major-general who is second-in-command of the US-led anti-Isis coalition, said on Tuesday there was no evidence of an increased Iranian threat. He was slapped down by a US spokesman.

Why tensions are rising in the Middle East: https://imasdk.googleapis.com/js/core/bridge3.305.0_en.html#goog_934100553

After the 2003 Iraq war, it emerged that British and US officials had privately complained of White House “cherry picking” to suit the case for war. One of the crucial claims was that Saddam Hussein was in league with al-Qaeda — a contention that was later debunked. History seems to be repeating itself.

In a testimony to Congress last month, Mr Pompeo implied the US could go to war with Iran today under the original 2001 authorisation. Indeed, the grounds were the same. “There is no doubt there is a connection between the Islamic Republic of Iran and al-Qaeda. Period, full stop,” Mr Pompeo said.

Much like Iraq in 2003, the US is presenting Iran with demands that it knows will be rejected. The timetable for military action is clear. Iran has given Europe’s three powers — France, Britain and Germany — 60 days to salvage the 2015 nuclear deal abandoned by the US. Failing that, Iran will resume uranium enrichment and its nuclear clock would restart. Mr Pompeo is depriving the EU3 of any leeway to keep the deal intact — the cost of US sanctions would be too great. Murkiness over who carried out this week’s attacks on oil tankers near the Strait of Hormuz hints at a wider menu of triggers for US military action.

Which brings us back to Mr Cheney. The Iraq war helped bring America’s unipolar moment to an end. The decade and a half since then has seen the re-emergence of great power rivalry. A war with Iran would risk far more. Saddam Hussein had less than 100,000 bedraggled troops. Iran has up to a million in uniform. Iraq had no credible allies. Iran is a Russian ally and a big oil exporter to China.

A US-Iran conflict would provide cover for Russia and China to further their ambitions. Russia could use the distraction to annex eastern Ukraine, or take a chunk of one of the Baltic states, then dare Nato to eject it. China, meanwhile, could present itself as the level-headed alternative to a rogue superpower.

Such a scenario is by no means outlandish — it is entirely plausible. The alternative path is that Donald Trump fires, or sidelines, Mr Bolton and Mr Pompeo. In that case, the drumbeat for war would fall silent. But that seems less likely. By Mr Cheney’s measure, therefore, the world should take out insurance against America’s next war of choice.

The view from Washington

In Washington, talk of a China threat cuts across the political divide

Amid accusations of theft and espionage, opinions have hardened




LAST OCTOBER bosses from some big, innovative companies were invited to an annexe of the White House. Amid the high-ceilinged pomp of the Indian Treaty Room, the executives signed one-day non-disclosure agreements allowing them to see classified material. Then the Director of National Intelligence, Dan Coats, and two senators told them how China steals their secrets.

The unpublicised event was the idea of Senator Mark Warner of Virginia, the senior Democrat on the Senate Intelligence Committee and himself a successful technology investor. He was joined by Senator Marco Rubio of Florida, a Republican on the committee.
Recent arrests of alleged Chinese spies reveal only a small fraction of what is afoot, Mr Rubio says. China “is the most comprehensive threat to our country that it has ever faced”. The aim, he insists, is not to hold China down but to preserve peace. He sees an imbalance in relations between America and China that, if left unaddressed, “will inevitably lead to very dangerous conflict”.

Speaking with rapid precision in his Senate office, Mr Rubio criticises an economic model that presses chief executives to maximise short-term profits. China has learned to use that system to turn firms into “advocates”, he charges. Too often politicians would vow to get tough on Chinese cheating. “Then these CEOs would be deputised by China to march down to the White House.”

Venture capitalists have also been invited to Warner-Rubio China road shows. Mr Rubio grumbles that the business plan of some Silicon Valley tech firms is to get bought up, without necessarily caring if the investors are Chinese.

Members of Congress have drafted proposals for a series of new export controls on products deemed important to national and economic security, notably from industries named as priorities in the “Made in China 2025” plan. That is a Chinese map for building world-beating companies in ten high-tech fields. Chinese investments face ever-tighter scrutiny by the Committee on Foreign Investment in the United States (CFIUS). The Foreign Investment Risk Review Modernisation Act recently extended the remit of CFIUS to new areas, such as property purchases near sensitive sites. A pilot scheme mandates reviews of foreign stakes in a wide array of “critical technologies”. Mr Rubio names telecommunications, quantum computing, artificial intelligence and any industry that collects large data sets as ones he wants closed to China.

The staging of that October road show—a bipartisan endeavour involving Congress and the intelligence agencies, close to the White House but not inside it—is revealing. Views on China have hardened across official Washington. A tough new consensus unites what might be called America’s foreign-policy machine, including members of both parties in Congress, the State Department, Pentagon, Department of Justice, spy agencies and the president’s own National Security Council. The machine includes the vice-president, Mike Pence, who turned a speech last October into a charge sheet of Chinese misdeeds. Mr Trump stands apart.

Pentagon chiefs and members of Congress are ever more publicly sounding the alarm about China’s intentions towards Taiwan, the democratic island of 24m people that America calls an ally but China claims as its own, saying it must be united with the motherland, by force if necessary. To China’s disquiet, Congress has passed laws signalling solidarity with Taiwan, urging the government to allow cabinet secretaries and American warships to visit the island. Some of President Donald Trump’s closest aides are long-time advocates for Taiwan. As president-elect in 2016 he was persuaded to talk by telephone with the island’s president, Tsai Ing-wen. Since then Mr Trump has blocked proposals for high-profile visits to show support for Taiwan as a democratic ally. He sees allies as a burden, and mighty China as America’s peer.

Whose side are you on?

Discerning a united view of China within Team Trump is hard. Trump aides use harsh language about the country. Referring to repression of Uighur Muslims in the north-western region of Xinjiang, the Secretary of State, Mike Pompeo, called China “one of the worst human-rights countries that we’ve seen since the 1930s”. That tone is a sign of their boss’s willingness to trample diplomatic niceties. But while Mr Trump’s views on China overlap with the Washington machine’s, they are not identical. Many officials are sincerely disgusted by Xinjiang, where perhaps a million Uighurs are being held in “re-education camps”. Asked how business ties between America and China may co-exist with get-tough policies, a senior administration official replies: “Concentration camps do spoil the mood, don’t they?”

Yet cold-war-style discussions of human rights are of little interest to Mr Trump. Michael Pillsbury is a China specialist at the Hudson Institute, a think-tank, and an outside adviser to the White House. In his view, “the president is not a super-hawk on China”. Such issues as Taiwan or Xinjiang do not resonate with Mr Trump as much as trade does, he admits. Even on trade, Mr Pillsbury calls him more cautious than advisers such as Peter Navarro, who would like American firms to leave China. Mr Trump has often said he does not want to hurt China’s economy, notes Mr Pillsbury. “He sees China as a source of profit and investment.”

The machine wants to change the fundamental principles guiding China’s rise. In contrast Mr Trump praises President Xi Jinping for putting China’s interests first.

Yet Mr Trump can be riled by aides telling him that China is “stealing our secrets”. He also sees political risks in any trade deal that can be branded a climb-down. “The president understands very clearly that the Democrats are waiting for him to be soft on China,” says Mr Pillsbury. Senator Chris Coons, a Democrat, agrees that being a hawk on China in today’s Congress is “comparable to the 1950s when there was no downside, politically, to being anti-Soviet”.

Tellingly Mr Trump’s China tariff escalation on May 10th was accompanied by defensive tweets asserting that China yearns for a “very weak” Democrat to win the 2020 election instead. A senior Trump administration official endeavours to reconcile the different camps. The aim is not economic decoupling, he says. But in sensitive industries, “the political and financial risk associated with doing business in China will continue to rise”.

Modern-day Chinese mandarins obsess over differences within the Trump administration, not realising that the hardening of the Washington mood predates and will outlast Mr Trump. Evan Medeiros of Georgetown University, a former principal Asia adviser to President Barack Obama, notes that “the bureaucracy of a much more competitive relationship” is being put in place.

Taking a proper gander

Last November the Department of Justice established a China Threat Initiative, staffed by prosecutors and FBI investigators, to detect Chinese attempts to steal trade secrets and influence opinion, in particular on university campuses. At the Department of Homeland Security, a new National Risk Management Centre watches for high-risk firms working on critical infrastructure. A State Department office formerly focused on terrorism, the Global Engagement Centre, has a new mission countering propaganda from China, Russia and Iran.

Pentagon anxieties about China coincide with a realisation that when troops rely on high-tech kit, cyber-attacks can kill. Mr Eikenberry, the former general, observes that in the 1970s or 1980s perhaps 70% of the technology that mattered to military commanders was proprietary to the government, and the rest off-the-shelf and commercial. “Now it is 70% off-the-shelf, much of it coming from Silicon Valley,” he says. Thus when American trade negotiators debate China policy, “the security people are in the room.”

A study commissioned by the Pentagon, “Deliver Uncompromised”, warns that insecure supply chains place America’s armed forces at “grave risk” from hacking and high-tech sabotage, for instance by the insertion of malware or components designed to fail in combat. The study, by Mitre, a research outfit, notes that modern fighter jets may rely on 10m lines of software code, so it matters if tech firms use code of unknown provenance, as some do.

Pentagon chiefs have created a new Office of Commercial and Economic Analysis whose mission includes scouring defence contracts for Chinese companies, down to third-tier suppliers. James Mulvenon, an expert on Chinese cyber-security, explains that “the Pentagon has decided that semiconductors is the hill that they are willing to die on. Semiconductors is the last industry in which the US is ahead, and it is the one on which everything else is built.” He already sees more high-value defence contracts going to semiconductor foundries in America.

Randall Schriver is assistant secretary of defence for Indo-Pacific Security Affairs and a China specialist. Asked if the Pentagon will press businesses to leave China, he replies carefully. “Companies can do what companies do. We are much more aware of and keen to address vulnerabilities in our defence supply chain.”

Official Washington has moved beyond asking whether China is a partner or a rival. The only debate concerns the magnitude of China’s ambitions. According to Mr Rubio, Mr Xi thinks that “China’s rightful place is as the world’s most powerful country.”

Some political appointees in Mr Pompeo’s State Department sound eager to declare that an East-West clash of civilisations is under way. On April 29th the State Department’s director of policy planning, Kiron Skinner, told a forum hosted by New America, a Washington think-tank, that there was a need for a China strategy equivalent to George Kennan’s containment strategy for the Soviet Union. Not content with that bombshell, Ms Skinner ventured that China is a harder problem. “The Soviet Union and that competition, in a way it was a fight within the Western family,” she said, citing the Western roots of Karl Marx’s ideas. “It’s the first time that we will have a great-power competitor that is not Caucasian.”

Leaving aside the ahistoricism of Ms Skinner’s comments—for China’s Communists drew deeply on Marx and Lenin—they are self-defeating. A clash of civilisations leaves no room for Chinese liberals, let alone for Taiwan, a democracy with deep roots in Chinese culture. As for the idea of containing one of the world’s two largest economies, that would be a nonsense even if American allies and other countries were willing to help, which they are not.

There are more cautious voices. A recent essay for the Paulson Institute by Evan Feigenbaum, an Asia hand in the administration of President George W. Bush, argues that those accusing China of remaking the global order are both misstating and understating the challenge. China is selectively revisionist, wrote Mr Feigenbaum. Rather than seeking to replace today’s international system, it upholds many of the “forms” of multilateralism while undermining “norms” from within the UN and other bodies.

In a break between votes, in a windowless office deep in the Capitol, Mr Coons urges Congress to try the hard work of dealing with China as it is and not as America wishes it to be. He does not think China is hostile to the idea of a rules-based order, but concedes that it has “behaved exceptionally badly on the world economic stage”. In today’s Washington, that is dovish talk.


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

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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.