Recessions have become rarer and more scary

A hard to predict financial crisis is the most probable source of the next downturn

Robin Harding

Desert Recession Sculptures
© James Ferguson

The world has seldom been worse-equipped to fight a recession. Yet it has never had fewer recessions to fight. That makes the next global downturn difficult to imagine but it will most likely be a traumatic and unlooked-for event, more like the sudden outbreak of a new disease than the annual onset of flu.

Recession alarms sounded loudly this summer thanks to an inversion of the US yield curve, which means rates on shorter-term debt are higher than those on longer-term ones. That came as the current economic expansion broke records and we experienced a global slide in measures of manufacturing sentiment.

With interest rates trapped at zero or close to it across much of the industrialised world, central banks have little room to respond. Any slump in economic activity is a frightening prospect.

Possibly, this bout of global weakness will be allowed to spiral into a US and global downturn.

Yet that would defy the pattern of recessions in recent decades, which has changed both in cause and frequency. They are rarer and, when they do begin, the spark is more often a financial meltdown than sliding business activity or an economic overheat.

Recession predictors have always had a terrible record but in the past, stopped-clock doom-mongers only had to wait a few years for their moment of glory. Now redemption can take decades. At 122 months, the current US expansion is the longest on record, just ahead of the period from 1991 to 2001.

The volatility of US output growth is lower than it has ever been

Former US Federal Reserve chair Janet Yellen argues it is a “myth” that economic expansions die of old age. Longer expansions mean recessions have become rarer. In the 35 years after the second world war, there were eight US recessions; in the 35 years following that, there were four. Trends in other developed countries are similar.

In the 1990s and 2000s, economists used to talk about a “great moderation”, the idea that output had become significantly less volatile since the early 1980s. But that proved embarrassing after the 2008 financial crisis and the phrase went away. The evidence since then, however, suggests the phenomenon is real. The volatility of quarterly growth in the US is now lower than it has ever been.

Several explanations have been put forward. One is the decline of inventory cycles in manufacturing: the use of just-in-time techniques has reduced the need to adjust stockpiles.

Another is the economy’s structural shift towards services. Demand for spinning classes, management consultancy, karaoke and plastic surgery may fluctuate with the overall economy, but unlike steel mills and automobile factories, they have no great cyclical dynamics of their own.

A third and probably more important explanation is the success of central banks in stabilising inflation and averting boom and bust cycles. Most US recessions in the postwar years began when the economy got too hot, inflation picked up and the Fed increased interest rates to choke off demand. It is now decades since that last occurred. More recently, central banks have struggled with a lack of inflation, not too much.

The current US expansion is now the longest on record - but growth has been anaemic in comparison with previous booms

When policymakers do not fear inflation, they can provide stimulus to offset a slowdown.

Indeed the risk is rather that they lack the ammunition to counter real shocks such as Brexit or US President Donald Trump’s tariffs on China. But they are certainly trying. The Fed is cutting interest rates, mirrored by India, Thailand, the Philippines and New Zealand among others in August alone. Fiscal stimulus is on the way in South Korea and the UK. China is set to do more.

This is where many recession predictions go wrong. When the threat is obvious, the policy response arrives in advance. A bet that the current global slowdown will turn into global recession is in part a bet that these current stimulus efforts will fail.

It is easy to follow this argument into a fallacy: policymakers will act to prevent a recession, so no serious recession is possible. In the early 2000s there was plenty of hubris along these lines — but 2008-09 was a brutal corrective. That recession began in the financial sector, with subprime loans and housing, just as the recession of 2001 began with the bursting of the dotcom bubble.

The business cycle may have damped but the financial cycle of Hyman Minsky is still with us.

Finance is the most probable source of the next downturn, when it comes.

If real economic fluctuations are hard to predict, timing a financial crisis is next to impossible.

Analysts may spot imbalances in markets but they can only guess at when and how they will unwind. There are some signs we are late in the current cycle. Asset valuations are high by historic standards. Private debt has risen a lot in China and some peripheral economies. The Trump administration is rolling back financial regulation. It all increases risk. But the signs of stress that often precede a crisis — wild ebullience or rising defaults — are not obvious.

None of this means a recession will not occur — unpredictability is the whole point — but based on the pattern of recent downturns, there is little sign that one is already under way. What is certain is that an economic slump under present conditions would be exceptionally hard to fight. That is likely to be the pattern for future recessions: rare and terrifying.

How to Fix the Global Retirement Crisis

By Reshma Kapadia 

Illustration by Andrea Ucini

The idea of moving into a nursing home is abhorrent to most Americans, but many older Swedes have to lobby to get into one. Aging parents in the U.S. may remind their adult children to visit them, but China requires it by law. Visit playgrounds in Japan and you’ll find elder-friendly fitness equipment instead of monkey bars and slides. We are at the beginning of a global aging boom—and countries all over the world are facing the same challenges. Some are coming up with creative ways to address the looming retirement crisis.

 There are more adults over 65 than there are children under 5, globally. And by 2050, one out of every six people—or 1.6 billion—will be over the age of 65, according to the United Nations’ latest estimates. That will be a big problema.

Cultural norms, demographics, and economic and political systems vary, but the challenge is the same: How do graying countries find fiscally sustainable ways to support longer life spans without bankrupting governments, overburdening the young, or abandoning those who need care?

Japan is at the leading edge of the trend—28% of its population is already 65 or older—forcing it to tackle the challenge head on. China has a bit more time, but not much: Its society is aging faster than any other. Life expectancies lengthened by 30 years within a half-century. That’s roughly half the time in which Western industrialized countries saw that happen, giving China far less time to prepare. Even Sweden, which regularly ranks high on retirement-preparedness lists and as one of the happiest places for older adults, faces budgetary pressures as those over 80 become the fastest-growing part of the population.

“I’d love to tell you that dramatic cultural differences dictate differences in investment and interest, but ageism is a global challenge. If we don’t tackle investing in prevention and wellness programs and extending the possibility of work lives, keeping people active and socially engaged, the costs are potentially overwhelming,” says Paul Irving, chairman of the Milken Institute Center for the Future of Aging. “Population aging is something we can either ignore at our peril, or we can embrace the reality and change our policies, practices, norms, and culture and capitalize on it.”

The magnitude of the demographic change is forcing a reckoning. At this summer’s G-20 meeting, the world’s top policy makers for the first time identified aging as a risk that needs to be addressed. No country has developed the perfect elixir, but a look around the world offers glimpses of what is working—as well as pain points that can inform how the U.S. tackles its own aging boom. Barron’s tapped policy watchers, academics, and experts on the aging industry globally to see which countries offer lessons for the U.S. in tackling various facets of aging, including working longer, retirement savings, long-term care, and caregiving.

A Guide to Working Longer

Japan has traditionally celebrated residents’ 100th birthdays by sending them a sake bowl. Originally made of silver, the bowls are now silver-plated, as the crush of centenarians strains the budget. Japan is ground zero for aging: It has the world’s longest life expectancy and a historically low fertility rate, which both contribute to labor shortages and put intense pressure on its pension system.

It also boasts one of the world’s highest labor-force participation rates among older adults; 59% of men ages 65 to 69 are still working, compared with just 38% in the U.S. “Necessity often drives innovation,” says Catherine Collinson, head of the nonprofit Transamerica Center for Retirement Studies. “There’s a tremendous sense of urgency, given the extreme nature of its aging population and labor shortages that have prompted them to rethink working lives versus retirement, and seek out innovative solutions.”

Japan has chipped away at the generosity of its national pension system for decades and has been gradually increasing the eligibility age—currently 65, though Prime Minister Shinzo Abe is considering raising it above 70. The retirement age in Corporate Japan is also changing. Mandatory retirement age used to be nearly a decade beyond the average life expectancy; but now, the retirement age is 60, and life expectancy is 84.

Japan has been providing incentives for companies to retain retiree-age employees, and it also requires companies to rehire those who still want to work after 60, though it can be at lower wages and responsibility levels.

But money is not the primary reason many Japanese work well past 65. Social engagement and a sense of ikigai—a view that one’s life is still worth living—rank high among the motivations to remain on the job, says Takaoh Miyagawa, an aging and retirement expert at life insurer Aegon Sony Life in Tokyo.  Consider Kamikatsu, a rural mountain village with a rapidly aging population. The residents revitalized its economy by creating a cottage industry—picking the colorful leaves that grow around town and selling them as garnish for Japanese cuisine and decorations. Kato Manufacturing hires retirees to work on the weekends and holidays to keep factories running continuously. Convenience stores and fast-food chains have proactively hired the elderly, and small businesses that have struggled to find talent amid a national labor shortage also have tapped retirees.

But Corporate Japan isn’t fully on board. Nearly 70% of older people want to work beyond the age of 65, but only 20% are actually employed, according to the AARP, the U.S. organization that focuses on issues facing retirees. The Japanese government is trying to change that, making expanding employment opportunities for older adults a key component of its national strategy to revitalize the economy. Its Silver Human Resource Centers offer short-term job opportunities in the community. They tend to be low-wage positions, but the program still represents the kind of strategy that the U.S. could emulate to help experienced workers remain productive and engaged, says Ramsey Alwin, director of AARP’s financial resilience thought leadership. Another way for Japan—and the U.S.—to employ older individuals is by offering more flexibility, opportunities to refresh skills, and lifelong learning, which would also help companies woo coveted younger talent, Alwin adds.

Takeaway: It’s an old, but true, bit of advice: When people work longer, they can continue to save, and their savings don’t have to stretch as far. But what’s possibly more important is the notion of ikigai: When older adults stay active and engaged longer, it lowers health-care costs.

The U.S. could incentivize companies to hire the elderly, as well as devise a system to pair them with work and volunteering opportunities.

A Guide to Funding Retirement

Getting people to work longer is one way that countries can improve the living standards of the old without increasing the burden on the young. The other is to help employees save more during their working years. No country has perfectly balanced the two, but Australia’s approach is one of the best, says Richard Jackson, founder of the Global Aging Institute. Indeed, Australia is among the highest-ranked developed economies, judged by the fiscal sustainability and income adequacy of its retirement system, based on the institute’s research.

The U.S. has a problem on the fiscal sustainability front. Social Security is a major source of retirement income for a large swath of Americans, but the trust for those payments will be depleted by 2035 unless changes are made. Australia once faced a similar situation. In the mid-1980s, it warned its citizens of the tremendous economic risk ahead if its government-funded pension didn’t morph into one largely funded by private savings.

In the midst of Australia’s last recession—28 years ago—the nation pushed through radical reforms and introduced a mandatory, fully funded employer pension system, known as the superannuation guarantee, or the “Super.” The pay-as-you-go account, launched in 1992, required a mandatory contribution from employers; it’s currently 9.5% but will rise to 12% of employees’ income in 2025.

Australia also instituted a means-tested, flat-rate Age Pension to ensure that everyone has enough income to sustain a basic living standard. This tops off any Super accounts that fall below a certain level. About three-quarters of retirees still get some benefit from the government. But by 2030, as Super accounts mature, only a single-digit share of the population will need the state benefit, reducing the burden on the country’s finances, estimates Pablo Antolin-Nicolas, a pension expert and principal economist at the Organization for Economic Cooperation and Development.

For average wage earners in Australia, the system will replace an estimated 43% of their income in retirement. That is slightly lower than in the U.S. But the system also creates a safety net that doesn’t exist in America, by giving everyone, even those who have taken time out for caregiving, a basic retirement income. Not having access to a work-based retirement plan is a major reason that some Americans don’t have enough saved for retirement.

Australia also gradually has been raising the age at which people can tap the Super. For those born before July 1960, it’s 55. For those born after June 1964, it’s 60. Australia is increasing the eligibility age for the Age Pension, too, from 65 to 67 by 2023. In addition, it is more difficult for Australians to take loans against their Supers than it is for Americans to borrow from their 401(k) accounts.

Australia still has things to work out. Like the U.S., it is trying to find the best way to convert savings into income in retirement. While the Land Down Under has offered tax incentives for retirees to shift their Super accounts into a lifetime stream of income, many still opt for a lump sum. But Antolin says the government is working with the private sector on a solution, focusing on a hybrid strategy that includes an annuity that starts generating income at 80 or 85 years of age, plus a withdrawal strategy to give individuals financial flexibility earlier in retirement.

Takeaway: Australia’s bold moves to put its retirement system on a more fiscally sound footing offer some ideas for the U.S. Among them: the value of gradually boosting the eligibility age for a pension and for tapping the Super; ways to keep people from raiding their savings; and, most importantly, a blueprint for creating a means-tested retirement safety net, alongside a pay-as-you go system with a substantial contribution rate and incentives for people to save even more.

No-Guilt Long-Term Care

Long-term care can drain a lifetime’s worth of savings in the U.S., not to mention the energy of family members who often provide the bulk of that care. But in Sweden, the government itself offers universal long-term care. The nordic nation, which puts a high value on individual independence, doesn’t have the cultural expectation that children will provide caregiving for their parents and other relatives, as is the norm in countries such as China.

In fact, only 5% of Sweden’s elderly live in multigenerational households, compared with 20% in other developed countries, including the U.S. and Australia, and more than 60% in countries such as Mexico, China, and India. Sweden also has the second-highest female labor-participation rate—just behind Iceland—which means that women, who bear the brunt of the caregiving duties throughout the world, aren’t readily available to do so.

“Everyone puts their parents in a nursing home, and it is also what the parents want,” says Marta Szebehely, professor of social work at Stockholm University, referring to older adults who need substantial assistance. Indeed, a 2015 survey showed that the majority of Swedes favored moving to a residential care facility if they needed aid more than twice a day.

But long-term care facilities in Sweden look different than nursing homes in the U.S. Whereas the model in the U.S. has typically been a hospital, in Sweden it’s the family home, Szebehely says. Facilities tend to be smaller, with nine to 12 apartments along a corridor that share a common area where people can take meals. But apartments also have their own kitchens, even for dementia patients, so that family members can come and cook for them. The smaller units also makes it easier for care givers to know the residents and provide the flexibility to personalize care. All care, whether home-based or in a residential facility, is regulated, unlike in the U.S., where regulation outside nursing homes is spotty.

Sweden isn’t exempt from challenges. Spending has not kept pace with the aging population, straining the system and reducing the number of available spots in residential facilities. Cutbacks mean that some older adults can end up waiting beyond the point when they feel they can live safely on their own, Szebehely observes.

Takeaway: The U.S. might benefit from developing long-term elder-care facilities modeled on the home, to allow personalization and flexibility. And finding ways to help Americans finance that long-term care is crucial.

A Guide to Caregiving

Whereas family bonds are voluntary, not obligatory, in Sweden, China has a very different approach. Filial piety is a central tenet of Confucianism and is entrenched in the culture; China passed a law in 2013 requiring children to visit aging parents.

While every society struggles with caring for the elderly, China gives new meaning to the words “caregiving crisis.” First, there are the sheer numbers: By 2030, 360 million Chinese—more than currently live in the U.S.—will be older than 60.

Already, no other country has to cope with so many families supported by so few children—a byproduct of the country’s former One Child Policy. The policy, in effect from 1979 through 2015, also has contributed to a gender imbalance, with researchers estimating there will be 30 million more men of marriageable age than women by 2020. Chinese women also now have higher levels of education and thus better career opportunities than prior generations did, making it harder for them to take on caregiving duties.

“There’s a deeply entrenched system that to be a good person is equivalent to being a good son or daughter. This young generation desperately wants to look after their parents, but there’s a deep inability to do so,” says Zak Dychtwald, founder of research and consulting firm Young China Group. “It’s an economic question, a political question, and a spiritual question.”
Forty years ago, before China shifted to a market economy from a communist system, about 80% of the population lived in the countryside. Older adults lived with their families. Mass migration to the city has changed the family dynamic very quickly, says Wang Feng, a sociology professor at the University of California, Irvine, and a former director of the Brookings-Tsinghua Center for Public Policy. Now, more than half of older Chinese adults—100 million—don’t live with their children.

With fewer family members tending to the elderly, China is just starting to build a long-term care industry. The government has prioritized improving health care for older adults, including long-term and rehab services. It has also called for the creation of at least one professional nursing home in every prefectural-level city. China has introduced policies to integrate community facilities like day-care centers for seniors, nursing homes, and home-based care at the neighborhood level to fill caregiving gaps.

In addition, Beijing is encouraging elder-care facilities to adopt technology, including tele-medicine, sensors and other monitoring devices to keep seniors safe, and beds that can turn into wheelchairs to alleviate the need for assistance getting up and about, says Timothy Ma Kam-Wah, the founding executive director of Senior Citizen Home Safety Association in Hong Kong.

These options have yet to gain traction.

China has been piloting programs that offer caregiver leave for only children, but take-up is low, as is the use of day-care centers. And while robots pop up in senior-care facilities, they are primarily offering entertainment.

Much of the development so far has been focused on cities and is not affordable to the masses, says Vivian Lou, an associate professor at the University of Hong Kong, where she focuses on caregiving. Adult children whose parents live in cities use technology to order their parents rides or groceries, and employ devices to help monitor them, but Lou worries about rural areas, as well as what happens when parents need help with feeding, bathing, or toileting.

Hiring live-in domestic help is expensive, as much as $1,000 a month in cities—that’s roughly what a recent Chinese university graduate working in financial services for a multinational corporation earns. “Very few can afford domestic help,” Lou says. “The caregiving burden will emerge as a social issue in five years and reach a peak within a decade.”

That could push China to take more-aggressive actions, potentially offering the U.S. some ideas as it faces the same challenges, especially in tackling the urban-rural divide for elder care. “The risk of aging breaking both the U.S. and China and upending world economies is huge for both countries,” says the Milken Institute’s Irving. “If there’s an argument for a collaborative relationship between the U.S. and China, aging might be it.”

Takeaway: Coordinating home-based, residential, and community-based care can help reduce care costs. And while robots probably won’t replace human care givers soon, age-related technology can make their jobs easier.

The Real Reason Trump Won’t Attack Iran

Starting a war to protect oil markets will only backfire.

By Emily Meierding
Iranians burn an image of U.S. President Donald Trump during a demonstration outside the former U.S. embassy headquarters in Tehran on May 9, 2018.
Iranians burn an image of U.S. President Donald Trump during a demonstration outside the former U.S. embassy headquarters in Tehran on May 9, 2018. ATTA KENARE/AFP/Getty Images

Iran is widely assumed to be responsible for last weekend’s bombardment in Saudi Arabia, in which drone and missile attacks struck two critical Saudi oil facilities, cutting the country’s oil production by 5.7 million barrels per day and reducing global oil supplies by 5 percent. If the Trump administration decides to retaliate militarily for these attacks, the ensuing confrontation would likely to be labeled another U.S. oil war in the Middle East.

This would be a serious mischaracterization, however. In this case, oil interests are far more likely to prevent war than provoke it. 
A war in the Persian Gulf would profoundly destabilize the global oil system. If the Trump administration strikes Iran, unilaterally or in conjunction with Saudi Arabia, and targets the state’s oil facilities, these attacks will take more resources offline. Although Iran’s oil output has declined significantly since the United States reimposed sanctions in 2018, the country still produces more than 2 million barrels of oil per day and exports about half a million barrels per day of petroleum products and liquefied petroleum gas to a variety of resource consumers. 
Airstrikes would remove these supplies for the market, while other oil producers are struggling to compensate for the loss of Saudi resources.

Tehran has also threatened to retaliate for U.S. or Saudi military action. If the Iranians targets Saudi oil installations, it could incapacitate additional facilities or interrupt repairs at Saudi Arabia’s Abqaiq and Khurais facilities. The initial attacks on these installations caused far more damage than many industry analyses anticipated, striking core processing facilities, including stabilization towers and storage tanks, with pinpoint accuracy.

Even if Tehran was not directly responsible for these attacks, Saudi officials have that the aggressors employed Iranian weapons. If these claims are accurate, Tehran has the capacity to inflict substantial further damage on the Saudi oil industry. Although Saudi Arabia has presumably reinforced its air defense system after this weekend’s attacks, the kingdom’s ability to protect critical oil facilities from drones and low-flying missiles is now uncertain.

Iran could also respond to U.S. and Saudi strikes by attempting to interrupt oil transportation. The Islamic Revolutionary Guard Corps navy has demonstrated its willingness to seize foreign tankers in the Persian Gulf, as it did on Monday and this July. The corps could also disable oil tankers with mines and other explosives, mimicking the attacks that occurred earlier this year.

Finally, Iran could attempt to close the Strait of Hormuz. The state has been threatening to block the waterway for months. And, while Iran’s naval forces may not be able to halt traffic entirely or maintain a closure over the long term, the attempt alone would roil global oil markets. Insurance rates for oil tankers transiting the strait have already increased tenfold between May and September. Any effort to block the waterway would provoke another drastic hike. Oil prices would also soar in response to the heightened geopolitical risk.

An escalating conflict in the Persian Gulf would jeopardize many states’ energy interests. Saudi Arabia would be hit on multiple fronts from an intensified Gulf conflict. Its oil installations would incur additional physical damage, and the state would lose more resource revenue from suspended oil sales. More importantly, state oil company Saudi Aramco’s reputation as a reliable oil supplier would take another severe hit.

Saudi officials have already been scrambling to restore confidence in the national oil company after this weekend’s attacks. Saudi Aramco’s CEO, Amin Nasser, announced on Tuesday that Abqaiq’s output will be restored by the end of the month and that the company’s long-anticipated initial public offering (IPO) will proceed as planned. However, skepticism is rampant, and any additional disruptions will wreak havoc on the company’s valuation, as well as on Saudi leader Mohammed bin Salman’s plans to use IPO proceeds to finance his country’s economic diversification. Fear of further instability limits Riyadh’s room for maneuver. As Robin Mills of Qamar Energy observed, “It will be all but impossible to proceed with the IPO if there are ongoing attacks.”

Conflict escalation in the Persian Gulf would also threaten Chinese and European energy security. Saudi Arabia is currently China’s top oil supplier, providing approximately 17 percent of the state’s crude imports. Chinese consumers also continue to purchase small amounts of Iranian crude, as well as petroleum products, despite U.S. sanctions.

European countries have halted purchases from Iran and are less dependent on Saudi oil.

However, EU member states still import more than 13 percent of their resources from Gulf oil producers. An intensifying regional conflict would threaten Europeans’ access to these supplies, force them to pay higher prices, and undermine their ongoing diplomatic efforts to return Iranian crude to the global oil market.

Unsurprisingly, Chinese and European officials have adopted a cautious attitude toward the crisis. Although China’s foreign ministry condemned the attack, spokesperson Hua Chunying advised the parties “to avoid taking actions that bring about an escalation in regional tensions.”

She also refrained from attributing responsibility for the strikes to a specific actor. German Chancellor Angela Merkel and British Prime Minister Boris Johnson pushed for an international response to the attacks. However, they also emphasized the “importance of avoiding the further escalation of tensions in the region.”

Given this reticence, if the United States wants to strike Iran, it will have to go it alone.

Invent a greener milk carton for the world

Tetra Pak’s innovation overtook the glass bottle but it needs to be improved

John Gapper

web_Tetra Pack recycling
© Ingram Pinn/Financial Times

The humble milk carton has been part of our lives for so long that it is easy to forget that it was a marvel when it first appeared in 1952. Tetra Pak’s technology made a billionaire of Hans Rausing, scion of the company’s Swedish founding family, who died last week at the age of 93.

The Tetra Pak cartons, made from layers of paperboard and polyethylene, soon displaced glass bottles because they were far lighter and could easily be stacked and distributed. Its aseptic carton, with a layer of aluminium foil that allowed heat-treated milk to remain fresh, followed in 1961.

But every technology has drawbacks and Rausing died at the moment when those of plastic are becoming distressingly obvious. Landfills are stuffed with bottles and cartons, and trillions of pieces of plastic float in the world’s oceans. What happens to the 189bn Tetra Pak containers made last year as they are discarded?

Carton makers such as Tetra Pak and SIG Combibloc of Germany are far from the only contributors to the ballooning volumes of packaging waste. In some ways, they are encouraging recycling. But the rise of the carton shows how complex and difficult is the environmental challenge.

The case for cartons is simple: they may be better than the alternatives. They are easy to transport and a study for German carton makers found that they have 78 per cent less climate impact than glass bottles. They also contain 75 per cent paper and only about 20 per cent plastic.

When collected and taken back to a specialist mill, they are also fairly recyclable. Their various layers separate out into paper, plastic and aluminium fibres when pulped in liquid, allowing the paper fibre to be mixed with virgin wood pulp and turned into cardboard boxes, tissues and the like.

This is the good news; the rest is less hopeful. First, recycling is far from universal even in Europe, which has a better record than the US. Only 47 per cent of materials from the 37bn beverage cartons made for European countries in 2016 were recycled.

Cartons are also prone to a broader paradox — as economies advance, people tend to recycle more but also to consume more. Croatia’s overall recycling rate for packaging in 2016 was 55 per cent, compared with Germany’s 71 per cent, but the average German generated four times as much packaging waste as the average Croatian.

This is a frightening prospect on a global scale. McKinsey & Co, the consultancy firm, estimates that China will comprise 28 per cent of the global packaging market by 2022 and emerging economies such as Vietnam suffer from widespread dumping not only of plastic bottles but of cartons.

Second, paperboard is easier to recycle than the plastic, or the 4 per cent aluminium content of aseptic cartons. In theory, the plastic and aluminium fibres that emerge from the soup of old cartons can be turned to other uses — the metal can become material for roofing tiles, while the polymer can be melted into pellets for gas heating or steam.

In practice, this only happens patchily and, as one study put it, “complete recycling in the strict sense is currently not feasible for beverage cartons”. A carton is carefully bonded and constructed, often with a plastic lid and a straw fixed to the side; what Tetra Pak has joined together is not easily put asunder.

Consumer consciousness of plastic waste is rising sharply, thanks to campaigns against ocean pollution. But people still like the convenience of cartons and they offer many benefits, including access to fresh milk and juice in countries without sophisticated supply chains and refrigeration.

This means companies such as Tetra Pak need to do more to make their products not only useful but also sustainable. In the short term, that involves stronger links with recycling mills and waste companies to ensure that the containers they pump into the world are returned and reused.

Tetra Pak last year agreed a partnership with Veolia, the French waste management group, to recycle more polymer and aluminium fibres from cartons for industrial use in Europe. Along with other carton makers, it is also increasing its use of recycled and environmentally approved raw materials, such as wood pulp from certified forests.

In the long term, the company faces a huge technological challenge to get to what it says is its ultimate aim — to construct cartons entirely out of renewable materials, including recycled plastic. Cartons would then no longer require fresh supplies of polymer from oil and gas refineries.

It sounds improbable but innovation in materials science was what originally enabled the milk carton. That also took a long time to perfect from the first idea of creating a tetrahedral paper carton in 1944 to the manufacture of aseptic containers 17 years later. As Hans Rausing’s father, Ruben, observed: “Doing something that nobody else has done before is actually quite hard.”

The multilayer carton turned out to be a far more useful invention than even the Rausings realised at the time. But, like plastic bottles and aluminium cans, it was imperfect. Making it greener is a worthwhile project.

Why rigged capitalism is damaging liberal democracy

Economies are not delivering for most citizens because of weak competition, feeble productivity growth and tax loopholes

Martin Wolf

© Capital flows to the financial centres - London, New York, Silicon Valley and Frankfurt - exacerbating inequality. FT illustration; Getty Images

“While each of our individual companies serves its own corporate purpose, we share a fundamental commitment to all of our stakeholders.”

With this sentence, the US Business Roundtable, which represents the chief executives of 181 of the world’s largest companies, abandoned their longstanding view that “corporations exist principally to serve their shareholders”.

This is certainly a moment. But what does — and should — that moment mean? The answer needs to start with acknowledgment of the fact that something has gone very wrong. Over the past four decades, and especially in the US, the most important country of all, we have observed an unholy trinity of slowing productivity growth, soaring inequality and huge financial shocks.

As Jason Furman of Harvard University and Peter Orszag of Lazard Frères noted in a paper last year: “From 1948 to 1973, real median family income in the US rose 3 per cent annually. At this rate . . . there was a 96 per cent chance that a child would have a higher income than his or her parents. Since 1973, the median family has seen its real income grow only 0.4 per cent annually . . . As a result, 28 per cent of children have lower income than their parents did.”

Chart showing the slowdown of US productivity growth

So why is the economy not delivering? The answer lies, in large part, with the rise of rentier capitalism. In this case “rent” means rewards over and above those required to induce the desired supply of goods, services, land or labour. “Rentier capitalism” means an economy in which market and political power allows privileged individuals and businesses to extract a great deal of such rent from everybody else.

That does not explain every disappointment. As Robert Gordon, professor of social sciences at Northwestern University, argues, fundamental innovation slowed after the mid-20th century.

Technology has also created greater reliance on graduates and raised their relative wages, explaining part of the rise of inequality. But the share of the top 1 per cent of US earners in pre-tax income jumped from 11 per cent in 1980 to 20 per cent in 2014. This was not mainly the result of such skill-biased technological change.

If one listens to the political debates in many countries, notably the US and UK, one would conclude that the disappointment is mainly the fault of imports from China or low-wage immigrants, or both. Foreigners are ideal scapegoats. But the notion that rising inequality and slow productivity growth are due to foreigners is simply false.

HEMEL HEMPSTEAD, ENGLAND - DECEMBER 05: Parcels are prepared for dispatch at Amazon's warehouse on December 5, 2014 in Hemel Hempstead, England. In the lead up to Christmas, Amazon is experiencing the busiest time of the year. (Photo by Peter Macdiarmid/Getty Images)
An Amazon warehouse in the UK. The platform giants are the dominant examples of monopoly rentiers

Every western high-income country trades more with emerging and developing countries today than it did four decades ago. Yet increases in inequality have varied substantially. The outcome depended on how the institutions of the market economy behaved and on domestic policy choices.

Harvard economist Elhanan Helpman ends his overview of a huge academic literature on the topic with the conclusion that “globalisation in the form of foreign trade and offshoring has not been a large contributor to rising inequality. Multiple studies of different events around the world point to this conclusion.”

The shift in the location of much manufacturing, principally to China, may have lowered investment in high-income economies a little. But this effect cannot have been powerful enough to reduce productivity growth significantly. To the contrary, the shift in the global division of labour induced high-income economies to specialise in skill-intensive sectors, where there was more potential for fast productivity growth.

Donald Trump, a naive mercantilist, focuses, instead, on bilateral trade imbalances as a cause of job losses. These deficits reflect bad trade deals, the American president insists. It is true that the US has overall trade deficits, while the EU has surpluses. But their trade policies are quite similar. Trade policies do not explain bilateral balances. Bilateral balances, in turn, do not explain overall balances. The latter are macroeconomic phenomena. Both theory and evidence concur on this.

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The economic impact of immigration has also been small, however big the political and cultural “shock of the foreigner” may be. Research strongly suggests that the effect of immigration on the real earnings of the native population and on receiving countries’ fiscal position has been small and frequently positive.

Far more productive than this politically rewarding, but mistaken, focus on the damage done by trade and migration is an examination of contemporary rentier capitalism itself.

Finance plays a key role, with several dimensions. Liberalised finance tends to metastasise, like a cancer. Thus, the financial sector’s ability to create credit and money finances its own activities, incomes and (often illusory) profits.

A 2015 study by Stephen Cecchetti and Enisse Kharroubi for the Bank for International Settlements said “the level of financial development is good only up to a point, after which it becomes a drag on growth, and that a fast-growing financial sector is detrimental to aggregate productivity growth”. When the financial sector grows quickly, they argue, it hires talented people. These then lend against property, because it generates collateral. This is a diversion of talented human resources in unproductive, useless directions.

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Again, excessive growth of credit almost always leads to crises, as Carmen Reinhart and Kenneth Rogoff showed in This Time is Different. This is why no modern government dares let the supposedly market-driven financial sector operate unaided and unguided. But that in turn creates huge opportunities to gain from irresponsibility: heads, they win; tails, the rest of us lose. Further crises are guaranteed.

Finance also creates rising inequality. Thomas Philippon of the Stern School of Business and Ariell Reshef of the Paris School of Economics showed that the relative earnings of finance professionals exploded upwards in the 1980s with the deregulation of finance. They estimated that “rents” — earnings over and above those needed to attract people into the industry — accounted for 30-50 per cent of the pay differential between finance professionals and the rest of the private sector.

TOPSHOT - US President Donald Trump (C) addresses supporters during a campaign rally in Rio Rancho, New Mexico, on September 16, 2019. (Photo by Nicholas Kamm / AFP)NICHOLAS KAMM/AFP/Getty Images
US president Donald Trump, a naive mercantilist, focuses on bilateral trade imbalances as a cause of job losses © Getty Images

This explosion of financial activity since 1980 has not raised the growth of productivity. If anything, it has lowered it, especially since the crisis. The same is true of the explosion in pay of corporate management, yet another form of rent extraction. As Deborah Hargreaves, founder of the High Pay Centre, notes, in the UK the ratio of average chief executive pay to that of average workers rose from 48 to one in 1998 to 129 to one in 2016. In the US, the same ratio rose from 42 to one in 1980 to 347 to one in 2017.

As the US essayist HL Mencken wrote: “For every complex problem, there is an answer that is clear, simple and wrong.” Pay linked to the share price gave management a huge incentive to raise that price, by manipulating earnings or borrowing money to buy the shares. Neither adds value to the company. But they can add a great deal of wealth to management. A related problem with governance is conflicts of interest, notably over independence of auditors.

In sum, personal financial considerations permeate corporate decision-making. As the independent economist Andrew Smithers argues in Productivity and the Bonus Culture, this comes at the expense of corporate investment and so of long-run productivity growth.

A possibly still more fundamental issue is the decline of competition. Mr Furman and Mr Orszag say there is evidence of increased market concentration in the US, a lower rate of entry of new firms and a lower share of young firms in the economy compared with three or four decades ago. Work by the OECD and Oxford Martin School also notes widening gaps in productivity and profit mark-ups between the leading businesses and the rest. This suggests weakening competition and rising monopoly rent. Moreover, a great deal of the increase in inequality arises from radically different rewards for workers with similar skills in different firms: this, too, is a form of rent extraction.

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A part of the explanation for weaker competition is “winner-takes-almost-all” markets: superstar individuals and their companies earn monopoly rents, because they can now serve global markets so cheaply. The network externalities — benefits of using a network that others are using — and zero marginal costs of platform monopolies (Facebook, Google, Amazon, Alibaba and Tencent) are the dominant examples.

Another such natural force is the network externalities of agglomerations, stressed by Paul Collier in The Future of Capitalism. Successful metropolitan areas — London, New York, the Bay Area in California — generate powerful feedback loops, attracting and rewarding talented people. This disadvantages businesses and people trapped in left-behind towns. Agglomerations, too, create rents, not just in property prices, but also in earnings.

Yet monopoly rent is not just the product of such natural — albeit worrying — economic forces. It is also the result of policy. In the US, Yale University law professor Robert Bork argued in the 1970s that “consumer welfare” should be the sole objective of antitrust policy. As with shareholder value maximisation, this oversimplified highly complex issues. In this case, it led to complacency about monopoly power, provided prices stayed low. Yet tall trees deprive saplings of the light they need to grow. So, too, may giant companies.

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Some might argue, complacently, that the “monopoly rent” we now see in leading economies is largely a sign of the “creative destruction” lauded by the Austrian economist Joseph Schumpeter. In fact, we are not seeing enough creation, destruction or productivity growth to support that view convincingly.

A disreputable aspect of rent-seeking is radical tax avoidance. Corporations (and so also shareholders) benefit from the public goods — security, legal systems, infrastructure, educated workforces and sociopolitical stability — provided by the world’s most powerful liberal democracies. Yet they are also in a perfect position to exploit tax loopholes, especially those companies whose location of production or innovation is difficult to determine.

The biggest challenges within the corporate tax system are tax competition and base erosion and profit shifting. We see the former in falling tax rates. We see the latter in the location of intellectual property in tax havens, in charging tax-deductible debt against profits accruing in higher-tax jurisdictions and in rigging transfer prices within firms.

A 2015 study by the IMF calculated that base erosion and profit shifting reduced long-run annual revenue in OECD countries by about $450bn (1 per cent of gross domestic product) and in non-OECD countries by slightly over $200bn (1.3 per cent of GDP). These are significant figures in the context of a tax that raised an average of only 2.9 per cent of GDP in 2016 in OECD countries and just 2 per cent in the US.

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Brad Setser of the Council on Foreign Relations shows that US corporations report seven times as much profit in small tax havens (Bermuda, the British Caribbean, Ireland, Luxembourg, Netherlands, Singapore and Switzerland) as in six big economies (China, France, Germany, India, Italy and Japan). This is ludicrous. The tax reform under Mr Trump changed essentially nothing. Needless to say, not only US corporations benefit from such loopholes.

In such cases, rents are not merely being exploited. They are being created, through lobbying for distorting and unfair tax loopholes and against needed regulation of mergers, anti-competitive practices, financial misbehaviour, the environment and labour markets. Corporate lobbying overwhelms the interests of ordinary citizens. Indeed, some studies suggest that the wishes of ordinary people count for next to nothing in policymaking.

Not least, as some western economies have become more Latin American in their distribution of incomes, their politics have also become more Latin American. Some of the new populists are considering radical, but necessary, changes in competition, regulatory and tax policies. But others rely on xenophobic dog whistles while continuing to promote a capitalism rigged to favour a small elite. Such activities could well end up with the death of liberal democracy itself.

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Members of the Business Roundtable and their peers have tough questions to ask themselves. They are right: seeking to maximise shareholder value has proved a doubtful guide to managing corporations. But that realisation is the beginning, not the end.

They need to ask themselves what this understanding means for how they set their own pay and how they exploit — indeed actively create — tax and regulatory loopholes.

They must, not least, consider their activities in the public arena. What are they doing to ensure better laws governing the structure of the corporation, a fair and effective tax system, a safety net for those afflicted by economic forces beyond their control, a healthy local and global environment and a democracy responsive to the wishes of a broad majority?

We need a dynamic capitalist economy that gives everybody a justified belief that they can share in the benefits. What we increasingly seem to have instead is an unstable rentier capitalism, weakened competition, feeble productivity growth, high inequality and, not coincidentally, an increasingly degraded democracy. Fixing this is a challenge for us all, but especially for those who run the world’s most important businesses. The way our economic and political systems work must change, or they will perish.

About Martin Wolf

As the FT’s chief economics commentator, Martin Wolf paints on a wide canvas. He focuses on the world economy, and has paid particular attention to globalisation, financial crises and, more recently, trade wars. Pro-market but pragmatic, he ranges broadly and skilfully from the challenge of climate change to the rise of populism, and even the prediction that interest rates would remain very low for a very long time.

No Coincidences

Doug Nolan

September 20 – Wall Street Journal (Daniel Kruger): “The Federal Reserve Bank of New York will offer to add at least $75 billion daily to the financial system through Oct. 10, prolonging its efforts to relieve funding pressure in money markets. In addition to at least $75 billion in overnight loans, the New York Fed… will also offer three separate 14-day repo contracts of at least $30 billion each next week… On Friday banks asked for $75.55 billion in reserves, $550 million more than the amount offered by the Fed, offering collateral in the form of Treasury and mortgage securities. The Fed’s operation was the fourth time this week it has intervened to calm roiled money markets. Rates on short-term repos briefly spiked to nearly 10% earlier this week as financial firms looked for overnight funding. The actions marked the first time since the financial crisis that the Fed had taken such measures.”

With the collapse of Lehman setting off the “worst financial crisis since the Great Depression”, instability in the multi-trillion repurchase agreement marketplace generates intense interest.

This crucial market for funding levered securities holdings is critical to the financial system’s “plumbing.” It is a market in perceived “money” – highly liquid and virtually risk free-instruments.

If risk suddenly becomes an issue for this shadowy network, the cost and availability of Credit for highly leveraged players is suddenly in question. And any de-risking/deleveraging at the nucleus of the global financial system would pose a clear and present danger of sparking “risk off” throughout Credit markets and financial markets more generally.

I’ll usually begin contemplating the CBB on Thursdays. This week’s alarming dislocation in the “repo” market was clearly a major development worthy of focus. But I was planning on highlighting the lack of initial contagion effects in corporate Credit, a not surprising development considering the New York Fed’s aggressive liquidity injections.

Investment-grade Credit default swaps (CDS), for example, closed Thursday trading near their lowest levels since February 2018. Junk bond spreads (to Treasuries) went out Thursday near the narrowest since early-November. Bank CDS, another important indicator, also continued to signal the “all’s clear” throughout Thursday trading. As of Thursday’s close, Goldman Sachs’ (5yr) CDS was up a modest three points for the week to 58, after closing the previous Friday near low going back to January 2018.

But Friday’s trading session came with additional intrigue. Investment-grade CDS jumped 15% to 59.7, the highest close in about a month. Goldman Sachs CDS rose 9.4% to 63.1, an almost four-week high. JPMorgan CDS rose 8.9% (to 42.7), BofA 11.0% (to 47.5) and Citigroup 5.7% (to 61.1). And as key financial CDS prices moved sharply higher, safe haven bond yields dropped. Treasury yields fell six bps in Friday trading to 1.72%, and Bund yields declined two bps to negative 0.525%. Even more curious, Gold popped almost $18 Friday to $1,517, boosting the week’s gain to $28.

The Fed’s return to system liquidity injections after a decade hiatus received abundant media coverage. For the most part, analysts were pointing to a confluence of unusual factors: $35 billion money market outflows to fund September 15th quarterly corporate tax payments; settlements for outsized Treasury auctions; and the approaching end to the quarter (where money center banks generally reduce balance sheet leverage for financial reporting and regulatory purposes).

Missing from the discussion was that this week’s money market tumult followed on the heels of instability in other markets. Is it coincidence that Monday’s spike in repo rates followed last week’s extraordinary bond market reversal – where 10-year Treasury yields surged 34 bps and benchmark MBS yields spiked an incredible 46 bps (2.37% to 2.83%)?

What a nightmare it’s been over recent months for those attempting to hedge interest-rate risk. After trading to 4.10% in November, benchmark MBS yields were down to 3.02% near the end of March. MBS yields then rose to 3.34% in April, before reversing lower to trade all the way down to 2.51% by late June. Yields were back up to 2.91% in mid-July – only to then reverse to a three-year low of 2.30% on September 4th. Collapsing MBS yields spur waves of refinancings, shortening the lives (“duration”) of existing MBS securities trading in the marketplace (as old MBS are replaced with new lower-yielding securities).

The marketplace for hedging MBS and other interest-rate risks is enormous. Derivatives really do rule the world. When market yields are declining, players that had sold various types of protection against lower rates are forced into the marketplace to acquire instruments for hedging their escalating rate exposure.

Much of this levered buying would typically be financed in the repurchase agreement (“repo”) marketplace. This type of hedging activity can prove strongly self-reinforcing. Intense buying forces Treasury and bond market prices higher, “squeezing” those short the market while spurring additional hedging-related buying. At the same time, the expansion of “repo” securities Credit boosts overall system liquidity, supporting the upside inflationary bias in bond and securities prices.

The recent downside dislocation in market yields included tell-tale signs of manic blow-off speculative excess. At 1.46% lows (September 3rd), an exuberant marketplace was calling for sub-1% Treasury yields – as if the unending supply from massive deficit spending would remain permanently divorced from market price dynamics. Meanwhile, booming corporate issuance was gobbled up at near record low yields - and the lowest spreads to Treasuries in two years. Inflows were inundating the bond ETF complex.

Excesses in U.S. fixed-income were unfolding as $18 TN of global investment-grade bonds traded at negative yields, including European corporate debt.

Things got conspicuously out of hand. With global central bankers in aggressive easing mode – including an ECB restarting the QE machine while pushing rates further into negative territory – market participants were in the mood to believe central banks had abolished market cycles. Like deficits and Current Account Deficits, speculative excess and leverage don’t matter.

While everyone was relishing the mania, trouble was building under the markets’ surface – in the “plumbing.” As yields collapsed, speculative leverage mounted. Surging prices incited a buyers’ panic in Treasuries, MBS, corporate bonds, CDOs and structured finance – a chunk of it financed in the “repo” and money markets.

Derivative player hedging activities also significantly boosted system leverage. All the speculative leveraging worked to expand system liquidity, crystallizing the market perception of endless liquidity abundance. While a deficient indicator of system liquidity, it’s still worth noting M2 “money” supply has expanded $560 billion over the past six months. Money market fund assets (retail funds included in M2) are up $350 billion since the end of April. Where’s all this “money” been coming from?

Market “melt-up” upside dislocations sow the seeds for abrupt market reversals and attendant upheaval. One day’s panic buying (on leverage) can be the following session’s frantic selling (unwind of leverage). Especially in the derivatives arena, self-reinforcing derivative-related dynamic (“delta”) hedging during an upside speculative blow-off is susceptible to abrupt reversals.

Hedging programs necessitate buying into rapidly rising markets, only to immediately shift to aggressive selling in the event of market weakness. The associated leverage spurs liquidity excess on the upside, creating vulnerability for illiquidity in the event of downside sell programs and speculative deleveraging.

It is surely no coincidence that this week’s “repo” ructions followed last week’s spike in yields and resulting deleveraging. Is it a coincidence that the marketplace experienced a powerful “rotation” that saw the favorite stocks and sectors dramatically underperform the least favored? Is it a coincidence that hedge fund long/short strategies have been clobbered, in what evolved into a powerful short squeeze and dislocation? Surely, it’s no coincidence the so-called “quant quake” foresaw this week’s quake in the repo market?

Let’s expand this inquiry. Is it a coincidence that this week’s money market upheaval followed by a few months dislocation in the Chinese money market? And is it mere coincidence that U.S. money market instability erupted on the heels of the ECB’s decision to restart QE?

There are No Coincidences. Chinese money market issues and currency weakness were fundamental to the global collapse in yields. Trade war escalation risked pushing China’s vulnerable Credit system and economy over the edge.

Global central bankers responded to sinking bond yields with dovish talk and monetary stimulus, feeding the unfolding bond market dislocation. Collapsing market yields and dovish central banks stoked melt-up dynamics in stocks and sectors seen benefiting from a lower rate environment. Growth stocks were caught up speculative melt-up dynamics, while short positions in underperforming financials and small caps were popular hedging targets.

Both momentum longs and shorts became Crowded Trades.

Meanwhile, booming markets and the resulting loosening of financial conditions quietly bolstered flagging growth dynamics – from China to the U.S. to Europe. The prospect of constructive U.S./China trade talks risked catching the manic bond market out over its skis.

Some stronger U.S. data sparked a sharp bond market reversal, with rising yields spurring a reversal of Crowded equities trades. Losing on both sides, the long/short players suffered painful losses. De-risking of long/short strategies incited a powerful short squeeze, a dynamic that gained momentum into expiration week.

The S&P500 is only about 1% from all-time highs. Yet there’s been some real damage below the market’s surface. The leveraged speculating community, in particular, has been shaken.

There were losses in Argentina and EM currencies more generally. Bond markets have turned unstable – on both the up- and downside. Long/short strategies have been bludgeoned. Short positions have turned highly erratic. And this week instability engulfed the overnight funding markets, with contagion effects for other short-term funding vehicles at home and abroad.

Trouble brewing.

The leveraged speculating community is the marginal source of liquidity throughout U.S. and global markets. Not only have they faced heightened risk across the spectrum of their holdings, they now confront funding market uncertainty into year-end. This doesn’t necessarily indicate imminent market weakness.

But it does signal vulnerability. Many players are afflicted with increasingly “weak hands.” They’ll exhibit less tolerance for pain. This dynamic increases the likelihood that market weakness will spur self-reinforcing de-risking and deleveraging.

There was considerable market vulnerability this time last year – with equities at all-time highs.

Global markets, economies, trade relationships and geopolitics are all more troubling today.

Central bankers have burned through precious ammunition, in the process spurring problematic late-cycle excess. Understandably, there is dissention within the ranks – from the Fed to the ECB and BOJ. Is monetary stimulus the solution or the problem?

Autumn is set up for some serious instability. There’s all this talk of the need for the Fed to create additional bank reserves. The issue is not a shortage of reserves but a gross excess of speculative leverage. It started this week. The Fed’s balance sheet will be getting much bigger.

The Fed and the markets were blindsided by this week’s repo market instability. The surprises will keep coming.


Why yields are the best guide to future stockmarket returns

John Cochrane’s landmark 2011 paper on discount rates

IN 2011 JOHN COCHRANE, a professor at the University of Chicago’s Booth School of Business, gave a presidential address on “Discount Rates” to the American Finance Association. It was published as a paper a few months later. In a sweeping take, Mr Cochrane set out how academics’ understanding of the way asset prices are determined has shifted over the past half-century. Many papers are described as “landmark”; this one has a better claim to the label than most.

His opening line (“Asset prices should equal expected discounted cash flows”) indicated that the basic premise has not changed. But plenty has. In the 1970s the focus of academic finance was on the “expected” part of that equation—the efficiency with which markets priced in any new information relevant to future cash flows. The emphasis has shifted. The “discounted” part, or the risk preferences of investors, has become the main organising principle for research, argued Mr Cochrane.

The old-school view was that when stock prices are high relative to earnings or dividends (ie, yields are low), it implies these cash flows are expected to grow quickly in future. The new school says it is changes in risk appetite—the discount rate that investors apply to future earnings—that explains much of the variation in asset prices. If prices are high and yields are low, that implies investors are willing to accept lower returns in future. Yields predict returns.

There are practical implications. A generation ago an investor might have looked to history for a guide to expected returns. Now yields are seen as a more useful steer. This is clearer with government bonds. The real annual return on American Treasury bonds was 1.9% between 1900 and 2018, according to Credit Suisse’s Global Investment Returns Yearbook. But history is bunk. It would not be wise to expect a 1.9% return when the yield-to-maturity on inflation-protected Treasury bonds is zero, as it is now.

The future cash flows from stocks are not as certain as those from government bonds. But Mr Cochrane argued that a similar principle holds with stocks over the long haul. “High prices, relative to dividends, have reliably preceded many years of poor returns. Low prices have preceded high returns,” he said. The predictive power of yields holds for bonds and stocks, but also for other assets, such as housing. And valuations based on aggregate earnings or book value predict stock returns just as well as the dividend yield.

A lot of people prefer the earnings yield. Share buy-backs have become a more popular way to return capital to stockholders than paying dividends. The earnings yield may be a better guide to expected returns. True, not all company earnings are distributed to shareholders in dividends or buy-backs; some are used to pay for investment to generate future earnings growth. On the other hand, that growth should also be considered part of expected returns.

If yields predict returns, that might seem to imply that astute investors can sell stocks when yields (and expected returns) are low and buy them back when yields are high. In practice, the signal from yield is too weak to be relied upon to catch turning points profitably. But what matters to a lot of investors is not so much what stocks will return in the short run, but how much extra they will return over safe bonds in the long run.

This extra reward is the equity risk premium—and to Mr Cochrane’s way of thinking the discount rate, the risk premium and the expected return on equities “are all the same thing”.

One forward-looking measure of the equity risk premium shows a wide variation over time (see chart). Investors with a long-term horizon might profitably use such variations to decide on the mix of risky stocks and safe bonds to hold in a portfolio. The higher the risk premium on stocks, the more the odds favour investors tilting their portfolio away from bonds.

A question for academic research is why exactly expected returns (or, if you prefer, discount rates) on stocks vary so much. One explanation is that, as memories of the previous market crash fade, people get more comfortable owning equities—until the next bear market makes them rethink.

In his address Mr Cochrane argued that in a market slump a typical investor is inclined to ignore the high premiums offered by stocks because he fears for his job. The correlation between employment income and stock prices is to blame. Future returns are remarkably hard to predict. Yields may only be a weak guide to them; but they are the best we have.

Why U.S.-China Supply Chains Are Stronger Than the Trade War

trade war supply chain impact

While the trade war between the U.S. and China continues to take its toll, global supply chains provide a “force for reason” in ending the standoff because they bind the two countries in prosperity, writes Wharton dean Geoffrey Garrett in this opinion piece.

Say the words “supply chain” and most people tune out. Supply chains sound technical, geeky and boring. But nothing could be further from the truth. Here are my three cheers for supply chains:
  1. Supply chains are at the core of the modern global economy.
  2. Supply chains will help resolve the China-U.S. trade war.
  3. Supply chains will make a new Cold War less likely.

If you listen to President Donald Trump talk about trade you will get the impression that international supply chains don’t exist. In the most important case, China and the United States, the President’s analysis goes something like this: Goods and services are either “made in America” or “made in China.” America “wins” when products made in America are exported to China. America “loses” when it imports products made in China. The trade imbalance represents the win-loss records for both countries, just like your favorite sports team.

On this accounting, America is losing badly. Hence the ongoing trade war. The problem is that Trumpian trade is a relic of a distant era, when products really were made in one country and sold to another. That model is long gone, transformed first by containerized shipping in the 1960s and then by the internet in the 1990s.

These revolutions dramatically lowered the costs of moving goods and services between countries. A brave new world of global supply chains emerged to leverage international differences in costs and skills to produce better and cheaper products.

In today’s global economy, products are put together in one country from components sourced in other countries and then sold all over the world. As a result, vastly fewer products are solely “made in America,” “made in China,” or indeed made in any one country.

There can be no doubt this has been a boon for consumers the world over. It is also one reason why economists downplay the significance of bilateral trade balances.

But the globalization of supply chains has outsourced once-American jobs to other countries, from autoworkers to radiologists, call center operators to accountants. This is why Trump thinks trade wars are good electoral politics.

The economics of trade wars are very different. The tit-for-tat escalation of tariffs between China and the U.S. will cost the average American consumer this year. American farmers are hurting from Chinese tariffs on soybeans and other agricultural products.

Big business is also losing badly from the trade war – led by powerful firms in the tech sector that are integral to the supply chains co-mingling the activities of both American and Chinese companies. Consider two iconic examples: Trump’s war on Huawei and his call for Apple to make iPhones in America.

A Tale of Two Supply Chains

Despite all the bluster, the Trump administration has yet to deliver on its promise to forbid Huawei from doing business with America. Why?

Because Huawei matters a great deal to American business. About one-quarter of the components in Huawei products are supplied by leading American tech companies, led by Broadcom, Flex, and Qualcomm. Add them all up and American suppliers make well over $1 billion a year from Huawei—not much less than Huawei’s Chinese suppliers do.

[Source: Reuters]

The same story was true for another Chinese smartphone and telecoms company, ZTE, a couple of years ago. After initial Trump bluster that the U.S. was going to ban ZTE from doing business in America, Trump declared a cease fire, tweeting on May 14, 2018: “ZTE, the large Chinese phone company, buys a big percentage of individual parts from U.S. companies.”

This logic applies even more to Huawei. In addition to American suppliers of components, Google has a big stake in Huawei’s success — because Huawei is the second largest smartphone maker in the world and all its phones employ Google’s Android operating system.

It would be a gross exaggeration to say that Huawei’s success is America’s success. But it makes an important rhetorical point: there is no denying that several large American tech firms benefit from Huawei’s success — and are harmed by the Trump administration’s war on Huawei.

Now flip the script from American components in Chinese equipment to Chinese assembly of American products — Apple.

Truth in advertising on the back of all Apple devices: “Designed by Apple in California. Assembled in China.” Note: It does not say “made in China” because Apple devices are almost exclusively assembled on the Chinese mainland, predominantly by a Taiwanese firm, Foxconn, from components coming from America, Asia, and Europe. Here was UT Dallas’s James Hogan’s description of the Apple supply chain in 2016:

The economics of Apple’s supply chain are at least as important. The value added by assemblers Foxconn and Pegatron is typically estimated at only about 5% of the total cost of making an Apple device. The rest comes from the components, none of which come from China. So much for “made in China.”

According to TechInsights, the total cost of the iPhone XS Max is $453. Compare that with the retail sticker price of $1099 and it’s easy to see why Apple is one of the world’s largest companies by market capitalization.

And it is no surprise that Apple CEO Tim Cook is a champion of China’s role in Apple’s success. In an interview defending “assembled in China” against Trump’s attacks in late 2017, Cook emphasized that Apple is in China because of quality not price: “The products we do require really advanced tooling, and the precision that you have to have, the tooling and working with the materials that we do are state of the art. And the tooling skill is very deep here. In the U.S. you could have a meeting of tooling engineers and I’m not sure we could fill the room. In China you could fill multiple football fields.”

So China is integral to Apple’s success, all the more so given that China is the largest market for Apple products outside America.

The Dangers of Decoupling

Once you take into account the supply chains underpinning Apple and Huawei and the enormous value American firms derive from them, it is easy to see why companies like Apple and Google, Broadcom and Qualcomm want the trade war to end. Up until now, they have put a break on extending the trade war to tech. In the future, they will be an important force pressing for a ceasefire.

But at least some in the Trump administration see supply chains as the enemy when it comes to China-U.S. relations. They want to “decouple” the two economies by disentangling the supply chains enmeshing the two economies together.

Decoupling would be very hard to do. It would also be incredibly costly in economic terms. But decoupling would have another, even more important, consequence: It would make military conflict between America and China more likely.

Immanuel Kant was perhaps the first person to conjecture that “the spirit of commerce … sooner or later takes hold of every nation, and is incompatible with war.” But critics of this notion that countries that trade with each other don’t go to war with each other point to World War I as the stunning counter example.

Britain and Germany went to war despite very deep trade relations between the two countries during a period of extensive globalization. Why won’t the same happen between China and America now?

My answer is that globalization in the first part of the 21st century is very different from that in the first part of the 20th century – because of global supply chains. 100 years ago, there were no global supply chains and scant multinational companies. Today, global supply chains powering MNCs are at the very core of the global economy.

Most importantly, America and China are co-dependent on each other with supply chain interconnections amounting to a dense thicket of ties binding the two countries together. This is not just “incompatible” with war, as Kant noted. It is closer to unthinkable.

That is why I am bullish that, despite their deep and real differences, America and China are not destined for war. That is also why I am deeply opposed to “decoupling.” Advocates promote decoupling in the name of national security. I believe the opposite would be true. Decoupling would profoundly harm America’s national security by reducing the costs of war with China and hence making military conflict more likely.

Global supply chains not only benefit consumers. They also are a force for reason in ending the trade standoff between America and China. And they also form the ties that bind the two countries together in both prosperity and peace.