Q4 2018 Z.1 "Flow of Funds"

Doug Nolan


I’ve been anxiously awaiting the Fed’s Q4 2018 Z.1 “flow of funds” report. It provided the first comprehensive look at how the period’s market instability affected various sectors within the financial system. From ballooning Broker/Dealer balance sheets to surging “repo” lending to record Bank loan growth – it’s chock-full of intriguing data. All in all, and despite a Q4 slowdown, 2018 posted the strongest Credit growth since before the crisis – led, of course, by our spendthrift federal government.

Non-Financial Debt (NFD) rose $2.524 TN during 2018 (5.1%), exceeding 2007’s $2.478 TN and second only to 2004’s $2.915 TN growth. NFD closed 2018 at a record 253% of GDP, compared to 230% to end of 2007 and 189% to conclude the nineties. By major category, Federal borrowings expanded $1.258 TN during the year, up from 2017’s $599 billion, and the strongest growth since 2010’s $1.646 TN. Year-over-year growth in Total Household borrowings slowed ($488bn vs. $570bn), led by a drop in Home Mortgages ($285bn vs. $312bn). Total Corporate borrowings slowed to $532 billion from 2017’s $769 billion. Foreign U.S. borrowings slowed to $207 billion from 2017’s $389 billion.

On a percentage basis, NFD increased 4.51% in 2018, up from 2017’s 4.10%. Federal debt grew 7.58%, almost double 2017’s 3.74%, to the strongest percentage growth since 2012 (10.12%). Household debt growth slowed to 3.22% (from 3.90%), with Mortgage borrowings up 2.83% (from 3.19%) and Consumer Credit growth easing slightly to 4.88% (from 5.04%). Total Corporate Debt growth slowed meaningfully from 2017’s 5.71% to 3.69%.

For Q4, on a seasonally-adjusted and annualized basis (SAAR), Non-Financial Debt (NFD) expanded $1.390 TN, the slowest expansion since Q4 2016 (SAAR $941bn). This is largely explained by the sharp drop-off in Federal borrowings (SAAR $444bn vs. Q3’s SAAR $1.180 TN).

Outstanding Treasury Securities ended 2018 at a record $17.842 TN, up $1.411 TN (8.6%) for the year to 85% of GDP. Treasuries have surged $11.791 TN, or 195%, since the end of 2007. Agency Securities (debt and MBS) rose $245 billion during 2018 to a record $9.113 TN (2yr gain $592bn). In total, Treasury and Agency Securities surged $1.656 TN last year – accounting for a full two-thirds of total Non-Financial Debt growth. Combined Treasury and Agency debt ended 2018 at a record $26,955 TN, or 129% of GDP (vs. 2007’s $14.685 TN, or 92%).

Broker/Dealer assets surged nominal $165 billion, or 21% annualized, during the quarter, the biggest quarterly gain since Q1 2010. For the year, Broker/Dealer assets jumped $262 billion (8.4%) to $3.359 TN, the largest annual increase since 2007. Debt Securities holdings jumped by $147 billion during Q4, led by a $162 billion increase in Treasuries to $251 billion (more than doubling y-o-y).

The Household Balance Sheet remains a key Bubble manifestation, during the quarter providing a hint of how quickly perceived household wealth will evaporate during a bear market. Household Assets dropped $3.056 TN during Q4 to $120.9 TN, led by a $3.883 TN decline in total equities holdings (Equities and Mutual Funds). And with Liabilities increasing $133 billion during Q4, Household Net Worth fell $3.190 TN (the largest drop since Q4 2008’s $3.835 TN) to $104.869 TN. Household Real Estate holdings rose $279 billion during the quarter and were up $1.319 TN for 2018.

As large as Q4’s drop in Net Worth was, it erased only somewhat less than the previous six month’s gain. For all of 2018, Household Net Worth increased $1.876 TN, with a gain of $47.586 TN, or 65%, since the end of 2008. With equities already regaining the majority of Q4 losses, I don’t want to read too much into Q4 ratios. But it’s worth noting that Net Worth as a percentage of GDP dropped to 512% from Q3’s record 523%, yet remains significantly above previous cycle peaks (484% in Q1 2007 and 435% to end 1999).

The Rest of World (ROW) balance sheet is also fundamental to Bubble Analysis. For the year, ROW U.S. asset holdings declined $192 billion, the first drop since 2008. And while ROW holdings of total Equities declined $650 billion (mostly on lower prices), Corporate Debt fell $283 billion (also largest drop since 2008). Notable as well, ROW Treasury holdings declined $63bn (to $6.222 TN) in 2018 after jumping $282 billion in 2017.

Q4 market instability left its mark in Z.1 data. Broker/Dealer Assets surged SAAR $544 billion ($165bn nominal), the biggest quarterly gain since Q1 2010. Broker/Dealer Treasury holdings jumped nominal $162 billion (SAAR $685bn), the largest rise since the unstable global backdrop of Q4 2011. The Asset “Security Repurchase Agreements” (Repos) jumped nominal $150 billion (SAAR $602bn) to $1.315 TN, the high since Q4 2013. This was the largest gain since tumultuous Q3 2011. Repo Liabilities jumped $213bn (SAAR $851bn) to $1.698 TN – the high since Q1 2014. Q4’s Repo Liabilities increase was the largest going all the way back to Q1 2010.

The full category “Federal Funds & Securities Repurchase Agreements” ballooned $317 billion (SAAR $1.235 TN), the largest gain since Q1 2010. Fed Funds and Repo ended 2018 at $3.881 TN – an almost five-year high. Ballooning “repo” Assets and Liabilities – and Broker/Dealer balance sheets more generally – reflected Q4 market instability and illiquidity.

I’ll infer that the Broker/Dealer community was being called upon to provide liquidity – both by buying securities and offering securities Credit to the marketplace (leveraged speculating community, in particular). They were also forced to warehouse leveraged loans and such -awaiting the return of buyers. Moreover, it’s a fair assumption that major trading/liquidity issues were unfolding throughout the derivatives marketplace.

It’s worth noting that Goldman Sachs Credit default swap (5yr CDS) prices ended Q3 at 61 bps. Prices finished 2018 at 106 bps and then spiked to as high as 129 bps on January 3rd – the high since Q1 2016’s China/market tumult. After ending Q3 at 55 bps, Morgan Stanley CDS traded to 106 bps on January 3rd. Over this period, JP Morgan CDS jumped from 40 bps to as high as 78 bps, and Bank of America Merrill Lynch CDS spiked from 45 bps to 83 bps. Investment-grade corporate CDS also traded to highs since 2016, as did junk bond spreads. As I espoused at the time, there’s no mystery why Chairman Powell orchestrated his abrupt U-Turn on January 4th. The system was rapidly approaching the de-risking/deleveraging/derivatives dislocation/market illiquidity precipice.

It wasn’t only the Broker/Dealers and “repo” market that experienced noteworthy quarters. Bank Assets jumped nominal $267 billion, or 5.7% annualized, to a record $19.299 TN. Robust Bank growth was led by a record $263 billion (SAAR $868bn) surge in Loans (almost 10% annualized), surpassing the previous high ($260bn) back in the Bubble heyday Q3 2007. In addition, Bank “repo” assets (lending against securities) jumped a record $161 billion (SAAR $643bn) to $703 billion (high since Q3 ’08). Meanwhile, Debt Securities holdings rose $129 billion (SAAR $286bn), the biggest increase since Q1 2012 (ending the year at a record $4.304 TN). During the quarter, Banks added aggressively to Treasuries (up SAAR $246bn) and Agency- GSE-backed Securities (up SAAR $187bn), while liquidating Corporate Bonds (down SAAR $121bn). Between Broker/Dealer and Bank buying, there’s no mystery surrounding the Q4 collapse in Treasury yields.

Speaking of collapsing yields: German bund yields dropped 11 bps this week to 0.065%, trading to the lowest yields since October 2016. French yields sank 17 bps to 0.41% - also a low since 2016. Italian yields dropped 23 bps this week to 2.50%, the low since July.

March 7 – Reuters (Francesco Canepa, Frank Siebelt and Balazs Koranyi): “European Central Bank President Mario Draghi caught even dovish rate-setters off guard by pushing… for unexpectedly generous stimulus after forecasts showed a large drop in economic growth, four sources familiar with the discussion said. At its policy meeting, the ECB delayed its first post-crisis rate hike into 2020 and offered banks more ultra-cheap loans…”

Yet sinking yields weren’t limited to Europe. Ten-year Treasury yields dropped 12 bps to 2.63% - with yields now down five bps for the year. Japan’s JGB yields declined three bps to negative 0.3%, near early-January market instability lows.

The wide – and widening – divergence between booming risk markets and more than resilient safe haven sovereign bond prices narrowed just a bit this week. The Shanghai Composite was slammed 4.4% Friday (reducing y-t-d gains to 19.1%) on fears Beijing is increasingly alarmed by speculative securities markets. They should be. More dismal data (i.e. February exports down 16.6%) – along with indications that the U.S./China trade deal is not the done deal many have been presuming – pressured markets from China to the U.S. Mixed signals – i.e. paltry February job gains (20k) in the face of a stronger-than-expected ISM Non-Manufacturing index – provide little clarity regarding underlying U.S. economic momentum.

For the most part, markets have been mesmerized by a flock of dovish global central bankers – while ignoring gathering storm clouds. Yet Z.1 data are a reminder of how quickly the markets buckled back in the fourth quarter. By now, I’ll assume the vigorous short squeeze and unwind of hedges have pretty much run their course. It has me pondering the next leg down in the unfolding bear market.

At some point, it’s not going to be as easy for central bankers and Beijing to reverse faltering markets. A big surge in Broker/Dealer assets, “repo” and bank lending would prove problematic if, instead of recovering, markets continue sinking into illiquidity. Financial conditions would tighten dramatically. No junk – or investment-grade issuance. Q4 ETF outflows and derivative issues offered a hint of what’s to come.

Foreign buyers have been losing interest in U.S. securities. And definitely don’t rule out a quick $10 TN drop in Household Net Worth – and attendant major economic ramifications. Silly me. Annual $2.0 Trillion federal deficits effortlessly monetized by our accommodating central bank will cure all ills – financial, economic, social, geopolitical and otherwise.

Global policymakers will regret becoming so adept at stoking speculative excess.


Global Economy Slows, Pushing Europe’s Central Bank to Make a Surprise Move

The European Central Bank, concerned about the sluggish eurozone economy, pushed back the date of its next increase in benchmark interest rates.

By Jack Ewing


The European Central Bank, concerned about the sluggish eurozone economy, pushed back the date of its next increase in benchmark interest rates.CreditCreditDaniel Roland/Agence France-Presse — Getty Images



FRANKFURT — Just a few months ago, the European Central Bank put the brakes on a vast economic stimulus program devised during the financial crisis. On Thursday, it unexpectedly reversed course and revived some of the measures, signaling the rising threat of a recession.

The quick turnabout, from confidence to concern, reflects the broader weakness in the global economy. A slowdown in China, exacerbated by rising trade tensions with the United States, has reverberated around the world, dragging down growth in Europe and elsewhere.

The United States is Europe’s largest trading partner, while China is an increasingly important market for its cars, pharmaceuticals and manufactured goods. The industrial powerhouse Germany barely escaped recession in the latest quarter, as the country’s economy was battered by the American tariffs on its steel and waning Chinese appetite for its machine tools and Volkswagens.

Europe has been particularly vulnerable to global forces, given the turmoil at home. The uncertainty over Britain’s exit from the European Union has put pressure on the British economy, while Italy and Spain have been shaken by their own political fisures.

The struggles abroad have the potential to blow back on the United States, which has been the star performer among global economies. History shows that the American economy cannot escape problems in Europe, given their deep commercial ties. And the Chinese slowdown amplifies the risks.

“We’re looking at the potential for a synchronized slowdown of the global economy,” said Carl B. Weinberg, chief international economist at High Frequency Economics.

Against that backdrop, the European Central Bank’s Governing Council voted unanimously on Thursday to bring back a stimulus measure intended to encourage lending. The move will help banks in countries with weaker economies like Italy that may have trouble raising money on capital markets at reasonable rates.

The stimulus program was used to prevent collapse of the eurozone following the 2008 financial crisis. It allows commercial banks to borrow money from the central bank at zero interest, but they have to promise to lend the money to businesses or consumers.

Mario Draghi, the president of the European Central Bank, implicitly blamed White House policies for the economic damage behind the decision. “Lower confidence produced by the trade discussions” was a key cause of economic slowdowns in Europe, China and emerging markets, Mr. Draghi said at a news briefing. He added, though, that he did not expect a recession.

The bank also pushed back the date of its earliest possible increase in benchmark interest rates by at least four months, saying there would be no change until 2020. That means that Mr. Draghi will serve his full nine-year term without ever having overseen a rate increase. He leaves office at the end of October.

“The bank is saying, ‘We are doing everything we can,’” said Florian Hense, an economist at Berenberg Bank in London.

The past decade had been rough for Europe.

The global financial crisis, which set off the European sovereign debt crisis, forced Mr. Draghi to unleash extraordinary stimulus measures to keep the eurozone from being torn apart. Mr. Draghi, who famously vowed to “do whatever it takes” to keep the bloc intact, oversaw a vast de facto money printing program in which the bank bought trillions of euros of government and corporate bonds.

Europe seemed to have finally turned a corner last year, and Mr. Draghi began cautiously unwinding its program of bond buying, a strategy known as quantitative easing. The bank stopped adding to its bond portfolio in December, and also set the stage for an increase in its key interest rates as early as this September.

Those moves were an expression of confidence that the world’s major economies would shrug off President Trump’s trade war and continue to grow strongly. But a few months later, the picture looks decidedly worse.

Italy is in recession and Germany came close. Britain’s attempt to leave the European Union proved even more difficult and disruptive than expected.

Even the weather seemed to conspire against Europe. An unusually dry and hot summer caused the water level in the Rhine River to drop so low that barge traffic became impossible, disrupting transport of chemicals and fuel, causing shortages and driving up prices.

The timing of the overseas slowdown could not be worse from the United States’ perspective. It’s happening just as the American economy is expected to slow down after the economic high of the tax cuts that went into effect last year starts to wear off.

In that environment, the United States and its companies will be more dependent on the health of trading partners like Europe. “The U.S. needs the rest of the world a bit more than last year,” said Brad W. Setser, a senior fellow at the Council on Foreign Relations.

Economic weakness abroad can also send American stock markets into a tailspin.

In 2011, when investors feared that a wave of European governments and companies might default on their debts, American stocks fell nearly 20 percent from their highs. In 2015, the S&P 500 plunged after China’s central bank made a surprise move that reduced the value of the country’s currency against the dollar.

The sudden announcement by the European Central Bank on Thursday was out of character. Typically, the bank changes policy gradually and gives investors plenty of warning.

The bank also displayed an unusually high level of determination and unity. All of the members of the Governing Council supported the decisions on Thursday, Mr. Draghi said. That has not always been the case. During the crisis years the council, which includes central bankers from all 19 countries in the eurozone, was often divided on its response.

Still, the central bank is treading cautiously, waiting to see what happens with the economy. It did not take the more radical step of increasing its purchases of government and corporate bonds. That form of stimulus is associated with extreme stress and might have been taken as a sign of panic.

Mr. Draghi also emphasized on Thursday that the central bank never really ended the bond buying program in December — it just stopped expanding it. When bonds in the bank’s portfolio pay interest or the borrowers pay the money back, the bank will use the funds to buy more bonds. That means the holdings, valued at $2.8 trillion, will remain stable.

And Mr. Draghi said the central bank would do more if the economy took a turn for the worse. “We are very open to act and determined to act when it’s needed,” he said.

The bank’s change of heart reflected the views of its in-house economists, who significantly lowered their forecasts for growth and inflation. They now expect eurozone growth in 2019 to be 1.1 percent, rather than the 1.7 percent growth they were forecasting only a few months ago.

The moves provided a short-lived jolt to European stock markets. The major indexes, which had been lower for the day, briefly jumped into positive territory. But any euphoria about the stimulus may have been outweighed by the realization that the central bank is more worried about the economy than investors thought. Stocks slumped in Europe and, later in the day, on Wall Street.

“Today’s announcements have some flavor of panic,” Carsten Brzeski, chief economist at ING Germany, said in a note to clients.


Peter Eavis contributed reporting from New York.

Donald Trump’s ill-timed rift with Europe

There is an opportunity for a new transatlantic alliance to benefit both US and EU

Rana Foroohar



Donald Trump may be about to fight the wrong trade war — again. Even as the US president claims to be making real progress with trade negotiations in China, the commerce department is set to give him confidential recommendations on his Section 232 auto investigations, which could allow him to use national security as cover for new tariffs on foreign vehicles. Mr Trump has 90 days to act on them, but many insiders believe there’s a good chance he will act sooner than that and launch auto tariffs on the EU and Japan.

It is hard to overstate what a disaster this would be. Mr Trump is touting a “breakthrough” on China trade because he wants to be seen as a “dealmaker”. But this is an unconvincing feint — the tensions between the US and China are big, existential, and will last for decades. He has reason to take the economic heat off both countries: China’s slowdown has hit US companies including Apple.

Meanwhile, Mr Trump may be about to use steel and cars as an awkward way to stumble into a free trade agreement negotiation with Europe, possibly to try to get rid of longstanding transatlantic trade issues, such as EU agricultural subsidies, which he sees as “unfair”.

While there is never a good time for a trade war with allies, this timing is particularly bad. Europe has its subsidies and industrial favourites, as does the US. But there is actually a huge opportunity at this moment for a new transatlantic alliance in a number of areas that would benefit both the US and the EU — particularly in relation to China, which is the real existential threat to the global trading system.

Take the auto industry of the future. While Mr Trump wants to slap tariffs on old-line cars and trucks, the automobile industry in both America and Europe is desperate to create common 5G standards for smart cars, and an autonomous vehicle industry that can compete with either Google or Waymo’s efforts.

That will almost certainly require an industry-wide global partnership to be established between the US, the EU and Japan, since no single producer can go it alone. While Mr Trump is making such an alliance harder, China moves ahead in the race to set standards.

Then there is the common ground on Big Tech. There is plenty of evidence that private and public interests on both sides of the Atlantic are desperate to create clear, common rules. This includes the German Facebook ruling which links privacy and competition in ways that are of interest to US regulators, and the state of California’s calls for “data dividends” in which people get paid by big technology companies for their personal data. Multinational companies supporting Europe’s General Data Protection Regulation have called for a US version of the same.

A common rule book would be a huge boon for industry in both regions. While trade in traditional goods and services has been flat for several years now, cross-border data flows grew a whopping 148 fold from 2005 to 2017, according to a new McKinsey Global Institute Analysis. Amazingly, the only World Trade Organization rules governing data flows are for financial services.

That is one reason why Australia and Japan are pushing negotiations to create some cross-border rules. This offers yet another opportunity for the US and Europe (both of which are involved in the negotiations) alongside many other liberal democracies, to set the ground rules for the digital age. The alternative is allowing China’s own brand of surveillance state capitalism to gain ground.

There are, of course, legitimate points of trade tension between the US and Europe. But there is so much more common ground, particularly when compared to China.

I recently spoke to a French diplomat who was preparing a list of ways in which he felt that the US and Europe were actually converging.

This was part of an effort to convince both his own government and the EU bureaucracy in Brussels that they should ignore Mr Trump’s boorishness and be open to the benefits of joining forces with the US to control the high-growth markets of the future before China claims them.

Among the items on the list was increasing support among US politicians and the public for the idea of a Green New Deal to cut the country’s greenhouse gas emissions and create jobs. Staffers to newly elected Democrat congresswoman Alexandria Ocasio-Cortez, the deal’s most prominent advocate, have met with Germany’s resurgent Green party politicians to discuss common ground.

Then there are the moves towards Big Tech regulation and digital taxation (both the US and the EU want to find a better way to tax intangibles). Even in healthcare, typically a point of transatlantic difference, there is growing common ground. Americans said it was the most important voting issue in last year’s midterm elections and young people in the US realise that some EU countries have designed health systems that are both better, and cheaper.

As polarised as the US and Europe seem, you can make a case that this is actually as good a moment as we have had in years to forge a new transatlantic alliance. But it is likely that Mr Trump is going to bungle it by turning a trade war that has been limited to China and the US into one that includes the world’s three major regions. And as we know, ménages a trois rarely end well.


The ECB is attempting to get ahead of events

With economic risks again mounting, the EU needs new instruments

The editorial board


The European Central Bank has promised to keep interest rates at their current record low until at least 2020 © Bloomberg


The European Central Bank’s U-turn this week — reviving part of its stimulus programme after two years of weaning the eurozone off easy money — took markets by surprise. It should not have done. Signs of eurozone weakening, especially in Germany, and in key partners such as China, had been evident for months. Once the US Federal Reserve signalled a pause before lifting rates again, the ECB became likely to follow suit. In his final months in the role, ECB president Mario Draghi is clearly trying to get ahead of events. Less clear is whether the bank has done enough, or has the means to do so, if the weakening continues.

The ECB’s downgrade of its eurozone growth forecast this year to 1.1 per cent, from 1.7 per cent just three months ago, reflects the scale of the uncertainties. Expectations of a strong expansion in the US this year have been scaled back. China, at its National Policy Council this week, lowered its target for economic growth in 2019 to a range of 6-6.5 per cent, from a hard target of 6.5 per cent in the past two years — in part because of its economic and trade frictions with the US.

Despite signs that Washington and Beijing might be near an agreement to end their current spat, trade tensions could easily flare elsewhere. The risk remains that US president Donald Trump might slap tariffs on cars and components from the EU, dealing a severe blow to the German and broader European economy. As the UK parliament prepares for crucial Brexit votes next week, a calamitous no-deal crash-out from the EU can still not be ruled out.

In response, the ECB has promised to keep interest rates at their current record low until at least 2020. While it stopped expanding quantitative easing in December, it has indicated it will keep constant the amount of financial securities it acquired under QE until after rates begin to rise. Taken together, that constitutes a delay to the moment when “quantitative tightening” will finally begin.

By promising a new round of cheap long-term loans to banks willing to expand lending, moreover, the ECB will enable Spanish, Italian and other banks to roll over funding they have already received, some of which is set to mature.

Such measures are sensible and welcome. If risks are contained and the economy stabilises, they may be sufficient. But the combination of persistently low core inflation and weak growth leaves the eurozone highly vulnerable. One sizeable negative shock could tip it again into recession, with knock-on effects that could once more strain the integrity of the single currency. Even while hoping for the best, therefore, eurozone authorities must prepare for the worst — to ensure rapid action can be taken if required.

In reality, there is little more the ECB itself can do. Political hostility from some EU capitals, plus legal constraints on how much of any one country’s debt it can acquire, make it difficult to restart asset purchases. Other EU institutions and governments must therefore be ready to do more.

Germany is already taking the right steps by raising wages. Other solvent governments should also be raising spending. One measure the EU could be preparing is a substantial, high-quality investment programme in green energy and infrastructure to provide both near-term stimulus and lasting benefits. The EU’s European Investment Bank could be used for such a purpose. If it printed bonds backed by all member states, there is no reason the ECB should not buy them.

If they are to ensure the future safety of the euro, EU policymakers need to put more instruments at their disposal.


Elizabeth Warren Wants a Wealth Tax. How Would That Even Work?

There are other tools that don’t involve quite the risks and challenges of targeting the richest families.

By Neil Irwin


Some of the nation's most powerful families would surely use their resources to fight a wealth tax. CreditCreditYuriko Nakao (Japan Politics Business)/Reuters



When the United States government wants to raise money from individuals, its mode of choice, for more than a century, has been to tax what people earn — the income they receive from work or investments.

But what if instead the government taxed the wealth you had accumulated?

That is the idea behind a policy Senator Elizabeth Warren has embraced in her presidential campaign. It represents a more substantial rethinking of the federal government’s approach to taxation than anything a major presidential candidate has proposed in recent memory — a new wealth tax that would have enormous implications for inequality.






Senator Elizabeth Warren's plan: a tax on a family’s wealth above $50 million at 2 percent a year, with an additional surcharge of 1 percent on wealth over $1 billion.CreditCharlie Neibergall/Associated Press


It would shift more of the burden of paying for government toward the families that have accumulated fortunes in the hundreds of millions or billions of dollars. And over time, such a tax would make it less likely that such fortunes develop.

It would create big new challenges for the I.R.S. in ensuring compliance. There is a reason many European countries that once had a wealth tax have abandoned it in the last couple of decades.

And that’s before you get to the legal and political challenges. There is an open debate around whether a wealth tax is constitutional. And some of the most powerful families in the country would certainly deploy their vast resources against a wealth tax, and against any candidate who embraces it.

Wealth, income, eh, what’s the difference?

The comedian Chris Rock had a routine in the early 2000s in which he expounded on the distinction between those who are rich and those who are wealthy.

Shaquille O’Neal, the star basketball player, was rich, Mr. Rock said. The team owner who signed his paycheck was wealthy. And that, in a nutshell, gets at the conceptual difference between trying to tax people’s income, as the tax code does today, versus their wealth.



Lakers center Shaquille O’Neal in 2002: Rich, but perhaps not wealthy.CreditLucy Nicholson/Agence France-Presse — Getty Images


The C.E.O. of Walmart makes about $22 million a year. He is rich by any definition. But the Walton family, descendants of the company’s founder, are mind-bogglingly wealthy. The Bloomberg Billionaires index estimates that Sam Walton’s three living children are worth around $45 billion each, putting them each among the 20 wealthiest people in the world.

A family that has accumulated enormous wealth can escape with surprisingly low income levels, and therefore tax burdens.

In an extreme example, Warren Buffett owns enough stock in Berkshire Hathaway to put his estimated net worth at $84 billion, but he pays himself $100,000 a year to be its chief executive. Even in years when his wealth rises by billions, he must pay tax only on his comparatively modest income and on the gains from shares that he chooses to sell.

Ms. Warren and other advocates of a wealth tax argue that this accumulation of untaxed or lightly taxed wealth is a bad thing. They say that it enables the creation of democracy-distorting dynasties who accumulate political power, and that tax policy should be used to rein them in more than the current tax code does.

What is the Warren plan?

Developed by Emmanuel Saez and Gabriel Zucman, two University of California, Berkeley, economists who are leading scholars of inequality, the proposal is to tax a family’s wealth above $50 million at 2 percent a year, with an additional surcharge of 1 percent on wealth over $1 billion.

Mr. Saez and Mr. Zucman estimate that 75,000 households would owe such a tax, or about one out of 1,700 American families.

A family worth $60 million would owe the federal government $200,000 in wealth tax, over and above what they may owe on income from wages, dividends or interest payments.

If the estimates of his net worth are accurate, Mr. Buffett would owe the I.R.S. about $2.5 billion a year, in addition to income or capital gains taxes. The Waltons would owe about $1.3 billion each.

The tax would therefore chip away at the net worth of the extremely rich, especially if they mainly hold investments with low returns, like bonds, or depreciating assets like yachts.

It would work a little like the property tax that most cities and states impose on real estate, an annual payment tied to the value of assets rather than income. But instead of applying just to homes and land, it would apply to everything: fine art collections, yachts and privately held businesses.

What are the arguments against it?

They are both philosophical and practical.

On the philosophical side, you can argue that people who have earned money, and paid appropriate income tax on it, are entitled to the wealth they accumulate.

Moreover, the wealth that individual families accumulate under the current system is arguably likelier to be put to work investing in large-scale projects that make the economy stronger. They can invest in innovative companies, for example, or huge real estate projects, in ways that small investors generally can’t.

It could disincentivize the kinds of moonshot investments that don’t pay steady, predictable returns but can transform society. After all, if wealthy investors are on the hook for a wealth tax every year, they may strongly favor investments that pay a steady, reliable dividend over those that are risky and will take many years to pay off.

Then there are the practical concerns.

Figuring out a person’s total net worth can be a lot of work. Just ask anyone who has had to sort through a large estate after the death of a relative to submit estate taxes.



Warren Buffett owns enough stock in Berkshire Hathaway to put his estimated net worth at $84 billion.CreditRick Wilking/Reuters


If the deceased owned financial assets like stock and bonds, it’s pretty easy to check a brokerage statement and surmise the value. But if the estate consisted of a collection of rare antiques — or interests in various real estate or oil and gas projects, or closely held companies — estimating the value is harder.

It can require an army of appraisers and other experts and an often prolonged period of I.R.S. audits and disputes over valuation.

“Presumably, a wealth tax would apply to the same sort of base, except that it would be annual rather than just when a person dies,” said Beth Shapiro Kaufman, an estates lawyer at Caplin & Drysdale.

The very wealthy would have a permanent, continuing need to tally the value of their assets and defend those valuations to the federal government. The Warren plan includes substantial new funding for I.R.S. staff to enforce the law.

And some people may have their wealth tied up in things not easily converted to cash. An early investor in Uber or another company that has achieved a high valuation without going public might have a high enough net worth to owe a wealth tax, but not the easily accessible funds to pay it.

Mr. Zucman argues that people wealthy enough to owe this tax would generally have ample access to credit, and that the law could even be structured to let people pay their tax obligations with illiquid assets.

Gene Sperling, a former National Economic Council director in the Obama and Clinton administrations who now supports a wealth tax, said: “If we were sitting here in 1932 saying we need to create a Social Security system, it would have seemed very complex, but if it’s important enough, you don’t let some complexity become a reason not to push forward.”

Couldn’t rich people just hide their assets overseas?

The wealth tax Ms. Warren proposes would also apply to assets that American citizens own overseas. So in theory, a wealthy American citizen would owe tax on his Panamanian bank account and his Swiss ski chalet.

Ensuring payment would be tricky, which is why the proposal includes all those new I.R.S. employees and stronger international coordination to stop tax avoidance and evasion — as well as an “exit fee” that Americans would need to pay if they sought to renounce their citizenship.

Have other countries tried this? Does it work?

There’s an old line attributed to a 17th-century French politician that the art of taxation is to pluck a goose so as to obtain the largest possible quantity of feathers with a minimum amount of hissing. In the recent past, wealth taxes have failed that test.

In the early 2000s, 10 developed countries had a wealth tax, according to the Organization for Economic Cooperation and Development. That is now down to three: Switzerland, Norway and Spain. France recently changed its wealth tax into a tax only on real estate, more akin to the American property tax.

One problem was that some of the wealth tax plans kicked in at a relatively low level, meaning a vast number of upper-middle-class people faced its nuisance and expense. In Europe, especially, it created incentives for people to relocate.

Mr. Zucman says the United States, as a large country, is better positioned than small countries where wealthy citizens are likely to be highly mobile already. The idea is that Americans will be less likely to renounce their citizenship to avoid paying out a couple of percent of their net worth every year.

Is this even legal?

An income tax is clearly authorized by the 16th Amendment, which states that Congress has the power to “lay and collect taxes on incomes, from whatever source derived.” A wealth tax is more likely to raise constitutional questions, and it’s a near certainty that well-funded opponents would wage a legal battle against it.

(Josh Barro at New York Magazine lays out the legal questions here.)

Is there a simpler way to reduce inequality?

There is. Some tax experts say changes to existing law would accomplish many of the goals of a wealth tax.

One example that Leonard Burman of Syracuse University and the Urban Institute has suggested is to eliminate a provision of current law in which assets that increase in value can go essentially untaxed across generations. 
If you start a company and its value appreciates over your lifetime, then it is transferred to a family member upon your death, no capital gains taxes are collected on those decades of appreciation. The family member gets to start over at its current valuation for capital gains purposes.

This “step-up” provision is one of numerous ways that families can accumulate great wealth with minimal taxation. It could be eliminated. Laws could be changed to make it harder to avoid the estate tax, which currently kicks in at about $11 million for an individual and about $23 million for a married couple.

If you want a tax system that leans more aggressively against dynastic wealth and high inequality, there are, in other words, tools that don’t involve quite the risks and challenges of a wealth tax.

But those are a lot harder to capture in a campaign ad, and in the public imagination.


The Birthplace of America’s New Progressive Era

At a time of rising inequality, White House tweet storms, and deepening political gridlock in Washington, DC, it is easy to think that the decline of American democracy is inexorable. And yet, as in the early twentieth century, states like California are embracing their constitutional role as laboratories of reform.

Laura Tyson , Lenny Mendonca

gavin newson california


BERKELEY – Since the end of 2014, we have been advocating a model of US governance based on the Tenth Amendment of the US Constitution, which states that, “The powers not delegated to the United States by the Constitution, nor prohibited by it to the States, are reserved to the States respectively, or to the people.” Increasingly, California has been exercising these constitutional rights.

Until recently, state and local governance seemed quaint and uninteresting. Most pundits covering the 2016 US presidential campaign simply assumed that Democrats would win the White House and possibly both houses of Congress, allowing them to pursue a national progressive policy agenda and to appoint Supreme Court justices.

History did not unfold as predicted. But if there is any silver lining to the past two years of gridlock at the federal level, it is that progressive federalism – that is, state-based and state-led reform – has become all the more appealing.

To anyone familiar with US history, today’s social, economic, and political conditions should sound familiar. Though stock markets are soaring and wealth is growing, most of the gains are flowing to the already rich. Technology is transforming daily life, but also fostering deep anxiety about the loss of jobs and occupations. Cities are thriving as magnets for the wealthy and ambitious, but many rural Americans, increasingly left behind, feel resentful. Hostility toward immigrants has become intense and sometimes violent, and disillusionment toward government has reached new heights. While plutocrats have stepped up to underwrite social reforms through philanthropy, many citizens are convinced that democracy itself has been hijacked by the wealthy.

This bleak picture captures both today’s America and the US during the early twentieth century, when the first Progressive movement emerged. The social and political reforms enacted during that period ultimately strengthened democracy, established now-indispensable economic institutions, and made America freer and fairer.

History is not repeating itself, but it is rhyming. During the Progressive Era, California, Oregon, Washington, Colorado, and Wisconsin led the charge against the growing influence of money in politics and the monopolization of oil, railroads, and other key sectors. Likewise, amid widespread discouragement and despair, a second progressive era is now taking hold across the US, particularly in the western states, which have a rich history of bringing democratic governance into line with changing economic realities.

Owing to its diverse citizenry and globally connected economy, California has already begun to address many of the challenges now facing the entire country. It has done so by pursuing an aggressive carbon-reduction program and adopting political reforms such as citizen-based redistricting, an open-primary system, and a “rainy day” fund for economic slowdowns.

Now, Gavin Newsom, California’s new governor, is leading a new stage of reform. With a booming economy and Democratic supermajorities in both houses of the state legislature, he is pursuing a progressive agenda that can both advance social justice and survive the next economic downturn.

Specifically, Newsom’s $209 billion state budget offers a concrete plan for combining fiscal prudence with progressive activism. To make the budget more resilient over the course of the business cycle, he will use some of the state’s large current surplus to expand the reserve fund and pay down prior debt, pension, and health-care obligations to public employees.

Moreover, to ensure more broadly shared growth in the long term, Newsom will also allocate a healthy share of the surplus to one-time investments – including nearly $2 billion for early-childhood education and childcare programs. He has also proposed expanding the state’s Earned Income Tax Credit to over one million more working Californians. And he has named a new “future of work” commission to develop policy proposals to create good jobs, as technology transforms the labor market.

In addition, to address the state’s affordable-housing crisis, Newsom is threatening to withhold infrastructure funds from cities that fail to meet their obligations. In his view, “transportation is housing and housing is transportation,” and both are directly related to the state’s climate and inclusive-growth goals. He has also recognized the potential of “Opportunity Funds,” which can direct more investment to parts of the state that have been left behind in the technology boom. And he has challenged the private sector to do more, leading several large not-for-profit organizations to announce a $500 million fund to preserve and provide affordable housing in the Bay Area.

While leading with public investment and new incentives, Newsom is also building on the subsidiarity principle established by his predecessor, Jerry Brown. Accordingly, he is delegating more decision-making authority and control over resources to regional and local authorities, in recognition of the fact that a large, diverse state has diverse needs.

Perhaps most creative of all are Newsom’s efforts to leverage the scale and bargaining power of California’s $2.7 trillion economy (the fifth-largest in the world, after the US, China, Japan, and Germany). He has already issued an executive order allowing the government to negotiate directly with manufacturers over drug prices for state workers, prisoners, and California’s 13 million Medicaid recipients. He has proposed $25 million in aid for asylum-seeking immigrant families. And, most recently, he has announced that he will withdraw and reallocate the California National Guard troops who were previously sent to the border as part of US President Donald Trump’s manufactured immigration crisis.

Finally, Newsom plans to exercise California’s right to impose its own (higher) fuel-efficiency standards for cars, as permitted under a half-century-old waiver from the Environmental Protection Agency. Because its market is so large, California’s standards tend to become the benchmark adopted by car manufactures nationwide. In fact, nowhere has California demonstrated the power of progressive federalism more than in climate leadership.

As in the early twentieth century, California is facing significant challenges; but it also has an opportunity to lead. With its government – and those in other progressive states – rising to the occasion, once-skeptical pundits are beginning to take notice, and talented public servants who normally focus on Washington, DC, are increasingly looking to work for states and cities at the vanguard of change.

Yes, the national media continue to dwell on Trump’s every tweet. Yet for the first time in decades, journalists are also being hired in Sacramento, to report from the frontline of policy innovation. As California ushers in a new progressive era, theirs will be the bylines to watch.

The views expressed in this column are those of the authors and do not necessarily reflect the official position of the State of California or any of the authors' affiliated organizations.


Laura Tyson, a former chair of the US President's Council of Economic Advisers, is a professor at the Haas School of Business at the University of California, Berkeley, and a senior adviser at the Rock Creek Group.

Lenny Mendonca is the Chief Economic and Business Adviser for the State of California. The views expressed here are his own.


Authoritarianism in the Information Age

The internet is the world’s greatest source of knowledge. Governments are learning how to use it for old, familiar purposes.

By GPF Staff

The U.S.-led global order has a distinct aversion to authoritarianism, and with good reason. The centralization of political power in the hands of a single individual or political party offends liberal democratic sensibilities. It also often leads to political regimes that are oppressive at home and aggressive abroad. But that’s not always the case. There is nothing stopping authoritarian regimes from maintaining peace or ensuring the equitable application of the rule of law any more than a democratic government can guarantee that a particular country will be peaceful or ensure the liberty of all of its citizens equally. Critics of authoritarianism are actually thinking of something more sinister: totalitarianism, an authoritarian regime in which the leadership wants total control over not just the state but the individual.

Totalitarianism is supposed to be virtually impossible in the 21st century. The totalitarian regimes of Nazi Germany and Stalinist Russia came of age in the first half of the 20th century – while television was in its infancy and well before the advent of the internet. These regimes were able to completely control the information their citizens consumed, which played a major role in their ability to ensure, if not domestic legitimacy, then at least the population’s slavish compliance with government directives. North Korea is the one truly totalitarian state left standing today – and the cost of maintaining this system has been its almost complete isolation from the international economic order, leaving most North Koreans brainwashed, poor and malnourished. The rising tide of economic growth was supposed to lift all boats, and the widening availability of information via the internet was supposed to be an inoculation against the re-emergence of such regimes.

It isn’t quite working that way.

Last week, the RBK Group, a Russian media firm, reported that the Russian government is preparing to temporarily disconnect the country from the internet to test the resilience of Russia’s internet space should an external aggressor sever Russia’s connection with the global internet. The test, expected to take place sometime before April 1, is the latest in a series of Russian moves to build an independent, distinctly Russian internet infrastructure. Russia portrays the development of this infrastructure as a defensive necessity, forced upon it by an increasingly aggressive United States, which, along with its allies, could manipulate the internet to damage Russian interests. Russia is not wrong about that, but there’s more to what Moscow is doing than just planning for contingencies.

Russia has made strengthening its internet infrastructure a national priority since at least 2014, when its Communications Ministry simulated the effects of being disconnected from the internet and relying on a domestic backup system. In October 2017, the Security Council of Russia urged the government to develop an independent internet infrastructure, and President Vladimir Putin mandated its creation by August 2018. In December 2018, a bill was proposed in the Russian State Duma that would create the Digital Economy National Program and introduce significant changes to Russia’s internet infrastructure, internet providers and telecommunications firms. The cutoff experiment is meant to provide Russian lawmakers with information to modify the proposed law on its second reading.

Some aspects of the bill are indeed aimed at making Russia’s internet a more self-reliant system. The bill includes a requirement that Russia develop a national domain name system. If you are reading this article on Geopolitical Futures’ website, you got here because the internet’s domain name system correctly interpreted the characters you typed into your web browser to direct you to our internet protocol address. What scares Moscow is that none of the 12 organizations that oversee the root servers for the DNS are in Russia; if Russia were cut off from the DNS, its access to information outside the country would be severed, and the effects would be disastrous. (In 2018, 5.1 percent of Russia’s gross domestic product came from the digital economy, a sector that’s bec0ming more and more critical as Russia tries to wean itself off oil.) One key aspect of the internet cutoff test will be how well Russia has managed to copy the information onto its domestic servers and how effectively the internet can work in Russia if relying on its own databases.

But there are other aspects of the Digital Economy National Program that are scarcely related to defending Russia’s cyber interests. All internet traffic in Russia will now be routed not by established network operators but by Russia’s Federal Service for Supervision of Communications, Information Technology and Mass Media, or Roskomnadzor – which will also be given authority to take over the entire system if a “threat” to the Russian internet emerges. All Russian network operators will have to install unidentified “special technical means” provided by Roskomnadzor that, when activated, will enable Roskomnadzor to block traffic from abroad. In effect, Russia’s new independent internet infrastructure is being constructed by authoritarian design and with totalitarian potential.

The changes could have a huge effect on how Russians use the internet. Currently, neither Roskomnadzor nor Putin himself can decide to ban Russians’ access to any given website. Only Russia’s courts have the authority to decide if a particular website or internet service is illegal. This draft law not only has the potential to change that hierarchy – it also mandates the technical and infrastructural changes necessary for Roskomnadzor to block certain websites or services with ruthless efficiency. Last year, for example, a court ordered the messaging app Telegram blocked for use in Russia because the service wouldn’t hand over its encryption keys to the Federal Security Service. Not only was Roskomnadzor unable to prevent Russians from using the app but, in attempting to do so, the agency inadvertently blocked access to everything from academic journals to Russian search engines like Yandex. The measures Russia is testing are meant to make such efforts more effective.

Russia is an authoritarian state largely by necessity. Its brief experiments with popular rule were short-lived and often resulted in chaos, violence and rampant corruption. Because of Russia’s size and diversity, authoritarianism has often been accompanied by totalitarian impulses, carried out by the Tsar’s Okhrana or the Soviet Union’s NKVD. Russia under Putin has, by and large, not succumbed to such heavy-handed tools. It was enough that Putin’s regime was seen as returning order and security to Russian society after the Soviet Union’s collapse, and then restoring Russia’s rightful place in the world as a major global power. But as Russia’s challenges have grown starker, and its government’s ability to meet them has lagged, there is less tolerance for dissent – and perhaps even less tolerance for Russian citizens to send messages or visit websites as they choose.

Russia is just the most recent example of a country restricting internet access. China, for instance, has been cracking down on the internet for decades. (Indeed, Russia’s steps to gain the power to block Russian citizens from accessing certain information mirror those taken by China.) Yet even with the Great Firewall in place, people in China have found ample ways to get around some of the Communist Party’s restrictions. In the years before Xi Jinping became president in 2012, many Chinese citizens were becoming more active on social media, at times even using the internet to criticize their government. It’s a sign of how much China has changed in the seven years since Xi came to power that such online criticism is becoming unimaginable.

Xi has taken a number of steps to police both how Chinese individuals behave online and what kind of information they can access. Soon after coming to power, Xi’s government issued the “seven baselines” – a set of regulations that provide internet users with guidelines for creating a “healthy online environment.” As a result, hundreds of thousands of Chinese accounts on various Chinese social media websites were eliminated. In 2015, China cracked down on providers of virtual private networks, which allow users to visit websites that the Great Firewall blocked. In 2017, Bloomberg reported that China had ordered three major state-owned telecommunications firms to bar individuals from using VPNs. The government denied releasing the order, but Xi has not been bashful about his objectives, telling the World Internet Conference in 2015 that he would not allow anyone to threaten China’s cyber sovereignty.

But the very idea of cyber sovereignty is strange. The internet is by definition not sovereign at all – it is a global network of computers connected by undersea cables and satellites in space. The internet is powerful because it belongs to no country in particular. Never before have human beings had such fast and easy access to information. And it is precisely that kind of freedom that China’s government fears. Xi is facing the extremely difficult task of simultaneously overhauling China’s economy and reinvigorating the Communist Party’s legitimacy – and to do so, Xi thinks he must control how average Chinese citizens think and what they believe. From northwestern Xinjiang province to Beijing’s most prestigious universities, from newspapers to the internet, Xi’s crackdown has been wide-ranging and part of a strategy to exert total control. In the end, Xi is not just blocking Chinese citizens from seeing certain websites. Because of how important the internet has become, he is controlling what information Chinese citizens know and using the internet to define what it means to be Chinese in the first place.

One should not take comfort in the notion that this is happening only in authoritarian countries like Russia and China. The kind of thought homogenization that these countries are pursuing does not only happen from the top down; it can just as well spring from the bottom up. In the U.S., the National Security Agency can monitor most of what U.S. citizens access on the web – a 2013 Wall Street Journal report estimated that 75 percent of U.S. internet traffic can be monitored by the NSA. Unlike in Russia or China, there is no political impetus for U.S. institutions to control what American citizens can access through the internet in such a heavy-handed way. But that doesn’t necessarily eliminate the underlying problem. The Chinese and Russian governments are policing what their people can access on the internet out of fear of independent thought, which might lead to opposition to their regimes. In the United States, the problem is not a would-be totalitarian dictator barring independent thought, but the lack of such thought altogether.

When an internet user in the U.S. searches a topic on Google, the search engine often produces thousands or even millions of results. Most of the time, users don’t actually go through all of them; a website called Advanced Web Ranking, which keeps track of what U.S. users click on when they Google something, found that 75 percent of users click on one of the first five things the search engine spits out. In a sense, the information that the average American consumes on Google is not necessarily the most accurate or insightful – it is the information that Google’s algorithm has decided is most useful. The same goes for Facebook, Twitter or any other social media sites. What users consume is defined by algorithms designed by coders holed up on their corporate campuses. What good is access to everything if no one ever accesses it? The internet has democratized information, not knowledge. What information Americans seek out is determined by preconceived notions about how things should be rather than by a rigorous search for what is. On the left, Americans want safe spaces to avoid those with whom they disagree. On the right, anyone who disagrees is simply fake news.

In 2006, the British-American scholar Tony Judt gave a remarkably prescient speech at New York University. It was the same year that Twitter was founded and just a year before the first iPhone was sold. Yet, even without these now-ubiquitous tools of American society – tools that allow Americans to access the internet at will and tweet vile things to each other – he seemed to see quite clearly that the United States faced a daunting problem: “What is at issue in America today is not the will to power of an abusive state, but the will to ignorance of society.” Judt invoked the great British historian Edward Gibbon and his study of the decline of the Roman Empire when he said Emperor Augustus “knew that the people would submit to slavery provided that they were repeatedly assured that they enjoyed all their ancient freedom.” The internet has not prevented successive U.S. presidents from repeatedly deploying U.S. military might abroad without Congressional approval. It has not stopped successive U.S. presidents from using executive orders to pursue issues far outside their purview. If anything, the internet has nurtured the kind of factions in the U.S. whose effects the government is supposed to control, not amplify, with the powerful in Washington slaves to whichever faction put them there.

The internet, like any technology, is a tool. It can be used by dictators to control thoughts and beliefs. It can be used by demagogues to whip up the prejudices of the masses. It can be used by countries to attack one another. It can be used by scientists to share important research and data. And it can be used to connect different people from different parts of the world. When used to weaponize information, the internet can construct 21st-century cults of personality. In its passive existence, the internet can lead to a kind of groupthink, a herd mentality that dulls one’s sense of the real world. Why, after all, should one seek out uncomfortable truths when there are so many cat videos and Larry Bird highlight reels to peruse on YouTube? The greatest source of political power has always been information, and the internet is the greatest tool for transmitting information since the printing press was invented. For better or for worse, individuals cannot live without it and states are learning new ways to use it for old, familiar purposes.