Ray Dalio - John Mauldin Discussion, Part 5

By John Mauldin



“The belief that wealth subsists not in ideas, attitudes, moral codes, and mental disciplines but in identifiable and static things that can be seized and redistributed is the materialist superstition. It stultified the works of Marx and other prophets of violence and envy. It frustrates every socialist revolutionary who imagines that by seizing the so-called means of production he can capture the crucial capital of an economy. It is the undoing of nearly every conglomerateur who believes he can safely enter new industries by buying rather than by learning them. It confounds every bureaucrat who imagines he can buy the fruits of research and development.

The cost of capturing technology is mastery of the knowledge embodied in the underlying science. The means of entrepreneurs’ production are not land, labor, or capital but minds and hearts.”

“Whatever the inequality of incomes, it is dwarfed by the inequality of contributions to human advancement. As the science fiction writer Robert Heinlein wrote, ‘Throughout history, poverty is the normal condition of man. Advances that permit this norm to be exceeded—here and there, now and then—are the work of an extremely small minority, frequently despised, often condemned, and almost always opposed by all right-thinking people. Whenever this tiny minority is kept from creating, or (as sometimes happens) is driven out of society, the people slip back into abject poverty. This is known as bad luck.’

President Obama unconsciously confirmed Heinlein’s sardonic view of human nature in a campaign speech in Iowa: ‘We had reversed the recession, avoided depression, got the economy moving again, but over the last six months we’ve had a run of bad luck.’ All progress comes from the creative minority. Even government-financed research and development, outside the results-oriented military, is mostly wasted. Only the contributions of mind, will, and morality are enduring. The most important question for the future of America is how we treat our entrepreneurs. If our government continues to smear, harass, overtax, and oppressively regulate them, we will be dismayed by how swiftly the engines of American prosperity deteriorate. We will be amazed at how quickly American wealth flees to other countries.”

“Those most acutely threatened by the abuse of American entrepreneurs are the poor. If the rich are stultified by socialism and crony capitalism, the lower economic classes will suffer the most as the horizons of opportunity close. High tax rates and oppressive regulations do not keep anyone from being rich. They prevent poor people from becoming rich. High tax rates do not redistribute incomes or wealth; they redistribute taxpayers—out of productive investment into overseas tax havens and out of offices and factories into beach resorts and municipal bonds. But if the 1 percent and the 0.1 percent are respected and allowed to risk their wealth—and new rebels are allowed to rise up and challenge them—America will continue to be the land where the last regularly become the first by serving others.”

—George Gilder, Knowledge and Power: The Information Theory of Capitalism
 

“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.”

—John Maynard Keynes, The General Theory of Employment, Interest and Money
 

“Nothing is more dangerous than a dogmatic worldview – nothing more constraining, more blinding to innovation, more destructive of openness to novelty.”

– Stephen Jay Gould, Dinosaur in a Haystack: Reflections in Natural History
 

I think Lord Keynes himself would appreciate the irony that he has become the defunct economist under whose influence the academic and bureaucratic classes now toil, slaves to what has become as much a religious belief system as an economic theory. Men and women who display appropriate skepticism on other topics indiscriminately funnel facts and data through a Keynesian filter without ever questioning the basic assumptions. Some go on to prescribe government policies that have profound effects upon the citizens of their nations.

And when those policies create the conditions that engender the income inequality they so righteously oppose, they often prescribe more of the same bad medicine. Like 18th-century physicians applying leeches to their patients, they take comfort that all right-minded people will concur with their recommended treatments.

This is part of an ongoing series of a discussion between Ray Dalio and myself. Today’s installment, adapted from a letter I wrote several years ago, addresses the philosophical problem he is trying to address: income and wealth inequality.

Last week I dealt with the equally significant problem of growing debt in the United States and the rest of the world. The Keynesian tools much of the economic establishment wants to use are exacerbating the problems. Ray would like to solve it with a blend of monetary and fiscal policy, what he calls Monetary Policy 3.

The Problem with Keynesianism

Let’s start with a classic definition of Keynesianism from Wikipedia, so that we can all be comfortable that I’m not coloring the definition with my own bias (and, yes, I admit I have a bias).

Keynesian economics (or Keynesianism) is the view that in the short run, especially during recessions, economic output is strongly influenced by aggregate demand (total spending in the economy). In the Keynesian view, aggregate demand does not necessarily equal the productive capacity of the economy; instead, it is influenced by a host of factors and sometimes behaves erratically, affecting production, employment, and inflation.

The theories forming the basis of Keynesian economics were first presented by the British economist John Maynard Keynes in his book The General Theory of Employment, Interest and Money, published in 1936 during the Great Depression. Keynes contrasted his approach to the aggregate supply-focused “classical” economics that preceded his book. The interpretations of Keynes that followed are contentious, and several schools of economic thought claim his legacy.

Keynesian economists often argue that private sector decisions sometimes lead to inefficient macroeconomic outcomes which require active policy responses by the public sector, in particular, monetary policy actions by the central bank and fiscal policy actions by the government, in order to stabilize output over the business cycle. Keynesian economics advocates a mixed economy—predominantly private sector, but with a role for government intervention during recessions.

 
 
(Before I launch into a critique of Keynesianism, let me point out that I find much to admire in the thinking of John Maynard Keynes. He was a great economist and taught us a great deal. Further, and this is important, my critique is simplistic. A proper examination of the problems with Keynesianism would require a lengthy paper or a book. We are just skimming along the surface and don’t have time for a deep dive.)

Central banks around the world and much of academia have been totally captured by Keynesian thinking. In the current avant-garde world of neo-Keynesianism, consumer demand—consumption—is everything. Federal Reserve policy is clearly driven by the desire to stimulate demand through lower interest rates and easy money.

And Keynesian economists (of all stripes) want fiscal policy (essentially, government budgets) to increase consumer demand. If the consumer can’t do it, the reasoning goes, then the government should step into the breach. This of course requires deficit spending and borrowed money (including from your local central bank).

Essentially, when a central bank lowers interest rates, it is encouraging banks to lend money to businesses and telling consumers to borrow money to spend. Economists like to see fiscal stimulus at the same time, as well. They point to the numerous recessions that have ended after fiscal stimulus and lower rates were applied. They see the ending of recessions as proof that Keynesian doctrine works.

This thinking has several problems. First, using leverage (borrowed money) to stimulate spending today must by definition reduce consumption in the future. Debt is future consumption denied or future consumption brought forward. Keynesian economists argue that bringing just enough future consumption into the present to stimulate positive growth outweighs the future drag on consumption, as long as there is still positive growth. Leverage just equalizes the ups and downs. This has a certain logic, of course, which is why it is such a widespread belief.

Keynes argued, however, that money borrowed to alleviate recession should be repaid when growth resumes. My reading of Keynes does not suggest he believed in the unending fiscal stimulus his disciples encourage today.

Secondly, as has been well documented by Ken Rogoff and Carmen Reinhart, there comes a point at which too much leverage becomes destructive. There is no exact way to know that point. It arrives when lenders, typically in the private sector, decide that borrowers (whether private or government) might have some difficulty repaying and begin asking for more interest to compensate for their risks. An overleveraged economy can’t afford the higher rates, and economic contraction ensues. Sometimes the contraction is severe, sometimes it can be absorbed. When accompanied by the popping of an economic bubble, it is particularly disastrous and can take a decade or longer to work itself out, as the developed world is finding out now.

Every major “economic miracle” since the end of World War II has been a result of leverage. Often this leverage has been accompanied by stimulative fiscal and monetary policies. Every single “miracle” has ended in tears, with the exception of the current recent runaway expansion in China, which is still in its early stages. (And this is why so many eyes in the investment world are laser-focused on China. Forget about a hard landing or a recession, a simple slowdown in China has profound effects on the rest of the world.)

I would argue (along, I think, with the “Austrian” economist Hayek and other economic schools) that recessions are not the result of insufficient consumption but rather insufficient income. Fiscal and monetary policy should aim to grow incomes over the entire range of the economy. That is best accomplished by making it easier for entrepreneurs and businesspeople to provide goods and services. When businesses increase production, they hire more workers and incomes go up.

Without income, there are no tax revenues to redistribute. Without income and production, nothing of any economic significance happens. Keynes was correct when he observed that recessions are periods of reduced consumption, but that is a result and not a cause.

Entrepreneurs must be willing to create a product or offer a service in the hope there will be sufficient demand for their work. There are no guarantees, and they risk economic peril with their ventures, whether we’re talking about the local bakery or hairdressing shop or Elon Musk trying to compete with the world’s largest automakers. If government or central bank policies hamper their efforts, the economy stagnates.

Many politicians and academics favor Keynesianism because it offers a theory by which government actions can become decisive in the economy. It lets governments and central banks meddle in the economy and feel justified. It allows 12 people sitting in a board room in Washington DC to feel they are in charge of setting the most important price in the world, the price of money (interest rates) of the US dollar and that they know more than the entrepreneurs and businesspeople who are actually in the market risking their own capital every day.

This is essentially the Platonic philosopher king conceit: the hubristic notion that a small group of wise elites is capable of directing the economic actions of a country, no matter how educated or successful the populace has been on its own. And never mind that the world has multiple clear examples of how central controls eventually slow growth and make things worse over time. It is only when free people are allowed to set their own prices of goods and services and, yes, even interest rates, that valid market-clearing prices can be determined. Trying to control them results in one group being favored over another.

In today's world, savers and entrepreneurs are left to eat the crumbs that fall from the plates of the well-connected crony capitalists and live off the income from repressed interest rates. The irony of using “cheap money” to drive consumer demand is that retirees and savers get less money to spend, and that clearly drives their consumption down.

Why is the consumption produced by ballooning debt better than the consumption produced by hard work and savings? This is trickle-down monetary policy, which ironically favors the very large banks and institutions. If you ask Keynesian central bankers if they want to be seen as helping the rich and connected, they will stand back and forcefully tell you “NO!” But that is what happens when you start down the road of financial repression. Someone benefits. So far it has not been Main Street. As George Gilder said,

Those most acutely threatened by the abuse of American entrepreneurs are the poor. If the rich are stultified by socialism and crony capitalism, the lower economic classes will suffer the most as the horizons of opportunity close. High tax rates and oppressive regulations do not keep anyone from being rich. They prevent poor people from becoming rich. High tax rates do not redistribute incomes or wealth; they redistribute taxpayers—out of productive investment into overseas tax havens and out of offices and factories into beach resorts and municipal bonds.


Without Savings, Nothing Happens

Those who were forced to endure Economics 101 may remember that Savings = Investment. In any real-world economic system, you must have savings in order to have investment in order for the economy to grow.
 
Generally, savings are actually leveraged to produce more investments (and thus eventual production and consumption) than if the “profit recipients” had simply spent the money themselves. This will become critically important next week.

This idea that consumption is better than savings is the heart of the Keynesian conceit. Yes, I know, I’ve written many a time about Keynes’s Paradox of Thrift: “It is a good thing for individuals to save, but if everybody saves then there is less consumption.” That seems true on the surface and makes a great sound bite, but it has an inherent flaw. It assumes that savings don’t become investments that increase productivity, which in turn leads to the production of more goods and services, which ultimately creates income, which then creates more demand.

Without savings, nothing happens. Nothing. There has to be capital of some kind from somewhere in order for economic activity to happen. Productivity growth is ultimately a product of savings, and it is productivity growth that will generate an increase in income for the country as a whole. There are consequences to the fact that savings are close to an all-time low.

And when those limited savings go to purchase government bonds, it takes money away from more productive and income-producing endeavors.

A static economy does not raise overall income or wealth. Only an economy that is growing as a result of a healthy level of savings and investment can produce the results Keynesian economists want: increased incomes for everyone.

Your typical Keynesian economist isn’t willing to wait for savings to become investment. They and the politicians they serve want results today. And the only way to get results today is to get people to spend today, while the process of saving and investing takes time.

Neo-Keynesian economists are ultimately teenage children who want the pleasure of consuming today rather than thinking about the future. And I won’t even go into the burden we are placing on future generations by borrowing money to goose our current economy and expecting them to pay that money back. We are building toward a future intergenerational war that is going to be very intense once our children learn how we misspent their future. But that’s yet another letter.

Maine and Montana

Early August sees me in New York for a few days before the annual economic fishing event, Camp Kotok. Then maybe another day in New York before I meet Shane in Montana and spend a few days with my close friend Darrell Cain on Flathead Lake.

After a long day spent in airports, I arrived at my home in Puerto Rico (Shane is in California) in the early evening with the full intent of writing and finishing a much different letter than the one above. Then I realized I did not have the key to the house. Shane and I had talked about dealing with such a contingency, but we never actually did it. That will shortly change. And while the key did materialize some six hours later, the new time constraints forced me to go back to previous material to address what is a serious obstacle to resolving the problems Ray and I see.

Next week, we will look at policies that not only increase savings and investment, but will restart economic growth and put us back on track to more equitable distribution of the economic pie.

And with that I will hit the send button and wish you a great week!

Your hoping to find a balance analyst,



John Mauldin
Chairman, Mauldin Economics

Donald Trump is making America scary again

The more the president deploys weapons of economic destruction, the more he undermines trust in the US

Gideon Rachman




Donald Trump’s domestic critics have often compared him to a mafia boss. James Comey, who Mr Trump fired as head of the FBI, said that dealing with the US president reminded him of his earlier career, “as a prosecutor against the mob”.

Mr Trump made his career in construction in New York and casinos in New Jersey, which may explain why his mannerisms seem strangely familiar to fans of The Godfather or The Sopranos.

But this is not merely about style. The president’s way of conducting foreign policy also seems to owe something to the mob. There is the emphasis on personal relations between bosses; the sense that only his own family members are completely trusted; the willingness to switch suddenly from warm words to threats and back again; the tendency to treat alliances as a form of protection racket — pay up, or we’ll stop protecting the neighbourhood; the preference for the offer you can’t refuse, rather than a genuine negotiation.

Mr Trump’s aides dismiss comparisons between the president and a mafia don as facile and insulting. But they would probably accept that Mr Trump’s goal to “make America great again” also involves making America scary again — or, in Washington-speak, “restoring deterrence”.

The theory goes that the previous US president, Barack Obama, was too professorial and reasonable. The heads of rival mafia families — the Putin mob in Moscow, the Xi family in Beijing — sensed weakness in his administration and began to take liberties. So America needed a tough-guy president; somebody willing to wave a baseball bat.

The Trump tribe thinks these tactics are working. Take last week’s showdown with Mexico. Angered by the flow of refugees across the US’s southern border, Mr Trump threatened to impose tariffs on Mexico. That caused Mexican officials to move swiftly to appease the Don, by agreeing to deploy more security forces along its own southern border and to process more asylum-seekers inside Mexico.

According to Mr Trump’s supporters, this is not an isolated example of successful bullying. The president ripped up the Obama administration’s nuclear deal with Iran and reimposed sanctions. The Iranian economy is reeling, and the regime may have to return to the negotiating table. The EU was bitterly opposed to the revocation of that deal and has tried to set up an alternative payments system to allow trade with Iran to continue. But senior European officials and businesspeople were informed that they could be barred from the US if they violated sanctions, and the scheme has yet to get going.

The White House is extending similar tactics to China. Meng Wanzhou, the chief financial officer of Huawei, the Chinese telecoms company, was arrested in Canada for allegedly violating US sanctions on Iran — a striking example of American extraterritorial reach. Now the US is blocking the transfer of technology to Huawei. Foreign companies that use American tech, such as the British chipmaker Arm, are having to fall in line.

The Trump administration believes that America’s central role in the global economy gives the country a unique array of coercive tools that it is only beginning to exploit. Foreign companies that violate US sanctions can be hit with fines that run into billions. Individual businesspeople can be targeted for arrest, or banned from entering America. Bypassing the US is very difficult because of the size of its market and the importance of its technology.

Mr Trump has now added tariffs, his weapon of choice, as another coercive tool, and not just on trade issues. The dispute with Mexico was about immigration. But the most potent economic weapon in America’s armoury stems from the fact that the dollar is the world’s reserve currency. If you make a large transaction in dollars, even outside the country, you will almost certainly engage with the US financial system. And that makes you vulnerable to the long arm of the American law.

Other countries are scratching their heads about how to fix this vulnerability. Displacing the dollar as the world’s favourite currency is a long and arduous business. All the current alternatives have flaws. Russia is not a large enough economy to support a global currency and doing business in Russia is hazardous. China’s renminbi is not fully convertible so cannot be seamlessly transferred around the world. The Chinese authorities fear that moving towards a fully-convertible currency would spark large-scale capital flight from China, which says something about the scariness of their own system.

The EU offers the rule of law, a large market and a fully convertible currency. But even the euro is not yet close to being a rival to the dollar — perhaps because the institutions underpinning the European currency are still under construction and memories of the eurozone crisis remain fresh.

The trouble with a policy of “making America scary again”, is that eventually the Trump administration will scare people off. It is trust in the American system, as much as the sheer size of the economy, that has given the US its central role in the global economy. But the more Mr Trump deploys weapons of economic destruction, the more he will undermine that trust and encourage foreigners to look for ways around America. Eventually, they will find them.


Strange Times

by: The Heisenberg

Summary

- In the week ahead, Jerome Powell faces a trial by fire on Capitol Hill.

- His plight underscores the difficulty in conducting monetary policy in an environment where the tail often wags the dog and political pressure is unrelenting.

- Meanwhile, PIMCO says it's time investors get used to central banks that are no longer independent.

- One way or another, policy normalization appears to be an impossibility.

- Get ready for more mind-bending market distortions.

 
Market participants have spent months obsessing over the following simple chart, which has served as fodder for countless "something has to give" articles in 2019.
 
(Heisenberg)
 
 
The supposed "disconnect" between plunging bond yields and record-high stocks is hardly a mystery and, as documented previously, it's not necessarily true that it has to "resolve" itself by stocks diving or yields exploding higher.
 
In the simplest possible terms, the concern is that the bond market is "saying" something dire about the outlook for growth and stocks are simply ignoring that warning.
 
The myriad curve inversions we've seen over the past several months lend credence to "looming recession" narrative which, again, stocks aren't heeding.
 
But in reality, what you see in that chart is easy enough to explain. 2019 has been the year of the coordinated dovish pivot from central banks including, of course, the Fed. That pivot is predicated on the same growth jitters reflected in developed market bond yields. Stocks are simply "saying" that rate cuts, dovish forward guidance and other measures will likely mean a recession is averted.
 
Because a renewed commitment to accommodative monetary policy means abundant liquidity, an end to quantitative tightening in the US, a possible return to monthly asset purchases in the EU, the postponing of any push towards normalization in Japan and rate cuts across multiple locales, bonds, stocks and credit are all bid, and so is gold on the assumption that easing amounts to currency debasement.

You could also argue that bond yields are reflecting lower estimates of the neutral rate and lower inflation expectations, neither of which need necessarily presage the kind of disaster which should prompt stocks to sell off.
 
While all of this is easy enough to explain in the context of the post-crisis monetary policy regime, it leads to strange outcomes - perverse dynamics, as I'm fond of calling them. The most ubiquitous of these is the famous "bad news is good news" paradigm, wherein poor economic data is welcomed as long as it's not overtly dour, because lackluster data underscores the need for rate cuts and central bank accommodation. The flipside of that is simply that good news can be bad news if something like, to use Friday's example, a blockbuster jobs report hits at a time when the Fed is on the fence regarding a rate cut at an upcoming meeting.
 
We're all used to this particular strange state of affairs by now, but what's new is that it's colliding with President Trump's penchant for boasting about the US economy. We hit while I called "peak cognitive dissonance" on Friday when, literally minutes after the jobs report hit the tape, Larry Kudlow and Peter Navarro were dispatched to TV news networks to sing the praises of the economy while simultaneously insisting that rate cuts are not only desirable, but necessary. Later, in remarks to reporters, Trump similarly oscillated between boasting about "great numbers" and employing his "rocket ship" metaphor to explain why the Fed should cut rates. This continued nearly until midnight.
 
At 11:24 PM on Friday evening, Trump said this on Twitter:
 
Strong jobs report, low inflation, and other countries around the world doing anything possible to take advantage of the United States, knowing that our Federal Reserve doesn’t have a clue! Our most difficult problem is not our competitors, it is the Federal Reserve!
 
I call this "peak cognitive dissonance" because while we've all become accustomed to finicky traders and "spoiled" markets reacting badly to this or that data point on the assumption a brighter economic outlook might compel central banks to tweak their forward guidance, we're now witnessing the President of the United States all but demanding rate cuts (and a return to QE, by the way) when the economy just created 224k jobs.
 
The only way that makes sense (and I say this objectively, not derisively) is in the context of countries where both fiscal and monetary policy are explicitly or implicitly beholden to the executive. Countries like, for instance, Turkey, where President Erdogan fired the central bank governor on Saturday for not cutting rates.

As I've been over on countless occasions (both on my site and on this platform), when the market starts leaning hard into rate cut bets, it is dangerous for central banks to disappoint those expectations. That is most assuredly an example of the tail wagging the dog, but that doesn't necessarily mean the dog is happy about the situation. That is, contrary to what you might be inclined to believe if you spent your time perusing conspiratorial blogs, the main argument for not disappointing lopsided market expectations if you're a central banker is not that you want to inflate stock market bubbles.
 
Rather, the argument for not blindsiding markets is that doing so risks triggering a messy unwind of crowded bets, a scenario which, depending on the setup, could tighten financial conditions (e.g., via a reversal of the "wealth effect" as stocks fall or through wider credit spreads). When financial conditions tighten significantly, it makes the case for easier monetary policy, which means disappointing initial market expectations could end up creating a scenario where what would have been preemptive easing turns into a reactive cut later. That isn't desirable, as it suggests policymakers were behind the curve.
 
Normally, in a situation like we're facing now as the Fed heads into the July meeting, Jerome Powell and his colleagues could simply stick to a moderately dovish line for the next couple of weeks, coast into the pre-FOMC blackout, then deliver a 25bp rate cut accompanied by a promise to do more if necessary. There are all kinds of ways to justify that, even after the June payrolls report.
 
Unfortunately, it isn't that simple. Because thanks to incessant public demands from the Trump administration, any rate cut that isn't clearly necessary will be seen as a political move.
 
While markets won't care one way or another what prompted the cut in the near-term, over the longer-term a Fed that's seen as overtly political will lose its credibility. Meanwhile, some Democrats will doubtlessly insist that the Fed has lost its independence and they won't have to look very hard to find evidence to support the allegation (hint: they'll just roll out clips of the President talking to reports and cite his dozens upon dozens of Fed tweets).
That's the setup for Powell's semi-annual monetary policy report to Congress which he'll deliver on Wednesday and Thursday. For all the reasons noted above, this normally mundane affair has the potential to become a spectacle, especially if the President live-tweets it (which is entirely possible).
 
If the Fed doesn't intend to cut at the July meeting, Powell (and the half-dozen other officials who will speak this week) will need to start walking back market pricing now, to ensure positions are squared and expectations recalibrated by the end of the month. You can read a full account of how expectations evolved on Friday in the "cognitive dissonance" post linked above, but suffice to say markets are still priced for a 25bp cut.
 
I continue to think staying on hold (i.e., not cutting) at the July meeting is a wholly untenable proposition. If the Fed manages to walk back expectations and STIR traders price out the July cut, stocks will likely roll over. That doesn't have to entail a dramatic selloff, but what it does mean is that equities probably can't sustain record highs if the rates market completely takes a July cut off the board. I've used the following chart before, and I'll update it and use it again here (with some new annotations and colors):
 
(Heisenberg)
 
 
That isn't the most precise way to illustrate the point, but it is the most straightforward. 2-year yields plunged as a July cut became (nearly) everyone's base case after the Mexico tariff threat, and the S&P surged. On Friday, 2-year yields jumped the most since January 4 as the jobs report effectively took a 50bp July cut off the table. Stocks didn't like that. They'll like it even less if the market starts to price out even a 25bp cut.

That is the reality Powell finds himself confronted with as he trudges wearily up to Capitol Hill, where he will most assuredly be asked if the Fed is feeling pressure from the White House to cut rates.
 
The Fed chair could plausibly use his testimony to reassert Fed independence and to recalibrate market expectations for the July meeting by talking up progress on trade (i.e., the G20 deal between Trump and Xi Jinping), the jobs report, somewhat better inflation data and reduced uncertainty. But you can be absolutely sure that market expectations and the consequences of disappointing them will not be far from his mind. It's also probably occurred to Powell that if he says anything this week to make markets reassess whether a July cut is in the cards and his remarks trigger a selloff in equities, the whole thing (his comments and their connection to any stock slide) will likely be amplified by comments from the President and his advisors.
 
So, what if Powell wants to make the case for a July cut while simultaneously satisfying lawmakers that the Fed isn't simply bowing to political pressure? How would he go about doing that?
 
Well, he would have to talk down the very same economy that Trump is talking up, even as both men are aiming at the same July rate cut (and yes, this is wholly ridiculous). Here's one plan, as detailed by BofA over the weekend:
If the data does not warrant a cut, how can Powell still justify easing? We think there is one angle he can use – he can argue that the reduction in rates is purely to boost inflation and is for “insurance” purposes. He can reference the lower neutral Fed funds rate and argue that the current stance of policy is too tight.
 
In other words, he could roll out the old standby about "subdued inflation" and then point to the same lower neutral rate mentioned above to argue, as Trump has, that policy is restrictive.
 
There are a couple of problems with that. For one thing, it would be embarrassing. This is, after all, the same Jay Powell who in October said rates were "a long way from neutral." More importantly, though, it would make an already complicated situation even more difficult to negotiate and it risks irritating markets anyway. Here's BofA:
But this would be yet another shift in the dialogue for Powell, further complicating their reaction function. Moreover, only a handful of Fed officials seem to be on board with this narrative. That said, if the Fed does take this path and cuts in July because of insurance reasons, it would likely imply only a few cuts rather than the start of a true easing cycle. As such, it would still disappoint markets.
 
So, what will Powell do? My guess is, he'll try to find a middle ground by saying "we will act as necessary to sustain the expansion" as many times as possible and in as many different ways as possible. Of course, there are only so many times you can paraphrase yourself, which means he'll invariably have to elaborate at some point. As we've seen on innumerable occasions since Powell took the reins from Janet Yellen, he is not particularly adept at elaborating.
 
With the dollar at a two-week high and yields clearly predisposed to rising on any hint that a 25bp cut at the July meeting isn't a sure thing, this is a dangerous situation.
 
As I hope came through loud and clear in the above, this is complicated immeasurably by the Fed's desire to assert its independence. Following last week's attacks on the Fed, PIMCO's Joachim Fels declared an end to the "heyday of central bank independence." You can read more here, but for our purposes, it's enough to note that Fels predicts central banks will be increasingly beholden to politicians and that will mean low rates and QE in "perpetuity."
 
Midway through last year, it seemed as though the days of documenting the distortions brought about by ultra-accommodative monetary policy might be behind us - that policymakers were set to finally try and normalize. It is now clear that the "state of exception" (as Deutsche Bank's Aleksandar Kocic called it in 2017) is indeed permanent - or at least semi-permanent.
 
Last year's cross-asset turbulence made it clear that the re-emancipation of markets isn't feasible from a practical perspective. If PIMCO's Fels is correct (and he probably is), policy normalization is on the verge of being effectively banned from on high.

The renewed commitment to accommodative policy is now bringing about outcomes that are not just strange, but wholly oxymoronic. For instance, there are now 10 € high yield bonds with negative yields. And yes, you read that correctly: Some "high" yield bonds are now negative-yielding.
 
(BofA)
 
 
Have a look at the blue line in that visual. That is a whole lot of interest rate sensitivity.
 
Consider this from Bloomberg:
But just look at the math. The Macaulay duration on a Bloomberg Barclays sovereign-debt index is near a record high of 8.32 years, meaning just a one-percentage-point increase in yields would equate to more than a $2.4 trillion loss.
 
Even if it were politically possible to raise rates and normalize policy, and even if central banks weren't particularly concerned about the addiction liability they're running in riskier assets, policymakers are now staring down an almost unfathomable pile of duration parked on all manner of balance sheets and not all of it is very liquid.
 
The upshot of this (now ~2,300 word) screed, is that between politics and market risks, there doesn't seem to be a way to crawl back out of the accommodation rabbit hole. Readers often ask why I refer to Deutsche's Kocic as the most brilliant mind on Wall Street. Well, consider everything said above and then recall the following passages from his 2017 "state of exception" note:
In its core, policy response to the crises was an extension of what in a political context is known as the state of exception: Market laws had to be suspended to restore normal functioning of the markets. The intrinsic contradiction of this maneuver is resolved only by understanding that suspension is temporary. Stimulus will have to be unwound.  
However, the accommodation has been in place for a very long time, during which traditional transmission mechanisms have atrophied and investors’ mindset has changed in a way that has altered irreversibly their behavior, the market functioning and its dynamics. 
Engineering a state of exception comes with considerable risk. The Fed (and central banks in general) carries an implicit responsibility for orderly re-emancipation of the markets, which makes stimulus unwind especially tricky. This highlights the deep dichotomy of power: While a state of exception is an exercise of power, there is a clear tendency to disown that power. And the only way to avoid facing the underlying dilemma is to never give up the power. This creates a new status quo — a permanent state of exception.
 
Fast forward two years (almost to the day, as the note those excerpts are from was published in the second week of July, 2017) and the "state of exception" does appear to be permanent.
 
Strange times, indeed. And, as the occurrence of negative-yielding "high" yield bonds makes clear, things are likely to get stranger still.

What to Do About China?

By attempting to "get tough" with China, US President Donald Trump's administration is highlighting the extent to which America's star has fallen this century. If the US ever wants to reclaim the standing it once had in the world, it must become the country it would have been if Al Gore had won the 2000 presidential election.

J. Bradford DeLong

delong210_BillOxfordGettyImages_hourglassontopofUSflag


BERKELEY – In a recent issue of The New York Review of Books, the historian Adam Tooze notes that, “across the American political spectrum, if there is agreement on anything, it is on the need for a firmer line against China.” He’s right: On this singular issue, the war hawks, liberal internationalists, and blame-somebody-else crowd all tend to agree. They have concluded that because the United States needs to protect its relative position on the world stage, China’s standing must be diminished

But that is the wrong way to approach the challenge. In the near term (1-4 years), the US certainly could inflict a lot of damage on China through tariffs, bans on technology purchases, and other trade-war policies. But it would also inflict a lot of damage on itself; and in the end, the Chinese would suffer less. Whereas the Chinese government can buy up Chinese-made products that previously would have been sold to the US, thereby preventing mass unemployment and social turmoil, the US government could scarcely do the same for American workers displaced by the loss of the Chinese market.

In the medium run (5-10 years), the US would face even larger problems, because China would have begun to replace US customers and suppliers with those of Europe and Japan. At the same time, an America that has just blown up its relationship with China will have a hard time convincing anybody else to fill China’s shoes as a trade partner and source of investment. Becoming the world’s irrational doofus comes with costs, after all.

That is why it is entirely foreseeable that America’s attempt to “get tough” with China could accelerate its own relative decline, effectively handing China the semi-hegemony it is already approaching. As for America’s geopolitical or even military options, there are few left. After more than two years of chaotic unilateral behavior, the Trump administration has squandered any chance it might have had to work with other countries to contain China.

Following Trump’s unlikely election victory in 2016, congressional Republicans who claimed to support free trade and American soft power could have sought to impose limits on the new administration. Instead, they joined the cult, and have served as Trump’s sycophants ever since. After two years, America’s alliances have been gravely weakened, even more so than after former President George W. Bush’s disastrous wars. The US will never reclaim the standing it had in 2000, and it probably cannot even recover the tenuous but still solid geopolitical position it enjoyed in 2016.

As for the military option, the Trump administration may well be envisioning a new cold war, with occasional hot-war proxy conflicts. And yet, nobody really has any idea what a twenty-first-century cold war would look like. We can be somewhat confident that it would not involve a nuclear confrontation, mass deployments of standing armies, the fomenting of armed insurgencies in colonial territories, or any of the other forms of imperial adventurism that defined the original Cold War. Mutually assured destruction still (one hopes) rules out a nuclear exchange or mobilization of conventional forces, and there aren’t really any colonial powers left.

When one considers all of the “unknown unknowns” associated with cyber warfare, one is left with no viable model to follow. Presumably, a great-power conflict would take the form of what the Prussian general Carl von Clausewitz called “politics by other means”; we just don’t know what that would look like. In the face of such uncertainties, it is folly to pursue politics by any means other than politics itself.

So, what should the US do to shore up its position vis-à-vis China?

For starters, it could show that it has a more competent and less corrupt government than China does – that it is still a healthy democracy that adheres to the rule of law. It could also work to improve its high-tech sector, by welcoming workers and ideas from all over the world and rewarding them handsomely. It could demonstrate that it is capable of overcoming political gridlock, fixing its broken health-care system, bringing its infrastructure into this century, and investing in new energy sources. It could finally start to limit the undue political influence of the superrich. It could once again become a society in which all citizens enjoy better standards of living than their predecessors, because the fruits of economic growth are equitably distributed.

In short, the US could start to become what it would have been if Al Gore had won the 2000 presidential election, if Hillary Clinton had defeated Trump, and if the Republican party had not abandoned its patriotism. Such an America would have the world’s respect and more than enough diplomatic power to forge a constructive and strategically sound compact with a rising China. To address the defining geopolitical challenge of this century, America must look inward, not abroad.


J. Bradford DeLong is Professor of Economics at the University of California at Berkeley and a research associate at the National Bureau of Economic Research. He was Deputy Assistant US Treasury Secretary during the Clinton Administration, where he was heavily involved in budget and trade negotiations. His role in designing the bailout of Mexico during the 1994 peso crisis placed him at the forefront of Latin America’s transformation into a region of open economies, and cemented his stature as a leading voice in economic-policy debates.


Supply Chains and Geopolitics

U.S. tariffs on China could disrupt supply chains on which American companies depend.

By George Friedman

The U.S. imposition of tariffs on China threatens to disrupt the supply chains of American businesses that may not fully recognize their dependence on Chinese products. Discussions around supply chains have sometimes included reference to geopolitics, primarily in terms of tensions between countries. But the connection is deeper. Supply chains are both inherently geopolitical and critical to how geopolitics understands the world.

There are two ways to look at the effects of the U.S.-China confrontation. In one, it appears completely asymmetrical. China’s exports to the U.S. are equivalent to about 4 percent of China’s gross domestic product. U.S. exports to China account for a little more than 0.5 percent of U.S GDP. If trade collapses completely, China’s economy will contract significantly; the American economy will contract very little. But this would be an undifferentiated financial analysis. The other way of looking at the effects of the confrontation reveals that the real economy is much more complicated.



The international financial system is an abstraction of reality. It evaluates the value of production and transaction and provides a framework for the flow of investment and financing. These are real and important things, but looking at the economy from a financial point of view captures only what has happened while lagging behind what is happening and what will happen.
 

The Mechanics of the Global Supply Chain
The concept of a supply chain is simple. All products begin with a primary element, from oil to manganese to corn. That element is refined so it can be sold to someone who will use it for purposes as diverse as cooking a meal or making a cellphone. Industrial production involves moving the primary element from its place of origin – like a mine or a farm – to locations where it is made into a specific product and moved to another factory or node, where it is further developed using components from other factories, then sent on to a string of other factories where it is further refined, until it can finally be sent to a consumer. The chain has multiple parts with branches and alternative movements that take a particular item to many points that produce seemingly unconnected things. A piece of cloth can become a shirt, or it might become a component of an electric drill, or perhaps used to wrap jewelry.

The global supply chain is, by its nature, enormously complex. It is also very difficult to create an abstract model of it because it is completely heterogeneous. Dissimilar things with utterly different histories are in constant motion. Whereas financial transfers are frequently abstract, without a physical dimension, the supply chain is inherently physical.

The immediate challenge to this model is the internet. But even that is a very physical thing. The cloud is a vast array of servers, located in a particular place, using physical entities that are manufactured and delivered to the site, and delivering its product through vast networks of physical fiber to other physical servers and then on to the user. The fastest way to take out the internet is not through cyberwar but with missiles targeting server farms. Transmission of any sort is a physical event. It can be interdicted.
 

The Supply Chain and the Trade War
Geopolitics is the study of the nation-state and its external and at times internal dynamics. It sees economics, politics and war as different dimensions of national behavior but still integrated into a single system. It uses geography to understand the constraints and imperatives in which the nation-state and its parts exist. Geopolitics looks at the military as a physical and therefore geographically constrained force. It sees the political system as shaped by geography as a nation comes to be in a certain time and place. And while its view of economics is aware of the abstract prism of finance, it is far more aware of the physical and geographical dimension of the economy – the supply chain.

The U.S.-China confrontation is expressed in the first interest as a financial relationship, generated by political forces. But it is intimately connected to China’s fear of a U.S. military blockade of the South China Sea and the United States’ fear of Chinese movement into the Western Pacific. China is afraid that its supply chains of both exports of finished products and imports of raw materials will be disrupted. The tariffs are a financial matter. The South China Sea is a military matter. Both become supply chain-focused economic matters.



 




The U.S. move is an undifferentiated strike on the Chinese economy. The Chinese response is that they don’t need to counter such a strike and that an alternative will inevitably emerge. The very process of imposing a higher price on Chinese goods disrupts the supply chain on which U.S. business has become dependent. In other words, the tariffs will be borne by the United States in the form of increased costs to its supply chain and to consumers. Now the question becomes who – the U.S. or China – will bear more of the pain caused by the United States through damage done to businesses dependent on Chinese components of their supply chain. The issue touches on internal pressures in both countries and each country’s strategic fears about the other. The U.S. attempt to impose pre-emptive pain on China is a valid tactic if the byproduct becomes too great for China to bear – something that will become clear by watching the political process in each county.

Each country’s ability to tolerate the pain is dependent on whether an alternative supply chain is available or can be rapidly found. The problem is that, in general, the greater the value of a product, the more complex its fabrication and the more specialized the supply chain. The rapid evolution to a new system of sourcing or a new product set being produced without these components is likely difficult to achieve at a cost rivaling the tariffs.

The United States has used intrusion into supply chains as a tool in the past. The battle against Japan in World War II began with the U.S. interrupting the flow of oil and steel to Japan. The Reagan administration blocked the sale of wheat to the Soviet Union in the 1980s. The only new thing about the trade war is that American companies have become dependent on supply chain components from certain countries, unaware of the fact that disruption of that supply chain by their own government was possible. Businesses tend to think of themselves as central to the economy, and not as potential collateral damage. They miss the point that the structure of the supply chain is inherently political and that relations between nations are constantly shifting. These companies are enormously sophisticated about their own supply chains but frequently naive about that supply chain’s geopolitical security.

I have focused on China here, but as I have written before, the U.S. is moving to be more aggressive in applying economic power and less aggressive in applying military power. Geopolitically this was predictable (and we did predict it). At the same time, the peculiar complexity of the supply chain requires an intimate understanding of particular supply chains along with geopolitical forces. The question for the U.S. and China is: Who can withstand greater pain, generated by the same action? China faces economic contraction. The U.S. faces supply chain disruptions for specific companies and increased costs for individual consumers. The value of geopolitics in examining this question is that it treats politics, economics and war as essentially different parts of the same thing.


The Decline And Fall Of The Roman Empire

by: Mark J. Grant



Summary
 
- An EU ruling could lead to an initial fine of up to 3.5 billion euros ($4 billion) and tighter oversight of Italy's fiscal policy.

- Also, any plans to issue new debt might be controlled by the European Commission, and not by the government of Italy.

- Deputy Prime Minister's Salvini's plan is to issue mini government bonds, with no interest or maturity, and in denominations of 10, 50 and 100 euros, which is a bizarre concept.

- The reality of implementing this "mini-BOT" strategy is that the Italian government is actually issuing their own currency, which would compete with the euro.
 

Rome - the city of visible history, where the past of a whole hemisphere seems moving in funeral procession with strange ancestral images and trophies gathered from afar. 
- George Eliot
 
The Romans and their empire was at its height in 117 CE. It was the most extensive political and social structure in western civilization. By 285 CE the empire had grown too vast to be ruled from the central government at Rome and so it was divided by Emperor Diocletian (284-305 CE) into a Western and an Eastern Empire. Rome eventually collapsed under the weight of its own bloated empire, losing its provinces one by one. In September 476, a Germanic prince named Odovacar won control of the Roman army in Italy. After deposing the last western Emperor, Romulus Augustus, Odovacar's troops proclaimed him King of Italy, bringing an ignoble end to the long, tumultuous history of ancient Rome.
 
Now, here we are 1,543 years later, and history seems to be rhyming once again. The names have changed of course, and the innocents desire protection, but the country is once again bloated and may be grinding to an ignoble end.
 
The EU's fourth largest economy hasn't just fallen short of complying with the European Union's budgetary rules but its government has openly and repeatedly flouted them. The EU tried leniency last year, and then it tried finger pointing. Now the European Commission is likely throw the textbook at Rome, and soon, in my opinion.

An EU ruling could lead to an initial fine of up to 3.5 billion euros ($4 billion) and tighter oversight of Italy's fiscal policy. Italy could, in fact, be fined up to 0.5% of GDP, and lose loans, and the purchasing of its sovereign and corporate debt, by the European Investment Bank and the ECB. Also, any plans to issue new debt might be controlled by the European Commission, and not by the government of Italy.
 
Edward Gibbon, in his classic work on the fall of the Roman Empire, describes the Roman era's declension as a place where "bizarreness masqueraded as creativity." We are rhyming again here too, as evidenced by Deputy Prime Minister's Salvini's plan to issue mini government bonds, with no interest or maturity, and in denominations of 10, 50 and 100 euros, which is a bizarre concept, without doubt.
 
The plan is to give them to private companies that are owed money by the Italian government.
 
The reality of implementing this "mini-BOT" strategy is that the Italian government is actually issuing their own currency, which would compete with the euro. Salvini has even contended that these notes would not increase the public debt, already at 132% of their GDP, because the mini government bonds would be off Italy's balance sheet and not be counted as public debt. Italy's Confindustria business lobby stated, "To think that the problem of public debt can be solved with mini-BOTs is like trying to solve it with Monopoly money."

The vicissitudes of fortune, which spares neither man nor the proudest of his works, which buries empires and cities in a common grave. 
- Edward Gibbon, The Decline and Fall of the Roman Empire
 
Salvini's crowd has stated in the past that these mini-BOTs could replace the euro as legal tender if Italy were to leave the Eurozone. Well, "Itexit" or "Itsgone" may be on the way and I wouldn't be ruling the possibility out. Last week the Italian parliament unanimously approved a motion backing the idea of mini-BOTs which makes you wonder just what they are considering behind closed doors. Agnese Ortolani, an analyst at the Economist Intelligence Unit, said the vote was "a signal that some prominent figures, within the ruling League party, might still be working on their euro exit plans."

Even the ECB's President Mario Draghi has waded into the controversy. Last Thursday he said mini-BOTs "are either money and then they are illegal, or they are debt and I don't think there is a third possibility." Fabio Sabatini, an associate economics professor at Rome's La Sapienza University, argues that the mini-BOT scheme only makes sense if seen as a way to make Italy's euro exit possible, without making the plan explicit. People like Salvini "are creating the conditions for a 'perfect storm' that would put us out of the currency union. The intention is to leave the euro, but without taking political responsibility for it, which would be devastating," Sabatini stated.

Justice, humanity, or political wisdom, are qualities they are too little acquainted with in themselves, to appreciate them in others. Valor will acquire their esteem, and liberality will purchase their suffrage; but the first of these merits is often lodged in the most savage breasts; the latter can only exert itself at the expense of the public; and both may be turned against the possessor of the throne, by the ambition of a daring rival. 
- Edward Gibbon, The Decline and Fall of the Roman Empire
 
Salvini is the "daring rival." Italy and the European Union, in my view, are either set-up for an internal battle where various minorities team up and overturn the control of the EU, as they wrest power from Germany and France, or where Italy gets to the point where they say, "Enough" and they leave the EU on their own, either before or after the Brexit occurrence. "End-Game" may be approaching.
 
Gird for battle.