The Anatomy of the Coming Recession

Unlike the 2008 global financial crisis, which was mostly a large negative aggregate demand shock, the next recession is likely to be caused by permanent negative supply shocks from the Sino-American trade and technology war. And trying to undo the damage through never-ending monetary and fiscal stimulus will not be an option.

Nouriel Roubini

roubini131_GettyImages_globelinegraphdown

NEW YORK – There are three negative supply shocks that could trigger a global recession by 2020. All of them reflect political factors affecting international relations, two involve China, and the United States is at the center of each. Moreover, none of them is amenable to the traditional tools of countercyclical macroeconomic policy.

The first potential shock stems from the Sino-American trade and currency war, which escalated earlier this month when US President Donald Trump’s administration threatened additional tariffs on Chinese exports, and formally labeled China a currency manipulator.

The second concerns the slow-brewing cold war between the US and China over technology. In a rivalry that has all the hallmarks of a “Thucydides Trap,” China and America are vying for dominance over the industries of the future: artificial intelligence (AI), robotics, 5G, and so forth. The US has placed the Chinese telecom giant Huawei on an “entity list” reserved for foreign companies deemed to pose a national-security threat. And although Huawei has received temporary exemptions allowing it to continue using US components, the Trump administration this week announced that it was adding an additional 46 Huawei affiliates to the list.

The third major risk concerns oil supplies. Although oil prices have fallen in recent weeks, and a recession triggered by a trade, currency, and tech war would depress energy demand and drive prices lower, America’s confrontation with Iran could have the opposite effect. Should that conflict escalate into a military conflict, global oil prices could spike and bring on a recession, as happened during previous Middle East conflagrations in 1973, 1979, and 1990.

All three of these potential shocks would have a stagflationary effect, increasing the price of imported consumer goods, intermediate inputs, technological components, and energy, while reducing output by disrupting global supply chains.

Worse, the Sino-American conflict is already fueling a broader process of deglobalization, because countries and firms can no longer count on the long-term stability of these integrated value chains. As trade in goods, services, capital, labor, information, data, and technology becomes increasingly balkanized, global production costs will rise across all industries.

Moreover, the trade and currency war and the competition over technology will amplify one another. Consider the case of Huawei, which is currently a global leader in 5G equipment. This technology will soon be the standard form of connectivity for most critical civilian and military infrastructure, not to mention basic consumer goods that are connected through the emerging Internet of Things. The presence of a 5G chip implies that anything from a toaster to a coffee maker could become a listening device. This means that if Huawei is widely perceived as a national-security threat, so would thousands of Chinese consumer-goods exports.

It is easy to imagine how today’s situation could lead to a full-scale implosion of the open global trading system. The question, then, is whether monetary and fiscal policymakers are prepared for a sustained – or even permanent – negative supply shock.

Following the stagflationary shocks of the 1970s, monetary policymakers responded by tightening monetary policy. Today, however, major central banks such as the US Federal Reserve are already pursuing monetary-policy easing, because inflation and inflation expectations remain low. Any inflationary pressure from an oil shock will be perceived by central banks as merely a price-level effect, rather than as a persistent increase in inflation.

Over time, negative supply shocks tend also to become temporary negative demand shocks that reduce both growth and inflation, by depressing consumption and capital expenditures. Indeed, under current conditions, US and global corporate capital spending is severely depressed, owing to uncertainties about the likelihood, severity, and persistence of the three potential shocks.

In fact, with firms in the US, Europe, China, and other parts of Asia having reined in capital expenditures, the global tech, manufacturing, and industrial sector is already in a recession.

The only reason why that hasn’t yet translated into a global slump is that private consumption has remained strong. Should the price of imported goods rise further as a result of any of these negative supply shocks, real (inflation-adjusted) disposable household income growth would take a hit, as would consumer confidence, likely tipping the global economy into a recession.

Given the potential for a negative aggregate demand shock in the short run, central banks are right to ease policy rates. But fiscal policymakers should also be preparing a similar short-term response. A sharp decline in growth and aggregate demand would call for countercyclical fiscal easing to prevent the recession from becoming too severe.

In the medium term, though, the optimal response would not be to accommodate the negative supply shocks, but rather to adjust to them without further easing. After all, the negative supply shocks from a trade and technology war would be more or less permanent, as would the reduction in potential growth. The same applies to Brexit: leaving the European Union will saddle the United Kingdom with a permanent negative supply shock, and thus permanently lower potential growth.

Such shocks cannot be reversed through monetary or fiscal policymaking. Although they can be managed in the short term, attempts to accommodate them permanently would eventually lead to both inflation and inflation expectations rising well above central banks’ targets. In the 1970s, central banks accommodated two major oil shocks. The result was persistently rising inflation and inflation expectations, unsustainable fiscal deficits, and public-debt accumulation.

Finally, there is an important difference between the 2008 global financial crisis and the negative supply shocks that could hit the global economy today. Because the former was mostly a large negative aggregate demand shock that depressed growth and inflation, it was appropriately met with monetary and fiscal stimulus.

But this time, the world would be confronting sustained negative supply shocks that would require a very different kind of policy response over the medium term.

Trying to undo the damage through never-ending monetary and fiscal stimulus will not be a sensible option.


Nouriel Roubini, a professor at NYU’s Stern School of Business and CEO of Roubini Macro Associates, was Senior Economist for International Affairs in the White House’s Council of Economic Advisers during the Clinton Administration. He has worked for the International Monetary Fund, the US Federal Reserve, and the World Bank.

Daily chart

America has half a million fewer jobs than previously thought

As central bankers meet in Jackson Hole, the Fed ponders its next move



IT IS NOT easy being a central banker these days. Jerome Powell, the chairman of the Federal Reserve, has come under particular scrutiny in recent months. Some commentators believe he has been too hawkish, even though he cut the Fed’s main interest rate by 25 basis points last month, and should cut rates more aggressively. President Donald Trump, who appointed Mr Powell, is now his most vocal critic, and recently tweeted that the Fed should cut its benchmark rate by “at least 100 basis points”.

Lowering interest rates would be a natural response to an economic downturn, but optimists have taken comfort from labour-market figures, which suggest that America’s economy is still humming along. The country’s unemployment rate currently sits at just 3.7%, its lowest level in five decades. The labour-force participation rate of “prime-age” workers aged between 25 and 54, although still below where it was before the financial crisis, has been rising steadily since 2015.

Still, investors are anxious. America’s trade war with China shows no signs of abating. The country’s manufacturing sector is growing at its slowest pace in nearly three years; and business investment contracted in the second quarter. Meanwhile Germany, Europe’s economic powerhouse, appears to be tipping into recession. Recent news from America’s Bureau of Labour Statistics has not helped matters. On August 21st the agency revised its figures, saying that employers added half a million fewer jobs in the year ending March 2019 than previously reported (see chart). The 0.3% downward revision to total non-farm employment was the biggest in a decade.


The bond market is also sending worrying signals. The yield on America’s short-term government bonds currently exceeds that of its longer-term debt. Such “inversions” have preceded each of the past seven recessions. A forecast from the Federal Reserve Bank of New York issued on August 2nd, based on historical data from the government-bond market, estimated that there was a 31% chance of a recession within the next twelve months. Up-to-date data would yield an even scarier forecast. Mr Trump was at one point so concerned that he floated the idea of issuing a new wave of tax cuts, though he appears to have since reconsidered.

All eyes are now on Mr Powell, who is due to speak tomorrow at an annual gathering of central bankers in Jackson Hole, Wyoming. Financial markets currently suggest the Fed has a 98% chance of cutting its benchmark rate by at least 25 basis points by September. Whether such a cut will be enough for Mr Powell to stave off a recession and placate his critics remains to be seen.

The Asian strategic order is dying

Forty years of prosperity in the region are now under threat

Gideon Rachman




When somebody is reaching the end of their life, they often suffer from lots of apparently unrelated ailments — fevers, aches-and-pains, unlucky falls. Something similar may happen when a strategic order is dying. Across east Asia, the past month has seen a rash of diplomatic and security incidents that are symptoms of a wider sickness.

In late July, the Chinese and Russian air forces staged their first ever joint aerial patrol in the region, causing South Korean warplanes to fire hundreds of warning shots at Russian intruders. The South Koreans are also facing the most serious deterioration in their relations with Japan in decades — with the Japanese imposing trade restrictions last week in a dispute that has its origins in the second world war. North Korea has also just restarted missile tests, endangering US-led peace efforts.

All of the other east Asian flashpoints — Taiwan, the South China Sea, Hong Kong and the US-China trade war — are also looking more combustible. Protests and strikes in Hong Kong are still gathering momentum. Chinese officials are now openly discussing military intervention and last week a White House official drew attention to a massing of Chinese troops, just across the border from Hong Kong. For the Trump administration, however, the major preoccupation remains its trade dispute with China, which also intensified last week, with the US imposing a new set of tariffs.

July also saw a Chinese oil exploration vessel enter waters claimed by Vietnam, leading to a stand-off between heavily armed Chinese and Vietnamese ships. The government of the Philippines too sounded the alarm about Chinese naval incursions and called for American assistance. China’s growing assertiveness was underlined by the news that Beijing is developing a military base in Cambodia, its first in south-east Asia.

Tensions over Taiwan continue to rise. In late July a US warship sailed through the Taiwan Strait and China released a defence white paper, accusing the Taiwanese government of pursuing independence and threatening a military response. The US meanwhile is talking of soon deploying intermediate-range missiles in east Asia, following its pullout from the Intermediate-Range Nuclear Forces Treaty last week.

On the surface, many of these incidents seem unconnected. But collectively they point to a regional security order that is coming apart. America’s military pre-eminence and diplomatic predictability can no longer be taken for granted. And China is no longer willing to accept a secondary role in east Asia’s security system. In these new circumstances, other countries — including Russia, Japan and North Korea — are testing the rules.

The past 40 years have been a period of unprecedented growth and prosperity across east Asia, which has also transformed the global economy. But Asia’s economic miracle relied on peace and stability. Those conditions were established in the mid-1970s, with the end of the Vietnam war and America’s rapprochement with China.

Since then, America has tolerated and even facilitated the rise of China. In return, China has tacitly accepted that America would remain the dominant military power in the Asia-Pacific region. You could label these arrangements the “Kissinger order” in east Asia, after Henry Kissinger, the US secretary of state who helped broker the new relationship between America and China in the early 1970s.

But both President Xi Jinping of China and President Donald Trump of the US have rejected basic elements of the Kissinger order. Mr Trump has abandoned the idea that US-Chinese ties are mutually beneficial, by launching his trade war, while Mr Xi has set about challenging America’s strategic pre-eminence.

China’s challenge to American power has raised the question of how long the US’s strategic dominance in Asia will last. Rather than offering reassurance, Mr Trump has added to the uncertainty by openly questioning the value of US alliances with Japan and South Korea. As one Asian foreign minister put it recently: “The damage that Trump has done will outlive Trump.”

The loss of the US’s regional authority is evident in Washington’s inability to control the feud between Japan and South Korea, its two most important regional allies. Even the Australians are beginning to doubt American leadership, with one senior Australian diplomat telling me recently that, with the trade war intensifying, “there will come a point when America and Australia will part company on policy towards China”.

But doubts about American leadership are not matched by any desire to embrace a China-dominated region. On the contrary, from Tokyo to Taipei and from Canberra to Hanoi, there is growing anxiety about Beijing’s behaviour. That anxiety is only increased by the growing closeness between China and Russia. From Moscow’s point of view, the recent joint air patrol underlined Russia’s return as a Pacific power — just as military intervention in Syria signalled its re-emergence as a power in the Middle East.

The Kissinger order in east Asia did not resolve most of the historic disputes and rivalries in the region. But it helped to freeze regional conflicts in place, buying time for peaceful development. Now the geopolitical climate has changed so frozen conflicts are moving again. As the ice melts, things can move fast in dangerous and unpredictable ways.


Officials See Few Options if Slowdown Hits

Amid debate over whether the U.S. is going into an economic downturn, there are few good options to deal with one if it happens

By Rebecca Ballhaus and Nick Timiraos


Policy makers have limited options to boost the U.S. economy amid signs it is slowing. Above, a Mercedes-Benz assembly plant in Vance, Ala. Photo: andrew caballero-reynolds/Agence France-Presse/Getty Images


After debating for days whether the U.S. is going into an economic downturn, Washington policy makers and Wall Street investors on Wednesday barreled into an even more difficult problem: There are few good options to deal with one if it happens.

With short-term interest rates already low, the Federal Reserve has little room to cut borrowing costs to spur spending and investment as it usually does in a slowdown. Meantime, the federal debt is exploding, which could hamstring any efforts to boost growth with tax cuts or spending increases.

Further complicating matters, Democrats and Republicans strongly disagree about how best to rev up the economy, with Democrats favoring higher spending and the GOP wanting lower taxes. Even within their own ranks there are disagreements about what course to take.

President Trump on Wednesday backed away from pursuing new tax cuts, a sharp reversal from a day earlier, when he described several such measures the White House was contemplating. Mr. Trump is in the awkward position of calling for economic stimulus at the same time he says the economy is strong.

“I just don’t see any reason to,” Mr. Trump told reporters at the White House when asked if he was contemplating tax cuts. “We don’t need it. We have a strong economy.”

He dismissed an idea he floated Tuesday: lowering capital-gains taxes by indexing investment gains to inflation. “I’m not looking to do indexing,” he said. “I think it will be perceived, if I do it, as somewhat elitist…I want tax cuts for the middle class, the workers.” He added that it was an option, but “not something I love.”

On Tuesday, speaking to reporters in the Oval Office, the president said he had been “thinking about payroll taxes for a long time” and that indexing was “something I’m thinking about.” He added, “I would love to do something on capital gains.”

White House officials, meanwhile, said the administration has long been examining a range of tax cuts as part of what Republicans have termed “Tax Cuts 2.0,” though no proposals are expected imminently and such a measure is unlikely to go anywhere in Congress.

The president also has been pressuring the Federal Reserve to cut interest rates at a clip typically only seen when the economy is severely struggling. On Wednesday morning, Mr. Trump compared Fed ChairmanJerome Powell,his own choice for the post, to a “golfer who can’t putt.”

Though unemployment remains exceptionally low, economic growth and hiring have slowed in recent months and some warning signs are flashing in bond markets. Most notably, long-term interest rates at times have dipped below short-term rates, something that has telegraphed recessions in the past and spooked investors in recent weeks.

Wednesday’s economic reports included some troubling new signs. U.S. job growth was weaker in the year through March than previously thought, government economists said. The Labor Department lowered its estimate of total U.S. employment in March by 501,000, or 0.3%. That brought down the average monthly increase in payrolls over the period to about 168,000 from 210,000—still solid but not as robust as once thought.

Other government data revisions in recent weeks also pushed down estimates of growth and corporate profits.

But it wasn’t all bad news: Sales of previously owned homes picked up in July, the National Association of Realtors said Wednesday, a sign that lower mortgage rates may be driving sales after a weak spring selling season. Some retailers also reported good profit numbers, another sign that households remain a pillar of the economy.

The Dow Jones Industrial Average rose 240.29 points Wednesday, or 0.93%, to 26202.73. It had surpassed 27000 in July, when downturn worries started to concern investors.

Academic research cited by top Fed officials in the past says that the central bank should move quickly to cut short-term rates in moments when it has little room to maneuver and the economy might be heading for a slide.

The Fed’s target rate is just over 2%, leaving far less room to cut aggressively than in the past.

But officials at the central bank aren’t yet convinced that drastic action is needed. Moreover, the Fed’s ranks are divided about what steps to take.

Fed minutes from its July 30-31 meeting released Wednesday showed several officials favored holding rates steady because they judged “that the real economy continued to be in a good place.”

Two of those officials, Boston Fed President Eric Rosengren and Kansas City Fed PresidentEsther George,dissented from the decision to cut rates by a quarter percentage point.

But two other officials, not identified in the minutes, favored a more aggressive half-point cut, which they said would better address “stubbornly low” inflation.

The minutes also showed the officials believed uncertainty surrounding the Trump administration’s trade policy wasn’t likely to let up anytime soon, creating a “persistent headwind” for the U.S. economic outlook.

Many business executives have said the uncertain outlook for U.S. trade policy could be holding back the economy. With the U.S. locked in sharp disagreements with China over a range of issues, that might not get resolved soon.

Mr. Powell disappointed some investors—and the president—at his news conference after the July meeting when he pushed back against market expectations of a more vigorous series of rate cuts to follow.

“Now we know why Powell had a hard time at the press conference. There wasn’t a clear consensus,” saidDiane Swonk,chief economist at Grant Thornton.

Washington’s appetite for budget deficits could be tested by a slowdown or recession. Federal spending tends to rise in a recession because mandatory payments on programs like unemployment insurance goes up. Meantime, tax receipts tend to slow as household income growth and business profits slow or decline.

On top of all of that, cutting taxes or increasing spending to kick-start growth could be a challenge since both can boost deficits. Federal deficits are projected to grow much more than expected over the next decade thanks to the two-year budget agreement lawmakers and the White House struck last month, the Congressional Budget Office said Wednesday.

The agency boosted its forecast of cumulative deficits over the next decade by $809 billion, to $12.2 trillion. That means an additional $12 trillion of debt on top of the $22 trillion already outstanding.

The increase primarily reflects higher federal spending under the new budget deal, partly offset by lower projected interest rates.

The CBO said the new agreement, which increased spending roughly $320 billion over the next two years above previously enacted spending caps, will add roughly $1.7 trillion to deficits between 2020 and 2029. That reflects CBO’s assumption that federal spending will continue to grow at the rate of inflation after 2021.

Deficits as a share of gross domestic product are expected to average 4.7% over the next decade, up from the 4.3% average CBO projected in May, and a significant increase from the 2.9% average over the past 50 years.


—Kate Davidson, Josh Mitchell and Alex Leary contributed to this article.


Why Markets Have Been A Tinderbox In August

by: The Heisenberg

Summary
 
- New estimates show that most of the manic moves in stocks and bonds this month can be explained by many of the self-feeding loops I've spent years discussing.

- In rates, the recent plunge in yields was mostly down to convexity hedging.

- In stocks, gamma hedging and CTA de-leveraging played a prominent role last week.

- And it's all exacerbated by disappearing liquidity.
 

If you're looking to assign blame for the manic market moves that have, through Monday anyway, defined the month of August, you can point to systematic flows and technically-driven price action.

I've discussed this at length here and elsewhere over the past two weeks, effectively documenting it in real time, but I think it's worth fleshing out a bit further for the audience here in the interest of perhaps shedding a bit more light on something that still isn't well understood by retail investors.
 
Starting in rates, I talked quite a bit in a Friday post for this platform about receiving flows and convexity hedging and the extent to which that had almost certainly played an outsized role in the frantic rally at the long-end of the US curve. 10-year yields fell below 1.50% and 30-year yields below 2.00% at the height of the rally last week.
 
(Heisenberg)
 
 
We've seen the bottom fall out for yields on several occasions in 2019 and while some of that is down to growth concerns, collapsing inflation expectations, a flight-to-safety and the assumption of lower rates, a large percentage of this month's downdraft in yields is attributable to mortgage investors and banks chasing the rally.
 
That sprint created some $500 billion in demand, according to JPMorgan, whose rates strategists on Tuesday reminded clients that these flows are easy to see. "[It's] clear from the behavior of derivatives markets, since most of these hedging flows occur in interest rate swaps," the bank noted.
(JPMorgan)
 
 
As I wrote Friday on this platform, this sets in motion a self-fulfilling prophecy. The lower long-end yields go, the more convinced market participants become that everyone else is panicking about the outlook for global growth. Those jitters beget still more demand for duration, which pushes yields even lower, forcing more hedging, and around we go.
 
And then there's the psychological impact on equities. The exaggerated moves in rates described above are part of the reason the 2s10s inverted. That inversion, in turn, dealt a grievous blow to investor psychology last Wednesday, when the Dow suffered its worst one-day drop of 2019.
 
This is a maddeningly circular and exceptionally precarious dynamic. When fundamental, discretionary investors sell on recession jitters tied to what, as noted above, was an exaggerated move in the bond market, that can push equity benchmarks through key levels, which starts tipping dominoes for systematic deleveraging by the likes of CTAs.
 
JPMorgan's Marko Kolanovic underscored all of this in a note out Tuesday morning. "This is an important data point for equity investors, as moves in rates (e.g. yield curve inversion) significantly impact investment sentiment”, he wrote, on the way to quantifying how much selling in and around last Wednesday's rout was attributable to programmatic/systematic strats. That figure, according to Marko, was roughly $75 billion, with 20% of it coming from CTAs.
 
Now, recall how, on August 11, I mentioned in a post for this platform that dealers' gamma positioning likely flipped negative after the FOMC, which meant that selling would beget more selling. Kolanovic on Tuesday underscored that assessment, noting that heading into last week, dealers' gamma positioning betrayed "a sizable short".

Try to appreciate how the dominoes fall. As yields move lower on what are, initially, fundamental concerns, convexity hedging flows turbocharge the bond rally. That has the potential to create a false optic, or to magnify recession concerns (I referred to it as a "Fata Morgana" earlier this year). Last week, that manifested itself in the inversion of the 2s10s, which led to selling in equities. Once stocks fell through key levels, it activated CTA de-leveraging and because dealers' gamma positioning was negative, their hedging exacerbated the situation.
 
Kolanovic on Tuesday said some 50% of the above-mentioned $75 billion in programmatic selling during or as a result of the August 14 selloff was attributable to index option delta and gamma hedging, which he calls "the single most important driver of price action during both the selloffs and rallies last week".
 
Mercifully, that positioning is back to neutral now, something Nomura's Charlie McElligott illustrated on Monday as follows:
 
(Nomura)
 
 
That, folks, is how modern markets can turn into tinderboxes.
 
If you're looking to explain why nine of the 14 sessions since the July FOMC have seen S&P moves of 1% or more (top pane in the figure), that's why.
 
 
(Heisenberg)
 
 
This is exacerbated materially by low liquidity. These flows are hitting during a month when liquidity is seasonally sparse, but this August has been particularly dry. More broadly, liquidity in S&P futures simply never recovered after the February 2018 vol. event.
(Deutsche Bank)
 
 
That's attributable to a variety of factors, but one of the issues is that HFT liquidity provision is volatility-dependent. That is, algos pull back when volatility rises.
 
Well, needless to say, the interaction of all the dynamics mentioned above has a tendency to push up volatility. If vol. spikes prompt HFTs to reduce liquidity provision, it can make a bad situation immeasurably worse. That goes for bonds too. As JPMorgan pointed out again on Tuesday, "fast market participants represent roughly 80% of the liquidity provision in the hot-run interdealer Treasury market."
 
Going forward, positioning has once again been washed out a bit, with hedge fund betas very low, for instance. As noted above, dealers' gamma positioning is (basically) neutral now, so that should serve to help tamp down volatility.
 
But, it is by no means clear that the impact of hedging flows in rates is behind us, and on top of that, the dollar is near YTD highs. Jerome Powell has the potential to exacerbate both the decline in bond yields and dollar strength on Friday if he doesn't strike the "right" tone in Jackson Hole.
 
Suffice to Boston Fed chief Eric Rosengren did not signal a willingness to back off his propensity to dissent against more rate cuts when he spoke to Bloomberg on Monday.
 
And President Trump did not signal a willingness to step back from his insistence on those same cuts when he spoke to Twitter.

Buttonwood

The LME is Europe’s only surviving “open outcry” venue

Traders still bark orders for copper as they have for more than a century




HER CLIENT’S huge order would cause prices to surge if the market got wind of it. She knew she needed to be crafty. “So I shouted as loud as I could, ‘I’ll sell at £795’.” The price sank. “By now I was pointing at everyone who had bid, but because they thought I was a heavy seller they backed off, only taking 25 tonnes at a time.” At the bell, the price fell to £780. That triggered automatic sell orders. At the next session she was able to buy back her stock—plus a few thousand tonnes for her client—on the cheap.

Every trader on the London Metal Exchange probably has a tale to tell of wrong-footed rivals. This story, told in “Ring of Truth”, a memoir by Geraldine Bridgewater, the LME’s first female trader, is from four decades ago. Little has changed. Traders still sit in a circle (the Ring) and yell orders for copper at each other, just as they have for more than a century. The LME is the only “open outcry” trading venue left in Europe. Its rituals seem as quaint as Morris dancing or the Trooping of the Colour.

Yet somehow the LME retains its relevance. It is now owned by Hong Kong Exchanges and Clearing (HKEX). Ms Bridgewater’s big trade was for the People’s Republic of China, a client she had shrewdly cultivated. China has since become the LME’s biggest source of custom. There is a rival exchange in Shanghai; China dislikes being a taker of prices set beyond its borders. Still, the LME is where the liquidity flows to. Its staying power owes a lot to incumbency—but also to transparency.

Metals-trading in London can be traced back as far as 1571. Back then, it happened alongside other kinds of merchant-trading on the Royal Exchange. A metals-only exchange that traded mostly copper and tin was formalised in 1877, at the peak of British industry’s global clout. In those days copper from Chile took three months to reach London. Merchants wanted to lock in the price of a shipment as it left port. That is how three-month futures became a standard. They are still the most traded LME contract today.

Other traditions are observed. Even on a brutally hot day in July everybody is dressed smartly, the men in jackets and ties. The noise rises a little as the bell signals the start of a new session.

Metals are traded in short, timed bursts to enhance liquidity. Traders sit on the red quarter-circle banquettes of the Ring. Account executives (in Ms Bridgewater’s day they were simply “clerks”) stand behind them straining to hear. They relay each quote, assisted by hand signals, to colleagues standing, with telephones cradled to each ear, in the brokers’ booths that make up an outer ring.

It looks chaotic. It certainly sounds it. But it is striking, given the noise, how calm the traders seem. It is essential for them to remain poker-faced. When they need to be heard, they lean forward. In between yells a trader might glance up at the main board, down at his dealing card or at his watch to see exactly how much time is left (the clock on the dealer board does not count seconds). Unlike in the trading pits of Chicago, most sessions are limited to one sort of commodity. And traders sit in the same spot every day.

Is all this fuss and noise strictly necessary? Only perhaps a tenth of trades that are cleared through the LME are agreed on in the Ring. Most are done over the phone or on the LME’s electronic trading platform. When HKEX acquired the LME in 2012, it must surely have thought it would soon be rid of the Ring. It is a costly pageant. Screen-based trading has lower overheads and is more profitable for the exchange. A lot of Ring trades are lending or borrowing between odd dates—from next Tuesday to Monday a fortnight hence, say. Only specialists want to make those kinds of bets.

Yet they are needed to underpin a system of daily contracts that extend out to the three-month contract. They are too complex to be carried out on-screen. Daily pricing matters to the miners, smelters and manufacturers who produce or consume the metals being traded. Long-term supply arrangements are based on LME prices. So the Ring survives. It is like a poker room—a loss-leader in a casino full of more profitable slot machines.

Some things have changed: daytime drinking is now banned. But the LME is still the place to find liquidity of the right sort. Trading could scarcely be more transparent (once you can speak the argot). Prices are trusted worldwide. Traders can feint, but must play fair. Tomorrow they will be face-to-face with the same people. You can’t help wishing that all financial markets were like this.

Japanese Banks Are Circling the Drain

Three decades of structural pressure from falling interest rates can no longer be escaped

By Mike Bird

After years of low and now negative interest rates, many Japanese banks are circling the drain. Photo: Photo Illustration by Emil Lendof/The Wall Street Journal; Photos: iStock 


Banking in a country where almost nobody defaults sounds easy. For Japan’s lenders, it is anything but.

After almost three decades of near-zero, zero, and now negative interest-rate policies, Tokyo has pushed its banking system to its limit.

The country’s smaller lenders in particular are facing an existential threat to their business models. Located in aging and shrinking prefectures, they lack the ability to increase fee-related incomes that major banks can raise.

Japan has too many banks, and consolidating them into larger players will buy time. But without a wholesale shift in the way it approaches its economic stimulus policies, the banking system will remain under constant pressure.



Since March 2016, shortly after the country’s negative interest rate policy was introduced, net income at major banks has declined by a fifth. At regional banks, the decline has been steeper: Net income is a third below its level three years ago.

Practically all of Japan’s regional banks have seen their share prices fall in the past 12 months. More than half have had declines exceeding 30%. They have underperformed the broader Japanese market for decades.

At the beginning of 1995, just before the Bank of Japancut its benchmark policy rate to 0.5%, loans by commercial banks with interest rates of below 1% were practically nonexistent. Over 90% of outstanding loans carried an interest rate of 3% or more. Today, 90% of Japanese loans carry an interest rate of less than 2%. The fastest-growing segment is the paltry 0.25% to 0.5% bracket, which has expanded by almost a 10th in the past year.

The interest offered to Japanese depositors, however, shifted much more quickly to very nearly zero. The upshot of this is that profitability held up for a while but now the 1.5 percentage point spread between interest rates on new loans and new time deposits that prevailed in the 1990s has declined to just 0.5 percentage point. Even with the country’s rock-bottom default rates, the resulting profits simply aren’t sufficient to run a bank.



Some of Japan’s major banks have found an apparent workaround, but one with its own serious risks. Those with the expertise and ability to do so have ventured overseas, acquiring assets and lending in currencies without such low interest rates.

Norinchukin Bank, a Japanese cooperative serving farmers and fishermen, has become a leviathan in the market for U.S. and European collateralized loan obligations, investment vehicles that buy up loans to junk-rated companies. Mitsubishi UFJ Financial Group ,Inc. reported foreign-currency assets of 111.158 trillion yen ($1.049 trillion) in the year to March, a figure that has risen more than 100% in the last 10 years, three times faster than its domestic assets.

Roaming abroad is more difficult for smaller banks, and it would be unwise even if it was possible: Bank for International Settlements research has demonstrated that banks without local operations and local funding were least resilient against shocks when operating overseas.

The precarious position of Japanese banks isn’t an example of negative interest rates failing but of them working perfectly well. Central bankers often complain about problems with monetary transmission—often a byword for banks not passing on interest-rate cuts—but Japan’s have done so.


Moving beyond the current dangerous impasse will require consolidation. The country has too many banks and too many rules that prevent them from merging. According to the Nomura Research Institute, of the 11 regional banks created by mergers in the past two decades, 10 reduced their operating expenses and nine became more efficient by downsizing.

Critics of Japan’s monetary policy would be wrong to imagine that higher interest rates would help either. As with lower rates, the change would take years to filter through, during which time defaults would rise and economic growth would stall.

On their current path, the future looks decidedly bleak. Atrophying profitability is likely to result in more frauds like that of Suruga Bank Ltd., a one-time regional banking star brought low by a document-falsification scandal relating to real-estate loans. If the economy takes a turn for the worse, any rise in bad loans would likely send the weakest players into financial distress—especially those that have extended further into property-market lending in recent years.

In the 1990s, Japan lost a decade of economic progress to a broken banking system. Today, it’s running the risk of a repeat.

Speaking Truth to Power

Many partisans accused President George W. Bush of lying and pressuring the intelligence community to produce intelligence to justify a war that Bush had already chosen. But the situation was complicated, and to understand the problems of speaking truth to power, we must clear away the myths.

Joseph S. Nye, Jr.

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CAMBRIDGE – US President Donald Trump’s nomination of John Ratcliffe, a highly partisan Congressman with little international experience, to replace Dan Coats as Director of National Intelligence raised the red flag of the politicization of intelligence. Opposition to Ratcliffe among Democrats and Republicans alike forced Trump to withdraw the nomination, but the question remains: Will power corrupt truth? Presidents need an intelligence director they can trust, but can the rest of the government trust that director to speak truth to power, as Coats did when he contradicted the president on issues like Russia, Iran, and North Korea?

Costly intelligence failures are not unique to the United States. France failed to foresee Germany’s attack through the Ardennes in 1940; Stalin was blindsided by Hitler’s attack in 1941; and Israel was surprised by the Yom Kippur War in 1973.

Trump, who is angry at the US intelligence services for pointing out the degree of Russian interference in his 2016 election, often justifies his dismissal of their work by referring to their inaccurate assessment that Iraq possessed weapons of mass destruction. Many partisans accused President George W. Bush of lying and pressuring the intelligence community to produce intelligence to justify a war that Bush had already chosen. But the situation was complicated, and to understand the problems of speaking truth to power, we must clear away the myths.

As the American weapons inspector David Kay later characterized the estimates of WMD in Iraq, “we were almost all wrong.” Even the United Nations’ chief inspector, the Swedish diplomat Hans Blix, said he thought that Iraq had “retained prohibited items,” and French and German opposition to the Iraq war was not based on different intelligence assessments regarding the weapons. But the US (and British) experience combined failures at three levels: collection, analysis, and public presentation.

Iraq was a difficult target for intelligence collection. Saddam Hussein was a dictator who instilled fear by killing those who talked, including his own son-in-law when he disclosed in 1995 that Saddam had a biological weapons program. The US and the United Kingdom had few reliable spies in Iraq, and they sometimes reported only indirectly on things they had heard but not seen. After the UN inspectors were expelled in 1998, the US lost access to their impartial human intelligence and often filled the vacuum with the tainted testimony of Iraqi exiles who had their own agenda. And neither country had access to Saddam’s inner circle, and thus had no direct evidence about the biggest puzzle of all: if Saddam had no weapons, why did he persist in acting as though he did?

Analysis was also weak. The analysts were honest, but, lacking evidence about Saddam’s thinking, they tended to succumb to “mirror imaging”: they assumed that Saddam would respond the way we (or any “rational” leader) would. Instead, he felt his power at home and in the region depended on his preserving his reputation for possessing WMD. Another problem was the analysts’ tendency to overcompensate for their earlier, opposite error.

After the first Gulf War, UN inspectors discovered that Saddam was closer to developing a nuclear weapon than analysts had thought. Vowing not to underestimate Saddam again, the analysts overestimated, a tendency that was reinforced by the trauma of 9/11. In practice, such dominant mental frameworks or “groupthink” should be challenged by a variety of analytical devices such as designating devil’s advocates and creating “red teams” to make the case for alternative interpretations, or requiring analysts to ask what change in assumptions would make their analysis wrong. By all accounts, this rarely happened.

So, what role did politics play? The Bush administration did not order intelligence officials to lie, nor did they. But political pressure can subtly skew attention even if it does not directly corrupt intelligence. As a wise veteran explained to me: “We had a big pile of evidence that Saddam had weapons of mass destruction, and a smaller pile that he did not. All the incentives were to focus on the big pile, and we did not spend enough time on the smaller pile.”

The presentation of intelligence to (and by) political leaders was also flawed. There was little warning that “weapons of mass destruction” was a confusing term in the way it lumped together nuclear, biological, and chemical weapons, which in fact have very different characteristics and consequences. The 2002 National Intelligence Estimate cited Saddam’s purchase of aluminum tubes as proof that he was reconstituting his nuclear program, but Department of Energy analysts, who had the expertise, disagreed. Unfortunately, their dissent was buried in a footnote that was dropped (along with other caveats and qualifiers) when the executive summary was prepared for Congress and a declassified public version. Political heat melts nuances. The dissent should have been discussed openly in the text.

Political leaders cannot be blamed for the analytical failures of intelligence, but they can be held accountable when they go beyond the intelligence and exaggerate to the public what it says. US Vice President Dick Cheney said there was “no doubt” that Saddam had WMD, and Bush stated flatly that the evidence indicated that Iraq was reconstituting its nuclear programs. Such statements ignored the doubts and caveats that were expressed in the main bodies of the intelligence reports.

Trust in intelligence runs in cycles in our democracy. During the Cold War, intelligence officials were often seen as heroes. After Vietnam, they became villains. September 11 restored public recognition that good intelligence is more important than ever, but the failure to find WMD in Iraq renewed suspicion again, and Trump has used it to obscure the problem of Russian interference in American elections.

The lessons for the next American DNI are clear. In addition to the bureaucratic tasks of coordinating budgets and agencies, he (or she) will have to monitor tradecraft in collection of intelligence, defend rigorous use of alternative techniques for analyzing it, and ensure careful presentation to political leaders and the public. Above all, the DNI has a duty to speak truth to power.


Joseph S. Nye, Jr. is a professor at Harvard University and author of Is the American Century Over? and the forthcoming Do Morals Matter? Presidents and Foreign Policy from FDR to Trump.