The legacy of 1989 was western complacency

As it shed its communist past, the east was told to embrace a flawed model

Tony Barber




Two months before the Berlin Wall fell on November 9 1989, East Germany’s Stasi secret police prepared a memorandum for the state’s communist leaders explaining why thousands upon thousands of citizens were fleeing to the west. The report dispensed with the usual claptrap blaming everything on western imperialism. Instead, the Stasi diagnosed East Germany’s problems as shortages of consumer goods and services, poor healthcare, travel restrictions, bad workplace conditions, oppressive bureaucracy and unfree media.

Anyone with personal memories of East Germany and the rest of the Soviet-led communist bloc knows that this analysis hit the nail on the head. Conditions varied across the region — Hungary was more open, Romania was a nasty dictatorship — but the essential point about the people’s hunger for western-style freedoms and living standards was completely correct.

Thirty years after the largely peaceful revolutions that dismantled communism, it is common to hear the view, in and outside central and eastern Europe, that something in the region has gone wrong. The demand for national independence, better economic conditions and democratic institutions has been met — albeit less convincingly in some countries than in others. Yet the view persists that 1989 has not quite turned out to be the irreversible turning point for the better that was hoped for.

Without doubt liberal democracy is on the defensive — although people in the glasshouses of Austria, Italy, the UK and US might want to think twice before throwing stones to the east. Democracy and the rule of law have been bent out of shape in Hungary and, to a lesser extent, in Poland and Romania. Rightwing populists form part of Estonia’s coalition government. Corruption in political and business circles is widespread across the region.

Still, it is not a picture of unrelieved gloom. EU and Nato membership has brought relative prosperity and security — a big improvement on the diplomatic, military and economic vulnerability that undermined them from 1918 to 1939. The fear to which Václav Havel, the late Czechoslovak playwright-president, gave voice in 1990 — that his region risked slipping into a post-cold war vacuum that would breed instability — has not become reality.

Nor is it correct that illiberalism and chauvinism reign supreme in central and eastern Europe. From Gdansk to Bucharest, from Bratislava to Skopje, there is much public and political resistance to these malignant phenomena. Compared with Brazil, China, the Philippines, Russia and Turkey (not to mention some western democracies) conditions in most of central and eastern Europe do not look exceptionally bad.

Nevertheless all is not well in the region. Why? One reason lies in the model that western governments in the 1990s prescribed for the east’s transition to free-market democracy. As it shed its communist past, the east was told to embrace not just liberal democracy but globalisation, open borders and the lightly regulated financial capitalism that the west viewed as the touchstone of its own economic success.

This model’s flaws were exposed in the 2008 financial crisis and the European refugee and migrant emergency of 2015-16. As in western societies, the doors opened in central and eastern Europe to nationalists, anti-immigrant nativists and anti-establishment populists. They found a receptive audience in voters in less prosperous, less internationalised towns and rural areas, who had long felt excluded from a meaningful say over how their countries reinvented themselves after 1989.

To be clear, the region’s leading pro-democracy reformers in 1989 were in no doubt about the desirability of following the western model. Nor were they necessarily wrong. Poland’s shock therapy programme — harsh in its initial impact and still uneven in some of its consequences — nonetheless modernised the economy in ways that no rulers, Polish or foreign, had achieved in centuries.

EU membership, too, has brought more pluses than minuses. Access to the single market, regional aid and, from ordinary people’s viewpoint, Europe-wide freedom of movement are cherished gains. Against that, a certain discontent with western Europe built up as central and eastern Europeans formed the impression that, to paraphrase George Orwell, all Europeans are equal but some are more equal than others.

This resentment has much to do with the western model grafted on to the east. In 1989, as during Europe’s 1848 revolutions, the people wanted civic freedoms and, in many cases, liberation from foreign overlords and their first independent states of modern times. But after 1989 the adoption of the western model — complete with EU membership, global capitalism and a liberal political philosophy — created tensions between liberalism allied to internationalism and the assertion of a newly acquired national sovereignty.

A similar battle between nationalists and liberals divided the German revolutionaries of 1848.

It paved the way to Germany’s unification under Otto von Bismarck on the principle of conservative nationalism, not liberalism. Now central and eastern Europe is experiencing its own contest between populist nationalism and liberal democracy. It would be brave to forecast a winner when some western societies are caught up in much the same struggle.

Last Year’s Treasure Becomes This Year’s Trash

by John Rubino
  

Not so long ago the US economy had some bright spots that seemed to justify a general sense of optimism.

The fracking revolution had turned the country into the world’s largest oil producer with, apparently, a lot more to come. And the growing number of tech “unicorns” – private companies with valuations exceeding $1 billion – promised a steady parade of flashy IPOs for as far as the eye could see.

This year both were exposed as frauds.

Iconic unicorns Uber, Lyft, Peloton and SmileDirect went public and then dropped rather than soared.

And now WeWork, the real estate “tech” company that in 2018 was worth $47 billion, has imploded.

The founder/CEO has been tossed out a high-rise window and a major investor has stepped in with a bailout that values the company at a paltry $8 billion – which still looks rich for a start-up whose losses exceed its revenues.

See the video in this article that explains WeWork’s business model and why it was always doomed to failure.

Now on to fracking, the process of pumping immense amounts of water dosed with a cocktail of industrial chemicals into the ground to force out heretofore inaccessible oil and gas.

Turns out that it only works for a few years on each well, putting drillers on a treadmill of ever higher debt (mostly via junk bonds) and soaring rig counts while producing zero profits.

Not surprisingly, traditional financing has dried up as once-burned banks and junk bond buyers balk at second helpings.

So frackers are turning to … wait for it … asset backed securities similar to the subprime mortgage bonds of the 2000s:

Frackers Float ‘Shale Bonds’ as Traditional Investors Flee
(Wall Street Journal) – Desperate for cash, shale companies are trying to court investors with a new and potentially risky financial instrument that resembles mortgage bonds. 
The companies are floating a type of asset-backed security that involves existing oil and gas wells. Producers transfer ownership interests in the wells to special entities that then issue bonds to be paid off by the output from the wells over time. 
Raisa Energy LLC, a Denver-based oil-and-gas company backed by private equity firm EnCap Investments LP, closed the first such offering in September and several others are planned before the end of the year, said people familiar with the transactions. The bonds will pay nearly 6% interest on the best quality wells, the people said, with higher rates on riskier assets. 
The investments are drawing attention from insurance companies, large money managers and other traditional investors of asset-backed securities. They represent a new avenue for shale companies as the industry’s traditional investors sour on the sector following years of disappointing returns. 

While similar in structure to securities backed by mortgages and auto loans, the securities pose potential risks because projecting the long-term output from shale wells remains an inexact science. Shale drilling only became a widespread method of extracting oil and gas in the past two decades. Modelling future production has proven difficult because of the complex geology of shale basins and large variability from one well to the next, engineers say. 
Thousands of shale wells drilled in the past five years are pumping less oil and gas than their owners forecast to investors, The Wall Street Journal previously reported. 
Investors will have to rely on companies’ estimates to model potential returns, said Harrison Williams, managing principal at Core Energy Advisors, which advises producers on asset sales. 
“The pitfalls are in the underwriting: Is the oil and gas there and will it come out?” Mr. Williams said. “Sometimes predicting reserves has a large component of art as well as science.” 
Securitizing wells may be one of the few sources of new money available to producers, said Jonathan Ayre, a partner at law firm Orrick Herrington & Sutcliffe LLP. It The firm is working with Guggenheim Securities, which also structured Raisa’s offering, on a similar securitization. 
“The appetite is definitely out there,” Mr. Ayre said. “For oil and gas companies looking to monetize their investments, there are not a ton of good options.”

For two such high-profile sector stories to become object lessons in credulity is of course bad for those companies’ investors. But the impact won’t stop there.

Fracking and tech IPOs were major reasons for positive animal spirits generally.

Take them away and the question becomes: if these guys can’t make money and enrich their investors, who can?

At some point the answer becomes “no one” and risk-off becomes the new normal.

S&P 500: The Calm Before The Storm

by: Victor Dergunov
 
Summary
 
- The S&P 500 and stocks in general are at another crucial inflection point.

- The U.S. economy is clearly worsening, yet the Fed appears reluctant to acknowledge the depth of the problems facing U.S. markets.

- Q4 could get bloody unless the Fed brings the "bazooka" out, which seems unlikely at this point.

- I discuss our portfolio's strategy and performance throughout Q1-Q3, and how various assets are likely to react going forward in Q4.
 
Source: Forbes
 
 
The S&P 500 (SP500)/SPX is at a crucial inflection point. On Friday the SPX closed right around 2,950, a critical resistance level. From a fundamental standpoint, key economic data has been worsening dramatically lately. Manufacturing and non-manufacturing data, employment indicators, as well as various other important economic indicators are pointing towards a possible recession in the U.S. in the near future.
 
Moreover, it appears that the Fed may be behind the curve. Also, the market may be overly optimistic on the measures the Fed is prepared to take to support the U.S. economy, the S&P 500, and stocks in general. Thus, it appears likely that SPX and stocks in general have much more downside risk than upside potential from here.
 
Furthermore, the combination of a slowing economy in the U.S. and the possibility of limited near term Fed action, continued trade disputes, and other factors will likely put additional strain on the U.S. consumer. This phenomenon could be enough to tip the U.S. economy into a recession within the next 6-12 months, and we may be in the early stages of a bear market (in stocks) already.
 
Technical View: Very Bearish
 
SPX 1-Year Chart
Source: StockCharts.com
 
If we look at the SPX’s 1-year chart, we see that the S&P 500 recently bounced off 2,850 support, filled the gap-up at around 2,950, and as of writing this article S&P 500 futures are down by around 0.5%.
 
What is very troubling from a technical perspective is the RSI. We see that at prior peaks the RSI went well above, or at least touched the 70 level. However, during the latest peak the RSI only reached about 60 before reversing and declining. This likely indicates weakening technical momentum, and a loss of appetite for risk assets amongst market participants.
 
Moreover, the SPX attempted to breakout above the 3,025-3,030 resistance level several times during its latest peak. The breakout attempts were unsuccessful, and moreover, the SPX put in a short-term double top as well as a longer-term double top simultaneously. Also, the upside-down black hammer candle before the latest selloff is a very bearish technical indicator.
 
It seems probable that the SPX will fail at 2,950 resistance, will trade down to 2,850-2,825 support, and will likely brake lower to retest the 2,725 level, unless the Fed brings out the “bazooka” soon (this seems doubtful in my view).
 
Regardless, a decline from 3,030 to 2,725 would be a textbook 10% correction. However, if SPX breaks below this level we could trade down much lower, and the odds of a bear market materializing appear to be increasing significantly.
 
What's Changed from Q3
 
Speaking from a macro point of view, the economy has worsened due to trade tensions, a recession in manufacturing, a slowdown in the services sector, questionable monetary policy from the Fed, and multiple other factors.
 
ISM manufacturing PMI has come in below 50 for two months in a row now. Moreover, the numbers have been far worse than analysts had anticipated. So, the U.S. manufacturing sector is clearly in recession now.
 
Now, the services sector appears to be closing in on contraction mode as well. ISM non-manufacturing PMI came in at just 52.6, vs an estimated 55, and far lower than last month's 56.4.
Let’s Take a Closer Look at Those Employment Numbers
 
The employment numbers are also coming in worse than expected lately. For instance the latest non-farm payroll report appears "not that bad", but if you look closely at the numbers, it was quite disappointing.
 
Firstly, the decline in the unemployment rate to 3.5% is insignificant at this point. In fact, the "official" unemployment rate typically hits bottom right before every recession starts, at least going back 60 years or so. You can read more about this trend and other bearish indicators here.
 
Furthermore, the real unemployment rate in the U.S. is likely closer to 7-8% than it is to 3.5%. This is due to millions of "discouraged" workers who have stopped looking for work and are simply not included in the official unemployment rate statistics.
 
What is important, and what is really troubling are several factors. First, we see that average hourly earnings were expected to grow by 0.3% MoM, but they came in flat at 0.0% MoM. Also, average hourly earnings grew by just 2.9% YoY, vs an expected 3.2% rise.
 
Furthermore, if you notice, private non-farm payrolls came in at just 114K vs the expected 133K.
 
This is a significant miss and it indicates that the employment picture in the private sector is much worse than was anticipated and is being advertised. In fact, the only reason the overall jobs numbers didn't miss by an extensive number was due to more government jobs being created.
 
This certainly is not good news, as government jobs ultimately have to be payed for by the tax payer.
 
Given that average hourly earnings are not rising as they should be, the economy is at or near maximum employment, this will put even more pressure on the consumer going forward.

Putting the Pieces of The Puzzle Together

There are a great deal of moving parts and pieces to the overall macro puzzle. However, if we focus on just a few, like the recession in manufacturing, worsening private employment numbers, much worse than expected services sector data, etc., we see that the U.S. economy may be like a house of cards, standing solely on the back of the U.S. consumer.
U.S. economy house of cards Source: Shutterstock.com
 
 
Sooner than later, the U.S. consumer will very likely buckle, and as about 70% of U.S. GDP comes from consumer spending we can probably expect a recession coupled with a bear market fairly soon.
 
In fact, I believe that there is a higher probability that we are in a bear market already, than that we are still in a bull one.
 
Thus, the Fed will need to act regardless. In fact, it's acting already, steadily lowering rates, recently "giving" big banks $100 billion. This is just another form of QE by the way, and I am sure there is a lot more to come in the next several years.
 
But what if the Fed doesn't lower its funds rate in October?
 
After all, there is about a 20% probability that the Fed won't act at all at this month’s meeting.
 
I believe these chances are much higher, especially if the stock market remains around current levels or goes higher between now and the end of this month. In fact, the Fed will likely only lower the funds rate later this month if the stock market deteriorates further from here.
 
Regardless, it appears that the Fed is behind the curve. Whether it is intentionally, or unintentionally, remains a topic for debate. Ultimately, the Fed may not be able to prevent the recession for much longer no matter what it does, as its recent actions seem to have a very limited effect on the economy.
 
Albright Investment Group's Q3 Portfolio Performance
 
Despite a few difficulties, primarily in the Bitcoin/cryptocurrency basket of our portfolio, Albright Investment Group AIG, had a very successful quarter.
 
A few highlights:
 
The stock and ETF portion of our portfolio (including non-physical metals) which made up roughly 45% of total portfolio holdings returned about 4.5% in Q3 vs the S&P 500’s roughly zero return. Moreover, other major averages like the Nasdaq, Russell 2000, and the NYSE composite finished the quarter firmly in the red.
Some top performing sectors in the quarter included gold/silver/miners (GSMs), up by over 6% in Q3, and defensive staples, which also returned around 6% in Q3 (this is not including dividends or covered call dividends, CCDs).
 
Technology was down by roughly 2% in the quarter, most other segments were relatively flat, and energy was the big underperformer delivering a loss of roughly 9% in the quarter.
 
Fortunately, we were able to minimize losses and maximize gains in many areas of our portfolio, including in energy by trading around positions throughout the quarter.
 
YTD Performance
 
Our stock/ETF portfolio outperformed all major averages in Q3. YTD (Q1-Q3) AIG’s stock/ETF portion of the portfolio was up by about 37% vs the S&P 500’s 17% gain. Basically, our stock and ETF portion of AIG’s portfolio more than doubled the S&P’s returns.
 
Our overall portfolio, including cryptocurrencies, cash, bands, physical metals, stocks and ETFs returned 30.54% YTD (Q1-Q3), beating the S&P 500 by roughly 80%.
 
The Takeaway
 
We can see that many of the top performing stocks are related to sectors such as GSMs, consumer staples, some top-quality technology, and other “safe-haven” sectors. I expect this sort of rotation and trend to continue throughout the rest of the year.
 
On the other hand, the worst performing stocks appear to be high multiple/high flying names in technology as well as in other sectors. Moreover, we see that energy names had an atrocious quarter in Q3. However, this could present an opportunity in quality energy and oil services names to recover significantly in Q4 if WTIC/crude oil goes and stays above the $55-$60 level.
 
In this environment, high multiple names may continue to underperform. However, high quality and grossly oversold energy names may see a rebound, especially if we see WTIC stabilize above $55 and proceed to move higher. On the other hand, if WTIC breaks down below $50, expect more downside in oil related equities regardless of “how cheap” they seem.
 
Bitcoin and the Cryptocurrency Complex
Despite a “difficult” Q3, AIG’s cryptocurrency basket is up by over 40% YTD. Moreover, we are likely at a time when it is advantageous to accumulate digital assets, as they have declined a great deal, and the market seems to be overreacting to recent news (noise).
 
Source: AIG's Material
 
What We are Doing with Our Portfolio Today and Why
 
We’ve decreased our non-GSM (gold/silver/miners) stock and ETF holdings to roughly 24%.
 
This is because we see increased risk of a recession on the horizon, and the stock market likely has far more downside risk than upside potential from here.
 
We have about 12% in cash. This is to have some dry powder ready to add to positions when necessary. This may or may not be positions in stocks, depending on future market dynamics.
 
Ultimately, the Fed will likely need to bring the funds rate down to zero and introduce a great deal of QE to keep the economy from stalling or crashing completely. However, before and while this is happening corporate profits will very likely decline and there should be a grizzly bear market in stocks coming up shortly. That is why we are very cautious on most equities going forward.
 
Source: MarketWatch.com
 
 
However, assets like gold, silver, gold mining companies, Bitcoin and some systemically important digital assets are great instruments to hold as the Fed lowers rates, increases its balance sheet, and balloons the monetary base.
 
Bitcoin and other mineable coins are inflation proof, as there are only a certain number of coins that can ever exist in circulation. Gold and silver are classic hedges against inflation and monetary base expansion.
In fact, if you compare gold's rise relative to USD monetary base expansion since then President Nixon decoupled the world's monetary system from the gold standard, their (gold's and U.S.’s. monetary base) expansions percentage wise have been nearly identical.
 
You can read more about this in this article here. Thus, we have about 22% of our portfolio allocated to the GSM segment. This figure will likely rise going forward to about 25% of portfolio holdings.
 
gold Image Source: TheLeaders-online.com
 
 
Also, as the Fed will very likely continue to bring medium and long term rates down to or close to zero. Thus, we should see trading instruments like TLT, IEF and others alike do extremely well as they appreciate in value as U.S. treasury yields decline.
 
Now, we have accumulated a sizable Bitcoin and digital asset position, which may seem excessive to some people. However, this is the future of currency, and digital store of value. I view Bitcoin and other systemically important coins as enterprises and not just currency/payment systems.
 
Bitcoin Source: Vox.com
 
 
In fact, I believe a fair comparison to blockchain, Bitcoin and other important coins would be the internet in the early 1990's and key companies like Microsoft (MSFT), Intel (INTC), Amazon (AMZN), etc. These companies that sprung out around the internet at the right time and filled their intended market positions became dominant market leading companies in the process.
It appears that a similar phenomenon may be taking place in the blockchain, Bitcoin, digital asset market right now. Therefore, I am quite confident these assets are going much higher over the next 5 - 15 years.
 
Nevertheless, I do not advocate investors to risk more than 20% of their portfolio investing in digital assets as there is still a lot of regulatory uncertainty surrounding the space. I general suggest market participants hold roughly 7.5%-20% of portfolio holdings in assets like Bitcoin, Litecoin, Dash, Zcash, etc.

Squeeze on U.S. Companies May Be Worse Than It Seems

American firms are in worse shape than reported earnings indicate

By Justin Lahart


An earnings metric that measures profits at U.S. companies down to the local diner, not just firms listed on the S&P 500, is painting a worrying picture. Photo: Eve Edelheit/Zuma Press


U.S. companies might be feeling a lot more pinched than they appear. That could have serious repercussions for both the stock market and the economy.

Earnings season is about to get under way, and it looks as if the news won’t be good. Analysts polled by FactSet estimate that earnings per share for companies in the S&P 500 fell by 4.1% in the third quarter from a year earlier. Even with the allowance that actual results probably won’t be quite as bad, since the bulk of companies usually top estimates, it looks as if it will mark the third quarter in a row that earnings slumped.


It is a comedown from last year when, buoyed by a strengthening economy and corporate tax cuts, earnings grew by 20%. Trade tensions and slower economic growth are weighing on sales, while rising labor costs are cutting into bottom lines. The net profit margin for the S&P 500—income as a share of sales—fell to an estimated 11.3% in the third quarter from 12% a year earlier, according to FactSet.

Margin pressures are more than just a problem for shareholders. Because they drive companies to cut costs, they can cause trouble for the economy. The hope is that since S&P 500 profit margins are still historically high, the cost-cutting impulse will be subdued.

But figures from the Commerce Department’s Bureau of Economic Analysis offer a very different view of what has happened with overall U.S. corporate profits over the past several years. Growth has been lower and margin pressures worse than the S&P 500 figures.



According to the BEA measure, after-tax profits in the second quarter were only 6% higher than they were three years earlier, which compares with a gain of 50% in S&P 500 net income over the same period. After-tax profits as a share of gross domestic product—a rough approximation of overall U.S. profit margins—slipped to 8.7% from 9.4% over that period, despite the profit boost from the 2017 tax cut.

There are important differences between the BEA profits measure and S&P 500 earnings numbers. First, the BEA is measuring profits at all U.S. companies, down to the local dry cleaner, while the S&P 500 figures are only for the large, public companies that make up the index. Many S&P 500 companies are multinationals with substantial overseas earnings that aren’t included in the BEA’s figures.

Additionally, the S&P figures are based on companies’ financial reports. The BEA, while using financial reports for its initial estimates, ultimately relies on tax data.

Still, there is substantial overlap between the two measures, and they usually track each other.

When they don’t, as in the late 1990s, when S&P 500 profits surged but BEA showed profits stagnating, it can be a sign that something is amiss. Ultimately, investors found that their confidence in big companies’ earnings power in the late 1990s was misplaced. Stocks fell sharply.

The most important difference between how profits are reflected in companies’ financial reports and how they are counted by the BEA might be in the treatment of capital gains, says economic consultant Joseph Carson. Indeed, the BEA itself has stated that the reason its measure didn’t show that late 1990s run-up in profits “was primarily attributable to capital gains.”

Under accounting rules, capital gains and losses can make their way into earnings in a variety of ways, notes David Zion, head of accounting and tax research firm Zion Research Group. If a company’s equity investments rise in value, for example, that unrealized gain can flow into the income statement. As a result of new accounting rules adopted last year, capital gains are now even more apt to show up in earnings.

The BEA, on the other hand, aims to measure profits companies generate through their business operations, and so excludes capital gains and losses.

The implication is that a fair amount of the earnings growth the S&P 500 has exhibited in recent years might be ephemeral, related to gains in the value of companies’ investments rather than the underlying strength of their operations.

Under the hood, then, profit margins aren’t as good as they appear. If business starts to falter, companies’ may take an ax to costs, with bad repercussions for the economy.

No More Half-Measures on Corporate Taxes

In the face of climate change, rising inequality, and other global crises, governments are losing out on hundreds of billions of dollars in tax revenue as a result of corporate tax arbitrage. Yet despite the obvious deficiencies of the global tax regime, policymakers continue to propose only piecemeal fixes.

Joseph E. Stiglitz

stiglitz263_In Pictures Ltd.Corbis via Getty Images_womenproteststarbucks


NEW YORK – Globalization has gotten a bad rap in recent years, and often for good reason.

But some critics, not least US President Donald Trump, place the blame in the wrong place, conjuring up a false image in which Europe, China, and developing countries have snookered America’s trade negotiators into bad deals, leading to Americans’ current woes. It’s an absurd claim: after all, it was America – or, rather, corporate America – that wrote the rules of globalization in the first place.

That said, one particularly toxic aspect of globalization has not received the attention it deserves: corporate tax avoidance. Multinationals can all too easily relocate their headquarters and production to whatever jurisdiction levies the lowest taxes. And in some cases, they need not even move their business activities, because they can merely alter how they “book” their income on paper.1

Starbucks, for example, can continue to expand in the United Kingdom while paying hardly any UK taxes, because it claims that there are minimal profits there. But if that were true, its ongoing expansion would make no sense. Why increase your presence when there are no profits to be had? Obviously, there are profits, but they are being funneled from the UK to lower-tax jurisdictions in the form of royalties, franchise fees, and other charges.

This kind of tax avoidance has become an art form at which the cleverest firms, like Apple, excel. The aggregate costs of such practices are enormous. According to the International Monetary Fund, governments lose at least $500 billion per year as a result of corporate tax shifting.

And Gabriel Zucman of the University of California, Berkeley, and his colleagues estimate that some 40% of overseas profits made by US multinationals are transferred to tax havens. In 2018, 60 of the 500 largest companies – including Amazon, Netflix, and General Motors – paid no US tax, despite reporting joint profits (on a global basis) of some $80 billion. These trends are having a devastating impact on national tax revenues and undermining the public’s sense of fairness.

Since the aftermath of the 2008 financial crisis, when many countries found themselves in dire financial straits, there has been growing demand to rethink the global regime for taxing multinationals. One major effort is the OECD’s Base Erosion and Profit Shifting (BEPS) initiative, which has already yielded significant benefits, curbing some of the worst practices, such as that associated with one subsidiary lending money to another. But, as the data show, current efforts are far from adequate.

The fundamental problem is that BEPS offers only patchwork fixes to a fundamentally flawed and incorrigible status quo. Under the prevailing “transfer price system,” two subsidiaries of the same multinational can exchange goods and services across borders, and then value that trade “at arm’s length” when reporting income and profits for tax purposes. The price they come up with is what they claim it would be if the goods and services were being exchanged in a competitive market.

For obvious reasons, this system has never worked well. How does one value a car without an engine, or a dress shirt without buttons? There are no arm’s-length prices, no competitive markets, to which a firm can refer. And matters are even more problematic in the expanding services sector: how does one value a production process without the managerial services provided by headquarters?

The ability of multinationals to benefit from the transfer price system has grown, as trade within companies has increased, as trade in services (rather than goods) has expanded, as intellectual property has grown in importance, and as firms have gotten better at exploiting the system. The result: the large-scale shifting of profits across borders, leading to lower tax revenues.1

It is telling that US firms are not allowed to use transfer pricing to allocate profits within the US. That would entail pricing goods repeatedly as they cross and re-cross state borders. Instead, US corporate profits are allocated to different states on a formulaic basis, according to factors such as employment, sales, and assets within each state. And, as the Independent Commission for the Reform of International Corporate Taxation (of which I am a member) shows in its latest declaration, this approach is the only one that will work at the global level.

For its part, the OECD will soon issue a major proposal that could move the current framework a little in this direction. But, if reports of what it will look like are correct, it still would not go far enough. If adopted, most of a corporation’s income would still be treated using the transfer price system, with only a “residual” allocated on a formulaic basis. The rationale for this division is unclear; the best that can be said is that the OECD is canonizing gradualism.

After all, the corporate profits reported in almost all jurisdictions already include deductions for the cost of capital and interest. These are “residuals” – pure profits – that arise from the joint operations of a multinational’s global activities. For example, under the 2017 US Tax Cuts and Jobs Act, the total cost of capital goods is deductible in addition to some of the interest, which allows for total reported profits to be substantially less than true economic profits.

Given the scale of the problem, it is clear that we need a global minimum tax to end the current race to the bottom (which benefits no one other than corporations). There is no evidence that lower taxation globally leads to more investment. (Of course, if a country lowers its tax relative to others, it might “steal” some investment; but this beggar-thy-neighbor approach doesn’t work globally.)

A global minimum tax rate should be set at a rate comparable to the current average effective corporate tax, which is around 25%. Otherwise, global corporate tax rates will converge on the minimum, and what was intended to be a reform to increase taxation on multinationals will turn out to have just the opposite effect.

The world is facing multiple crises – including climate change, inequality, slowing growth, and decaying infrastructure – none of which can be addressed without well-resourced governments.

Unfortunately, the current proposals for reforming global taxation simply don’t go far enough. Multinationals must be compelled to do their part.


Joseph E. Stiglitz, a Nobel laureate in economics, is University Professor at Columbia University and Chief Economist at the Roosevelt Institute. He is the author, most recently, of People, Power, and Profits: Progressive Capitalism for an Age of Discontent.