Dr. Li Wenliang

Doug Nolan



The S&P500 rallied 3.2% this week (trading to all-time highs Thursday), more than reversing (by 1.5 times) the previous week’s 2.1% decline. Ten-year Treasury yields rebounded as well, yet the eight bps rise was less than half the previous week’s 18 bps drop. Commodities markets couldn’t muster any recovery this week.

WTI crude fell another $1.24 (2.4%) to $50.32, a fifth straight weekly decline (“longest weekly losing streak since 2018”). The Bloomberg Commodities Index was little changed on the week. Copper did recover 1.4% - though a mere fraction of the previous week’s 6.2% drubbing. Ominously, the Singapore (small country, big financial sector) dollar dropped 1.8% this week, while the Japanese yen, Chinese renminbi and Malaysian ringgit all declined about 1.0%.

Sometimes it’s difficult to gauge which has the stronger underlying momentum – the safe havens or the risk markets (i.e. equities and corporate Credit). Ten-year Treasury yields are already down a notable 33 bps early in 2020.

The iShares long-term Treasury ETF (“TLT”) has a noteworthy 6.78% y-t-d return, outpacing the 3.16% return for the S&P500. It’s a remarkable dynamic that no longer rouses much interest. Both markets look at the world and really like what they see.

It’s worth noting 10-year Treasury yields began the week at 1.51%, not far from the 1.46% closing low from September 3rd. Treasury and global yields collapsed throughout the summer, with Treasury yields dropping over 100 bps in about four months. The U.S. yield curve briefly inverted in late-August, eliciting talk of a U.S. recession and a global downturn. January’s 225k gain in non-farm payrolls is just the latest economic indictor making those recession forecasts look goofy.

I saw summer market developments as much more about China and global monetary policy than economic prospects. I believe vulnerable Chinese financial and economic Bubbles are the predominant factor behind the irrepressible demand for global sovereign debt. China has evolved into the marginal source of global Credit along with global demand for commodities and much more.

China was in a particularly fragile state over the summer, with escalating financial stress in the face of deteriorating U.S./China trade negotiations. China’s aggressive stimulus measures along with a “phase 1” trade deal reduced near-term crisis risk. Global yields then somewhat normalized. Ten-year Treasury yields ended the year at 1.92%, up almost 50 bps from early-September lows. Bund yields ended 2019 at negative 0.19%, up from negative 0.72% on August 28th. Swiss bond yields jumped 66 bps off lows to end the year at negative 0.54%.

Then arrived the coronavirus outbreak. Suddenly, Chinese economic prospects look highly uncertain at best. Even if the outbreak somehow comes under control in the coming weeks, the economy will take a significant hit.

There’s a scenario where the situation continues to deteriorate and takes on longer-term significance. Global markets rallied this week on the PBOC’s aggressive liquidity injections, along with other stimulus measures.

There’s no doubting Beijing’s commitment to aggressive fiscal and monetary stimulus. I just believe almost everyone is too optimistic – drowning in central bank liquidity complacency.

China is confronting an unprecedented predicament, while concurrently facing acute financial and economic fragilities associated with a faltering Bubble.

Safe haven bonds and commodities have this right. Risk markets are simply playing a different game – an especially dangerous one at that. The Fed’s dual 2019 “U-turns” have profoundly changed risk market perceptions and behavior. Rates were cut, and liquidity was injected despite loose financial conditions, speculative markets and record stock prices. Understandably, risk market participants have been emboldened to believe the Fed and global central bankers have minimal tolerance for market instability.

To argue that the Fed’s $400 billion balance sheet expansion is neither QE nor culpable for surging stock prices completely misses the point. The Fed’s operations solidified the view that securities prices are the priority – even more so than the real economy. This fundamentally altered perceptions of market risk and, accordingly, price dynamics throughout equities, corporate Credit and derivatives.

Goldman Sachs Credit default swap (CDS) prices (5yr) ended the week at 45.7 bps. This was down from a high of 76 bps in October and compares to the 135 bps high on January 4th, 2019 – just minutes before Chairman Powell’s dramatic “U-turn”. Over the past five years, Goldman CDS have averaged 79 bps. Indeed, this Thursday’s 45.08 price was the low since September 2007. JPMorgan CDS closed the week near the low going back to 2007. Investment-grade corporate CDS prices also dropped back down to the lows since before the crisis. Friday’s closing price of 46 bps compares to the five-year average of 67 bps.

Is systemic risk really at the lowest point this week since before the crisis?

Ridiculous. For starters, China poses a clear and present danger to both the global economy and financial system. China has added a scary amount of debt over the past decade – its “miracle” economy surely the poster child for Credit excess-induced structural maladjustment.

Debt has grown tremendously across the globe.

Today’s global market and financial excesses are unprecedented. Risk is extraordinarily high, certainly owing to central bank stimulus and these wacky securities and derivatives prices.

In this context, it’s not difficult to explain global safe haven yields. And it is actually not much of a challenge to define the factors behind booming risk markets. Markets have become precariously distorted and dysfunctional. Central bank monetary stimulus has succeeded in completely turning risk analysis on its head. In all the craziness, China fragilities are a positive.

The coronavirus likely constructive to the U.S. economy. Even risky political and geopolitical dynamics are seen in positive light. They all ensure monetary stimulus as far as the eye can see.

And the obvious retort would be: “Doug, what’s new here?” What’s changed is the degree to which the risk markets are conditioned to disregard risk. Even a development with the clear potential to be highly disruptive to global economies and finance can be ignored. Comments I’m hearing and reading are the most detached from reality that I can recall. In my 30 plus years of following the markets, I’ve never seen such a divergence between market risk perceptions and reality.

The 2019 policy and monetary fiasco fundamentally altered market behavior. Risk markets have become incapable of adjusting for uncertainty and elevated risks. Markets instead fixate on the certainty of ongoing monetary stimulus and liquidity abundance. This incapacity for well-founded risk assessment and healthy market corrections is today a major source of systemic risk. How can eventual market adjustments not be violent and destabilizing?

Coronavirus infections have surged to 34,500, up 190% in a week. Friday’s cases increased 10% from Thursday, a slowing in the growth rate. The number of cases outside of China have increased, but there is reason for hope the outbreak to this point is largely confined to China.

There is, as well, justification for fear.

Case in point: The Diamond Cruise ship now docked off Yokohama had 61 infections of the 273 passengers tested – now the largest outbreak outside of China. There are an additional 3,400 passengers that have yet to be tested. Japan’s Ministry of Defense will be prioritizing passengers for additional testing. Passengers originally believed they were subject to a 14-day quarantine.

Now everything is unclear. There are even concerns that the virus may be transmitted through ventilation systems. It is clear many have tested positive for the virus despite being asymptomatic, leaving open the possibility that tens of thousands could be unknowingly infected. In Germany, a team of researchers this week reported that the coronavirus can remain infectious on surfaces for up to nine days.

But nothing compares to the nightmare unfolding in Wuhan.

February 6 – New York Times (Amy Qin, Steven Lee Myers and Elaine Yu): “The Chinese authorities resorted to increasingly extreme measures in Wuhan on Thursday to try to halt the spread of the deadly coronavirus, ordering house-to-house searches, rounding up the sick and warehousing them in enormous quarantine centers. The urgent, seemingly improvised steps come amid a worsening humanitarian crisis in Wuhan, one exacerbated by tactics that have left this city of 11 million with a death rate from the coronavirus of 4.1% as of Thursday — staggeringly higher than the rest of the country’s rate of 0.17%. With the sick being herded into makeshift quarantine camps, with minimal medical care, a growing sense of abandonment and fear has taken hold in Wuhan, fueling the sense that the city and surrounding province of Hubei are being sacrificed for the greater good of China.”

More from the NYT: “The steps were announced by the top official leading the country’s response to the virus, Vice Premier Sun Chunlan, as she visited Wuhan on Thursday. They evoked images of the emergency measures taken to combat the 1918 Spanish Flu pandemic that killed tens of millions people worldwide. Despite the severity of the new measures, however, they offered no guarantee of success. The city and country face ‘wartime conditions,’ Ms. Sun said. ‘There must be no deserters, or they will be nailed to the pillar of historical shame forever.’”

Just imagine being in Wuhan – panicked by the catastrophe overwhelming the local healthcare system – and having a medical worker arrive at your door, demand to take your temperature, and then force you leave your home to be warehoused in a stadium converted into a containment facility. While not as Draconian as Wuhan and Hubei Province, there are various degrees of quarantine in major cities throughout China.

February 6 – New York Times: “The doctor who was among the first to warn about the coronavirus outbreak in late December — only to be silenced by the police — died Friday after becoming infected with the virus… The death of the 34-year-old doctor, Li Wenliang, set off an outpouring of grief and anger on social media, with commenters on social media demanding an apology from the authorities to Dr. Li and his family…” Question last week from a NYT reporter: “How long will it take you to recover? What do you plan to do afterward?” Li: “I started coughing on Jan. 10. It will take me another 15 days or so to recover. I will join medical workers in fighting the epidemic. That’s where my responsibilities lie.”

The coronavirus will leave deep scars on the Chinese people. Trust in the government has been shaken. The future cannot appear as bright as a month ago. How could this experience not harbor deep-seated fear and insecurity? And it all crashes headlong into inflated expectations.

We cannot comprehend ramifications at this point. But it goes so far beyond when automobile and technology manufacturing can return to a semblance of normality – or when western retailers will reopen their Chinese stores.

Most of all, this crisis transcends PBOC and global central bank monetary stimulus. The apt question, once again, is whether all this “money printing” is more the solution or the problem.

Both the PBOC and Fed have recently expended huge amounts of stimulus in desperate measures to sustain booms. It leaves one contemplating how much stimulus will be expended when Bubbles start bursting. At this point, such stimulus measures are a losing game. They’re feeding the mania and exacerbating fragilities.

A partial and defective US-China trade truce

A large problem remains: Washington does not know what it is trying to achieve

Martin Wolf

Jaw Jaw print


“Jaw, jaw is better than war, war.” These words of former British prime minister Harold Macmillan (wrongly attributed to Winston Churchill) are the right response to the “phase one” trade agreement between the US and China. The agreement has huge defects of omission and commission. The conflict is far from resolution.

US objectives also remain confused and confusing. But the two superpowers have at least reached an agreement. The preamble to the agreement even states that “it is in the interests of both countries that trade grow”. This is a truce, not peace. It leaves a high level of protection in place. Yet a truce is welcome.

The deal itself covers intellectual property, “forced” transfer of technology, agriculture, access for financial services and currency manipulation. It also includes a commitment by Beijing to “import various US goods and services over the next two years in a total amount that exceeds China’s annual level of imports for those goods and services in 2017 by no less than $200bn”.

That implies a rough doubling. The agreement, equally notably, includes a tough bilateral dispute resolution system. Finally, the agreement leaves the vast bulk of US tariffs in place, while forgoing — or maybe merely postponing — additional ones.

A graphic with no description

Note that many of the new Chinese policies announced by the agreement are already in place.

As Weijian Shan, a well-informed outside investor, notes in Foreign Affairs, China had begun lifting restrictions on foreign ownership, including in financial services. It has strengthened laws protecting intellectual property.

And China has also long since ceased to manipulate its currency. In these areas, the US is pushing on an open door — or at least one that its Chinese counterparts in these negotiations want to open, in China’s own interests. The results will be good for China’s economy.

The agreement does not cover the biggest bugbears in the relationship, notably commercial cyber theft, industrial subsidies and, even more broadly, the Made in China 2025 programme, aimed at upgrading the economy’s technological sophistication.

Disputes relating to technological interdependence, notably over Huawei, and supply chains that include Chinese production in areas deemed sensitive for US security are also outside this agreement.

Chart showing that Trump is failing to eliminate US trade deficits. US trade and current account balances as a % of GDP, 2011 to 2019


This then is a partial agreement. It is also defective. The most important defect is at the heart of US president Donald Trump’s administration: its lust for quantitative management of trade.

The dominant thrust of this agreement is towards market opening and reliance on market forces, including in currency markets. One can (I would) disagree with the methods used, notably bilateral tariffs of very doubtful legality under World Trade Organization rules. But the objectives at least are consistent with longstanding US policy.

Chart showing that there has been little change in US-China bilateral balances. US bilateral trade with China as a % of US GDP, 2011 to 2019

Yet then we see an extraordinary commitment to specific values of Chinese purchases of US goods and services. That is sure to reinforce the state’s role in China’s economy. It is sure, too, to require Beijing to discriminate against competing imports from other trading partners.

The US is forcing China to break core principles of non-discrimination and market-oriented policy, in an effort to reduce the overall US trade deficit by reducing its bilateral deficits. This is both ludicrous and dangerous.

Moreover, despite the administration’s efforts, the overall US trade deficit is larger, relative to gross domestic product, than when Mr Trump was inaugurated. This is not surprising: the trade balance is not determined by trade policy. To think otherwise is a basic fallacy.

Chart showing that China’s dependence on trade with the US is in decline. China-US trade as % of Chinese GDP, 2011 to 2019


Nor is this the only huge defect. Another is that this agreement cannot end the uncertainty.

Thus, if, in the US view, China is not living up to its side of the deal, it will act against China and, in the last resort, the agreement may end.

Yet there is a more fundamental uncertainty. The US does not know what it is trying to achieve in relation to China. This trade deal is largely about opening up China and so making it a more normal market economy. That would reinforce Chinese integration into the global economy, while making the Chinese economy more competitive. But the deal also seeks to manage trade, which is sure to reinforce the role of the Chinese state. In other areas — again, notably technology and investment in the US — the aim clearly is economic decoupling from China.

Coupling? Managing? Decoupling? This disarray reflects continuing US confusion.

Chart showing that trade decoupling is beginning slowly. Trade shares (% of total), years compared 2016 and year to Sept 2019


Nor is this the only respect in which trade uncertainty will endure, though it may be the most important. It is widely expected that the next stage in the Trump administration’s trade wars will be an assault on EU trade practices. The US has also recently reached agreement with the EU and Japan on the need for tougher global rules on subsidies, aimed at China.

That will not mean much without enforcement.

But the US has also now neutered the WTO’s dispute settlement procedure, which can only add to the uncertainty and render efforts to upgrade WTO rules irrelevant.

Chart showing that the deal calls for $200bn additional Chinese purchases over the next two years. China’s purchases of US goods and services ($bn) Bar chart showing 2017 baseline, plus additional purchases for 2020 , Plus additional purchases for 2021


It is a huge pity that the US has in effect taken the issue of China out of the WTO.

As Paul Blustein noted in his excellent book Schism, there were viable alternatives.

Nevertheless, continuing friction between the two superpowers now seems unavoidable. Agreement on enforceable trade rules may be possible, albeit difficult, in specific areas.

But China will never agree to accept permanent economic and technological inferiority. If imposing the latter is the dominant US objective, this is just the early stage of a very long conflict.

We may be able to welcome an occasional partial truce like this one.

But the war itself is likely to continue indefinitely.

Trump to Propose $4.8 Trillion Budget With Big Safety-Net Cuts

White House seeks savings through curbs on Medicare, Medicaid while boosting funds for military, veterans

By Kate Davidson and Andrew Restuccia

President Trump’s 2020 budget proposes to cut spending by $4.4 trillion over a decade. Of that, it targets $2 trillion in savings from mandatory spending programs.
Photo: kevin dietsch/pool/Shutterstock .


WASHINGTON—President Trump is expected to release a $4.8 trillion budget Monday that charts a path for the start of a potential second term, proposing steep cuts to social-safety-net programs and foreign aid and higher outlays for defense and veterans.

The plan would increase military spending 0.3%, to $740.5 billion for fiscal year 2021, which begins Oct. 1, according to a senior administration official. The proposal would cut nondefense spending by 5%, to $590 billion, below the level Congress and the president agreed to in a two-year budget deal last summer.

A White House budget reflects an administration’s priorities and represents the opening bid in spending negotiations for the next fiscal year. The new budget proposal is unlikely to become law, however, as Democrats control the House and spending bills in the GOP-led Senate need bipartisan support.











































This year, the budget also reveals Mr. Trump’s fiscal policy objectives should he win reelection in November, and his campaign messaging will likely reflect its broad strokes. The president’s aides have been meeting since late last year to craft a second-term agenda.

Among the agencies that would receive the biggest boost is NASA, which would see a 12% increase next year as Mr. Trump seeks to fulfill his goal of returning astronauts to the moon by 2024. On the other hand, the Environmental Protection Agency’s spending would be slashed by 26%.

The plan would request $2 billion in new funding for construction of the wall on the southern U.S. border, the senior administration official said—Mr. Trump’s signature 2016 campaign promise that sparked fights with Democrats in Congress, leading the president to trigger a historic five-week government shutdown last winter after lawmakers refused to fund the project. The latest $2 billion request is significantly less than the $5 billion the administration sought last year.

The White House proposes to cut spending by $4.4 trillion over a decade. Of that, it targets $2 trillion in savings from mandatory spending programs, including $130 billion from changes to Medicare prescription-drug pricing, $292 billion from safety-net cuts—such as work requirements for Medicaid and food stamps—and $70 billion from tightening eligibility access to federal disability benefits.

In campaigning for the White House Mr. Trump had promised voters he would protect funding for Medicare and Medicaid. His new budget’s proposals to find savings through changes to those programs reflect longstanding GOP efforts to reduce federal safety-net spending, and come the week after all but one Republican senator voted to acquit the president of impeachment charges passed by House Democrats.

The budget assumes the $1.5 trillion tax-cut package enacted in 2017, set to expire by 2025, is extended, and projects revenues in line with last year’s proposal. It also expects economic growth will be faster than most economists predict if the president’s policies are implemented.

The White House projects the economy will grow 3.1% in the fourth quarter of 2020 compared with a year earlier, and 3% in 2021, and that it will continue to expand at that pace for the rest of the decade. But the administration expects year-over-year growth—comparing total GDP for the year—to be slightly lower in 2020 than it forecasted last year, the senior administration official said, echoing Treasury Secretary Steven Mnuchin last week.

In his State of the Union address last week, Mr. Trump touted the strength of the economy, foreshadowing a central theme of his reelection campaign.

“We are moving forward at a pace that was unimaginable just a short time ago, and we are never going back,” he said.

After a brief pickup in 2018, however, growth last year settled back to the roughly 2% pace that has prevailed during the decade since the last recession ended, where many economists expect it to remain. At the same time, unemployment has fallen close to a 50-year low.

The federal budget deficit would shrink to $966 billion next year from an estimated $1 trillion in 2020. The administration forecasts an end to annual deficits by 2035. During his 2016 campaign, Mr. Trump discussed paying off the federal debt within eight years.

Though Mr. Trump’s budget officials have pushed routinely for spending cuts to reduce deficits, the president has reached two separate agreements with congressional Democrats to boost spending above limits set in 2011.

Meanwhile, tax cuts enacted in 2017 have reduced government revenues as a share of economic output, pushing deficits as a share of GDP to 4.7%, well above the 2.7% average over the past 50 years.

The administration forecasts the 10-year Treasury yield, which reflects the cost of government borrowing to finance the deficit, will average 2% in 2020 and rise gradually over the next decade, well below the rates forecast in last year’s budget. The change reduces projected net interest costs by $600 billion over the next decade.

Winners in Mr. Trump’s budget include the Department of Veterans Affairs, with a 13% increase next year, and the Department of Homeland Security, with 3%. The National Nuclear Security Administration’s budget would get a 19% boost.

On the other hand, the Department of Housing and Urban Development’s budget would be cut by 15%, although the proposal includes $2.8 billion in homelessness assistance grants. Mr. Trump has repeatedly criticized Democratic-led cities, saying they have failed to address homelessness.

The Commerce Department’s budget would be reduced by 37% from 2020, but officials said much of that cut can be attributed to the completion of the census. Foreign aid would be slashed by 21%.

The Centers for Disease Control and Prevention would see its budget decline 9%, but with the coronavirus sparking global panic, $4.3 billion in funding for fighting infectious diseases would be preserved.

Separately, the administration has notified Capitol Hill that it might reprogram $136 million in funds from fiscal year 2020 to address the virus, the administration official said, though no decision has been made on whether the money is needed.

The budget also proposes moving the U.S. Secret Service from DHS to the Treasury Department, in a win for Mr. Mnuchin, who has pushed for such a move. The change would require congressional approval.

Security assistance to Ukraine would remain at current levels following Mr. Trump’s decision last summer to suspend congressionally approved aid as he pushed the country to investigate 2020 Democratic candidate Joe Biden, an episode at the center of the impeachment saga.

The budget eliminates funding for the Yucca Mountain Nuclear Waste Repository in Nevada. Mr. Trump has said he hopes to work with state politicians, who widely oppose the repository, on an alternative. Nevada is a battleground state in the coming presidential election.

Copper Prices Hit an Almost Three-Year Low Because of Coronavirus. The Worst Is Yet to Come.

By Myra P. Saefong


Photograph by Andrey Rudakov/Bloomberg 


An economic slowdown in China following the spread of the new coronavirus, and the potential loss of demand for copper, pulled prices for the industrial metal to its lowest in almost three years. Some analysts say the worst may be yet to come.

“Prices certainly have further to fall, especially if the contagion intensifies,” says Hakan Kaya, senior portfolio manager of the Neuberger Berman Commodity Strategyfund (ticker: NRBAX).

Even if the virus ends up being an economic “nonevent” outside of China, many investors may be looking to make their portfolios less risky, he adds.

“My worry is that almost everyone will be simultaneously looking for a catalyst exit, potentially creating all sorts of liquidity spirals and seriously impacting copper,” he says.

Copper has taken a significant hit so far this year. On Feb. 3, copper futures logged a 13th straight session decline, the longest such streak on record, based on data going back to November 1984, according to Dow Jones Market Data. Prices settled that day at $2.507 a pound, the lowest since May 2017. Copper futures settled at $2.593 a pound on Feb. 6.

During that roughly two-week streak of losses, copper was down 13%, which John Caruso, senior asset manager at RJO Futures, says was “undoubtedly oversold.” Still, “China is the world’s largest consumer of raw commodities, and with both an economic slowdown and a possible pandemic, traders are having a difficult time gauging true value at the moment.”

Caruso says that China’s economy was showing signs of a slowdown even before the virus, pointing to the latest industrial profit figures. Chinese industrial-company profits dropped by 6.3% year on year in December, following growth of 5.4% in November.

“Clearly, industrial demand for copper has slowed over the past quarter, and with the outbreak of coronavirus, this has simply doubled down on the slide in prices and expected demand forecasts,” says Caruso. “You’ve got widespread panic in China; commerce and industry will undoubtedly be [affected] by the virus—to what extent is still difficult to determine.” Many companies in China have temporarily shuttered operations.

The market is in a “deflationary vortex,” reflecting a likely slowdown in both the Chinese and U.S. economies, and the unknowns of a possible coronavirus pandemic, Caruso says. He added that RJO Futures is not advising clients to buy copper at this time. Instead, the commodity brokerage suggests that shorter-term traders sell rallies closer to the $2.60 to $2.65 price level, when they “signal overbought within [a] bearish trend.”

Rohan Reddy, an analyst at exchange-traded funds provider Global X, believes, however, that copper prices are likely to recover following their recent decline, as demand rebounds on the back of accelerated growth in emerging markets.

The market may see more demand as electric vehicles, which use a “substantial” amount of copper, become more mainstream, and many countries that produce copper, such as Chile, have been “prone to bouts of volatility in copper production,” which may be a “catalyst to rebalance supply and demand,” says Reddy.

He believes the global economy looks to be on a “strong footing.” It’s a volatile market, he says, “but for an investor with a longer-term outlook, there is a compelling case for an entry into the copper market.”

Caruso, meanwhile, warns that a breakdown below $2.40 suggests a retest of multiyear lows of $2 to $1.90 a pound, though copper may still rise as high as $3.15 to $3.30 “if economic and supply/demand fundamentals accelerate the bull case” for the metal. He says he is near-term bearish on copper, and would turn bullish when prices top $2.88.


Restoring Fiscal Order in the United States

The United States’ federal budget deficit is currently projected to explode, increasing the federal debt to unprecedentedly high levels. A very gradual fiscal consolidation, with federal spending as a share of GDP declining slightly each year, would both raise economic growth and create a more resilient economy.

John B. Taylor

taylor5_TsokurGetty Images_USdollarmoneyface


STANFORD – In recent years, the US government has taken several essential economic-policy steps. The tax reform embedded in the 2017 Tax Cuts and Jobs Act (TCJA), the recent United States -Mexico-Canada (USMCA) trade agreement, “phase one” of a China-US trade deal, and recent regulatory reforms are all needed to revive and strengthen economic growth. It is now time for another essential policy step: correcting the trajectory of fiscal policy.

The Congressional Budget Office’s (CBO) current baseline projection of federal government spending in future years far outpaces federal government revenue, as the figure below clearly shows. The result is an exploding federal budget deficit, which will bring the federal debt as a share of GDP to 144% by 2049, according to the CBO baseline, and likely to the 219% projected in the CBO’s alternative fiscal scenario. These debt levels are unprecedented in US history.

In contrast to previous periods when the deficit fell after similar upward bursts, the current CBO projections show no such reversal. The large deficit will crowd out important federal programs, including needed infrastructure investment, as well as private investment needed for economic growth. Debt service will account for a rising share of spending, and the high debt will likely increase interest rates by more than the CBO assumes, leading to an economically perilous debt spiral.

It does not have to be this way. The figure also shows a sensible targetfor spending as a share of GDP, establishing a path toward fiscal consolidation. This target moves very gradually – by only 0.1 percentage point per year – reducing the share of federal spending in GDP from 20.7% to 19.5%.

This gradual path does not represent “austerity” in any meaningful sense. Federal spending would grow at a rate slightly less than the growth rate of GDP, leading to smaller deficits over time. If credible, the plan would have no negative demand effects on GDP.

According to CBO research that I cited when I testified before the House Budget Committee in November, such a target would lead to higher GDP growth and more income per person, in contrast to current CBO projections of exploding deficits.

But achieving this target means that the future expenditure share of GDP would be substantially lower than projected by the CBO under current policy. As John Cogan explains in his recent book The High Cost of Good Intentions, consolidation paths like this require reforms that boost the efficiency of government programs – such as keeping the growth of Social Security spending per person in line with inflation.





Some economists – such as Jason Furman of Harvard University’s Kennedy School – have argued for another type of fiscal reform, which would increase the magnitude of automatic stabilizers. I disagree.

Yes, there are good reasons for the federal deficit to rise automatically during economic downturns and to fall during booms. Such movements tend to stabilize the economy, and they occur automatically as a result of programs like unemployment compensation and a progressive tax system.

But automatic stabilizers have been working well for many years. Regression estimates show that their recent size has been about the same as it has been for the past half-century. As real GDP declines relative to its potential (that is, as the output gap rises), spending growth increases and tax revenue growth declines, resulting in a larger cyclical deficit.

From 2000 to 2018, the output gap accounted for 38% of the cyclical component of the deficit, about the same as the 36% share over the five decades from 1969 to 2018, based on data from the CBO’s January 28, 2019, report on the automatic stabilizers. One can see this relationship in the scatter plot below, showing the cyclical deficit and the GDP gap during 1969-2018. The dots are scattered tightly around a straight line with a slope of 0.36.

One reason sometimes given to justify strengthening the automatic stabilizers is that monetary policy can no longer do the job because it is constrained by the zero bound on interest rates.

But it is better to fix monetary policy by using rules, including rules for forward guidance, than it is to change the automatic stabilizer component of fiscal policy when the problem lies elsewhere.






The current federal budget is off track and needs to be reformed.

The problem is that spending is projected to grow too rapidly relative to revenues, not that the deficit responds too modestly to the ups and downs in the economy.

The reform suggested here would focus on the problem with a very gradual fiscal consolidation, which would make the policy process more permanent, pervasive, and predictable.

Most important, it would both accelerate GDP growth and create a more resilient economy.



John B. Taylor is Professor of Economics at Stanford University and Senior Fellow at Stanford’s Hoover Institution. His most recent book (with George P. Shultz) is Choose Economic Freedom.

Shadow Banks Come Into the Light in Global Lending

Nonbank financial institutions have a growing presence in cross-border credit, but we won’t know the real effect until a downturn arrives

By Mike Bird




In cross-border credit, regular banks are out, and shadow banks are in. Our limited knowledge about how the latter will behave in a downturn is a reason for concern.

According to Bank for International Settlements data released this week, nonbank financial institutions are leading the growth in cross-border lending, with cross-border banking claims in the third quarter up 17% from a year earlier. That’s the fastest growth in at least six years, when records began.

Banks’ cross-border claims on and liabilities to nonbank financiers have risen by nearly $8 trillion since the end of 2013, while their cross-border exposure to other banks has actually declined slightly under the weight of increasingly stringent regulation.

Shadow banks, which include brokers, clearinghouses, funds, investment trusts and structured finance vehicles, get a bad rap from the unfortunate name. And the Financial Stability Board’s attempt to rebrand them as “nonbank financial intermediaries”—snappy!—hasn’t taken off.

Nothing is inherently wrong about their becoming more important. But the shift raises questions about how they’ll behave in a sharp slowdown or financial crisis.

The rise of shadow banking since the 2008 crisis is a lesson in being careful what you wish for.

Research last year from the Barcelona Graduate School of Economics suggested that raising bank capital requirements spurred activity by nonbank lenders—unsurprisingly. It also determined that some nonbank lenders made that crisis worse because they lacked stable funding sources.

Nonbank financiers also tend to be less well hedged against international risks than banks, according to International Monetary Fund research published last year. That contributes to higher volatility in capital flows as funds’ risk appetites swell and shrink.

That’s not the whole story, of course. Nonbank financing has been made safer in recent years.

The complex structured vehicles that characterized the sector before the financial crisis are a far smaller presence. Reforms have made money-market funds more stable.

Ultimately, investors won’t know what effect the growth of the sector has had until a downturn arrives. Then the sector’s big cross-border presence might end up being an important—and underappreciated—factor in how the drama unfolds.

A Problem of Accumulation

Jared Dillian


People complain about the Fed. Endlessly. Incessantly.


I get the feeling that we give the Fed too much credit.

The Fed simply controls one interest rate, the Federal funds interest rate, which isn’t all that important of an interest rate. It also does so incompetently.

It can print money and buy securities like it’s doing right now, and that makes stocks and bonds go up in the short term. But it doesn’t explain the last 30 years of behavior in the capital markets.

If you’re looking for an explanation for why the stock market is going parabolic, it’s not the Fed.

Ok, it’s not entirely the Fed.

It’s the Baby Boomers.

Baby Boomers are, as you know, a giant demographic bulge in the population. They’re responsible for the prosperity that we enjoy, and they’ll be responsible for the downturn that we won’t enjoy.

They’ve been working and enjoying high salaries and saving and investing for years. And for the last 10 years or so, they’ve been retiring and living off their retirement savings.

Sometime in the next few years, more of them will be retired (and dis-saving) than working (and saving). And we will experience capital starvation rather than capital surplus. Stocks should go down, and interest rates should go up.

Years ago, I bought Peter Zeihan’s The Accidental Superpower and never got around to reading it. Read it on a flight last week. His chapter about demographics is compelling.

To Zeihan, demographics (and geography) are destiny. I agree with that to a certain extent. But I will add that ideology is also destiny, though he would probably say that was a function of demographics and geography.


The Bad Good News

We will experience a shortage of capital for a number of years. The good news is there’s another large generation coming along to pick up the slack from Generation X: the Millennials.

And there will be an echo of the previous boom. But times are going to be hard for Gen Xers like me in their peak earnings years.

Taxes are going to go up a lot, among other things.

So in the long run, things will get better. You know what they say about the long run.

Up until recently, I never paid much attention to demographics. As a quote unquote “trader,” I ignored demographics because it didn’t provide useful signals.

But demographics provides the cleanest possible explanation for this:




Not whatever the Fed was doing.

You don’t have to be Garry Kasparov to figure out what happens next: stocks go down, long-term yields go up, and the Fed goes into overdrive to forestall what looks like a recession. It cuts short-term rates—a lot, possibly into negative territory—and the yield curve steepens dramatically.

If you’re wondering, real estate doesn’t do well in this scenario, either, as Boomers unload their primary residences, downsize, and indebted Millennials can’t pick up the slack.

I have a reputation as sort of the macro doom guy, and I see no shortage of ways for things to go wrong.

But nobody looking at US demographics could reasonably come up with a happy ending here.

And that’s before we even get into a conversation about entitlement programs, which is unpleasant.

There Is No Escape

How does this affect your asset allocation?

2020: Long stocks and bonds and real estate

202?: Cash, maybe commodities

What I’m looking for is a period of underperformance of equities that lasts a really long time, like, possibly as long as 1969–1982.




On Wall Street, beliefs change over time.

The current belief is that stocks will go up forever.

That belief will change—all beliefs change.

After all, investors in Japan probably don’t think that stocks go up forever. Investors in Europe probably don’t think that stocks go up forever. In fact, there probably isn’t another country in the world where people think stocks go up forever. The average investor really doesn’t have a good grasp of how unusual this is.

What we have now—and what we have had for years—is a historic gap between the performance of financial assets (stocks and bonds) and other assets (commodities). I expect that mispricing to resolve itself eventually.

When? Again, demographics gives us no clue on timing. If you have a portfolio that is mostly stocks, it is probably worth thinking of a little diversification. You don’t have to sell the top tick.

As for the Baby Boomers, maybe it’s time to sell short some businesses with terrible demographics, like Tommy Bahama, Harley Davidson, and AOL/EarthLink domains.

Speaking of the Boomer-caused prosperity and the subsequent downturn: Both can be equally scary, but a great way to deal with that is through strength in numbers.