Pacifist Germany defies Europe’s nationalist tide

Berlin has not shrunk from the darkest chapters of continental history


There was a time when Europe thought it had made its peace with history. The nations of East Asia — Japan, China, Korea — might nurture the embers of conflicts past, but Europe had liberated itself with the creation of the EU. You did not have to be an ardent Europhile to see that economic integration served as the midwife for postwar reconciliation.

All this was before Poland’s authoritarian government reopened a claim for war reparations against its neighbour Germany, and Hungary’s prime minister Viktor Orban sought to rehabilitate the reputation of his country’s fascist wartime leader Miklos Horthy. The ruling Law and Justice party (PiS) in Warsaw now wants to criminalise any suggestion that some Poles were complicit in the operation of Nazi concentration camps.

Nations mostly celebrate history by marking triumphs over adversity or, sometimes, bathing in the nostalgia of past glories. In its moment of denial, Brexit Britain cannot get enough of Churchillian reminiscence about standing alone. The new nationalism is rooted in mostly imagined grievance.

Mr Orban has never quite reconciled himself to the loss of Hungarian territory under the Treaty of Trianon in 1920. Jaroslaw Kaczynski, the leader of PiS, sees a German or Russian plot around every corner.

The nationalist right has a keen eye for enemies. Jews have always been a favourite target. Now they are joined among adversaries of old by Muslim refugees arriving from the Middle East. Nor is Mr Orban alone in his revisionist take on 1930s dictators. In far-right Italian circles you often hear that history has “misunderstood” the fascist leader Benito Mussolini.

Harder to comprehend have been angry demonstrations in Athens against suggestions that the former Yugoslav Republic of Macedonia might more simply be called Macedonia. The tiny Balkan state stands accused of seeking to appropriate Greek heritage. But is Greece’s identity really quite so fragile? Surely after the tribulations of recent years the nationalists could find more recent grudges than an argument about the lineage of Philip of Macedon?

There is one European nation that has never sought to forget the history of the continent during the first half of the 20th century. Germans remain at once uncomfortable about talking about the past, but determined to confront it. This way they can legitimise the present.

Walk the streets of Berlin and there is no escape from Hitler’s calumnies — from the small, gold memorial plaques studded in the pavement to mark places where individual Jews were seized, to the grim but inspiring Holocaust memorial next to the Brandenburg gate and the bleak account of the rise of Nazism in the museum of German history.

Next week foreign and defence policy chiefs from across the advanced western democracies will gather for the annual Munich Security Conference. Two of the conclusions of their deliberations can be written in advance. Donald Trump’s disavowal of global leadership in favour of “America first” nationalism leaves Europe to do more to safeguard its own security. And the nation most able to shoulder more of the defence burden? Germany.

The hosts cannot complain. It was in Munich that chancellor Angela Merkel last summer offered a caustic assessment of Mr Trump as an unreliable partner. Only last month in Davos she called for Europe to “take its destiny into its own hands”. Talk to policymakers in Berlin and you get the same message: as Europe’s most powerful nation, Germany will play its part.

I wonder. Ms Merkel may tell international audiences that Germany will pay up for defence and security, but the draft coalition agreement her Christian Democrats have negotiated with the Social Democrats tells a rather different story. Beyond a few bromides — “German foreign policy is dedicated to peace” — the draft says nothing about Germany’s role in preserving an open international order. As for defence, well, “the Bundeswehr remains an indispensable element of German security policy”.

Critics call this freeriding. And there is something of that. Germany is a stable, prosperous society and its citizens have grown wealthy as others paid for Europe’s security. But no one should underestimate the weight of history.

Berlin’s Invaliden cemetery was built more than 250 years ago on the orders of Frederick the Great to memorialise Prussia’s war heroes. Among the graves is the tomb of the warrior Gerhard von Scharnhorst. But do not expect grandeur — the monuments sit on a small scrap of ill-tended land hemmed in by apartment blocks and the canal behind the city’s main railway station.

Scharnhorst shares the ground with the authors of Operation Valkyrie, the abortive attempt by military officers to assassinate Hitler. Somewhere, in an unmarked grave, lies Reinhard Heydrich, the SS officer who chaired the infamous Wannsee conference.

This is our “Arlington”, a former German foreign minister told me laconically. Another way of putting it would be to say that Germany’s stubborn pacifism keeps clear sight of history. That is inconvenient for those of us who believe that Europe does indeed need to do more to defend itself. But Germany at least has held on to a true account of events that angry nationalists pretend to have forgotten.

The Era of Fiscal Austerity Is Over. Here’s What Big Deficits Mean for the Economy.

It depends on whether you look at the short, medium or long term.

By Neil Irwin

When he was running as a Republican vice-presidential candidate in 2012, Paul Ryan spoke in front of a national debt clock.CreditBrian Snyder/Reuters

The last seven weeks amount to a sea change in United States economic policy. The era of fiscal austerity is over, and the era of big deficits is back. The trillion dollar question is how it will affect the economy.

In the short run, expect some of the strongest economic growth the country has experienced in years, and some subtle but real benefits from a higher supply of Treasury bonds in a world that is thirsty for them.

In the medium run, there is now more risk of surging inflation and higher interest rates — fears that were behind a steep stock market sell-off in the last two weeks.

In the long run, the United States risks two grave problems. It may find itself with less flexibility to combat the next recession or unexpected crisis. And higher interest payments could prove a burden on the federal Treasury and on economic growth. This is particularly true given that the ballooning debt comes at a time when the economy is already strong and the costs of paying retirement benefits for baby boomers are starting to mount.

It’s hard to overstate how abrupt the shift has been.

When the Congressional Budget Office last forecast the nation’s fiscal future in June, it projected a $689 billion budget deficit in the fiscal year that begins this coming fall. Analysts now think it will turn out to be about $1.2 trillion.

One major reason is the tax law that passed on Dec. 20, which is estimated to reduce federal revenue by about $1.5 trillion over the next decade, or $1 trillion when pro-growth economic effects modeled by the congressional Joint Committee on Taxation are factored in. A budget deal passed in the early hours of Friday morning includes $300 billion in new spending over the next two years for all sorts of government programs and $90 billion in disaster relief, without corresponding cuts elsewhere in the budget.

It is a stark reversal from 2010 to 2016, when congressional Republicans insisted upon spending cuts and the Obama administration insisted on raising taxes (or, more precisely, allowing some of the Bush administration’s tax cuts to expire). Those steps, combined with an improving economy, cut the budget deficit from around 9 percent of G.D.P. in 2010 to 3 percent in 2016.

The Near Term: Strong Growth in 2018

In almost any economic model you choose, the new era of fiscal profligacy will create a near-term economic boost. For example, Evercore ISI, the research arm of the investment bank Evercore, estimates that the combination of tax cuts and spending increases will contribute an extra 0.7 to 0.8 percentage points to the growth rate in 2018, compared with the policy path the nation was on previously.

Economists generally think that these policies will have a lower “multiplier” than these policies would have if they took place during a recession, when there is more spare capacity in the economy. But that doesn’t mean the multiplier becomes zero.

“Some people assume that because this was a bad process and the tax bill is really regressive that it won’t have a short-term growth impact, but I think that’s wrong,” said Adam Posen, president of the Peterson Institute for International Economics. “We shouldn’t confuse whatever distaste one has for the composition of the package for totally overwhelming the multiplier effects.”

Put a different way, it would be very hard for the government to pump an extra half-trillion dollars into the economy in a single year without getting some extra economic activity out of it.

Another potential near-term positive for the global financial system could be the effect of billions of dollars in bonds issued by the Treasury. For years the world has experienced what some analysts call a “safe asset shortage,” too few government bonds and other investments viewed as reliable relative to demand.

This has arguably been a factor in depressed interest rates and sluggish growth across much of the advanced world. More Treasury bonds floating around might reduce those pressures.

The Medium Term: Depends on Economic Slack, and the Fed

Over the next two or three years, things get more murky. What happens will depend on how the economy responds to the additional fiscal stimulus, and how the Fed responds to that.

The big question is whether the economy has the room to keep growing without higher inflation emerging. The unemployment rate is already low at 4.1 percent, so there aren’t exactly hordes of jobless people available to be put back to work. That means there is a chance that all this extra money flooding into the economy doesn’t go toward more economic output but just bids up wages and ultimately consumer prices.

If that happens, the Federal Reserve would almost certainly raise interest rates more than it now plans, essentially engineering an economic slowdown to try to keep inflation from accelerating. In that scenario, the apparent benefits of tax cuts and spending increases would be short-lived.

But there’s no certainty that will happen. It may be that the United States has more growth potential than standard models suggest. Perhaps corporate income tax cuts and looser regulation on business will unleash more capital investment and higher productivity, as conservatives argue. Maybe some of the millions of prime-age adults who have dropped out of the labor force in recent years will come back in, creating more economic potential.

“The really big question mark we have is how much slack there really is in the economy,” said Donald Marron, a scholar at the Urban Institute who was once acting director of the Congressional Budget Office. “If you look at conventional measures, unemployment looks really low, but on the other hand if you look back to what we used to think of the potential of the economy a few years ago, we may have some room to grow.”

The Long Run: Higher Debt-Service Costs and Less Room to Maneuver

The public debt was already on track to rise relative to the size of the economy before the new tax and spending deals; now it will probably rise faster. The Congressional Budget Office projected last June that the nation’s debt-to-G.D.P. ratio would rise to 91 percent in 2027, from 77 percent in 2017.

The C.B.O. hasn’t updated those numbers to reflect the new tax and spending legislation, but the Committee for a Responsible Federal Budget estimates that it will turn out to be between 99 and 109 percent, depending on whether provisions of the tax law are allowed to expire as they are scheduled to.

But those numbers are just an abstraction. The question is what effects higher debt loads might have for Americans in 2027 and beyond.

Higher debt service costs are one big one. Taxpayers in 2027 were forecast to pay $818 billion a year in interest costs even before the tax cuts and spending increases, or 2.4 percent of G.D.P.

That will presumably be higher, because taxpayers will be paying interest costs on more debt, and probably at higher interest rates.

And there is probably some point at which the amount of debt the government takes on crowds out private investment; to the degree that the supply of funds to borrow is finite, every dollar the government borrows is not available to be lent to a homeowner taking out a mortgage or a business looking to expand. That said, in practice, the supply of loanable funds is not finite — households may save more with higher interest rates, for example, and foreign capital might flow in.

The bigger costs of a high national debt may come in how much flexibility policymakers have to respond to a future recession or crisis. If the United States finds itself in a major war or a deep recession, its starting point in terms of debt load will be much higher than it was at the onset of the Iraq War or the 2008 financial crisis.

“It’s about risk management,” Mr. Posen said. “We may need that fiscal capacity for something else.”

Neil Irwin is a senior economics correspondent for The Upshot. He previously wrote for The Washington Post and is the author of “The Alchemists: Three Central Bankers and a World on Fire.” 

Beware The Inflation Trap

by: Eric Parnell, CFA  Summary

- Sustained inflation pressures are on the rise.

 - Or are they?

- Putting the latest widely accepted mainstream financial media narrative to the test.

- What's really going on.

- Implications for your portfolio and how to capitalize.

- This idea was discussed in more depth with members of my private investing community, The Universal

It is the mainstream financial media narrative du jour. After years of relatively benign pricing pressures during the post crisis period, we are now entering a phase of sustainably higher inflation.

This notion has raised the specter that the U.S. Federal Reserve will need to raise interest rates more quickly than expected, has sent U.S. Treasury yields higher, and has shaken the U.S. stock market to the core over the past two weeks. But while the narrative certainly makes good sense, a key question remains critically important to ask. Are we really seeing any signs of the rise in inflation that so many have already assumed as given? And what does the true answer to this question mean for our stock and bond allocations?
From The Top
Let’s take this discussion from the top. Here’s how the story goes:
Lower corporate tax rates will be driving a substantial increase in corporate earnings over the coming year, which in turn will feed through to increased economic activity and an acceleration in real GDP growth. Given that the labor market is already tight, this will also bring with it increased wage pressures and will have too much money chasing too few goods in general, thus resulting in sustainably higher inflation pressures going forward. Bond yields will rise as a result, while the ultimate fate for stocks will depend on whether companies can grow earnings to more than compensate for the rise in inflation. Assuming the right companies will be able to do so, favor stocks over bonds in a diversified portfolio strategy, and bias toward growth and cyclical names over defensive allocations within the stock allocation.
This narrative makes completely good sense. And a close monitoring of the news flow from the mainstream financial media provides confirmation for this outlook.
But relying on qualitative confirmation leaves us exposed to the risk of error in our analysis and conclusions. Thus, it is worthwhile to consider the following. Is the underlying quantitative data actually confirming this is the case?
Why is this question important? Because throughout the post crisis period, we have heard that sustainably higher inflationary pressures were looming right around the corner. Yet after nine years, they never actually materialized. In fact, the same narrative was being told throughout the years following the bursting of the technology bubble leading up to the onset of the financial crisis. This included gasoline prices cresting at over $4.10 per gallon in the summer of 2008, which equates to $4.62 per gallon in today’s dollars. Yet sustainably higher inflation pressures never materialized then either. In fact, the exact opposite has been taking place ever since.
Taking A Walk
Corporate Earnings

Let’s take a quantitative walk through the widely accepted narrative outlined above.
We will begin with the increase in corporate earnings. Now over the last three years, annual GAAP earnings on a nominal basis have been flat. After peaking in 2014 Q3, we entered into an earnings recession thanks in large part to the collapse in oil prices. But we have emerged from this earnings recession over the past year and in 2017 Q3 corporations on the S&P 500 Index (SPY) managed to set a new all-time high in annual GAAP earnings at $107.08 per share (the latest reading is still more than -2% below the previous highs on an inflation adjusted basis, but this is a needling observation given as we are likely to clear this hurdle once and for all either in 2017 Q4 or 2018 Q1). So from a realized, in the books perspective, corporate earnings are still effectively no higher today than they were three years ago.
Of course, history is not the story when it comes to corporate earnings. Instead, it is in the forecast, as annual corporate earnings are forecasted to increase at a robust pace over the coming year as the effects of the corporate tax cuts passed by Congress at the end of 2017 increasingly make their way into the numbers. For example, by 2018 Q4, annual GAAP earnings are currently forecasted to be $145.67 per share, which if realized would be a remarkable +40% increase in corporate earnings over the coming year.

So while trailing corporate earnings over the past few years may not necessarily fit the narrative, the forecasts for the coming year certainly do. The only problem here is that forecasts are predictions and not yet fact. And the possibility remains that corporate earnings could end up coming in well below what is currently being forecasted today. After all, such an outcome certainly would not be unheard of when it comes to corporate earnings. Moreover, the 2018 Q4 earnings season is still a long way away in the future from February 2017 and A LOT can happen between now and then.
GDP Growth
OK. Let’s take the leap and assume corporate earnings growth is going to be robust over the coming year. This strong earnings growth should presumably be working its way through to GDP forecasts. In short, as corporate earnings forecasts accelerate, so too should expectations for expected GDP growth.

But what is notable that, at least so far, the forecasts for GDP growth remain relatively subdued. Projections for 2018 Q1 from the New York Fed’s Nowcast has not budged since tax cut legislation was officially passed. In fact, it has modestly tailed off in recent weeks. As for the Atlanta Fed’s GDP Now forecast, it popped a few weeks ago but has since faded back lower.

Nonetheless, the GDP growth forecasts in the 3% to 4% range are still solid. But are they sustainable?
According to the Economic Forecasting Survey from The Wall Street Journal, the consensus view at least to date is that they are not. Derived from a survey of more than 60 economists on more than 10 major economic indicators on a monthly basis, not only is the consensus view for 2018 Q1 coming in below the Fed bank forecasted range currently at a more pedestrian 2.85%, but the forecasts for future GDP growth in coming quarters is for the pace of growth to fade toward the 2.5% range or below, not accelerate. We have had GDP growth running in this range throughout much of the post financial crisis period, and inflationary pressures have largely remained in check throughout.
So on this second point, this feels much less consistent with the mainstream financial media narrative and not so inflationary. But you know what they say about economist predictions, right?
Jobs And Wage Growth
Let’s for the sake of argument take the leap of faith (the antithesis of relying on quantitative proof, of course) that economists are flat wrong on their GDP forecasts and growth actually ends up accelerating instead of fading. This leads to the next question. Does our current place in the economic cycle support such an acceleration? Put more simply, where are all of the workers going to come from to fill the new jobs to increase output and drive the economy higher.
When looking at the current unemployment rate, we see that at 4.1% we are approaching the lowest levels in joblessness in the United States in nearly the last half century. Only once before since 1971 was the unemployment rate lower than it is today, and that was in 2000 at the end of the longest economic expansion in U.S. history. And the last time that the unemployment rate was even close to the current low in May 2007, a recession also soon followed. Thus, the current unemployment rate alone suggests we might be much closer to the end of an economic expansion, not the start of a new acceleration phase. And the onset of recessions are more often than not disinflationary to deflationary, not inflationary.

But wait a second. If the unemployment rate is already low and the high octane juice of corporate tax cuts have just been injected into the economy, couldn’t we see a scenario where already tight labor markets lead to increased wage growth pressures, thus sparking an inflation outbreak. Certainly, but if this were the case, and this was what has indeed been unfolding over the past several months that has contributed the rise in Treasury yields, it is not showing up in any meaningful way in the actual wage growth data. At least not yet.

If anything, the current data on jobs and wage growth is less reassuring. For not only, would the unemployment rate have to fall to unprecedentedly low levels over the last half century to keep the economic expansion going, but the wage growth pressures that still remain latent today despite all of the new found economic optimism would finally have to ignite. Perhaps they will, but they have not yet. And perhaps corporates have a machine or two that they might seek to install instead with their next capital budgeting decision. And last I checked, I haven’t seen too much money in the hands of a machine chasing too few goods at the store.

So the narrative that we outlined at the beginning of the article is not so cut and dry when taking a walk through the data. But maybe some of these factors do not matter. Maybe we don’t even need GDP growth and wage increases to spark inflationary pressures. After all, the U.S. government is expanding the deficit and the debt like we are already deep in recession, and many of us can still remember the stagflationary 1970s when falling economic growth, rising unemployment, and falling corporate earnings still resulted in higher inflation. Maybe we could be having inflation pressures simply brewing on their own.
With this in mind, let’s just get right to the bottom line and look at the data that would typically be signaling a sustained rise in inflation.
Let’s begin with a headline reading most of us know best, which is the Consumer Price Index from the U.S. Bureau of Labor Statistics. The following chart shows current inflation on a year over year basis.

What we see is that at least through the latest reading from December 2017, the core inflation rate less food and energy is only at 1.76%. This is well below the readings from this time last year when the inflation rate was running at a relatively hotter 2.22%. And it is even further below the recent peak readings over 2.3% in both April 2012 and February 2016.

Not a core CPI person? The headline CPI number is telling an even more definitive disinflation trend story. For not only is the current headline number at 2.21% well below the peak readings of less than a year ago at 2.79% in February 2017, but they are still meaningfully below the peak readings of 3.81% back in September 2011.
OK. So inflation is not yet showing up in the headline numbers. But we all know that CPI is a lagging indicator for the economy. After all, by the time inflation shows up in the CPI data, the horse is already out of the barn and galloping down the road from a portfolio management standpoint.
Thus, let’s consider some leading inflation indicators to see if they are showing signs of inflation heating up in the coming months.
First, we will consider a proprietary indicator from the Economic Cycle Research Institute (ECRI) in the U.S. Future Inflation Gauge. This is an indicator that is designed to move in advance of a change in inflation. Put simply, this reading should be rising well in advance of an increase in actual inflation pressures. So where is this reading at present? After peaking all the way back in 2016, it has been flat to fading ever since. And over the last few months, it actually shrank by -1.5% in December 2017 and -0.2% in January 2018. And while it rose marginally in February 2018, it is still measurably below the readings from nearly two years ago.

OK. But this is a proprietary index that could be subject to error. So let’s just go with the numbers in their simplest form. Lex parsimoniae, right? What are the simplest and straightforward leading inflation indicators telling us?
We begin with the five year breakeven inflation rate, which is a measure of expected inflation over the next five years based on Treasury (TLT) data. Yes, inflation expectations have risen since last summer, but they also remain below levels from this same exact time last year.

Moreover, they remain well below the peak inflation expectations from a few years back in the post crisis period from 2011 to 2013. Put simply, if investors are worried about inflation now, they were even more worried about it a year ago, five years ago, and seven years ago versus today. And during past instances of even greater worry, their concerns turned out to be unfounded.

We continue on by taking a look at the yield curve. A common story I have repeatedly heard on the mainstream financial news is that the yield curve has been steepening lately, thus confirming the rising inflation narrative. Sure, it might have steepened a few basis points in recent days, but it is still as flat as a pancake compared to where it was six months ago, a year ago, or five years ago. This alone is definitively disinflationary if not deflationary and certainly not inflationary – after all, why would an investor be willing to accept an increasingly diminishing and generally minimal maturity risk and inflation risk premiums for lending money to the U.S. Treasury for an extra 25 years if they thought a meaningful inflation outbreak was nigh?

High yield bonds (HYG) provide added confirmation to this story. For if inflation was really set to sustainably climb going forward, we would almost certainly be seeing high yield bonds (JNK) getting crushed, as spreads relative to U.S. Treasuries are already at historical tights.

And while high yield bonds have sold off as of late during the recent correction, they are still trading above on an unadjusted price basis versus the levels reached in late 2016 when inflation was also assumed to be right around the corner but never actually materialized.

Commodities prices (DJP) also do not suggest that inflation pressures are building in any meaningful way. Instead, they continue to linger not far above their post crisis lows.

Even copper (JJC) and oil (USO), which have seen solid increases in price over the past two years, are still below the much higher levels from the first half of the decade.
The Bottom Line
Putting this all together, inflation pressures remain largely benign today. And a variety of economic and market indicators suggest that inflation may continue to remain benign and potentially even weaken into the forecast outlook.
It is very possible that we may ultimately see an outbreak of real sustained inflationary pressures going forward. But while the qualitative narrative of why this should be the case certainly makes sense, it is simply still not showing up in the quantitative data in any meaningful way.
So what then explains the steady sharp rise in bond yields in general and U.S. Treasury yields in particular? If it’s not the expected inflation that everyone is assuming, exactly what is it? The likely answer? The same answer it has been every other time in recent history. And the same answer that is likely behind the recent liquidation cycle sweeping through the U.S. stock market. What is this likely answer? One word. China. And this will be the topic of a follow up article on Seeking Alpha on this same topic.
But aren’t investors selling bonds? No. In fact, investors have poured inflows of more than +$60 billion net into bond mutual funds and ETFs since the start of 2018 according to the Investment Company Institute. And if U.S. retail and institutional investors are not selling bonds right now, then such selling is likely coming from faraway lands that own a good chunk of U.S. debt. Such selling influences are not driven by fears of inflation. Instead, they are driven by a variety of other mechanical factors. And they have often proven to be not sustaining over time.

What about the Fed? Won’t the fact that they are raising interest rates cause bond yields to continue to rise? On the short end of the curve, sure. But a variety of other factors other than what the Fed is doing with short-term interest rates are determinants for intermediate-term to long-term bond prices.
And if it turns out that the pace of Fed tightening is faster than the pace of economic growth in the coming quarters, current long-term rates may actually appear attractive at some point in the not too distant future.
What about the Fed’s quantitative tightening (QT)? Doesn’t the fact that the Fed is now selling bonds (BND) from their balance sheet mean that bond yields are going higher? Possibly, but remember that the Fed selling bonds (AGG) is just one market participant in a vast and deep bond marketplace. For as long as the volume of buyers exceeds whatever the Fed has to sell at any given point in time, prices can certainly rise. Do not forget that bond yields consistently rose during all three implementations of quantitative easing (QE) when the Fed was actively buying bonds on a daily basis. Thus, it is not outside of the realm of possibility that bond yields could consistently fall the more the Fed is selling into the marketplace as a result of QT.
If it indeed the case that the rise in bond yields have little to do with inflation expectations and much more to do with spillover effects from China (NYSEARCA:FXI), this implies the following.
First, stay long bonds. This does not mean that you need to overweight or back up the truck in owning bonds. But it also does not mean that you should throw them overboard from your portfolio either. Stay long, strategic and selective with your bond allocations.
Second, remain patient and seek opportunities. The current sell off in bonds is potentially setting up for good buying opportunities. Just recognize that you may be buying these bonds against a steady media narrative wave against this idea. Such is where the best opportunities can be derived, however.

Third, do not overlook related stock market opportunities. Selected quality defensive stocks (NYSEARCA:DIA) with high and growing dividends are trading at increasingly interesting valuations as the current market pullback continues to unfold. These may present some of the best upside opportunities in the years ahead depending on how economic events play out in the coming quarters.
Lastly, look beyond the narratives being put forth by the mainstream financial media as to why asset prices are moving in any given direction on any given trading day. For more often than not, what is actually taking place is something entirely different from what it may seem.
Remain watchful and diligent, avoid becoming dogmatic in any particular view, do your own homework, and formulate your own conclusions as to what is taking place in capital markets at any given point in time. Then act accordingly. For it is through this process that some of the best long-term investment opportunities can be generated.
And when it comes to inflation, beware falling into the inflation trap.

India’s Path From Crony Socialism to Stigmatized Capitalism

Arvind Subramanian  

Union budget session displayed on billboard In Mumbai

NEW DEHLI – Is India about to get its mojo back? As the country’s exports accelerate on the back of today’s synchronous global economic expansion, the negative effects of the November 2016 demonetization of high-value bank notes and the enactment last July of a new goods and services tax (GST) are receding. Provided that macroeconomic pressures from high oil prices are contained, and sharp corrections to elevated asset prices are managed, India is poised to regain its status as the world’s fastest-growing major economy.

But ongoing efforts by the government will be key to reviving private investment and sustaining medium-term growth. Specifically, economic policymakers must address the long-standing problem of over-indebted firms and under-capitalized public-sector banks – the so-called “twin-balance-sheet problem.”

To that end, many distressed companies have been forced to clean up their balance sheets under a new bankruptcy code that was adopted in December 2016, and more companies are likely to follow suit this year. Meanwhile, the government has also announced a large recapitalization package (about 1.2% of GDP) to shore up public-sector banks, so that they can write down their stressed assets.

As these reforms take hold, Indian firms should finally be able to resume spending, and banks will once again be able to lend to the critical but currently indebted infrastructure and manufacturing sectors. India’s economic reforms have taken a long time to implement. But if they continue to be a success, they will provide valuable lessons for future leaders about the proper role of the private sector not just in India, but around the world.

In India, the private sector – and capitalism generally – evokes feelings of deep ambivalence. This is for good reason, given that India’s private sector still bears the stigma of having been midwifed under the pre-1990s “License Raj” – an era remembered for its red tape and corruption. To this day, some of India’s legendary entrepreneurs are believed to have built an empire simply by mastering the minutiae of India’s tariff and tax codes, and then manipulating them brazenly to their advantage.

Some of the private sector’s stigma was cleansed by the boom in information and communications technology that started in the 1990s. The ICT sector had developed by virtue of its distance from, rather than proximity to, government. Indian ICT firms adopted exemplary governance standards, were listed on international stock exchanges, and thrived in the global marketplace. And, by extension, they improved the standing of Indian capital.

But after that era of good capitalism, the stigma returned. During the infrastructure boom of the mid-to-late 2000s, public resources were captured under a “Rent Raj,” which put terrestrial rents (land and environmental permits), sub-terrestrial rents (coal), and even ethereal rents (spectrum) up for grabs. Moreover, the infrastructure investments of this period were funded by reckless and imprudent lending by public-sector banks, which often funneled resources to high-risk, politically connected borrowers.

As a result, the Indian public concluded that majority equity holders (“promoters”) had little skin in the game, and that “limited liability” really meant no liability at all. And now that rapid technological change is threatening the ICT sector’s business model – providing low-cost programming services to foreign clients – even India’s “cleanest” capitalist industry is confronting governance challenges.

More broadly, one could say that India has moved from “crony socialism” to “stigmatized capitalism.” And under stigmatized capitalism, the prevailing zeitgeist has hobbled policymakers’ efforts to address the legacy of the twin-balance-sheet problem, which, in turn, has constrained growth.

Indeed, the mere thought that major shareholders’ debts would be forgiven at taxpayers’ expense has created political paralysis for years. After all, why should ordinary people bear the burden of fat cats who are laughing all the way to the bank?

Seen against this background, it is easier to understand why India’s economic reforms have taken so long to adopt, and why they have been so difficult to implement. At the same time that the government has had to resolve the twin-balance-sheet problem, it has had to ensure that promoters cannot regain access to their assets, driving up fiscal costs.

India’s early-stage experience with capitalism has lessons that other countries should heed in an age of rising tech giants. The Indian model, whereby public-sector-banks lent to private firms, proved so toxic and difficult to replace that public-sector bank ownership itself has lost much of its traditional socialist appeal. The irony is that after a long and bruising experience with crony capitalism, the best thing for India now might be more capitalism, starting in the financial sector.

Arvind Subramanian is Chief Economic Adviser to the Government of India.

Data-Dependent ... on Imaginary Data

Federal Reserve officials like to say their policy course is “data-dependent.” That sounds very cautious and intelligent, but what does it actually mean? Which data and who’s interpreting it? Let’s ask a few questions.

Photo: Federal Reserve Board of Governors
First, how could their policy choices not be data-dependent? The only alternatives would be that they made decisions randomly or that there was an a priori path already determined by previous Fed policymakers that they were forced to comply with. A predetermined path would, of course, eventually be leaked, and then everybody would know the future of Fed policy. Until they changed it.
Of course, they do depend on data, and lots of it, but are they looking at the right data? If it is the right data, theoretically speaking, is it accurate? As we will see, more often than not they are basing their decisions on data created by models that rely on potentially biased assumptions derived from past performance, etc. Often the data they look at is actually a sort of metadata, a kind of second-derivative model, with all sorts of built-in assumptions, quite removed from the actual data.
That approach is actually reasonable when you realize that the amount of data that must be managed is simply too large for any human being to process in a coherent manner. The data has to be massaged, and that means making assumptions that create the models in the programs. Those are assumptions are not made by computers, they are made by human beings who are doing the best they can – using models based on assumptions they build in to guide them as to what assumptions they should make about the data. Convoluted? Yes.
I certainly don’t know all the answers to the problems with national and global economic data and metadata management, and it’s far from clear the Fed knows those answers, either. Whatever your economic and political ideology, we can all agree that these are big problems. Today we’ll look at how big.
First, a quick update on the Strategic Investment Conference. This is especially for the many of you who wish you could attend but have conflicts. For you, we have something new: the SIC Live Stream Virtual Pass. Video coverage for all the conference sessions will be streamed live over the internet straight to your computer or mobile device! It’s not quite like being there, but it’s darned close.
The technology to do this is quite expensive, as you may imagine. We’re making the investment because this year’s message is so important. Our theme this year is “Crossroads” because that’s exactly where the world is. We are at an inflection point and have big choices to make. Right ones will speed us along. Wrong ones could slow us nearly to a halt.
We are actually approaching multiple crossroads simultaneously. You know the list: In addition to the Fed, other central banks are on the cusp of big policy shifts, too. Geopolitical challenges are cropping up everywhere, and some big emerging-market countries are on shaky ground.
We’ll be exploring those crucial issues and more at SIC with 25+ top experts. If you can’t join us in San Diego, the Live Stream Virtual Pass will bring the conference to you. You’ll see all the sessions and even be able to submit questions to the speakers.
I’m doing this because I want every reader to have every opportunity to get ready for what’s coming. The SIC Live Stream Virtual Pass will be your ticket, and at a very reasonable cost.
Invisible Derivatives
Here’s a garden-variety mainstream media market narrative right now. I made this up, but similar thoughts are voiced everywhere.
US growth is finally taking off after years of stimulus. We’re near full employment, and wages are starting to rise. Consumers are opening their wallets just as tax cuts and deregulation embolden business to expand. At the same time, we are hitting resource constraints that have the economy close to maximum output. The resulting concern about inflation is pushing interest rates higher and taking some froth out of the stock market.
There are a lot of people who agree with this narrative, especially those who talk to us via the mainstream media. The problem with that story is that they are assuming facts that aren’t necessarily proven, two in particular:
• We’re nearing full employment.
• The economy is close to maximum output, or “potential GDP.”
Are those statements correct? How do we know? How do we even define full employment and maximum output? Measuring them isn’t like sticking a thermometer in your holiday prime rib to see how it’s cooking (which, by the way, if you are serious cook, you absolutely must be doing).
I thought about this problem with definitions last week when I read a Washington Post op-ed by Jared Bernstein. He was the chief economist for Vice President Joe Biden and now works at a left-of-center Washington think tank. He’s also not someone I would normally quote, since we are on quite different policy ground politically and economically. But we also have some common ground, and I think it’s important to note that. And for the record, more and more economists of all stripes are beginning to come around to this very same view.
But Jared does a particularly good job in a brief space of framing the issues. Here’s the lead to Jared’s article.
Recent events have exposed a hole in the middle of economists’ knowledge of key economic parameters: We know neither the unemployment rate at full employment nor the potential level of gross domestic product (GDP).
That hole is particularly important right now. The combination of the deficit-financed tax cut and the new spending bill are pumping hundreds of billions into an economy that many argue is already at full employment. If so, then much of this extra spending won’t lead to new investment, jobs or higher real pay. When the economy’s human and capital resources are fully utilized (meaning actual GDP is equal to potential GDP), fiscal stimulus just generates inflation and higher interest rates. Even if the extra demand might create some wage pressure, it will be met with higher inflation, so real wages – the paycheck’s actual buying power – won’t change at all.
The problem is that those making that argument are implicitly asserting that they know that the “natural rate of unemployment” – the lowest rate consistent with stable inflation – is roughly equal to the current unemployment rate. That is, they believe we’re at full employment. But the truth is they have no way of knowing that, and one key indicator – inflation – suggests they may be wrong.
Those are three paragraphs that I could have written and defended. I think that fact is significant. Jared and I more than likely to disagree on what economic policies we should follow – but we can’t even have that argument until we can agree on what the data says and means. And we can’t at this point. We have to rely on anecdotes and hints, at best.
This state of affairs is startling once you start thinking about it. Economists are reaching conclusions and policymakers are making decisions based on derivatives of invisible derivatives.
Sound crazy? Yes, but it’s happening.
Giant Mystery
Let’s talk about these two stats, full employment and potential GDP. They have multiple layers.
“Full employment” means all the people who want to work are gainfully employed. For the record, the Fed thinks that full employment is an unemployment rate of about 4.7%, while the BLS tells us that unemployment is currently running at 4.1%. Those who aren’t working are either in between jobs or face some barrier, like a criminal record or lack of skills.
Therefore, if we are indeed close to full employment, employers who need more help must offer higher wages, which leads to inflation. At least that has been the pattern historically.
But is it really that simple? In any given month, we have only a rough approximation of how many people are unemployed and an even rougher idea of how many might become employed but are currently not even looking. The numbers come from survey data, with all the inherent limitations surveys entail. There are actually two different federal surveys, and sometimes they disagree wildly. Over time they get in line, but on a month-to-month basis?
Not so much. Beyond those surveys, what we think we know is mostly conjecture and assumptions about what we want the data to say.
For instance, simple observation and the actual surveys suggest that many Americans, while nominally employed full-time, aren’t earning as much as they once did. Nor are they as productive as they once were or as they could be. If that’s a widespread pattern, it means the economy still has “slack.” Production could rise significantly without adding any new workers. What we have is not “full employment” in any real sense.
We use survey data to infer how many people are employed, how much they are paid, and so on. In the process we observe people who aren’t employed. We try to figure out why they don’t have jobs and what circumstances might bring them back into the labor force. It’s a many faceted mystery no one has solved, yet we make important policy decisions based on our fragmentary understanding of that mystery.
Let’s look at a few different ways to measure what we mean by full employment. The Bureau of Labor  Statistics (BLS) suggests that if you haven’t been looking for a job in the last 30 days, you are not in the workforce. Thus you don’t count as unemployed.
First off, that way of defining unemployed runs contrary to all of our personal experiences. There are lots of people who have not been able to find a job and have given up looking, but if they were offered a decent-paying job they would take it.
Choosing to say that they are no longer in the labor force after just 30 days of not looking seems rather arbitrary and unrealistic to me.
Now let’s take a look at the US labor force participation rate since 1990 via the St. Louis Fed’s FRED database:
There are a lot of reasons for the participation rate to have fallen so much, and the dropoff is an extraordinarily complex and difficult thing to get your data head around. But policymakers and economists want to have simple answers and solutions, so they make assumptions and then confidently tell us that their assumptions are the correct ones: This is what the data means. And they don’t bother to attach a 50-page white paper that parses all of the different variables that go into making those assumptions about the participation rate.
Just saying…
My friend Lance Roberts (via Michael Lebowitz) adjusts the unemployment figure based upon a methodology that includes the people who have quit looking for jobs. He compares that adjusted rate to the U3 rate in the chart below.
Is Lance’s number the real employment rate? I would suggest that it’s not, because a lot of people who are not in the labor force really aren’t looking for jobs. They are students, or they are  on disability, and so forth. Lance performed the exercise to make us think about the employment numbers.
If you argue that we are at “full employment,” then it follows that you are expecting wage inflation. But that is not what we’re seeing. Eighty percent of workers are seeing very little wage growth at all. This instructive chart comes from my associate Patrick Watson’s latest Connecting the Dots letter:
For there to be demand-led inflation, consumers need to actually have some of that wage growth in order to be able to spend more money. Yet real savings as a percentage of disposable income is down to just above 2%, a long way from the long-term average of 8%. And credit card debt is still rising while disposable income is flat.
Let’s hear from my friends at 720 Global:
The first graph below shows the traditional Phillips curve as typically displayed (U-3 and recent three-month wage growth). The second is a modified Phillips curve which uses the revised U-3 from above and one-year forward wage growth.
Both graphs … demonstrate that only 28.84% of the change in wages was due to the change in the unemployment rate. Visual inspection [of the first graph] also tells you the relationship between wages and unemployment is weak. It is this graph that has many economists declaring the Phillips curve to be irrelevant. The second graph has a (warning: economic geekspeak) statistically significant R² of .7047 and a visible confirmation that the Phillips curve relationship continues to hold. Recently, Federal Reserve Bank of Chicago President Charles Evans stated, in relation to the Phillips curve, “We don’t have a great understanding of why it’s gotten to be so flat.” Mr. Evans, perhaps employment is not as strong as you and your Fed colleagues think it is.
720 Global goes on with more math before they produce this important graph:
If one believes that the laws of supply and demand continue to hold true, then the revised Phillips curve graph above argues that the unemployment rate is in reality much closer to 9% than 4.1%. To believe that the Phillips curve is useless, one must be willing to ignore a more rigorous assessment of labor market and wage data. The only reason economists and Fed officials voluntarily ignore this data is that it belies the prettier picture of the economy they wish to Paint.
Does anyone else see a problem here? Those who crunch the data see what they want to see and disregard the rest. If you want to see low unemployment, you find data that gives you low unemployment. You don’t look at contrary measures.
The Fed has taken this position in spite of the fact that most Fed economists truly believe in the Phillips curve. They just don’t believe in it enough to take it to its logical conclusion, as 720 Global did.
Then there’s “potential GDP,” or the nation’s theoretical maximum noninflationary output. What does it tell us? First, note that we barely have a grip on actual GDP, even though it is a function of (mostly) observable data. A small army of people spend their entire careers collecting GDP inputs. They do a fine job, too; but no one really knows if they are collecting the right data to support the conclusions everyone draws. Further, GDP does not measure all the things that we used to buy at significantly higher prices, which contributed to GDP but are now (for instance) available in our phones for “free.”
I have spent entire letters talking about the limitations of GDP measurement. I thoroughly understand why we must have the measure, but we need to recognize what it is and isn’t. It is not a meaningfully, accurate number delivered from Mount Olympus by the economic gods. It is, at best, a concatenation of approximations, the movement of which, based on those approximations, can give us insights into the economy – but not with any real precision. Google Maps gives you very precise directions. The GDP number is more like “We are going west; we are not going north.”
We then use this estimated GDP, this fuzzy and incomplete growth measure, to infer potential GDP, or how high this nebulous number could go if some of its inputs changed.
Then we wonder how close we are to this vague derivative of an incomplete measure of a hypothetical construct, so that we can modify fiscal and monetary policies. It’s important to understand that if we have in fact now begun to exceed our potential GDP, then economic theory suggests that inflation – and perhaps not even mild inflation –  is right around the corner. I am not a doctorate-holding economist, but to me this seems an unwise assumption to make.
Others think so, too. Here’s Jared Bernstein again:
It’s true that influential institutions such as the Federal Reserve and the Congressional Budget Office (CBO) believe that the “natural” unemployment rate is above the current one, meaning our labor force is beyond fully employed. Their estimates are 4.6 percent and 4.7 percent, respectively, while the actual rate is 4.1 percent. The CBO also asserts that our current level of GDP – $19.7 trillion – represents full capacity.
But the evidence undermines much confidence in these authoritative-sounding point estimates. First, understand that neither of these measures – the natural rate or potential GDP – can be observed. They must be estimated based on the movements of other variables. For example, the key relationship underlying the natural rate is the one between unemployment and inflation, with the basic insight being that once economic capacity is exhausted, any more demand just shows up as more inflation (note the link between the debate over fiscal spending right now).
This is a key point. No one can directly observe the natural unemployment rate or potential GDP. “They must be estimated based on the movements of other variables,” Bernstein says. Much of our economic data is similarly inferred.
Astronomers can look into the heavens and infer that planets they cannot see are revolving around stars they can see. They can do this because they understand with some precision how gravity works. Moreover, gravity doesn’t sometimes work differently because people wish it would. Wile E. Coyote kept learning this the hard way. Economics enjoys few such certainties, even though many economists think it does, or at least wish it did.
Zero Confidence
This brings us to the present market conundrum. Is the economy close to overheating, or not? Perfectly sincere people look at the same data and come to radically different answers. That wouldn’t happen if economics were a hard science. We would apply the data to known laws and the correct answer would be obvious. It isn’t obvious at all, but policymakers act like it is.
I’m not saying we should go to the other extreme, doing nothing until we have 100% certainty. That’s not wise, either. The key is to recognize that we have blind spots and then work around them. For instance, physicians don’t know everything (certainly not as much as we like to believe they do) about the human body, but they make good use of what they do know. The lab tests show an infection, and they treat it; the CT scan shows a suspicious mass, and they remove it.
Would you let a doctor cut you open based on data as reliable as, say, GDP or unemployment? Of course not. That would be crazy. And your doctor would probably agree, because the Hippocratic Oath says “Do no harm.” Economists have no such oath. Maybe they should.
Airplanes are an even better example. Your pilot delivers you to your destination safely thanks to extensive, accurate data on the plane’s course, altitude, speed, and so on. Now imagine a plane in which Federal Reserve staff had filled the cockpit with instruments meeting their standards. Would you get on that plane?
Let me think for a nanosecond. No. I would not board such a plane because I would have zero confidence that it was taking me to the right city. A San Francisco flight could easily end up in Cleveland – if it arrived anywhere at all without crashing.
All this is very obvious to people who lack graduate degrees, yet for some reason the economics profession persists in thinking it knows things it simply does not.
Economists have physics envy. They want their profession to be a hard science, when it is probably one of the softer of the soft sciences.
Believing that the data they have is precisely meaningful gives people like Federal Reserve governors the mistaken impression that they have what they need to manage the economy successfully. They don’t. They have lots of data and not so much information.
Hence, to my great surprise, I find myself 100% agreeing with Jared Bernstein’s conclusión:
Our best move is thus to admit the uncertainty, toss the point estimates, and follow the data, particularly inflation. Recognize that we’re driving a car with no reliable indicators of engine overheating, so we’ve got to use our eyes and ears to gauge the heat. That doesn’t call for recklessly pumping the gas or the brakes. It does call for more humility about the limits of our knowledge.
Having “more humility about the limits of our knowledge” would be an excellent step toward more rational monetary policy. Will the Powell Fed take that step? I hope so… but I’m not holding my breath.
Think about this: 12 people sit around a table, chew the fat over masses of data and metadata, and then set the price for the most important commodity in the world: the US dollar, the world’s reserve currency. How do they know they’re right? Well, they tell us confidently, it’s all in the data.
If the market is competent to set long-term rates or LIBOR, then maybe we should trust the market to set short-term rates. That doesn’t mean there would be no role for the Fed. There are points in the economic cycle when the Fed can be quite useful, typically during a liquidity crisis that follows hard on the heels of too much irrational exuberance.
Want to have some fun? Read this at the Financial Times Alphaville site. A former Fed insider recounts the debate at the FOMC meeting when the committee was trying to implement QE3. It’s hilarious in a sort of “Oh my God, it can’t really be this bad can it?” way. Not exactly confidence-inspiring. And yes, I’ve talked with lots of people who have been “in the room,” and it can get that bad.
And yet the chairman of the Federal Reserve comes out after the meeting and confidently announces whatever the policy decision is, not mentioning the questions and disagreements and uncertainty and frustration of the members who sat around the table. By the way, these FOMC meeting minutes are not released for five years. I guess that’s because the parents don’t want to let the children hear them arguing.
And with that I will hit the send button. Technically, I should have spent a good deal of time talking about inflation and the CPI in conjunction with this question of the analysis of data, but the letter is long as it is. Next week we will spend the entire time talking about inflation and the assumptions we make about it. That’s an exploration I look forward to sharing with you.
Sonoma and the SIC in San Diego
I will be meeting with Mauldin Solutions business associates Sunday night through Monday night; then Tuesday morning I’ll fly off to San Francisco and then drive up to Sonoma to be with my friends at Peak Capital Management for their annual client conference. It will be a fun conference, as I have a lot of friends flying in. I’ve been wanting to spend some quality time with them. Peak has graciously allowed me to stay a few days, and I am going to bookend their conference.
After that conference I am home for a week to nail down my presentations at the Strategic Investment Conference in San Diego. I mentioned at the beginning that we are doing a video live stream of the conference. Some of the links we used when first sending that information out did not work. I am assured that this one does: SIC Live Stream Virtual Pass.
It’s the next best thing to being there. By the way, I didn’t mention it above, but you will be able to go online and ask questions and vote on the questions that those in the room are asking. We are doing everything to make the Virtual Pass as close to the real thing as possible.
Sidebar: It happens every year. This is our 15th conference, and for the last seven or eight in particular we have gotten a lot of people who should be on the stage signing up at the last minute. Last year and this year I kept a few sessions open, waiting to see who would show up that I should ask to join us as presenters. But no sooner had we finally “pulled the trigger” this year than we had several people sign up that I wished we had on the stage. Oh well, maybe next year. But for those who are attending, I will point them out from the podium so you can catch them at breaks and dinners.
Have a great week. Shane and I are going to try to relax for a day or so while we can, because life gets really busy for the next three weeks, without a lot of opportunity for breaks. People around me tell me it’s important to take breaks. I have not been very good at that over the years, but I’m going to get better. After I get back from the gym…
Your “data-dependent” analyst,

John Mauldin