Moody's Downgrades China

Doug Nolan


Marie Diron, Moody’s associate managing director, Sovereign Risk Group, commenting Wednesday on Moody’s Chinese downgrade (Bloomberg Television): “It is likely to be a very medium-term and gradual erosion of credit metrics and we are looking at the policies that the government is implementing. The authorities have recognized the risks that come with high leverage and have a very broad agenda of structural reforms and we take that into account to the point that we think leverage will increase more slowly than it has in the past. But still these measures will not be enough to really reverse the increase in leverage.”

I’ve always felt the rating agencies got somewhat of a bum rap after the mortgage finance Bubble collapse. Sure, their ratings methodologies were flawed. In hindsight, Trillions of so-called “AAA” MBS were anything but pristine Credits. And, again looking back, it does appear a case of incompetence - if not worse. Yet reality at the time was one of home prices that had been inflating for years with a corresponding long spell of low delinquencies and minimal loan losses, along with GDP and incomes seemingly on a steady upward trajectory. The GSEs had come to dominate mortgage finance, while the Fed had market yields well under control. 


Washington surely wouldn’t allow a housing crisis, which ensured that markets were absolutely enamored with anything mortgage related. So the mortgage market enjoyed bountiful liquidity conditions, and it was just difficult for anyone – including the ratings firms – to see what might upset the apple cart.

The ratings agencies were basically oblivious to the key issue of deepening structural maladjustment throughout the mortgage finance Bubble period. They were inattentive to what a major de-leveraging episode could unleash. But so were the Federal Reserve, Wall Street and the world. Analysis and models did not incorporate latent (financial and economic) fragilities that had compounded from years of rapid credit growth and asset inflation. These days there’s a similar inability to comprehend the myriad global risks associated with the runaway Chinese Bubble.

The Moody’s downgrade spurred a bevy of articles this week examining China’s debt issues (i.e. “Total outstanding credit climbed to about 260% of GDP by the end of 2016, up from 160% in 2008”; “$9 trillion local bond market”; “debt has been increasing lately by an amount equal to about 15% of the country’s output each year”). Interestingly, I saw no mention that Chinese debt growth this year will likely approach $3.5 TN. Not only will this exceed U.S. 2017 debt growth, it will significantly surpass even peak annual U.S. debt expansion from the mortgage finance Bubble period.

May 23 – New York Times (Keith Bradsher): “China has gone on a spending spree, borrowing money to build cities, create manufacturing giants and nurture financial markets — money that has helped drive the economic powerhouse in recent years. But the debt-fueled binge now threatens to sap the energy of the world’s second-largest economy. With its economy maturing, China has to pile on ever more debt to keep its growth going, at a pace that could prove unsustainable. And the money is increasingly flowing through opaque channels that operate outside the regulated banking system, leaving China vulnerable to blowups. A major credit agency sounded the alarm on Wednesday, saying the steady buildup of debt would erode China’s financial strength in the years ahead… China’s debt has been increasing lately by an amount equal to about 15% of the country’s output each year, to keep the economy growing from 6.5% to 7%.”

The world has never witnessed such a Credit expansion. Moody’s noted the Chinese economy’s ongoing dependency on stimulus measures. I would argue that the key issue has evolved into China’s systemic addiction to ever-increasing expansions of “money” and Credit. The almost singular focus on debt to GDP ratios understates Chinese fragilities. They succumbed to the debt trap: massive ongoing expansion of Credit - or bust. How sound is this Credit? How stable is the Chinese financial sector? And, perhaps most pressing, how vulnerable is their currency?

May 24 – New York Times (Keith Bradsher): “Moody’s… downgraded its rating of China’s sovereign debt one notch on Wednesday, citing concerns over growing debt in the country, which has the world’s second-largest economy. In recent years, as China’s stunning economic performance of past decades has become difficult to sustain, the country has used debt to fuel growth… When it comes to pumping money into a financial system, China has made the Federal Reserve in the United States and the European Central Bank look almost lackadaisical. It has expanded its broadly measured money supply by more than the rest of the world combined since the global financial crisis. Now it has 70% more money sloshing around its economy than the United States does, even though the American economy is bigger… China has accumulated its towering debt remarkably quickly. Goldman Sachs looked last year at how fast debt had accumulated relative to the size of the economy in 55 countries since 1960. It found that by the end of 2015, China was already in the top 2% of all credit expansions — and its debt shot up even higher last year. All of the other large expansions occurred in very small economies, some of which essentially lost control of their finances.”

Moody’s report focused on the risk of further leveraging. This is clearly an issue. Corporate debt is at very high levels ($18 TN, or 170% of GDP) and corporations (many with earnings and cash-flow issues) continue to pile on additional borrowings. Much of this debt is “non-productive,” as companies borrow to meet rising debt service and to plug expanding cash-flow deficits. Even more alarming, the bloated financial sector continues to balloon, issuing risky loans while creating new deposit “money”. From the NYT (Keith Bradsher) article above, China “has 70% more money sloshing around its economy than the United States.” Even more than “leverage,” China’s Wild West Risk-Intermediation Mayhem has created momentous systemic risk. Much of the risky “Terminal Phase” debt growth – financing inflated apartment values, uneconomic enterprises, economic maladjustment and chicanery – is being transformed into perceived safe and liquid “money” and money-like financial instruments.

The bulls were quick to downplay the importance of Moody’s action, stating both that China has minimal dependence on external financing and that the country still enjoys $3.0 TN of international reserve assets. I would view the issue differently. Yes, China has an extraordinarily large international reserve cushion, though holdings have declined $1.0 TN from June 2014. Most importantly, this large hoard has allowed authorities to prolong the Bubble and delay the type of harsh measures required to rein in Credit, speculation and now deeply imbedded boom-time psychology. Chinese savers are accumulating wealth they never dreamed of, backed by an economy with serious deficiencies and a financial sector of dubious standing.

Moody’s and others – certainly including Wall Street generally - handle China with kid gloves. 

Chinese authorities have backed away from needed reforms. The late-2015/early-2016 scare forced Beijing to effectively impose capital controls. Rather than promoting open and effective market-based mechanisms, the game has turned to only more zealous interventions: stabilize financial markets and promote rapid Credit growth necessary to sustain 6-7% GDP expansion, while cajoling and controlling to limit the capacity of all this Chinese “money” to flow out of the country.

Chinese authorities have also been pressing Chinese corporations and financial institutions to borrow in overseas markets. This kills two birds... China can offload some high-risk, late-cycle Credit to international investors, while also attracting needed financial inflows. The problem is that foreign investors fear capital control measures and don’t trust the renminbi. So much of this borrowing is done in dollar-denominated debt. And the large issuance of dollar-denominated debt only exacerbates systemic vulnerability to an abrupt renminbi devaluation.

May 24 – Reuters (Adam Jourdan and Samuel Shen): “The decision by Moody's… to downgrade China's credit rating is ‘illogical’ and overstates the levels of government debt, a commerce ministry researcher said in an editorial in the official People's Daily newspaper… Mei Xinyu, a researcher at China's Ministry of Commerce, wrote in a front page editorial of the paper's overseas edition the downgrade… overstated China's reliance on stimulus and the country's debt levels. Moody's downgraded China's credit ratings… for the first time in nearly 30 years, saying it expects the financial strength of the economy will erode in coming years as growth slows and debt continues to rise. China's Finance Ministry said… the downgrade overestimated the risks to the economy and was based on ‘inappropriate methodology’. China's state planner said debt risks were generally controllable.”

I’ve closely monitored China for years now. I recall reading some years back how Chinese officials had studied and learned from the Japanese Bubble experience. I’ve been waiting patiently for China to wrestle control of a precarious Credit Bubble. They have instead repeatedly taken tepid steps to curb various sectoral excesses – real estate, local government debt, stock market, corporate debt and, of late, shadow banking and insurance. Attempts to tamp down excess in one spot have only ensured it pops out elsewhere. The gravest policy misstep has been their failure to take a more systemic approach to Credit growth and asset inflation.

Basically, whenever tightening policies began to bite, Beijing would in short-order reverse course and stimulate. After a while, Chinese tightening measures lacked credibility. Moreover, the greater the inflation of Credit, financial institutions and perceived wealth, the more confident the Chinese population (including investors in real estate and financial assets, bankers, and corporate CEOs) became that Beijing would never tolerate a bust. Beijing these days essentially backs local government debt, the big state banks, corporate debt and apartment prices, not to mention $22 TN of “money” (“M2) and trillions more of money-like “wealth management products” and such. The scope of Beijing’s contingent liabilities is unparalleled.

The Moody’s executive stated that “It is likely to be a very medium-term and gradual erosion of credit metrics.” The Credit “metric” that matters most is my hypothetical chart of systemic risk that turned parabolic with the rapid acceleration of Credit of rapidly deteriorating quality. This “Terminal Phase” Dynamic unfolds during a period of momentous structural maladjustment, with government policies invariably exacerbating already deep structural impairment. It’s worth recalling that the Japanese enjoyed incredible economic growth and restructuring for more than three decades before blowing up their Credit system during the final four years of the boom. The Chinese situation is much more precarious.

I found myself this week thinking back to Dallas Fed President Robert McTeer’s 2001 comment, “Let's all hold hands and buy an SUV.” It was at the time a rather ridiculous central banker prescription for recovery from recession. Things, however, turned only more outrageous the following year, with the arrival of the Bernanke Doctrine at the Federal Reserve (and central banking more generally). Since then policy floodgates have been thrown wide open. What passes these days for reasonable policy would have been unimaginable fifteen years ago.
Chinese authorities apparently believe they can grow out of debt and structural issues. No matter what, they can always stimulate. And no need to dig holes and then refill them. Just tear down old apartments and structures and fabricate glossy tall new ones. Throw “money” at any problem, always plenty freely available. And there’s always endless new enterprises and technologies to support. Lend money around the world so buyers can afford to buy Chinese products. The quantity of debt doesn’t really matter all that much; just keep growing.

May 21 – Bloomberg (Alfred Liu, Moxy Ying, and Enda Curran): “In 1997, the Asian financial crisis touched off a six-year property bust in Hong Kong that shaved more than two-thirds off prices and saddled the city with a stagnant economy and deflation. As Hong Kong gets ready to celebrate the 20th anniversary of its handover to China, which happened just as Asia’s crisis began to unfold, that pain seems all but forgotten. Prices are at all-time highs. Mortgage borrowing is booming. Developers are bidding up the cost of land to records. People young and old are lining up to buy newly built apartments. In short, the kind of fervor that preceded the last bust is back. That’s got experts fretting about the potential fallout should the city of about 7.4 million people experience another crash. By several measures, Hong Kong looks more vulnerable this time around.”

The global government finance Bubble has “gone to unimaginable extremes - and then doubled.” And there are various elements of previous Bubbles that have coalesced into something that somehow masks inherent fragilities and the risk of devastating collapse. I think back to the commercial real estate Bubbles, junk bonds and LBOs from the late-eighties. Bond market leverage (“government carry trade”) and derivatives (mortgage IOs and POs) from the early-nineties. There was Mexico, SE Asia and EM from the mid-nineties. Russia and LTCM fiascos later in the decade. The “tech” and corporate debt Bubbles, followed by the great mortgage finance Bubble. Individually, we’ve seen these kinds of things before and we know they end badly. But as one gigantic, comprehensive, almost all-inclusive Bubble garnering the attention and support from policymakers around the world, it’s different enough this time that risks are dismissed or downplayed. Greed trumps fear.

I look around the world and see an unprecedented Bubble in Chinese Credit and investment. EM more generally has borrowed enormous amounts of debt, much of it in dollars and foreign currencies. European securities markets have inflated into historic Bubbles. Bond markets around the global are mispriced like never before. Almost everything providing a yield – from commercial real estate to corporate debt to dividend stocks – trades today at inflated values. Especially considering the Trillions that have been issued – and Trillions more in the offing – Treasury prices are detached from market pricing mechanisms.

The Trillions of central bank “money” that has spurred a historic Bubble in “risk free” securities has worked similar magic on risk assets, notably corporate Credit, equities and EM debt. The reckless abandon that took derivatives markets by storm during the mortgage finance Bubble period has gone to even greater extremes, this time on a global basis. 
 
Everywhere, it seems market perceptions are more detached than ever from reality. I continue to see confirmation that China is a major global Bubble weak link.

May 26 – Bloomberg (Chris Anstey and Enda Curran): “Chalk up another win for the visible hand in China’s markets over the principle of the private sector determining prices. A move by authorities to smooth out daily changes in the yuan’s fixing versus the dollar, taken on its own, suggests a shift away from any eventual float of the currency. The news comes in a week when officials were suspected of having intervened in the stock market to limit damage to sentiment after Moody’s… downgraded China’s sovereign credit rating. Both developments underscore the importance the Communist Party leadership places on specific outcomes, rather than the embrace of free markets that Western nations once pressed on China. President Xi Jinping has every interest in avoiding turmoil in the currency and equity markets this year as he oversees a critical reshuffle of top officials. While relatively minor, the change ‘is surely a negative step for financial openness,’ said George Magnus, an associate at Oxford University’s China Centre and former adviser at UBS Group AG. It’s ‘another step by Xi Jinping and the leadership to exert control where the deference to market forces was making at least limited headway.’”

May 25 – Wall Street Journal (Lingling Wei and Saumya Vaishampayan): “China’s central bank is effectively anchoring the yuan to the dollar, a policy twist that has helped stabilize the currency in a year of political transition and market jitters about China’s economic management. The yuan weakened more than 6% against the dollar in 2016; this year, it is up roughly 1%, and the expectation that the currency will fluctuate—a gauge known as implied volatility—is around its lowest in nearly two years.”

After a brief bout of selling in Chinese and Asian equities, there was little market reaction to the Moody’s downgrade. Perhaps telling, Chinese authorities revalued the renminbi higher both Thursday and Friday, with the Chinese currency gaining a notable 0.43% for the week. 
 
With my belief that China’s currency may prove their system’s weak link, I find it intriguing that officials would be compelled to move immediately to manipulate its value higher. I believe Beijing prefers a weaker currency to support its massive export sector and to stoke moderately higher inflation. And while their currency policy may be somewhat posturing to the new U.S. administration, I suspect they are more fearful of an unwind of foreign-financed leveraged “carry trades” that have accumulated in higher-yielding Chinese Credit. In the past I’ve referred to the Chinese renminbi as a “currency peg on steroids.” There’s never been an EM currency with the potential for such massive outflows from domestic savers and international speculators alike.

May 26 – Bloomberg: “For ever yuan that the People’s Bank of China injects into the nation’s financial system, it’s up to the banks to decide how far they stretch it in the form of loans to the economy. Right now, they’re working overtime. China’s money multiplier -- the ratio between the broadest measure of money in use, M2, and base money created by the central bank -- has climbed to the highest on records that date to 1997, data compiled by Bloomberg show. Each yuan of base money is being turned into more than 5 in the real economy. The turbocharged multiplier is helping compensate for the drainage of cash caused by Chinese savers and companies venturing abroad. It’s also helping economic growth…”


Donald Trump’s pluto-populism laid bare

For all the sound and fury, the president is governing like a traditional Republican

by: Martin Wolf


 

The first 100 days of Donald Trump’s presidency have brought some good news and some bad news. The good news is that, albeit chaotically, he is governing more as an orthodox post-Reagan Republican than most expected. The bad news is that he is governing more as an orthodox Republican than most expected. This now seems true in all the main policy areas, both domestic and international. It is clearly true in economic policy.

The idea of rebuilding US infrastructure has faded. The trade protectionism looks halfhearted.

But deregulation is still an objective. So is tax reform, with the familiar combination of unfunded giveaways and magical thinking on deficits. Mr Trump’s policies look ever more like Reagan’s, but from a more unfavourable starting point.

In announcing the tax plan, the White House did in an essential respect reinforce experience with this administration. It is hard to think of another government that would announce radical reforms of the tax system in a one-page document as sketchy as this one. It would be laughable if it were not so damaging to the US reputation for competent policymaking. The plan must be dead on arrival in Congress, in large part because it is not alive in the first place.




The single page released by the White House last week does, however, contain very similar ideas to those announced by candidate Trump. This makes it possible for us to go back to the analysis published by the Tax Policy Center in October. While we have little reason to expect a plan just like this to be enacted, that earlier analysis does help us understand how far the administration’s starting point remains from common sense on fiscal policy.

Start with the effects on the fiscal deficit. According to the TPC, the plan would raise the federal deficit (even after allowing for beneficial macroeconomic effects) by a little under 3 per cent of gross domestic product for as long as it remains in place. But, according to the International Monetary Fund, the US is already running a general government structural deficit of 4 per cent of GDP, forecast to rise to just under 6 per cent of GDP in the early 2020s.






With the addition of the proposed tax cuts, a structural general government deficit of well over 8 per cent of GDP might emerge in the 2020s. This would cause an explosive rise in debt. That could not be allowed to happen, particularly since US general government net debt is now more than 80 per cent of GDP, up from 45 per cent before the crisis and far lower when Reagan came to office. The structural deficit needs to be reduced, not increased. Yet this fiscal boost is not intended to be temporary and would also occur when unemployment is at 4.5 per cent of the labour force. It would be of the wrong kind, at the wrong time.

Defenders suggest, in response, that the plan might pay for itself, via increased activity. Given the low unemployment rate, this seems quite unlikely. Yet US Treasury secretary Steven Mnuchin has even suggested that, in combination with other administration policies, tax cuts could raise US trend growth to 3 per cent, from the current trend of slightly below 2 per cent.




Such a rise in growth would help. But it is very unlikely, for reasons explained by Jason Furman, former chairman of the Council of Economic Advisers. For it to happen, he argues, it would be far from sufficient for the decline in labour force participation to reverse. There would also be a need for a rise in the growth of output per hour from the 1.2 per cent achieved in the last decade to 2.8 per cent. That rate of productivity growth has been extremely rare in the past, over any extended time period. It would be mad for policymakers simply to assume this will happen (See charts.)

The question then is whether these huge tax cuts could be offset elsewhere. The border tax adjustment to corporation tax now seems to be a dead idea. So the only solution would be huge cuts in spending. To reduce spending by, say, 2.5 per cent of GDP would mean a cut in federal spending of about 12 per cent. But nearly 90 per cent of that spending goes on defence, health, income security, veterans’ benefits, social security and interest. On the assumption that these items will be protected, every other item of federal spending would have to be eliminated. The federal government would, in many areas, vanish.

The tax proposals also look astoundingly regressive. According to the TPC’s analysis, the top 0.1 of the income distribution might receive an average tax cut approaching 14.2 per cent of after-tax income, while middle-income households would receive an average tax cut of 1.8 per cent. Among the startlingly regressive changes would be repeal of the alternative minimum tax, repeal of estate taxes and huge reductions in corporate tax rates, including on so-called pass-through businesses. To those that have it shall be given. That is the doctrine of Mr Trump. It is also the old Republican trickle-down doctrine in purest form.

Mr Trump won the nomination by promising to be a different sort of Republican. He is not.

What he has achieved is to make the “bait and switch” yet more obvious. Post-Reagan Republicans reached out to the base by campaigning on cultural issues, while legislating for the upper 1 per cent. That is “pluto-populism”. Mr Trump added infrastructure spending, trade protectionism and support for Medicare and social security. But he too plans to deliver for the top 1 per cent.

Pluto-populism is highly politically effective. But it works by making the base ever angrier and more desperate. That is playing with political fire. The republic may survive Mr Trump. But what comes after?


Damn the Deficits, Huge Tax Cuts Ahead!

By: Peter Schiff


Donald Trump has made good on one of his most audacious campaign promises by submitting what he describes as the biggest tax cut in U.S. History. For once, at least, this does not appear to be Trumpian braggadocio. It really may be the mother of all tax cuts. But if passed, what may this bunker buster do to the economy? While I have rarely met a tax cut I didn’t like, this one just may be more likely to send the economy into a downward spiral than it is to send up to orbit.

As I mentioned in my January commentary, Donald Trump’s big-spending, tax-cutting campaign rhetoric threatened to make him the biggest borrower in presidential history. He comes to office at a particularly vulnerable time for budget dynamics. After contracting by nearly two thirds from 2010 to 2015 (from the mind-bending $1.3 trillion to the merely enormous $438 billion), the Federal deficit started expanding again in 2016, moving up to $587 billion (Govt. Publishing Office, Office of Management & Budget (OMB). Current projections have it going up nearly every year over the next two decades. The Congressional Budget Office expects it to permanently surpass $1 trillion annually by 2021 or 2022. But these ominous forecasts were made well before anyone thought Trump had a snowball’s chance of ever becoming president. Now that he is in the office, those projections will be the floor. The ceiling is anyone’s guess.

The forecasts assume that the taxing and spending laws in place during the Obama Administration won’t change. The steep increase in projected deficits towards the end of this decade and into the next is largely driven by the retirement of the Baby Boom generation, which will lead to simultaneous increases in entitlement spending and decreases in tax revenue.

This brick wall has been hiding in plain sight for decades but the can-kickers in Washington have serially failed to do anything to avert the inevitable collision.

(These forecasts also optimistically assume that the economy never again enters recession, inflation never again rears its ugly head, and that our creditors never get concerned enough about our growing debt to demand a premium for the risk of financing it.)

But now that Trump occupies the Oval office, this date with destiny may come much sooner…and she will definitely be ordering the lobster.

Before I go negative, let me give credit to Trump for picking the right taxes to cut. He kills the estate tax, an ugly beast that should have been euthanized years ago. Some may see this simply as a gift to the very rich. But legal wizards have long since devised strategies that offer almost complete protection from the death tax. None of these structures offer any real benefit to the businesses these millionaires typically own, or to the economy in general. Killing the tax will cost the government almost nothing, but it will remove tremendous impediments that have prevented family-run companies from growing over generations. He also kills the Alternative Minimum Tax, a complex parallel system of taxation that few understand but somehow manages to ensnare more and more taxpayers every year.

Most importantly, he brings down the corporate tax rate from the globally non-competitive rate of 35% to the much more manageable 15%. Taxing corporations has always been a bad way to raise revenue. Corporations, after all, don’t pay taxes, which are simply treated as a cost of doing business. The real costs are borne by customers, who must pay higher prices, and employees, who must suffer with lower wages. But high domestic corporate taxes have hamstrung U.S. corporations and greatly contributed to the decline of American manufacturing. A more competitive corporate sector will shower benefits on all manner of consumers and employees.

On the individual tax side, his decisions are much more problematic. Although Trump makes the sensible decision of compressing the seven individual tax brackets into just three (10%, 25%, and 35%), and doubles the standard personal deductions (thereby saving many people from the hassles of itemization), the headline-grabbing component of the proposals has to do with the lowering of the “pass-through” tax rate to the same 15% level that applies to corporations. This means that wealthy business owners, highly paid freelancers, and partners at law firms, medical groups, and management consultancies, will qualify for the 15% rate.

This will be a huge windfall to some of the richest people in the country, who typically pay the highest marginal tax rate (currently 39%). And since the top one percent account for nearly 50% of tax revenue, this one provision promises to cost Uncle Sam plenty and to dramatically shake up the corporate landscape.

Small business owners and independent contractors will in fact receive the benefit of the 15% pass through rate. But “Mom and Pop” entrepreneurs rarely have income that is high enough to be taxed at the higher rates. These smaller earners will likely be be trading a 15% tax for a 15% tax. All the big benefits will go to the really big fish. Whereas the vast majority of Tom Cruise’s income would have been taxed at the 39% rate, it will now be taxed at just 15%. His taxes will be reduced by nearly 60% from current law. The same holds true, in lesser degree, to lawyers, doctors, and consultants making more than a few hundreds of thousands of dollars annually.

Is there any reason that could justify why a hedge fund manager making a million dollars per year should pay 15%, but a full time CEO at a corporation making half that would be subject to the highest marginal rate of 35%? It’s absurd. Now I’m not a big fan of the “progressive” tax system, whereby the tax rate goes up with income. I think a “flat” tax system, in which everyone paid the same rate, would be better. (Ideally I would like to see income taxes replaced by far less onerous and intrusive consumption taxes). But I certainly don’t believe in a “regressive” tax system in which lower-earning citizens pay higher rates than those at the top.

But that’s exactly what Trump is trying to do.

Given this wide disparity in tax rates, we can assume that the employment landscape will adjust dramatically. We should expect that legions of highly-paid full-time employees will start to form Limited Liability Corporations (LLCs) to work freelance rather than as employees. There are few barriers that would prevent such a shift, and the growth of internet-based work scenarios will continue to break down the traditional barrier between employee and freelancer.

Yes, there are some labor rules that seek to separate employees from freelancers, but those rules may be easily circumvented, especially when the reward is so great. Rather than envy the lawyer earning more and paying less, the CEOs of the country will likely incorporate and sell their services freelance to their former employers.

This shift will mean that a great many of the country’s highest earners will be paying taxes at the lowest rate. As a result, the reductions in tax revenue would likely be far greater than what is predicted in the standard modeling.

But unlike most prior tax cuts, the Trump version does not even make any attempt to balance the cuts with corresponding cuts in government spending. If Trump’s tax cuts don’t immediately generate sustained 4% growth or more, we may be staring down the barrel of $2 annual deficits. Is this an experiment that we really want to try?

But even if the reforms can kick the economy into higher gear, thereby creating higher revenues with lower rates (The Laffer Curve), our current low interest rate environment provides significant obstacles to permit that growth to be sustained. If growth kicks up to the 4% range, the Federal Reserve will have to accelerate its rate increase schedule to keep interest rates in line with GDP growth and to prevent inflation, already above its official 2% target, from running out of control. Plus the markets will also act to adjust interest rates higher due to greater demand for credit and rising inflation. These higher rates will act as a stiff headwind to an economy that has grown increasingly dependent on ultra low rates.

But increases in rates would also cost the economy in another way. Our current bonded national debt is ready to surge past the $20 trillion mark. The Trump tax cuts will push it beyond that very quickly. If the Fed raises rates to keep pace with higher growth, then the Government will have to pay much more to finance the outstanding debt. At $20 trillion, every point of increase in interest rates will cost the government $200 billion annually. At that level, if interest rates were at 3.75%, instead of the current .75%, then the Federal Government would have to come up with about another $600 billion per year in interest payments. (That number will be much higher when the debt grows past $20 Trillion).

But it's not just Uncle Sam that is over-loaded with debt. Corporations and households would see their interest costs surge as well with rising interest rates. So what lower taxes giveth, higher interest rates will taketh away.

Consider the housing market. Not only will higher interest rates substantially increase the cost of home ownership (through higher mortgage rates), but Trump’s tax proposals will dramatically increase the cost of ownership for those living in high tax states. Under the proposal, homeowners will no longer be able to deduct property taxes, and a doubling of the standard deduction means a much larger percentage of homeowners will not be able to deduct mortgage interest from their federal income tax. Plus, with the top tax rate reduced from 39.6% to 15%, the mortgage interest deduction will be far less valuable to those higher earners who can still take advantage of it. Higher mortgage rates and lower tax subsidies will increase the cost and decrease the appeal of home ownership. This could lead to a crash in real estate prices, especially in the high end of the market. Falling prices could wipe out what little home equity many Americas have left, and lead to another wave of foreclosures. The losses to Fannie Mae and Freddie Mac could be significant, with the costs falling directly on the Federal government, further driving up annual deficits.

The reality is that years of massive deficits, runaway government spending, artificially low interest rates, and three rounds of quantitative easing, have left the economy so sick that any tax cut large enough to revive it may actually kill it instead. If the Fed tries to keep it on life-support a bit longer by suppressing interest rates with a massive QE4 program, we risk run-a-way inflation and a dollar crisis with economic consequences far more profound than those of the financial crisis of 2008. The only silver lining to this cloud may be that the coming fiscal train wreck leaves lawmakers no choice but to slash government spending. If the real Republican agenda is to starve the beast, its success is assured.


Lessons from the Anti-Globalists

Joseph E. Stiglitz
.Macron French Elections

 

NEW YORK – The likely victory of Emmanuel Macron in the French presidential election has elicited a global sigh of relief. At least Europe is not going down the protectionist path that President Donald Trump is forcing the United States to take.
 
But advocates of globalization should keep the champagne on ice: protectionists and advocates of “illiberal democracy” are on the rise in many other countries. And the fact that an open bigot and habitual liar could get as many votes as Trump did in the US, and that the far-right Marine Le Pen will be in the run-off vote with Macron on May 7, should be deeply worrying.
 
Some assume that Trump’s poor management and obvious incompetence should be enough to dent enthusiasm for populist nostrums elsewhere. Likewise, the US Rust Belt voters who supported Trump will almost certainly be worse off in four years, and rational voters surely will understand this.
 
But it would be a mistake to conclude that discontent with the global economy – at least how it treats large numbers of those in (or formerly in) the middle class – has crested. If the developed liberal democracies maintain status quo policies, displaced workers will continue to be alienated. Many will feel that at least Trump, Le Pen, and their ilk profess to feel their pain.
 
The idea that voters will turn against protectionism and populism of their own accord may be no more than cosmopolitan wishful thinking.
 
Advocates of liberal market economies need to grasp that many reforms and technological advances may leave some groups – possibly large groups – worse off. In principle, these changes increase economic efficiency, enabling the winners to compensate the losers. But if the losers remain worse off, why should they support globalization and pro-market policies? Indeed, it is in their self-interest to turn to politicians who oppose these changes.
 
So the lesson should be obvious: In the absence of progressive policies, including strong social-welfare programs, job retraining, and other forms of assistance for individuals and communities left behind by globalization, Trumpian politicians may become a permanent feature of the landscape.
 
The costs imposed by such politicians are high for all of us, even if they do not fully achieve their protectionist and nativist ambitions, because they prey on fear, inflame bigotry, and thrive on a dangerously polarized us-versus-them approach to governance. Trump has leveled his Twitter attacks against Mexico, China, Germany, Canada, and many others – and the list is sure to grow the longer he is in office. Le Pen has targeted Muslims, but her recent comments denying French responsibility for rounding up Jews during World War II revealed her lingering anti-Semitism.
 
Deep and perhaps irreparable national cleavages may be the result. In the US, Trump has already diminished respect for the presidency and will most likely leave behind a more divided country.
 
We must not forget that before the dawn of the Enlightenment, with its embrace of science and freedom, incomes and living standards were stagnant for centuries. But Trump, Le Pen, and the other populists represent the antithesis of Enlightenment values. Without blushing, Trump cites “alternative facts,” denies the scientific method, and proposes massive budget cuts for public research, including on climate change, which he believes is a hoax.
 
The protectionism advocated by Trump, Le Pen, and others poses a similar threat to the world economy. For three-quarters of a century, there has been an attempt to create a rules-based global economic order, in which goods, services, people, and ideas could move more freely across borders.
 
To the applause from his fellow populists, Trump has thrown a hand grenade into that structure.
 
Given the insistence of Trump and his acolytes that borders do matter, businesses will think twice as they construct global supply chains. The resulting uncertainty will discourage investment, especially cross-border investment, which will diminish the momentum for a global rules-based system. With less invested in the system, advocates for such a system will have less incentive to push for it.
 
This will be troublesome for the entire world. Like it or not, humanity will remain globally connected, facing common problems like climate change and the threat of terrorism. The ability and incentive to work cooperatively to solve these problems must be strengthened, not weakened.
 
The lesson of all of this is something that Scandinavian countries learned long ago. The region’s small countries understood that openness was the key to rapid economic growth and prosperity. But if they were to remain open and democratic, their citizens had to be convinced that significant segments of society would not be left behind.
 
The welfare state thus became integral to the success of the Scandinavian countries. They understood that the only sustainable prosperity is shared prosperity. It is a lesson that the US and the rest of Europe must now learn.
 
 


The World That World War II Built

By George Friedman


On June 4-7, it will be 75 years since the Battle of Midway, the battle in which the United State won the war in the Pacific and prevented the defeat of Britain and Russia. Guadalcanal, El Alamein and Stalingrad followed, all mostly fought in the second half of 1942. Over two years of horror would remain – neither Japan nor Germany was prepared to concede the point – but the war was won by the beginning of 1943.

These were extraordinary battles in an extraordinary war. I want to devote some time this year to considering the battles on their anniversaries and, I want to try to explain how these battles were an interlocking whole – really a single, rolling, global battle that collectively decided the war. By the end of the year, my goal is to show that a single global battle, beginning at Midway and ending at Stalingrad, defined the fate of humanity.

Systemic Wars

This is not simply antiquarian interest, although surely June 1942 to February 1943 must rank with Salamis, where the Greeks stopped the Persian surge into Europe; Teutoburg, where the Germans halted the Roman advance; or Lepanto, where Christian Europe halted Muslim Ottoman expansion. These battles defined the future of a civilization; June 1942 to February 1943 defined the future of the entire world.

World War II defined the global civilization in which we now live. It ended Europe’s imperial project, opened the door to American global power, created what was called the Third World and set the stage for the emergence of the Asian mainland as a significant global player. The war also bred a distrust of nationalism, gave rise to multinational institutions and turned an interest in technology into an obsession with its redemptive powers. We live in the shadow of World War II and are now in a global revolt against the world it created.

All of this must be discussed, but to understand a war, we must understand it on its own terms, its own grammar. Many talk of wars without wanting to understand their logic, from the details of an artillery barrage to the tonnage of supplies that must flow to the battlefield. War, as all things, is a matter of detail, and the detail must be framed by both the logic of a war and its purpose. World War II had a unique logic. Many Americans long for the days when Americans were united in war. They mistake World War II as the way in which Americans once fought wars, with shared values. That was never the case. The American Revolution, the Mexican-American War, of course the Civil War, and the Spanish-American War were all fought with a vocal and angry faction opposing the war while it was underway. The dissent of Vietnam or Iraq was the norm of American warfighting, and World War II (and to a lesser extent World War I) was unique in its unity. That’s because it was a unique war.

I divide wars into two types: political wars, of which there are many, and systemic wars, of which there are only a handful. Political wars are those intended to achieve limited ends. The ends may be important but not existential. The loss of the war does not mean disaster for the nation. Most wars are like this, and many have idiosyncratic or diffuse ends. The Korean War was intended to demonstrate the will of the United States in resisting communism. The Vietnam War sought to shore up the U.S. position in Southeast Asia – a significant but not decisive goal – and to maintain the credibility of the U.S. commitment to the alliance system it depended on.

Throughout the history of all powerful nations, political wars abound. They are frequently not intended to be won in a conventional sense but to signal resolve or achieve limited political goals. A defeat is manageable. Such wars appear frivolous and unnecessary to segments of the population and therefore breed dissent – which is tolerated, since the wars are not worth the price of silencing dissenters.

Systemic wars differ in two ways. First, avoiding them is usually not an option. Second, losing them can be catastrophic. They aren’t rooted in transitory political interests but in tectonic shifts in the global system. The shifts are not driven by the intent of a nation but by the inevitable rise and decline of nations, the imbalances this creates, and the inevitable rebalancing, which frequently leads to wars. These wars are rare because tectonic shifts take a long time to occur, longer to mature, and longer still to lead to changes in power that are both widespread enough and consequential enough to end in war.

The Napoleonic Wars in Europe in the 19th century were systemic, as was the Seven Years’ War in the 18th century. Mongol invasions, European imperialism and the like all were systemic events containing decisive wars. World War II was a systemic war. Some argue that it was a continuation of World War I, and in Europe this was true. But World War II was different from World War I in an important way: The Pacific war between the Japanese and Americans added a new dimension.

Rebalancing the System

Yet both world wars flowed from the rise and fall of powers. In the 19th century, three new powers began to emerge: Germany, Japan and the United States. Germany destabilized Europe. Japan destabilized East Asia. The United States destabilized the world. The unification of Germany in 1871 created a power of enormous economic dynamism, but one extremely vulnerable to simultaneous military attack from Russia and France and to blockade by Britain.

Japan was also an economic dynamo but, bereft of natural resources, was unable to maintain its industrial base without imports of oil and other industrial minerals. Its access to these minerals depended on the willingness of suppliers to sell and ability to deliver them through waters controlled by the British and American navies. The newly emergent economic powers were both militarily insecure. This compelled them to seek a rectification of the balance of power against older and frequently weaker powers.



A U.S. Navy Ceremonial Band bugler salutes during an event to commemorate the 70th anniversary of the Allied forces victory in the Pacific and the end of World War II on Sept. 2, 2015, at the World War II Memorial in Washington, DC. Alex Wong/Getty Images


The rise of the United States was the most radical shift. The U.S. had become the leading economic power in the world in a startlingly short time. The United States’ only vulnerability was from the sea, and the major naval powers were the British and Japanese. The United States constructed a massive navy in response, which unsettle the Japanese in the extreme and made the British uneasy. But behind this was a fundamental reality. The European empires, and particularly the British, were built on a balance of power that was no longer in place. The existing system didn’t make room for the Germans and Japanese, but it also had no place for the Americans. The Americans did not seek formal empire, but they rejected the idea that they should be excluded from economic activities in the British and French empires. A system that marginalized the United States, Japan and Germany was unsustainable.

Systemic wars are complex. Alliances shift, and the motives of allies diverge. The Japanese fear of a U.S. blockade triggered the attack on Pearl Harbor. U.S. lend-lease to Britain was contingent on the British surrendering their naval bases in the Western Hemisphere to the United States. The British fought to preserve the empire. The U.S. was content to see it collapse.

The Soviet Union was intent on fomenting uprising in Britain and the United States, but both supported Soviet military operations against the Germans. I make no attempt here to write the story of World War II but rather to point out that systemic wars involve many nations, tend to be global and are complicated. Their outcome also determines the fate of nations and, for a while, of the world.

One measure of a systemic war is the degree to which the geopolitical systems change. The first change resulting from World War II was the collapse of all European empires in the 20 years following the war’s end. The second was the rise of the United States, not only as a major economic power but also as the dominant military power. Both Japan and Germany, the nations that rose along with the United States, collapsed after the war and then re-emerged as primarily economic powers, and as such, were limited forces in the world. The defeat of Japan opened the door for a communist regime in China that was succeeded by a more complex system that allowed China to emerge as a major economic power.

The next phase of history consisted of the global confrontation between the United States and the Soviet Union. That confrontation involved both a strategic cordon around the Soviet Union and a major contest between the United States and the Soviet Union for the domination of the remnants of Europe’s empire. It also consisted of a confrontation of nuclear forces, a weapon that emerged from World War II.

The Forces of Chance and Will

Powers rise and fall, but the process doesn’t happen quickly. It’s driven by shifts deep within the structures of societies. It takes generations or even centuries – too long to be decided by individual leaders or elections.

What is decisive in the story are wars. War, particularly modern wars, are driven by necessity. Modern wars are wars of industrial production, and the size and creativity of the industrial plant shape the outcomes of wars, as does the ability to destroy the enemy’s industrial capability. At the same time, there appear to be moments in the systemic war that don’t seem tied to the underlying structure of war-making but much more to the durability of a social order, the commitment of warriors and the chances of war.

Geopolitics is, as I have argued and tried to show, predictable. If you consider the deep structure and the imperatives and constraints of the nation-states, and ignore personalities and the public opinion of the moment, you can discern the process that is underway and see where it might be going. You can predict who will be in a war and who is likely to win it. But it is in war that the eccentric forces of will and chance coalesce to create outcomes that, if not violating expectations, give it unexpected dimensions.

It was from June 1942 to February 1943 that those eccentric possibilities showed themselves. They allow us to be surprised, certainly by how the war turned out, but also by how close it came to not turning out as we might have expected. Seventy-five years after Midway, Guadalcanal, El Alamein and Stalingrad, there are few who fought in those battles who are still alive. That is a good point for us to consider during these months. We now have to gain perspective over what was, in retrospect, a little more than eight months that redefined the world.

It is one thing to see the deep structure of a thing. But in systemic wars, you must also master the battles, in the grammar of war itself. So, in contrast to history, which moves slowly from a human standpoint, battles are measured in seconds, minutes, hours and days. The long wars we speak about today are political wars. Systemic wars rip apart the world and redesign it in a matter of years, with the heart of the matter determined frequently in minutes. In two weeks, we will begin with what I regard as the single-most decisive battle of World War II for all combatant powers: Midway, where the allies could have lost but didn’t, all because of events that transpired in mere minutes.