Why rigged capitalism is damaging liberal democracy

Economies are not delivering for most citizens because of weak competition, feeble productivity growth and tax loopholes

Martin Wolf

© Capital flows to the financial centres - London, New York, Silicon Valley and Frankfurt - exacerbating inequality. FT illustration; Getty Images

“While each of our individual companies serves its own corporate purpose, we share a fundamental commitment to all of our stakeholders.”

With this sentence, the US Business Roundtable, which represents the chief executives of 181 of the world’s largest companies, abandoned their longstanding view that “corporations exist principally to serve their shareholders”.

This is certainly a moment. But what does — and should — that moment mean? The answer needs to start with acknowledgment of the fact that something has gone very wrong. Over the past four decades, and especially in the US, the most important country of all, we have observed an unholy trinity of slowing productivity growth, soaring inequality and huge financial shocks.

As Jason Furman of Harvard University and Peter Orszag of Lazard Frères noted in a paper last year: “From 1948 to 1973, real median family income in the US rose 3 per cent annually. At this rate . . . there was a 96 per cent chance that a child would have a higher income than his or her parents. Since 1973, the median family has seen its real income grow only 0.4 per cent annually . . . As a result, 28 per cent of children have lower income than their parents did.”

Chart showing the slowdown of US productivity growth

So why is the economy not delivering? The answer lies, in large part, with the rise of rentier capitalism. In this case “rent” means rewards over and above those required to induce the desired supply of goods, services, land or labour. “Rentier capitalism” means an economy in which market and political power allows privileged individuals and businesses to extract a great deal of such rent from everybody else.

That does not explain every disappointment. As Robert Gordon, professor of social sciences at Northwestern University, argues, fundamental innovation slowed after the mid-20th century.

Technology has also created greater reliance on graduates and raised their relative wages, explaining part of the rise of inequality. But the share of the top 1 per cent of US earners in pre-tax income jumped from 11 per cent in 1980 to 20 per cent in 2014. This was not mainly the result of such skill-biased technological change.

If one listens to the political debates in many countries, notably the US and UK, one would conclude that the disappointment is mainly the fault of imports from China or low-wage immigrants, or both. Foreigners are ideal scapegoats. But the notion that rising inequality and slow productivity growth are due to foreigners is simply false.

HEMEL HEMPSTEAD, ENGLAND - DECEMBER 05: Parcels are prepared for dispatch at Amazon's warehouse on December 5, 2014 in Hemel Hempstead, England. In the lead up to Christmas, Amazon is experiencing the busiest time of the year. (Photo by Peter Macdiarmid/Getty Images)
An Amazon warehouse in the UK. The platform giants are the dominant examples of monopoly rentiers

Every western high-income country trades more with emerging and developing countries today than it did four decades ago. Yet increases in inequality have varied substantially. The outcome depended on how the institutions of the market economy behaved and on domestic policy choices.

Harvard economist Elhanan Helpman ends his overview of a huge academic literature on the topic with the conclusion that “globalisation in the form of foreign trade and offshoring has not been a large contributor to rising inequality. Multiple studies of different events around the world point to this conclusion.”

The shift in the location of much manufacturing, principally to China, may have lowered investment in high-income economies a little. But this effect cannot have been powerful enough to reduce productivity growth significantly. To the contrary, the shift in the global division of labour induced high-income economies to specialise in skill-intensive sectors, where there was more potential for fast productivity growth.

Donald Trump, a naive mercantilist, focuses, instead, on bilateral trade imbalances as a cause of job losses. These deficits reflect bad trade deals, the American president insists. It is true that the US has overall trade deficits, while the EU has surpluses. But their trade policies are quite similar. Trade policies do not explain bilateral balances. Bilateral balances, in turn, do not explain overall balances. The latter are macroeconomic phenomena. Both theory and evidence concur on this.

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The economic impact of immigration has also been small, however big the political and cultural “shock of the foreigner” may be. Research strongly suggests that the effect of immigration on the real earnings of the native population and on receiving countries’ fiscal position has been small and frequently positive.

Far more productive than this politically rewarding, but mistaken, focus on the damage done by trade and migration is an examination of contemporary rentier capitalism itself.

Finance plays a key role, with several dimensions. Liberalised finance tends to metastasise, like a cancer. Thus, the financial sector’s ability to create credit and money finances its own activities, incomes and (often illusory) profits.

A 2015 study by Stephen Cecchetti and Enisse Kharroubi for the Bank for International Settlements said “the level of financial development is good only up to a point, after which it becomes a drag on growth, and that a fast-growing financial sector is detrimental to aggregate productivity growth”. When the financial sector grows quickly, they argue, it hires talented people. These then lend against property, because it generates collateral. This is a diversion of talented human resources in unproductive, useless directions.

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Again, excessive growth of credit almost always leads to crises, as Carmen Reinhart and Kenneth Rogoff showed in This Time is Different. This is why no modern government dares let the supposedly market-driven financial sector operate unaided and unguided. But that in turn creates huge opportunities to gain from irresponsibility: heads, they win; tails, the rest of us lose. Further crises are guaranteed.

Finance also creates rising inequality. Thomas Philippon of the Stern School of Business and Ariell Reshef of the Paris School of Economics showed that the relative earnings of finance professionals exploded upwards in the 1980s with the deregulation of finance. They estimated that “rents” — earnings over and above those needed to attract people into the industry — accounted for 30-50 per cent of the pay differential between finance professionals and the rest of the private sector.

TOPSHOT - US President Donald Trump (C) addresses supporters during a campaign rally in Rio Rancho, New Mexico, on September 16, 2019. (Photo by Nicholas Kamm / AFP)NICHOLAS KAMM/AFP/Getty Images
US president Donald Trump, a naive mercantilist, focuses on bilateral trade imbalances as a cause of job losses © Getty Images

This explosion of financial activity since 1980 has not raised the growth of productivity. If anything, it has lowered it, especially since the crisis. The same is true of the explosion in pay of corporate management, yet another form of rent extraction. As Deborah Hargreaves, founder of the High Pay Centre, notes, in the UK the ratio of average chief executive pay to that of average workers rose from 48 to one in 1998 to 129 to one in 2016. In the US, the same ratio rose from 42 to one in 1980 to 347 to one in 2017.

As the US essayist HL Mencken wrote: “For every complex problem, there is an answer that is clear, simple and wrong.” Pay linked to the share price gave management a huge incentive to raise that price, by manipulating earnings or borrowing money to buy the shares. Neither adds value to the company. But they can add a great deal of wealth to management. A related problem with governance is conflicts of interest, notably over independence of auditors.

In sum, personal financial considerations permeate corporate decision-making. As the independent economist Andrew Smithers argues in Productivity and the Bonus Culture, this comes at the expense of corporate investment and so of long-run productivity growth.

A possibly still more fundamental issue is the decline of competition. Mr Furman and Mr Orszag say there is evidence of increased market concentration in the US, a lower rate of entry of new firms and a lower share of young firms in the economy compared with three or four decades ago. Work by the OECD and Oxford Martin School also notes widening gaps in productivity and profit mark-ups between the leading businesses and the rest. This suggests weakening competition and rising monopoly rent. Moreover, a great deal of the increase in inequality arises from radically different rewards for workers with similar skills in different firms: this, too, is a form of rent extraction.

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A part of the explanation for weaker competition is “winner-takes-almost-all” markets: superstar individuals and their companies earn monopoly rents, because they can now serve global markets so cheaply. The network externalities — benefits of using a network that others are using — and zero marginal costs of platform monopolies (Facebook, Google, Amazon, Alibaba and Tencent) are the dominant examples.

Another such natural force is the network externalities of agglomerations, stressed by Paul Collier in The Future of Capitalism. Successful metropolitan areas — London, New York, the Bay Area in California — generate powerful feedback loops, attracting and rewarding talented people. This disadvantages businesses and people trapped in left-behind towns. Agglomerations, too, create rents, not just in property prices, but also in earnings.

Yet monopoly rent is not just the product of such natural — albeit worrying — economic forces. It is also the result of policy. In the US, Yale University law professor Robert Bork argued in the 1970s that “consumer welfare” should be the sole objective of antitrust policy. As with shareholder value maximisation, this oversimplified highly complex issues. In this case, it led to complacency about monopoly power, provided prices stayed low. Yet tall trees deprive saplings of the light they need to grow. So, too, may giant companies.

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Some might argue, complacently, that the “monopoly rent” we now see in leading economies is largely a sign of the “creative destruction” lauded by the Austrian economist Joseph Schumpeter. In fact, we are not seeing enough creation, destruction or productivity growth to support that view convincingly.

A disreputable aspect of rent-seeking is radical tax avoidance. Corporations (and so also shareholders) benefit from the public goods — security, legal systems, infrastructure, educated workforces and sociopolitical stability — provided by the world’s most powerful liberal democracies. Yet they are also in a perfect position to exploit tax loopholes, especially those companies whose location of production or innovation is difficult to determine.

The biggest challenges within the corporate tax system are tax competition and base erosion and profit shifting. We see the former in falling tax rates. We see the latter in the location of intellectual property in tax havens, in charging tax-deductible debt against profits accruing in higher-tax jurisdictions and in rigging transfer prices within firms.

A 2015 study by the IMF calculated that base erosion and profit shifting reduced long-run annual revenue in OECD countries by about $450bn (1 per cent of gross domestic product) and in non-OECD countries by slightly over $200bn (1.3 per cent of GDP). These are significant figures in the context of a tax that raised an average of only 2.9 per cent of GDP in 2016 in OECD countries and just 2 per cent in the US.

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Brad Setser of the Council on Foreign Relations shows that US corporations report seven times as much profit in small tax havens (Bermuda, the British Caribbean, Ireland, Luxembourg, Netherlands, Singapore and Switzerland) as in six big economies (China, France, Germany, India, Italy and Japan). This is ludicrous. The tax reform under Mr Trump changed essentially nothing. Needless to say, not only US corporations benefit from such loopholes.

In such cases, rents are not merely being exploited. They are being created, through lobbying for distorting and unfair tax loopholes and against needed regulation of mergers, anti-competitive practices, financial misbehaviour, the environment and labour markets. Corporate lobbying overwhelms the interests of ordinary citizens. Indeed, some studies suggest that the wishes of ordinary people count for next to nothing in policymaking.

Not least, as some western economies have become more Latin American in their distribution of incomes, their politics have also become more Latin American. Some of the new populists are considering radical, but necessary, changes in competition, regulatory and tax policies. But others rely on xenophobic dog whistles while continuing to promote a capitalism rigged to favour a small elite. Such activities could well end up with the death of liberal democracy itself.

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Members of the Business Roundtable and their peers have tough questions to ask themselves. They are right: seeking to maximise shareholder value has proved a doubtful guide to managing corporations. But that realisation is the beginning, not the end.

They need to ask themselves what this understanding means for how they set their own pay and how they exploit — indeed actively create — tax and regulatory loopholes.

They must, not least, consider their activities in the public arena. What are they doing to ensure better laws governing the structure of the corporation, a fair and effective tax system, a safety net for those afflicted by economic forces beyond their control, a healthy local and global environment and a democracy responsive to the wishes of a broad majority?

We need a dynamic capitalist economy that gives everybody a justified belief that they can share in the benefits. What we increasingly seem to have instead is an unstable rentier capitalism, weakened competition, feeble productivity growth, high inequality and, not coincidentally, an increasingly degraded democracy. Fixing this is a challenge for us all, but especially for those who run the world’s most important businesses. The way our economic and political systems work must change, or they will perish.

About Martin Wolf

As the FT’s chief economics commentator, Martin Wolf paints on a wide canvas. He focuses on the world economy, and has paid particular attention to globalisation, financial crises and, more recently, trade wars. Pro-market but pragmatic, he ranges broadly and skilfully from the challenge of climate change to the rise of populism, and even the prediction that interest rates would remain very low for a very long time.

No Coincidences

Doug Nolan

September 20 – Wall Street Journal (Daniel Kruger): “The Federal Reserve Bank of New York will offer to add at least $75 billion daily to the financial system through Oct. 10, prolonging its efforts to relieve funding pressure in money markets. In addition to at least $75 billion in overnight loans, the New York Fed… will also offer three separate 14-day repo contracts of at least $30 billion each next week… On Friday banks asked for $75.55 billion in reserves, $550 million more than the amount offered by the Fed, offering collateral in the form of Treasury and mortgage securities. The Fed’s operation was the fourth time this week it has intervened to calm roiled money markets. Rates on short-term repos briefly spiked to nearly 10% earlier this week as financial firms looked for overnight funding. The actions marked the first time since the financial crisis that the Fed had taken such measures.”

With the collapse of Lehman setting off the “worst financial crisis since the Great Depression”, instability in the multi-trillion repurchase agreement marketplace generates intense interest.

This crucial market for funding levered securities holdings is critical to the financial system’s “plumbing.” It is a market in perceived “money” – highly liquid and virtually risk free-instruments.

If risk suddenly becomes an issue for this shadowy network, the cost and availability of Credit for highly leveraged players is suddenly in question. And any de-risking/deleveraging at the nucleus of the global financial system would pose a clear and present danger of sparking “risk off” throughout Credit markets and financial markets more generally.

I’ll usually begin contemplating the CBB on Thursdays. This week’s alarming dislocation in the “repo” market was clearly a major development worthy of focus. But I was planning on highlighting the lack of initial contagion effects in corporate Credit, a not surprising development considering the New York Fed’s aggressive liquidity injections.

Investment-grade Credit default swaps (CDS), for example, closed Thursday trading near their lowest levels since February 2018. Junk bond spreads (to Treasuries) went out Thursday near the narrowest since early-November. Bank CDS, another important indicator, also continued to signal the “all’s clear” throughout Thursday trading. As of Thursday’s close, Goldman Sachs’ (5yr) CDS was up a modest three points for the week to 58, after closing the previous Friday near low going back to January 2018.

But Friday’s trading session came with additional intrigue. Investment-grade CDS jumped 15% to 59.7, the highest close in about a month. Goldman Sachs CDS rose 9.4% to 63.1, an almost four-week high. JPMorgan CDS rose 8.9% (to 42.7), BofA 11.0% (to 47.5) and Citigroup 5.7% (to 61.1). And as key financial CDS prices moved sharply higher, safe haven bond yields dropped. Treasury yields fell six bps in Friday trading to 1.72%, and Bund yields declined two bps to negative 0.525%. Even more curious, Gold popped almost $18 Friday to $1,517, boosting the week’s gain to $28.

The Fed’s return to system liquidity injections after a decade hiatus received abundant media coverage. For the most part, analysts were pointing to a confluence of unusual factors: $35 billion money market outflows to fund September 15th quarterly corporate tax payments; settlements for outsized Treasury auctions; and the approaching end to the quarter (where money center banks generally reduce balance sheet leverage for financial reporting and regulatory purposes).

Missing from the discussion was that this week’s money market tumult followed on the heels of instability in other markets. Is it coincidence that Monday’s spike in repo rates followed last week’s extraordinary bond market reversal – where 10-year Treasury yields surged 34 bps and benchmark MBS yields spiked an incredible 46 bps (2.37% to 2.83%)?

What a nightmare it’s been over recent months for those attempting to hedge interest-rate risk. After trading to 4.10% in November, benchmark MBS yields were down to 3.02% near the end of March. MBS yields then rose to 3.34% in April, before reversing lower to trade all the way down to 2.51% by late June. Yields were back up to 2.91% in mid-July – only to then reverse to a three-year low of 2.30% on September 4th. Collapsing MBS yields spur waves of refinancings, shortening the lives (“duration”) of existing MBS securities trading in the marketplace (as old MBS are replaced with new lower-yielding securities).

The marketplace for hedging MBS and other interest-rate risks is enormous. Derivatives really do rule the world. When market yields are declining, players that had sold various types of protection against lower rates are forced into the marketplace to acquire instruments for hedging their escalating rate exposure.

Much of this levered buying would typically be financed in the repurchase agreement (“repo”) marketplace. This type of hedging activity can prove strongly self-reinforcing. Intense buying forces Treasury and bond market prices higher, “squeezing” those short the market while spurring additional hedging-related buying. At the same time, the expansion of “repo” securities Credit boosts overall system liquidity, supporting the upside inflationary bias in bond and securities prices.

The recent downside dislocation in market yields included tell-tale signs of manic blow-off speculative excess. At 1.46% lows (September 3rd), an exuberant marketplace was calling for sub-1% Treasury yields – as if the unending supply from massive deficit spending would remain permanently divorced from market price dynamics. Meanwhile, booming corporate issuance was gobbled up at near record low yields - and the lowest spreads to Treasuries in two years. Inflows were inundating the bond ETF complex.

Excesses in U.S. fixed-income were unfolding as $18 TN of global investment-grade bonds traded at negative yields, including European corporate debt.

Things got conspicuously out of hand. With global central bankers in aggressive easing mode – including an ECB restarting the QE machine while pushing rates further into negative territory – market participants were in the mood to believe central banks had abolished market cycles. Like deficits and Current Account Deficits, speculative excess and leverage don’t matter.

While everyone was relishing the mania, trouble was building under the markets’ surface – in the “plumbing.” As yields collapsed, speculative leverage mounted. Surging prices incited a buyers’ panic in Treasuries, MBS, corporate bonds, CDOs and structured finance – a chunk of it financed in the “repo” and money markets.

Derivative player hedging activities also significantly boosted system leverage. All the speculative leveraging worked to expand system liquidity, crystallizing the market perception of endless liquidity abundance. While a deficient indicator of system liquidity, it’s still worth noting M2 “money” supply has expanded $560 billion over the past six months. Money market fund assets (retail funds included in M2) are up $350 billion since the end of April. Where’s all this “money” been coming from?

Market “melt-up” upside dislocations sow the seeds for abrupt market reversals and attendant upheaval. One day’s panic buying (on leverage) can be the following session’s frantic selling (unwind of leverage). Especially in the derivatives arena, self-reinforcing derivative-related dynamic (“delta”) hedging during an upside speculative blow-off is susceptible to abrupt reversals.

Hedging programs necessitate buying into rapidly rising markets, only to immediately shift to aggressive selling in the event of market weakness. The associated leverage spurs liquidity excess on the upside, creating vulnerability for illiquidity in the event of downside sell programs and speculative deleveraging.

It is surely no coincidence that this week’s “repo” ructions followed last week’s spike in yields and resulting deleveraging. Is it a coincidence that the marketplace experienced a powerful “rotation” that saw the favorite stocks and sectors dramatically underperform the least favored? Is it a coincidence that hedge fund long/short strategies have been clobbered, in what evolved into a powerful short squeeze and dislocation? Surely, it’s no coincidence the so-called “quant quake” foresaw this week’s quake in the repo market?

Let’s expand this inquiry. Is it a coincidence that this week’s money market upheaval followed by a few months dislocation in the Chinese money market? And is it mere coincidence that U.S. money market instability erupted on the heels of the ECB’s decision to restart QE?

There are No Coincidences. Chinese money market issues and currency weakness were fundamental to the global collapse in yields. Trade war escalation risked pushing China’s vulnerable Credit system and economy over the edge.

Global central bankers responded to sinking bond yields with dovish talk and monetary stimulus, feeding the unfolding bond market dislocation. Collapsing market yields and dovish central banks stoked melt-up dynamics in stocks and sectors seen benefiting from a lower rate environment. Growth stocks were caught up speculative melt-up dynamics, while short positions in underperforming financials and small caps were popular hedging targets.

Both momentum longs and shorts became Crowded Trades.

Meanwhile, booming markets and the resulting loosening of financial conditions quietly bolstered flagging growth dynamics – from China to the U.S. to Europe. The prospect of constructive U.S./China trade talks risked catching the manic bond market out over its skis.

Some stronger U.S. data sparked a sharp bond market reversal, with rising yields spurring a reversal of Crowded equities trades. Losing on both sides, the long/short players suffered painful losses. De-risking of long/short strategies incited a powerful short squeeze, a dynamic that gained momentum into expiration week.

The S&P500 is only about 1% from all-time highs. Yet there’s been some real damage below the market’s surface. The leveraged speculating community, in particular, has been shaken.

There were losses in Argentina and EM currencies more generally. Bond markets have turned unstable – on both the up- and downside. Long/short strategies have been bludgeoned. Short positions have turned highly erratic. And this week instability engulfed the overnight funding markets, with contagion effects for other short-term funding vehicles at home and abroad.

Trouble brewing.

The leveraged speculating community is the marginal source of liquidity throughout U.S. and global markets. Not only have they faced heightened risk across the spectrum of their holdings, they now confront funding market uncertainty into year-end. This doesn’t necessarily indicate imminent market weakness.

But it does signal vulnerability. Many players are afflicted with increasingly “weak hands.” They’ll exhibit less tolerance for pain. This dynamic increases the likelihood that market weakness will spur self-reinforcing de-risking and deleveraging.

There was considerable market vulnerability this time last year – with equities at all-time highs.

Global markets, economies, trade relationships and geopolitics are all more troubling today.

Central bankers have burned through precious ammunition, in the process spurring problematic late-cycle excess. Understandably, there is dissention within the ranks – from the Fed to the ECB and BOJ. Is monetary stimulus the solution or the problem?

Autumn is set up for some serious instability. There’s all this talk of the need for the Fed to create additional bank reserves. The issue is not a shortage of reserves but a gross excess of speculative leverage. It started this week. The Fed’s balance sheet will be getting much bigger.

The Fed and the markets were blindsided by this week’s repo market instability. The surprises will keep coming.


Why yields are the best guide to future stockmarket returns

John Cochrane’s landmark 2011 paper on discount rates

IN 2011 JOHN COCHRANE, a professor at the University of Chicago’s Booth School of Business, gave a presidential address on “Discount Rates” to the American Finance Association. It was published as a paper a few months later. In a sweeping take, Mr Cochrane set out how academics’ understanding of the way asset prices are determined has shifted over the past half-century. Many papers are described as “landmark”; this one has a better claim to the label than most.

His opening line (“Asset prices should equal expected discounted cash flows”) indicated that the basic premise has not changed. But plenty has. In the 1970s the focus of academic finance was on the “expected” part of that equation—the efficiency with which markets priced in any new information relevant to future cash flows. The emphasis has shifted. The “discounted” part, or the risk preferences of investors, has become the main organising principle for research, argued Mr Cochrane.

The old-school view was that when stock prices are high relative to earnings or dividends (ie, yields are low), it implies these cash flows are expected to grow quickly in future. The new school says it is changes in risk appetite—the discount rate that investors apply to future earnings—that explains much of the variation in asset prices. If prices are high and yields are low, that implies investors are willing to accept lower returns in future. Yields predict returns.

There are practical implications. A generation ago an investor might have looked to history for a guide to expected returns. Now yields are seen as a more useful steer. This is clearer with government bonds. The real annual return on American Treasury bonds was 1.9% between 1900 and 2018, according to Credit Suisse’s Global Investment Returns Yearbook. But history is bunk. It would not be wise to expect a 1.9% return when the yield-to-maturity on inflation-protected Treasury bonds is zero, as it is now.

The future cash flows from stocks are not as certain as those from government bonds. But Mr Cochrane argued that a similar principle holds with stocks over the long haul. “High prices, relative to dividends, have reliably preceded many years of poor returns. Low prices have preceded high returns,” he said. The predictive power of yields holds for bonds and stocks, but also for other assets, such as housing. And valuations based on aggregate earnings or book value predict stock returns just as well as the dividend yield.

A lot of people prefer the earnings yield. Share buy-backs have become a more popular way to return capital to stockholders than paying dividends. The earnings yield may be a better guide to expected returns. True, not all company earnings are distributed to shareholders in dividends or buy-backs; some are used to pay for investment to generate future earnings growth. On the other hand, that growth should also be considered part of expected returns.

If yields predict returns, that might seem to imply that astute investors can sell stocks when yields (and expected returns) are low and buy them back when yields are high. In practice, the signal from yield is too weak to be relied upon to catch turning points profitably. But what matters to a lot of investors is not so much what stocks will return in the short run, but how much extra they will return over safe bonds in the long run.

This extra reward is the equity risk premium—and to Mr Cochrane’s way of thinking the discount rate, the risk premium and the expected return on equities “are all the same thing”.

One forward-looking measure of the equity risk premium shows a wide variation over time (see chart). Investors with a long-term horizon might profitably use such variations to decide on the mix of risky stocks and safe bonds to hold in a portfolio. The higher the risk premium on stocks, the more the odds favour investors tilting their portfolio away from bonds.

A question for academic research is why exactly expected returns (or, if you prefer, discount rates) on stocks vary so much. One explanation is that, as memories of the previous market crash fade, people get more comfortable owning equities—until the next bear market makes them rethink.

In his address Mr Cochrane argued that in a market slump a typical investor is inclined to ignore the high premiums offered by stocks because he fears for his job. The correlation between employment income and stock prices is to blame. Future returns are remarkably hard to predict. Yields may only be a weak guide to them; but they are the best we have.

Why U.S.-China Supply Chains Are Stronger Than the Trade War

trade war supply chain impact

While the trade war between the U.S. and China continues to take its toll, global supply chains provide a “force for reason” in ending the standoff because they bind the two countries in prosperity, writes Wharton dean Geoffrey Garrett in this opinion piece.

Say the words “supply chain” and most people tune out. Supply chains sound technical, geeky and boring. But nothing could be further from the truth. Here are my three cheers for supply chains:
  1. Supply chains are at the core of the modern global economy.
  2. Supply chains will help resolve the China-U.S. trade war.
  3. Supply chains will make a new Cold War less likely.

If you listen to President Donald Trump talk about trade you will get the impression that international supply chains don’t exist. In the most important case, China and the United States, the President’s analysis goes something like this: Goods and services are either “made in America” or “made in China.” America “wins” when products made in America are exported to China. America “loses” when it imports products made in China. The trade imbalance represents the win-loss records for both countries, just like your favorite sports team.

On this accounting, America is losing badly. Hence the ongoing trade war. The problem is that Trumpian trade is a relic of a distant era, when products really were made in one country and sold to another. That model is long gone, transformed first by containerized shipping in the 1960s and then by the internet in the 1990s.

These revolutions dramatically lowered the costs of moving goods and services between countries. A brave new world of global supply chains emerged to leverage international differences in costs and skills to produce better and cheaper products.

In today’s global economy, products are put together in one country from components sourced in other countries and then sold all over the world. As a result, vastly fewer products are solely “made in America,” “made in China,” or indeed made in any one country.

There can be no doubt this has been a boon for consumers the world over. It is also one reason why economists downplay the significance of bilateral trade balances.

But the globalization of supply chains has outsourced once-American jobs to other countries, from autoworkers to radiologists, call center operators to accountants. This is why Trump thinks trade wars are good electoral politics.

The economics of trade wars are very different. The tit-for-tat escalation of tariffs between China and the U.S. will cost the average American consumer this year. American farmers are hurting from Chinese tariffs on soybeans and other agricultural products.

Big business is also losing badly from the trade war – led by powerful firms in the tech sector that are integral to the supply chains co-mingling the activities of both American and Chinese companies. Consider two iconic examples: Trump’s war on Huawei and his call for Apple to make iPhones in America.

A Tale of Two Supply Chains

Despite all the bluster, the Trump administration has yet to deliver on its promise to forbid Huawei from doing business with America. Why?

Because Huawei matters a great deal to American business. About one-quarter of the components in Huawei products are supplied by leading American tech companies, led by Broadcom, Flex, and Qualcomm. Add them all up and American suppliers make well over $1 billion a year from Huawei—not much less than Huawei’s Chinese suppliers do.

[Source: Reuters]

The same story was true for another Chinese smartphone and telecoms company, ZTE, a couple of years ago. After initial Trump bluster that the U.S. was going to ban ZTE from doing business in America, Trump declared a cease fire, tweeting on May 14, 2018: “ZTE, the large Chinese phone company, buys a big percentage of individual parts from U.S. companies.”

This logic applies even more to Huawei. In addition to American suppliers of components, Google has a big stake in Huawei’s success — because Huawei is the second largest smartphone maker in the world and all its phones employ Google’s Android operating system.

It would be a gross exaggeration to say that Huawei’s success is America’s success. But it makes an important rhetorical point: there is no denying that several large American tech firms benefit from Huawei’s success — and are harmed by the Trump administration’s war on Huawei.

Now flip the script from American components in Chinese equipment to Chinese assembly of American products — Apple.

Truth in advertising on the back of all Apple devices: “Designed by Apple in California. Assembled in China.” Note: It does not say “made in China” because Apple devices are almost exclusively assembled on the Chinese mainland, predominantly by a Taiwanese firm, Foxconn, from components coming from America, Asia, and Europe. Here was UT Dallas’s James Hogan’s description of the Apple supply chain in 2016:

The economics of Apple’s supply chain are at least as important. The value added by assemblers Foxconn and Pegatron is typically estimated at only about 5% of the total cost of making an Apple device. The rest comes from the components, none of which come from China. So much for “made in China.”

According to TechInsights, the total cost of the iPhone XS Max is $453. Compare that with the retail sticker price of $1099 and it’s easy to see why Apple is one of the world’s largest companies by market capitalization.

And it is no surprise that Apple CEO Tim Cook is a champion of China’s role in Apple’s success. In an interview defending “assembled in China” against Trump’s attacks in late 2017, Cook emphasized that Apple is in China because of quality not price: “The products we do require really advanced tooling, and the precision that you have to have, the tooling and working with the materials that we do are state of the art. And the tooling skill is very deep here. In the U.S. you could have a meeting of tooling engineers and I’m not sure we could fill the room. In China you could fill multiple football fields.”

So China is integral to Apple’s success, all the more so given that China is the largest market for Apple products outside America.

The Dangers of Decoupling

Once you take into account the supply chains underpinning Apple and Huawei and the enormous value American firms derive from them, it is easy to see why companies like Apple and Google, Broadcom and Qualcomm want the trade war to end. Up until now, they have put a break on extending the trade war to tech. In the future, they will be an important force pressing for a ceasefire.

But at least some in the Trump administration see supply chains as the enemy when it comes to China-U.S. relations. They want to “decouple” the two economies by disentangling the supply chains enmeshing the two economies together.

Decoupling would be very hard to do. It would also be incredibly costly in economic terms. But decoupling would have another, even more important, consequence: It would make military conflict between America and China more likely.

Immanuel Kant was perhaps the first person to conjecture that “the spirit of commerce … sooner or later takes hold of every nation, and is incompatible with war.” But critics of this notion that countries that trade with each other don’t go to war with each other point to World War I as the stunning counter example.

Britain and Germany went to war despite very deep trade relations between the two countries during a period of extensive globalization. Why won’t the same happen between China and America now?

My answer is that globalization in the first part of the 21st century is very different from that in the first part of the 20th century – because of global supply chains. 100 years ago, there were no global supply chains and scant multinational companies. Today, global supply chains powering MNCs are at the very core of the global economy.

Most importantly, America and China are co-dependent on each other with supply chain interconnections amounting to a dense thicket of ties binding the two countries together. This is not just “incompatible” with war, as Kant noted. It is closer to unthinkable.

That is why I am bullish that, despite their deep and real differences, America and China are not destined for war. That is also why I am deeply opposed to “decoupling.” Advocates promote decoupling in the name of national security. I believe the opposite would be true. Decoupling would profoundly harm America’s national security by reducing the costs of war with China and hence making military conflict more likely.

Global supply chains not only benefit consumers. They also are a force for reason in ending the trade standoff between America and China. And they also form the ties that bind the two countries together in both prosperity and peace.

China's Golden Corridor – Gold Reserves and Negative Yield

by Marin Katusa


Earlier this year, gold prices hit all-time highs in most major currencies.

The British Pound… the Canadian Dollar… the Australian Dollar… the Indian Rupee… the Japanese Yen… the Chinese Yuan… the South African Rand… and more.

It also broke above $1,500 in dollar terms. The highest it’s been in 6 years.

This shouldn’t come as a total surprise…a trade war between global economic powers, global debt spiraling out of control…

Iran and North Korea building up weapons…

The world is in uncharted waters.

Are the chickens going to come home to roost?

Today I’ll share a few of the major key themes that every investor needs to be aware of right now.
The Chinese Yuan is in Freefall

Given the recent onslaught of tweets from Donald Trump, you’d think the Chinese Yuan had just started falling.

In reality though, the Yuan has been depreciating since 2014.

This trend was further magnified when the Chinese government let the Yuan fall below its symbolic threshold of 7 Yuan per U.S. dollar.

When this happened, the #POTUS tweeting machine went out in full force, labeling China a currency manipulator.

Below is a chart which shows the historical exchange rate between the Yuan and the U.S. dollar.

Currency devaluation aside, it makes a lot of sense to own assets which hold their value.

Physical assets like gold, art and vintage wine all make for excellent hedges against currency devaluation.

But it’s tough for major institutions or governments to buy enough art or wine to truly protect themselves. This leaves gold as the number one acquisition.

It should come as no surprise that central banks have been very active in buying gold.

Especially China’s…
The Chinese Central Bank is Buying TONS of Gold

And I mean that literally.

Just so far this year, the Chinese have acquired 2.7 million ounces (92.5 tons) of gold. Using a spot price of $1,500, that’s $4 billion worth of bullion.

Below is a chart showing Chinese Gold Reserves.

As a country focused on exporting more than it imports, it’s no surprise China wants to keep its currency value low. I could see the Chinese accumulating more gold over the coming months if their currency continues to weaken due to the trade war.

The U.S.-China trade war has not only impacted the American and Chinese economies, but the entire pattern for global trade as well.

Leading global economic indicators like national Purchasing Manufacturing Indexes have only recently begun to nosedive. And this could easily be just the tip of the iceberg.

To make matters worse, it’s getting harder and harder to find somewhere safe to park cash.

In times of chaos, government bonds are usually a standard go-to investment.
However, times are changing.

Right now, many government bonds actually have a negative yield.

You read that right – if you invest $100 into negative yield or a government bond in almost any European nation, you’re going to get back less than $100 in 10 years’ time.

How crazy is that?

Below is a table which shows the current yields on government bonds in nations around the world. The darker the red, the more negative the yield.

I don’t see this changing anytime soon either.

I believe there’s more devaluation to come.

Below is a chart which shows the soaring amount of negative yield government debt. It has recently surpassed $15 trillion.

More alarming is the amount of corporate debt that has also hit negative yield. Currently there is over $1.2 trillion in negative yield corporate debt.

Just a few years ago there was virtually none. Below is a chart showing this dramatic increase.

Unquestionably there is blood in the streets of the bond market. Investors have no choice but to look for other places as stores of value.

That’s when investors look to the famous "pet rock" and "barbarous relic" for some wealth protection.

After all, it’s that or slowly lighting your money on fire buying bonds in countries with negative interest rates.

With bond yields the least attractive they’ve been in years, investors and central banks are turning to gold.

And with the recent surge in the Commitment of Traders long positioning and the price of gold smashing through $1,500… many pundits are saying "THIS IS IT!"

The technical chartists are all coming out with their best head and shoulders, bull flag, sliding wedge and upside-down watermelon patterns that determine the next leg up in gold.

To be honest, I couldn’t care less what the talking heads say their target price is.

From a fundamental perspective gold is very strong right now.

With nearly two decades of experience managing a fund focused on the commodity sector… I know that being positioned in the best gold developers and gold producers offers tremendous leverage to rising gold prices.

My subscribers and I are up over 100% on one of my strongest conviction investments so far this year.

Many of our other positions are up over 50% so far this year. Our portfolio is incredibly well positioned to profit from the global market chaos.

The unrest in China, the trade war and the rise of negative yield debt aren’t likely to be cleanly resolved anytime soon.

And in the meantime, many will flock to the safest haven they know – gold.

Editor's Note: Negative interest rates are spreading like wildfire around the world. Investors have no choice but to look for other places as stores of value.

That's why many smart investors are running towards gold. It's also why the big buyers, like China and Russia, are accumulating as much gold as possible.

Here's the bottom line...

Negative interest rates and the devaluation of currencies will hurt a lot of people, particularly savers and retirees. But they will also give rocket fuel to the coming bull market in precious metals.