In the US-China Trade War, a Cease-fire Ends Nothing

Long-term economic competition is at the mercy of even longer-term geopolitical competition.

By Phillip Orchard   


Last Saturday in Buenos Aires, over grilled steak and Malbec one assumes were produced domestically, U.S. President Donald Trump and Chinese President Xi Jinping reached something of cease-fire in the trade war. Four days later, it’s unclear whether they agree on what they agreed to. The official statements they’ve issued subsequently clashed in scope, tone and substance. Not that the finer points will make much of a difference for the next few years. The U.S. and China are just beginning what will surely be a long, ugly process of economic disintegration that will disrupt both countries and, given their economic influence, alter the structure of the global economy.

But when the dust settles, each will still have ample interest in doing business with the other, making a narrower yet mutually beneficial long-term arrangement possible in the future. The only way that changes is if the broader strategic competition with China dramatically intensifies, in which case the U.S. will have every reason to weaponize trade.

The White House’s version of events is as follows: China pledged to buy a “very substantial” amount of U.S. agricultural, energy and industrial goods, with purchases of farm products beginning immediately. Beijing also agreed to negotiate immediately on Chinese practices such as forced technology transfers, intellectual property protection, non-tariff barriers and cyber theft. In exchange, the U.S. promised to delay until March a planned 15 percent jump in the September round of 10 percent tariffs targeting some $200 billion in Chinese exports. (It wasn’t until Monday that Trump said China, home to the world’s largest auto market, would remove tariffs on U.S. auto exports, which increased to 40 percent in July.)

But Beijing has said nothing about the 90 day extension, nor about which goods it’s planning to buy, nor how it will buy them. (It has yet to confirm Trump’s announcement about auto exports; neither have Trump’s trade advisors, for that matter.) At no point did China even exhibit a willingness to talk about the trade practices that helped spark the trade war in the first place, at least not publicly. According to Beijing, the upcoming talks will focus on scrapping all tariffs imposed by both countries and on reaching a consensus on trade.

To be clear, the differences in the statements reflect the necessity of political salesmanship. But they also attest to the difficulties that confound a more permanent agreement: China can’t concede on the biggest issues at stake, and the U.S. isn’t under enough immediate economic or political pressure to back down. So regardless of what’s up for discussion, extending talks by a few months is won’t make these challenges any less difficult.
Why the U.S. Won’t Back Down
The difficulties lie not in the arithmetic of tariffs and trade but in the nature of the trade relationship itself. China’s trade surplus ($375 billion in goods) is certainly an issue – bringing it down was a centerpiece of Trump’s presidential campaign – but it isn’t the main issue. In many ways, it testifies to the power of U.S. consumers and the sophistication of the U.S. economy, and fixating on reducing the headline figure won’t bring back labor-intensive jobs lost to China. The U.S and China could have a mutually beneficial trade relationship and still run a hefty trade imbalance — so long as the U.S is able to compete with China on a level playing field. Currently, it’s not. What the U.S. needs is the ability to sell what the U.S. specializes in (high-end goods and services) in China’s rapidly growing market without facing informal tariffs or fearing, for example, loss of sensitive intellectual property to emerging Chinese competitors that have unlimited access to state lending. It means playing by the common set of rules China agreed to when it joined the World Trade Organization in 2001, and abiding by WTO rulings to resolve complaints, just as the U.S. and its other trading partners do when disputes inevitably arise. Ad hoc, state-directed purchases of U.S. goods by China to dent the deficit won’t address these underlying structural issues.

Early on, Beijing thought it could buy its way out of the trade war by dramatically ramping up purchases of high-dollar U.S. goods it needed anyway, such as oil and gas, and by implementing modest reforms on market access and foreign investment. (In May, Xi’s top economic adviser, Liu He, thought he had reached a temporary deal with U.S. Treasury Secretary Steven Mnuchin, who even declared the trade war “on hold,” only to see the deal quickly scuttled by more hawkish figures in the White House.) Beijing would happily buy however much stuff it would take to allow Trump to claim victory on the deficit. Doing so would certainly be cheaper and easier than trying to bail out all the Chinese exporters that were about to get slammed by the U.S. tariffs at an economically inopportune time.

Reinforcing Beijing’s strategy was the (correct) belief that tariffs would take a financial toll on the U.S. too. They would hurt U.S. consumers whose living standards had improved thanks to cheap Chinese goods, U.S.-based firms dependent on inputs made in China, and U.S.-owned exporters with factories in China. (This doesn’t even account for the pain caused to U.S. exporters by Chinese counter-tariffs.) Beijing assumed that with midterm elections around the corner, Trump would have little appetite for a mutually destructive trade war that would rattle markets and put the White House at odds with constituencies such as farmers and free-traders that traditionally vote Republican. And this, Beijing hoped, would discourage the U.S. from pushing for structural overhauls in Chinese trade practices.

Beijing’s strategy evidently fell short. The U.S. economy is humming along at the peak of the business cycle. The trade war has certainly hurt certain U.S. sectors, and there will be long-term costs to the U.S. economy if it loses access to China’s gigantic consumer market — especially if high-value exporting countries in Europe and Asia don’t face the same barriers. But the pain has been subtle enough, and trade policy esoteric enough, to prevent the trade war from becoming a major political issue. In fact, the congressional districts in which trade influenced voters’ decisions tended to be the those that have benefited from new tariffs, particularly on steel and aluminum. There weren’t very many of them, but they generally supported the trade war.

More problematic for Beijing is that something of a bipartisan consensus has formed in the U.S. that China has stopped making progress on its WTO commitments and that the onus is on the U.S. to stop China from enjoying the benefits of the global trade system without abiding by its rules. (This view isn’t exactly new; it was the main impetus behind the Trans-Pacific Partnership, from which Trump withdrew.) There’s also a growing consensus that Chinese practices such as forced technology transfers, outright technology theft, and its overt, state-backed “Made in China 2025″ plan to dominate high-tech industries are indeed a threat to U.S. interests and the “rules-based order” — even if there’s ample disagreement over whether punitive tariffs are an effective way to address them.

Add to this the suspicions surrounding Chinese geopolitical ambitions. For those who think Washington and Beijing are sliding inexorably toward a new Cold War, the goal of forcing a change in Chinese industrial policy is beside the point. For them, anything that weakens China is worthwhile: There is no compromise.

Why China Can’t Back Down

China, for its part, can’t make the sweeping changes Washington demands without giving up the tools it thinks it needs to solve its own political and economic problems — problems Beijing thinks far outweigh those created by losing access to the U.S. market.

Beijing needs to be able to tightly control the yuan, intervene on behalf of domestic firms, and use the tools of the state to export excess industrial capacity (i.e. the Belt and Road Initiative). Large state-owned firms are needed to soak up excess labor. To deal with rising wages, slowing growth and an unenviable demographic outlook, China needs to make a mad dash up the manufacturing value chain into high-tech sectors. But during the decades when high-tech exporters like Japan, South Korea, Taiwan and Germany were moving to the technological and industrial vanguard, China was an isolated backwater. It’s playing from behind, and the government is willing to do whatever it takes to skip to the front of the line. Hence why the state is (allegedly) encouraging tech transfer by forcing foreign firms who want to operate in China to form joint ventures with local firms. It’s (allegedly) supporting commercial espionage. It’s (overtly) shoveling money into state-owned firms in industries deemed “strategic.”

The U.S. just doesn’t have the leverage to change China’s priorities. The cost of U.S. tariffs is likely to be, at most, around 2 to 3 percent of GDP. The cost of failing to keep people employed, moving into high-end exports and spurring sustainable long-term growth may well be the Communist Party’s time in power.

Beijing can make some modest reforms and thus some modest concessions, of course. For example, it’s been taking small steps to boost intellectual property protections and lifting caps on foreign ownership of firms in China. But these are improvised measures meant to reward friendly countries and reassure investors, and more importantly, they are largely in line with Xi’s broader reform agenda. They aren’t going to fundamentally change anything about the Chinese model, and thus they are unlikely to satisfy Washington as it negotiates an agreement. Moreover, China has pledged to do these sorts of things before. Even if China’s intentions are pure this time around, it will take time to convince Washington of its sincerity.

Trade as a Weapon

All this suggests that the U.S. and China are beginning to dramatically rewire their respective economies. The U.S. will stop indirectly helping China, either by creating incentives for multinational firms to reroute supply chains around China or by encouraging U.S. exporters to tailor their products to other markets (or both). Most of what the U.S. buys from China is made by multinational firms, which will become more willing to take on the costs of relocating if it becomes clear that tariffs are here to stay. To expedite this process and bolster a rules-based global trading system, the U.S. will eventually once again embrace the benefits of multilateral trade blocs such as the TPP.

China, meanwhile, will have little choice but to shift focus to preserving market access in Europe and other wealthy states. It will also crack down on any social fallout from the intense but ultimately temporary disruption that follows, while hoping that increased domestic consumption will ease the pain. The truth is, China’s dependence on the U.S. market was shrinking before the trade war even began, and rather than force Beijing to rethink its trade policies, that war has convinced the government that it must reduce its dependence on foreign markets and technology. With enough partners outside the U.S., and with enough money to throw at the challenge, it may actually succeed.

Even so, there’s no reason to think the world’s two largest economies are inevitably headed toward a wholesale disengagement, the likes of which the world hasn’t seen since the Cold War. If the U.S. cannot compel China to change, it will eventually lose interest in futile measures that cut off trade in areas where trade is mutually beneficial.

Cheap Chinese electronics are not a national security threat. And the Chinese consumer market will remain nearly irresistible to U.S. exporters. It’s easy to see the two countries settling on a limited but largely healthy trade relationship in the future, even if the thornier points of contention never go away. Whether or not this happens will really come down to the broader geopolitical competition between the U.S. and China. If the overriding goal is to contain China or to bring down the ruling party, then the U.S. will need every tool at its disposal to do so.

The Rise of the “Petroyuan”

For the past decade, China’s strategy for internationalizing the renminbi has involved greater reliance on the IMF’s Special Drawing Rights as an alternative international reserve currency. But the launch of renminbi-denominated oil trading this year suggests that China will now pursue de-dollarization head-on.

John A. Mathews , Mark Selden

chinese flag oil refinery

SYDNEY/ITHACA – It is now just ten months since China launched its oil futures contract, denominated in yuan (renminbi), on the Shanghai International Energy Exchange. In spite of forebodings and shrill alarms, the oil markets continue to function, and China’s futures contracts have established themselves and overtaken in volume terms the dollar-denominated oil futures traded in Singapore and Dubai.

Of course the volume of trades on the Shanghai INE still lags behind that of the Brent oil contracts traded in London and the West Texas Intermediate oil futures traded in New York. The Chinese oil futures contract is, however, being taken seriously by multinational commodity traders (like Glencore) and is priced in a manner that is comparable to the Brent and WTI indices. As we argue in The Asia-Pacific Journal, these results suggest that China’s oil futures could bring the renminbi to the core of global commodity markets.

The launch of the oil futures contract can be anticipated to widen the scope for renminbi-denominated commodity trading. As more of China’s oil imports come to be priced in its domestic currency, foreign suppliers will have more renminbi-denominated accounts with which they can purchase not only Chinese goods and services, but also Chinese government securities and bonds. This can be anticipated to strengthen Chinese capital markets and promote the renminbi’s internationalization – or at least the progressive de-dollarization of the oil market.

For the past decade, China’s strategy for internationalizing the renminbi has involved greater reliance on the International Monetary Fund’s Special Drawing Rights as an alternative international reserve currency. The People’s Bank of China’s then-governor, Zhou Xiaochuan, spelled out the strategy in an essay in 2009. With new allocations of SDRs to emerging industrial powers like China, the SDR, based on a basket of currencies including the renminbi, could serve not only as a development tool, but also as a means of international payment to rival the US dollar. In the wake of the 2008 global financial crisis, an SDR-centered international financial system became an enticing prospect for other countries as well.

Zhou’s 2009 essay galvanized these efforts, as he pointed to the evident inadequacies of the dollar-centered system (such as the impact of chronic US deficits) and outlined the SDR’s advantages as an alternative means of international financial settlement.

The establishment of renminbi-based oil trading at a time when China and many other economies confront aggressive US tariffs, and possible further development of renminbi-based trade in other commodity markets, suggests that the US dollar could face an unprecedented challenge to its hegemony. It may in the near future no longer be seen as the anchor of the international monetary system, bringing to an end to what Valéry Giscard d’Estaing famously called the “exorbitant privilege” enjoyed by the US as a result of the dollar’s centrality in international trade.

If China’s ultimate goals include internationalizing the renminbi, its more immediate objective, prompted in part by US tariffs or sanctions on China and other countries, is de-dollarization of the international system. This is reflected in the shift to promoting an oil futures contract traded in Shanghai, which represents a decisive break with China’s SDR-focused strategy.

It is also a way for China to capitalize on the US trade sanctions imposed against it – exposing liabilities in these sanctions. Both Russia and Iran, for example, are selling oil to China and accepting payment in renminbi, in response to actual or potential sanctions imposed on them by the US. They also have extensive imports from China, as well as other reasons for seeking strengthened ties.

China no doubt views the emergence of renminbi-denominated oil contracts as a means for Chinese companies to buy oil and gas in their own currency, thereby avoiding exposure to foreign currency fluctuations and firing a shot across the bow of US dollar supremacy. The fact that China is now the world’s largest oil importer, as well as its leading trading and manufacturing economy, lends weight to its “petroyuan” and other initiatives to internationalize the renminbi. If China can withstand US counterattacks, its efforts will lay the financial groundwork for the emergence of a multipolar world.

John A. Mathews is Professor Emeritus in the Faculty of Business & Economics at Macquarie University, Sydney, and the author of Greening of Capitalism.

Mark Selden is a senior research associate in the East Asia Program, Cornell University and the editor of The Asia-Pacific Journal: Japan Focus.

Banks May Be Safer in a Debt Crisis, But Investors Aren’t

Regulators are worried about what happens in bond markets when institutional investors face a liquidity crunch

By Paul J. Davies

Get ready for a rocky ride in bond markets. The price of a safer banking system is more danger for investment institutions. 
U.S. and U.K. regulators last week sounded warnings about the knock-on effects for corporate debt markets when large institutional investors face demands for liquidity. These demands could cause more turmoil than in the past because investors now provide much more corporate funding and are more exposed to collateral calls from derivatives.
One element of this is leverage: The U.S. Federal Reserve in its debut Financial Stability Report and the Bank of England in its regular one both noted a recent rise in borrowing by hedge funds. Separately, the Fed noted that lending commitments by large banks to nonbank financial firms rose to nearly $1 trillion by the middle of this year, from less than $600 billion five years ago. Most of the growth went to closed-end investment and mutual funds, real-estate investment trusts and special purpose vehicles.

The Fed is also concerned about the potential for runs from open-ended mutual funds. A drop in corporate debt prices could prompt a rush to redeem funds, sparking further falls and so on.

The Bank of England focused on the risk to asset managers, insurers and pension funds from greater demands for liquidity linked to derivatives used to boost returns or hedge exposures. Big moves against an investor’s derivative positions force it to put up more collateral, usually cash. If firms don’t have the cash, they may have to sell other assets, such as corporate bonds. This too could spark a vicious spiral of falling prices, institutions unloading assets and investors redeeming funds, the Bank said.

The Fed is concerned about the potential for runs from open-ended mutual funds. Photo: Andrew Harnik/Associated Press 

Nonbanks have become much more important providers of credit to companies and individuals since the financial crisis as a result of stiffer regulations and higher capital requirements for banks. The Fed noted that mutual fund holdings of corporate debt had grown to about $2.3 trillion in September this year, from more than $500 billion at the end of 2009 in 2018 dollars.

Another debt crisis is less likely to threaten the financial system’s survival because banks are less exposed. But the flip side is that end investors will suffer more losses directly.

Also, banks are less able to cushion price falls. They used to soak up sales with substantial holdings of temporary inventory, but this is no longer possible. So even as investor holdings of corporate bonds have grown bigger, the exit doors have got smaller.

Institutional investors who are sensitive to market values—either because of their own leverage or because their clients panic—are likely to make market routs worse. And as the Fed noted, routs seem more likely with business borrowing at historically high levels and valuations of corporate bonds and loans also high.

Banks may now be safer, but investors aren’t.

Can the World Bank Redeem Itself?

Development outcomes depend on poor countries’ external economic environment, which is shaped by the policies of the major economies. And when it comes to promoting sound policies, the World Bank has fallen far short in recent decades, exemplified by three major intellectual sins of omission.

Devesh Kapur , Arvind Subramanian

world bank group building

CAMBRIDGE – In recent years, as the World Bank’s financing role has been eclipsed by the rise of private capital and a surge in money from China, its leaders have been desperately seeking a new mission. And interminable reorganizations, politicized appointments, and the changing priorities of successive presidents have contributed to the perception that the institution is less than functional. But can that change?

The World Bank has tried to reinvent itself as a supplier of global public goods and a “knowledge bank” that provides data, analysis, and research to its developing-country clients. And few would deny the Bank’s achievements when it comes to gathering indicators of economic activity, measuring poverty, identifying deficiencies in the provision of health and education, and, in earlier years, designing and evaluating development projects.

But many, such as the Nobel laureate economist Angus Deaton, have criticized the World Bank’s overall performance. One problem is that development outcomes also depend on poor countries’ external economic environment, which is shaped by the policies of the major economies. And when it comes to promoting sound policies, the World Bank has fallen far short in recent decades, exemplified by three major intellectual sins of omission.

The first relates to the World Bank’s role in the Latin American debt crisis of the early 1980s. As its official history shows, the Bank restricted research on the implications of excessive borrowing during the crisis. Moreover, it did little to make the case for debt write-downs, despite the reckless increase in lending by big banks.

Instead, through its structural-adjustment lending, the World Bank, along with the International Monetary Fund, effectively became a debt collector for creditors. The result was a lost decade for Latin America, but not for the bankers. The resulting moral hazard would encourage another bout of exuberant lending, which led to further financial crises in developing countries in the subsequent decade.

The World Bank was also silent when its developing-country clients’ access to life-saving medications was being restricted. In the late 1980s, the leading industrialized countries – the United States, Europe, and Japan – began to push for stronger patent regimes that would boost their own pharmaceutical companies’ profits.

In 1995, developing countries were forced to sign the onerous Trade-Related Aspects of Intellectual Property Rights agreement at the World Trade Organization. Moreover, under Section 301 of the US Trade Act of 1974, sanctions were imposed on several developing countries, from Chile to India, accused of failing to strengthen patent protections sufficiently.

Even when the AIDS crisis was ravaging Sub-Saharan Africa in the early 2000s, global patent rules were not just maintained, but actually tightened further, until pressure from civil society finally forced the expansion of access to affordable treatment. The World Bank, however, said little.

This brings us to the World Bank’s third failure, the consequences of which are unfolding today. During much of the 1980s and 1990s, the Bank oversaw structural adjustment programs in developing countries that focused on deregulation, privatization, and economic liberalization, especially trade opening, all of which helped to enable globalization. While there were undoubtedly problems with many aspects of such a one-size-fit-all package of policies – the Washington Consensus, as it was known – the trade liberalization component helped accelerate lower-middle-income and middle-income countries’ economic convergence with developed countries.

But, today, the United States is rejecting trade openness, imposing unilateral tariffs and other barriers, and renegotiating trade deals on worse terms. And the World Bank’s silence is deafening. Its senior leadership has said nothing about the serious threat posed by the actions of the US or of other major players. While the Bank’s annual report, released in September, talks of a commitment to “researching today’s most pressing topics,” trade is not among them.

This is not just some oversight; during all of these episodes, the Bank knew that its responsibility was to act as an advocate for its poor clients. Instead, it decided – every time – to kowtow to its most powerful shareholders and their vested interests (such as Big Pharma and the financial industry), arguably in exchange for additional resources for its soft-loan window (the International Development Association) and, less frequently, capital increases for the International Bank for Reconstruction and Development (IBRD) and International Finance Corporation.

For example, this April – after the US had launched its trade war with tariffs on steel and aluminum – the Development Committee of the World Bank Board of Governors endorsed a package that included a $7.5 billion paid-in capital increase for the IBRD. This required the support of President Donald Trump’s administration, leading to silence from the Bank until June, when it finally warned of the negative impact of trade protectionism on global growth.

One might wonder whether such a Faustian bargain could be worthwhile if it means that the World Bank has more resources to promote development in poor countries. But while money certainly matters, the evidence suggests that development outcomes are determined more by factors like state capacity and national policies, and crucially, a supportive global environment. Rising trade protectionism, tighter immigration policies, and a lack of action on climate change by the world’s biggest economic players – particularly the US – thus pose serious threats to development, which a little extra money for the World Bank cannot offset. The ends do not justify the means: money may not matter that much, while ideas matter immensely in the broader fight against poverty (as this year’s Nobel Economics laureate, Paul Romer, has shown).

The World Bank cannot erase its troubling history of silence. But it may be able to redeem itself. Its new chief economist is an expert on trade. The Bank’s leadership should empower her to lead the charge in making the intellectual case for open markets for goods, services, and people.

The World Bank is well aware that its mission – “to reduce poverty, and improve living standards by promoting sustainable growth and investment in people” – cannot be achieved without an open global system. If it chooses not to uphold a core tenet of its mission, and instead continues to try ingratiating itself with its largest shareholders, it will not only fail its clients throughout the developing world; it will also lose whatever is left of its raison d’être.

Devesh Kapur is a professor at the School of Advanced International Studies at Johns Hopkins University and co-author of The World Bank: Its First Half-Century.  
Arvind Subramanian, a former chief economic adviser to the government of India, is a senior fellow at the Peterson Institute for International Economics and a visiting lecturer at Harvard’s Kennedy School of Government. He is the author of Eclipse: Living in the Shadow of China’s Economic Dominance.

European Threats

By John Mauldin

Someone asked recently how many times I had “crossed the pond” to Europe. I really don’t know. Certainly dozens of times. It’s been several times a year for as long as I remember.

That makes me an extremely unusual American. Most of us never visit Europe, except maybe for a rare dream vacation. And that’s okay because our own country is wonderful and has a lifetime of sights to see. But it does affect our perspective on the world. Many of us don’t fully grasp how important Europe is to the US and global economy.

We may soon get a lesson on that. I’ve talked about Italy’s ongoing debt crisis, which is not improving, but Europe has other problems, too. Worse, events are coalescing such that several potential crises—all major on their own—could strike at the same time, and not too long from now. As I’ve been saying for about three years, there is no reason for the US to have a recession on its own. I think events elsewhere will push us into it, and Europe is a really big current risk. I know from my visits to Europe and discussions with friends there, they see all sorts of problems with Trump and particularly his tariffs.

However, another concern is that the various actors in Europe are not playing nice with each other. I tell my European friends the same forces that yielded Trump are coming to a European country near them. In some places, they already have.

So, in my never-ending quest to keep you ahead of the curve, I’ll review what’s happening “over there.” This may be a turnabout for European readers who rely on me to describe what’s happening over here. But as you’ll see, we are far more connected than separated by distance.

(Note: The link is to my favorite version of “Over There” written by George M. Cohan, here sung by James Cagney in 1942 for the film Yankee Doodle Dandy. It was written at the beginning of World War I and quickly became the number one song of not just that era but also the World War II era. Younger generations may not remember music with so much unbridled, enthusiastic patriotism. They can be excused for not quite understanding such feverish intensity. It was a different era.)

Monetary Drug Withdrawal

Last week my British friend Jim Mellon sent me a fascinating article with an alarming title: “News from Euroland—Recession Imminent.” I’m not certain when Jim sleeps, as I get a few emails from him every day at seemingly random times, always with pithy, on-target reading material. (Although I can usually figure out when he is in Great Britain by their timing.)

Now, I am not one who falls prey to click-bait headlines (nor is Jim) and I’m also well aware Europe’s economy is weakening. I would not have said recession was imminent but reading this article left me more than a little concerned. The author, economist Victor Hill, ties events together in ways many haven’t considered.

Hill begins the piece this way:

 Across Europe, and particularly in the 18-member Eurozone, the economic news is sobering. It’s now clear that the credit crunch in emerging markets which has played out over most of this year, plus the slowdown in China, are having negative consequences in Europe. Yet, despite the ongoing trauma of Brexit, the UK is cruising along relatively smoothly—for now.

A number of critical events are about to coincide…

The first such event is the impending end of the European Central Bank’s quantitative easing “Asset Purchasing Programme,” which has been propping up asset prices with wholesale purchases of bonds, stocks, and anything else that isn’t nailed down.

Mario Draghi and his crew borrowed our Federal Reserve’s plan and, if possible, made it even crazier. You can see in the chart they have been stepping down purchases. The pace should reach zero in early 2019. But this doesn’t account for assorted other loan programs, which some would like to see continue or even expand. Germany opposes all such policies and I think will get its way, especially since Draghi will be leaving next year.

This means the Eurozone is about to lose a monetary drug on which it has grown highly dependent. But those 18 nations will not be the only ones affected. The larger EU needs a thriving core to stimulate growth for the whole continent.

Note that Draghi will finish his term as ECB president in October 2019. Economists (what do they know?) project he will make his first interest rate increase just one month before he leaves, in September. That means taking rates from -0.40 bps to -0.20, still below zero.

In all likelihood, his replacement will have to be approved by Germany. What will be the new president’s appetite for negative rates even in the face of recession? Will he listen to the Bundesbank? Will the ECB once again expand its balance sheet? What is left to buy? All good questions with no answers yet but potential market dangers.

And if Europe falls into recession earlier in 2019, will Draghi reverse himself and resume expanding the balance sheet, buying yet more assets that are not nailed down? The Italians would certainly like that.

European Disunion

Hill’s second “critical event” is Brexit, the latest plan for which is set for a December 11 vote in the UK’s Parliament. As of now its prospects look dim, at least without changes that the EU side says it won’t accept. That may not be true because, as we have learned, European officials are masters at vowing inflexibility and then bending when forced.

But let’s have some sympathy for Prime Minister Theresa May. She is dealing with a rebellion in her own party, has lost numerous votes and it is not clear she can force her (let’s call it) Brexit-lite proposal through Parliament. You can read about her troubles here.

This deal has monster implications for economics and investments and you really need to pay attention. I think I would vote against, not that anyone in Great Britain will care, as it seems to me that her compromise leaves Europe with more control over what a “final” agreement would look like. It’s not exactly what the “leave” crowd originally wanted. But in reality there are no good choices. If this is voted down, I see real chances for problems everywhere.

Another national vote might seem sensible, except that would look like the elites keep taking votes until they get the outcome they want. It would make a large part of the country upset no matter what. As I said, no good choices…

Regardless, it is highly uncertain what happens next. The UK gave formal notice it would leave the EU on March 29, 2019, whether terms of separation are reached by then or not. A “hard Brexit” would be chaotic, to say the least, as it would leave businesses trying to operate in a legal vacuum. World Trade Organization rules might serve as a backstop in some matters but the massive trade volume between the UK and EU would certainly slow. Can they walk that notice back? Fudge a little bit on the date? This is the EU. They can do anything they bloody well like. Damn the rules and full speed ahead…

On the other hand, remaining in the EU would enrage the millions who voted to leave and probably bring down the May government. Where it would go from there is anyone’s guess. It is hard to even imagine “democratic socialist” Jeremy Corbin as Prime Minister. So both economies are probably in for a shock unless some miracle produces orderly separation terms in the next three months, which seems unlikely.

The third critical event, says Hill, is the growing Italian crisis, which I’ve been warning about for quite some time. That kettle is getting ready to boil over. Now banks in Italy are having trouble refinancing their bond issues, which is forcing them to curtail lending to an already-weak private sector. Rising mortgage rates are cutting into consumer spending. Italy is arguably already in recession but the situation looks likely to get worse—which is a big problem for its creditors, mainly Germany, which we will discuss in a bit.

But Hill says, I think correctly, that the Italian crisis is no longer just economic, if it ever “just” was. It is emblematic of a culture war that is pitting anti-immigration populist movements against “elites” they believe are hostile to their interests. As happened elsewhere, unemployed and working-class people are losing faith in the system. We see this most recently in the violent gas-tax protests in France.

This protest movement has an altogether different feel when you pay close attention. It is not just about higher fuel taxes. It is about almost half the country being angry at the educated city-dwelling elite while the brunt of increased taxes falls on an increasingly burdened rural middle class. The French government now consumes 46.2% of GDP, making it the most-taxed OECD nation. Even a slight tax increase affects the working class disproportionately. And when it increases taxes on something like diesel fuel, which is critical in rural areas, it is particularly hard.

In Europe and around the world, we see this pushback against what is seen as an elite group at the top (the “Protected”) which pays no attention to the problems of their less successful “Unprotected” brethren. And those brethren are demanding attention.

This “morality play” is spreading through Europe. We now see German political patriarch Wolfgang Schauble backing a candidate to replace Merkel as head of the CDU (Christian Democratic Union), who is openly courting the same voters that have left their party and gone to the anti-immigration and populist Alternative for Germany (AfD). That means a conservative push for Germany and a more populist approach for mainstream parties.

The common thread running through these events is the idea of a united Europe. This idea was a driving force in the foundation of the European Union and is common in the establishment and/or “elite.” Up until a few years ago, the idea was popular across the political spectrum but support has weakened as economic times changed. It was never particularly feasible, but the effort made sense for a continent so damaged by centuries of repeated wars. The problem is that the EU can’t achieve its goals unless it gets stronger and much of the public has had its fill of centralization. I don’t know how they can solve this. Brexit, if it happens, may turn out to have been the test case for a full dissolution.

How that will unfold is hard to predict. For now, there are more immediate problems. Victor Hill thinks “a disorderly Brexit will be the spark that sets the Eurozone tinderbox aflame in the first half of 2019.” The tinderbox is already full in Italy and France. It won’t take much heat for that kettle to boil over.

But that’s not all.

Trade Threats

Speaking of unity, last weekend’s Buenos Aires G20 summit was a chance for world leaders to forge common ground on important global issues. That’s not exactly what happened but President Trump’s trade discussion with Chinese president Xi Jinping looked initially like a bright spot. They agreed to stop making things worse for a few months, at least. Markets were more skeptical after digesting the news—rightly so, at least from my standpoint.

As I’ve said, there are real issues with China on intellectual property and more. It is not unreasonable to ask for an open and fair playing field. China is no longer an emerging market nation. It has emerged, at least the eastern half. Beijing should play by the same rules as the rest of the developed world. But getting agreement with China is going to be a hard slog.

One encouraging but little-reported G20 event: US Secretary of State Mike Pompeo and Treasury Secretary Steven Mnuchin gathered their peers from the smaller G7 group for an unscheduled dinner. According to Ian Bremmer, they made significant progress on working together to solve the China issues. This should be positive if it continues.

Meanwhile, however, Louis Gave explains why problems with China may be bad news for Europe at a time when Europe doesn’t need any more challenges (bold is mine).

It is no secret that Trump is surrounded by men who want to “take China down,” who have argued at length that China is a house of cards built on unsustainable credit, and that all the US needs to do is give a gentle nudge for the whole edifice to come crashing down. So far, this talk of China’s vulnerability has proved way off-target. For all of the dire predictions of an imminent debt crisis and financial meltdown, China is still standing very much upright.

So, if Trump wants a win, where should he look? If a long cold war of attrition with China doesn’t look promising, perhaps bashing Europe—specifically Europe’s auto industry and lack of defense spending—could prove more attractive, especially as Europe is now politically rudderless and economically slowing. My bet would be that in the coming weeks, Trump stops speaking about China, and instead starts bashing Europe. And doubtless his favorite targets will be France and Germany, perhaps as payback for the slights he endured at last month’s commemoration of the World War I armistice. If nothing else, Trump has shown that he is a firm believer in the old adage that revenge is a dish best served cold.

I pay attention when Louis speaks. He often sees events that happen “around the curve.” His premise is simple: The automotive industry drives the German economy. Germany, in turn, drives the European economy. So if Trump decides to follow through on the car tariffs he’s threatened, it could be a serious blow. German auto executives met with him in Washington this week but the threat is still alive.

Oh, and one more thing. Deutsche Bank, Germany’s financial crown jewel, seems to be in deep trouble. Its shares, which never recovered from the 2007–2008 ugliness, dropped to all-time lows this week after German police raided the bank’s offices in a money-laundering probe. We don’t know exactly what the fire is but there sure is a lot of smoke. Other European banks are not exactly thriving but DB seems to be in particular trouble.

It is hard for us in the US to realize how important European banks are. European businesses, particularly small ones, get almost all their financing from banks. When Italian banks have trouble funding their bonds, that means Italian businesses will suffer.

So add all this up. We could see Europe faced with monetary tightening, hard Brexit, an Italian breakdown, popular unrest not just in France but all over, a trade war and a German/Italian bank crisis all at the same time. Again, this is not a far-off possibility. It could all be happening in the next three or four months.

If some combination of these crises develops into a perfect storm, the pain won’t stay in Europe. US, Canadian, Latin American, and Asian companies that do business with Europe will lose sales and have to lay off workers. Lenders everywhere who own Euro debt will face losses. Highly leveraged derivatives could blow up, forcing bailouts and currency interventions. We don’t know where it would lead but certainly nowhere good.

And it will end up being played out in the equity markets all over the world. Stay tuned…

The markets have been quite volatile for the past few weeks. My preferred ETF trading strategy, called Mauldin Smart Core, has performed well in this environment. Full disclosure, I have recently closed my own personal investment advisory firm down and moved my registration to my longtime friend Steve Blumenthal of CMG. As a personal business strategy, he has all the infrastructure and team to support me, and it really does allow me to spend more time researching and reading and writing. I am co-portfolio manager for the Mauldin Smart Core strategies which is available as a mutual fund or managed accounts.

We have done a report called “Investing During the Great Reset,” which explains our strategy and rationale. If nothing else, it will show you how I want to deal with the risk of a coming potential bear market and give you ideas for doing it yourself or in your own firm. Of course, I hope that some of you will become clients. But I am perfectly willing to help you whether you do or not. I want as many people as possible to get from where we are today to the other side of The Great Reset.

Puerto Rico, Cleveland, and San Francisco

As you read this letter, Shane and I will be in Puerto Rico. Then we go to Cleveland in the middle of the month to visit with my doctor, Mike Roizen and go through the Cleveland Clinic’s Wellness Program for a few days for checkups and in my case, perhaps a few tune-ups. Then in early January (8–9) Pat Cox and I are tentatively scheduled to go to San Francisco to attend a Biotech Showcase and then a program sponsored by Jim Mellon at Juvenescence. We will talk with a number of emerging biotech companies, especially those focused on anti-aging. It will be a fascinating two days.

The home team at Mauldin Economics, especially Shannon Staton and I, are focused on the 2019 Strategic Investment Conference. It is coming together nicely and promises to be our best conference ever. You want to save the dates of May 13–16 to come to Dallas at the Omni Hotel. Be prepared to have your mind expanded. It will be one powerhouse presentation after another.

Since the beginning, my focus has always been to have speakers I would want to hear for myself. I’m as much an attendee as anyone else. You can’t get it all absorbed in just one sitting, which is why I spend weeks afterward reviewing the audio and video. SIC really has become the most important macroeconomic conference of the year, anywhere. When you see who is speaking, you’ll want to be there.

And with that, I will hit the send button. On a personal note, I have never been as busy with more to-do items on my list as right now. I’m looking forward to tackling that list and perhaps having a little time to reflect over the holidays.

Have a great week and break up your routine. Do something or see something new! It will help keep you young.

Your breaking up his routine analyst,

John Mauldin
Chairman, Mauldin Economics