Our Nuts Are in Danger

John Mauldin

 


Life would be so much easier if we didn’t have to worry about our financial futures. Though I suppose we don’t have to worry. Animals don’t. Squirrels instinctively store away nuts and thus live through winter without much thought.

We humans have retirement winters, and we’re more sophisticated than squirrels. We generally outsource the job of managing our nuts/money to professionals. All well and good if we save enough and if the professionals do their jobs right. As we saw last week, the elected squirrels who run Social Security haven’t evolved to face changing conditions. Our Social Security nuts are in danger.

But the problem is even bigger. Today I want to continue this theme using some recent corporate news as our springboard. Economic changes have made future planning increasingly difficult for government retirement systems, private pension plans, and individual investors. How do you generate a reliable income stream for an uncertain but potentially lengthy lifespan in a world where interest rates are barely above zero and possibly below it?

The easy answer is “save more,” but that strategy has limits. We all have current expenses. Yes, we can live simpler lives, but we can’t save 100% of our income. Yet that’s what it will take in some scenarios.  

If you’re starting to envy the squirrels, you aren’t the only one.

Big Gaps

Remember “defined benefit” pensions? That is the kind of plan in which the employer guarantees the worker a set monthly benefit for life. They are increasingly scarce except for small closely held corporations.

My US accountant has set up well over 1,000 defined benefit plans, including two for me. His primary customers are dentists. The same rules apply for small closely held businesses as for large corporations. These plans can be great tools for independent professionals and small business owners.

But if you have thousands of employees, DB plans are expensive and risky.

The company is legally obligated to pay the benefits at whatever the cost turns out to be, which is hard to predict. The advantage is you can use some hopeful accounting to set aside less cash now and deal with the benefit problems later. The problem is “later” comes faster than you would like, and procrastination can be a bitch.

At some point, the risks outweigh the benefits, which is why few large companies have open DB plans these days. But the plans are often still in effect for older workers, and the amounts are large and frequently underfunded. Companies are slowly dealing with the problem.

And that brings us to the lesson for today. On October 7, General Electric (GE) announced several changes to its defined benefit pension plans. Among them:

  • Some 20,000 current employees who still have a legacy defined benefit plan will see their benefits frozen as of January 2021. After then, they will accrue no further benefits and make no more contributions. The company will instead offer them matching payments in its 401(k) plan.

  • About 100,000 former GE employees who earned benefits but haven’t yet started receiving them will be offered a one-time, lump sum payment instead. This presents employees with a very interesting proposition. Almost exactly like a Nash equilibrium. More below…

The first part of the announcement is growing standard. Employers prefer 401(k) plans because they transfer investment risk to the employees. Other than the matching payments—which end when the worker quits or retires—the company has no future obligations.

The second part is more interesting, and that’s where I want to focus.

Suppose you are one of the ex-GE workers (and I’ll bet I have some readers in that group) who earned benefits. As of now, GE has promised to give you some monthly payment when you retire. Say it’s $1,000 a month. What is the present value of that promised income stream? It depends on your life expectancy, inflation, interest rates and other factors. You can calculate it, though. Say it is $200,000.

Is GE offering to write you a generous check for $200,000? No. We know this because GE’s press release says:

Company funds will not be used to make the lump sum distributions. All distributions will be made from existing pension plan assets in the GE Pension Trust. The company does not expect the plan's funded status to decrease as a result of this offer. At year-end 2018, the plan's funded ratio was 80 percent (GAAP).
 

So GE is not offering to give away its own money, or to take it from other workers. It is simply offering ex-employees their own benefits earlier than planned. But under what assumptions? And how much? The press release didn’t say.

If that’s you, should you take the offer? It’s not an easy call. First, you are making a bet on the viability of General Electric. In September 2000, GE stock traded at $58+ per share. As I write this it is $8.45. The board has slashed dividends and the dividend yield is now only 0.47%.

As of April, GE had $92 billion in liabilities in its pension plan, on assets a little below $70 billion. Commendably, the company is “pre-funding” $4–5 billion into the DB plan. As we will see, however, this is chump change to the actual obligations.

In various ways, the choice GE pensioners face is one many of us will have to make in the coming years. GE isn’t the only company in this position.

You’re still affected even if you don’t have a DB plan. Lots of people are reaching retirement age to find they only have 80% (and often less) of their “fully funded” amount. They have to fill the gap somehow. Most often, that means reducing expenses or working longer, if you’re able.

Rising Pressure

When GE says its plan is 80% funded under GAAP, it necessarily makes an assumption about the plan’s future investment returns. Here’s what they say in the 2018 annual report.
 


Source: GE

 
I dug around and found the “expected rate of return” was 8.50% as recently as 2009, when they dropped it to 8.00%, then 7.50% in 2014, to now 6.75%.

So over a decade they went from staggeringly unrealistic down to seriously unrealistic. They still assume that every dollar in their pension fund will grow to almost $4 in 20 years.

That means GE’s offered amounts will probably be too low, because they’ll base their offers on that expected return. GE hires lots of engineers and other number-oriented people who will see this. Nevertheless, I doubt GE will offer more because doing so would compromise their entire corporate viability, as we’ll see in a minute.

In any case, more companies will do such things and affected workers won’t be happy. We’ll see the same in state and local government pensions, which are often even more underfunded and have even more absurd investment projections. These are becoming untenable and lump sum offers like GE’s help highlight that fact.

This, in turn, will raise pressure on plan sponsors to reduce those projections, which will increase the amounts they must contribute to their plans, which (for the corporate ones) will reduce earnings.

See where this is going?

We are right now entering an earnings season that may not be disastrous but doesn’t look too impressive, either. It is getting harder to justify the valuations investors place on many stocks.

If you take out the buyback activity from companies themselves, and the index funds and ETFs that buy indiscriminately as yield-starved investors give them more cash, who is really buying stocks in any major way?

And what happens when they stop buying?

If you’re holding stocks, you better have an answer.

Victoriously Breaking Even

In last week’s Social Security discussion, I noted a fatal flaw in ideas to convert the system into private accounts. Two flaws, actually: 1) Most people don’t know how to invest successfully and 2) now is a terrible time to learn.

(Note, that probably doesn’t include you. You’re reading this letter so you have at least some basic economic and financial literacy. But you represent maybe 5% of the population.)

I dislike saying “it’s different this time” but it really is. Today’s conventional investment wisdom came from an era when there was this thing called “risk-free rate of return.” Everyone could count on earning something, though perhaps not much, without risking it all. Inflation might erode your principal over time but you could at least see it coming.

Now there is no such option. Banks and Treasury securities pay zero, almost zero, or slightly below zero in some places. Don’t like it? Start adding risk. That is your only choice now.

We are in a world where simply breaking even counts as a victory… and that is a serious problem if you need to fund a long retirement.

My friend John Hussman’s September letter, Going Nowhere in an Interesting Way, is a fascinating and important read on this topic. (Over My Shoulder members can read my annotated version here.)

Hussman’s main point: It’s folly to assume stocks will continue performing the way they have in recent years. First, the last two decades haven’t been so great. The S&P 500 total return since 2000 was just 5.4% annually and getting there took the most extreme valuations in US history.

He calculates that assuming 4% nominal growth in economic fundamentals and a historically normal valuation 20 years from now, average annual gain for the next two decades will be -1.0%. Yes, that’s a negative sign.

Ok, that’s just stocks, you may say. I’m a bond guy. Fair enough. So maybe instead of -1.0% you’ll earn a positive 2%. That still makes real growth difficult.

Investment math is actually pretty simple if your return assumption is 0%. Calculate how much you need to retire, and save that much. Hussman does it more elegantly. 

Suppose an investor has accumulated a lump-sum of savings, and wants to finance a long-term stream of real, inflation-adjusted spending. How large must the initial “endowment” be, as a multiple of annual spending, to finance those future outlays, assuming that it’s passively invested in a conventional portfolio mix (60% S&P 500, 30% Treasury bonds, 10% Treasury bills)?

As a convention, we assume a 36-year horizon, representing a 64-year-old investor hoping to fund spending over a potential 100-year lifespan. There’s nothing special about that horizon, and we obtain similar results using any horizon beyond about two decades, because long-dated distributions have very little impact on the total present value.

The chart below presents our estimate of the Endowment to Spending Multiple going back to 1928. The equity market return estimates are based on the Margin-Adjusted P/E before 1950, and the ratio of nonfinancial market capitalization to corporate gross value-added after 1950. The bond market return estimates use the yield to maturity on long-term Treasury bonds at varying horizons.


 
You’ll notice that the current E/S Multiple is over 31, which basically says that if you insist on passively investing a lump-sum in a conventional portfolio mix in order to fund your retirement, you’d better already have nearly all the dollars you hope to spend, because the prospects for significant long-term capital growth from present valuations are dismal. Contrast this with 2009, when the estimated E/S multiple was 18, or with 1982, when the E/S multiple fell to a record low of 9.

 
A pretty dismal outlook: If you want to fund an income stream, your lump sum should be 31X the annual income you seek.

But Wait, There’s More

At the risk of sounding like Ron Popeil of Ronco fame (But Wait, There’s More!), whom readers of a certain age will remember nostalgically, there is more. Sadly, you can’t buy it on late-night television.

The reality is simple. Valuations are high and returns based on historical numbers do not suggest anything close to the 6.75% GE expects, let alone the ridiculous numbers public pension plans expect.

I asked mi buen amigo (I’m trying to learn Spanish) Ed Easterling of Crestmont Research to send me his latest numbers. Based on historical numbers using the Shiller model (other models would be slightly worse) it looks like this. We are currently in the top decile.


 
Get that? Historical returns based on 110-year models suggest future returns will be anywhere from -1.8% to +3.6%, from where we are today.

Note that 3.6% compound is the top end past historical performance. Also note that I have continually cited academic arguments that the debt situation that we are in today, both as a government and privately, preclude the potential for above-historical-average growth, suggesting lower growth is more likely.

Then quickly, let’s look at the seven-year projected returns from GMO:
 


Source: GMO

 
Note that these are real returns and not nominal returns. So GMO is actually projecting seven-year returns somewhere around -1.5%. Still quite ugly.

What happens when we have a recession? Remember those ugly things? Pension plan assets suffer a major hit and unfunded liabilities soar! Do you really think central banks can forestall recessions forever? When they are already at the zero bound? Look at the historical frequency, again from Crestmont Research.


Source: Crestmont Research

 
We are in the first decade to have no recession in, well, forever. Think we can dodge that bullet in the 2020s? Gods forbid, what happens if we have two? The stock market goes sideways for a really long time. Kind of like the 2000s. Then what does GE’s 6.75% return assumption look like? Especially in the zero-bound world of bonds? The answer is “burnt toast.”

Let’s generously assume a 2%+ dividend yield from where we are today. But the chance of a multiple expansion is damn near zero. The Shiller multiple is already 28.6%. (Yes, I get that you can spin P/E multiples numerous ways, but Nobel Laureate Bob Shiller does as well as anybody to reduce the spin.)

GE has $92 billion in pension liabilities offset by roughly $70 billion in assets, plus the roughly $5 billion they’re going to “pre-fund.” But that is based on 6.75% annual return. Which roughly assumes that in 20 years one dollar will almost quadruple. What if you assume a 3.5% return? Then you are roughly looking at $2, which would mean the pension plan is underfunded by over $100 billion—and that’s being generous. GE’s current market cap is less than $75 billion, meaning that technically the pension plan owns General Electric.

This is why GE and other corporations, not to mention state and local pension plans, can’t adopt realistic return assumptions. They would have to start considering bankruptcy.

If GE were to assume 3.5% to 4% future returns, which might still be aggressive in a zero-interest-rate world, they would have to immediately book pension debt that might be larger than their market cap.

GE chair and CEO Larry Culp only took over in October 2018. We have mutual friends who have nothing but extraordinarily good things to say about him. He is clearly trying to both do the right thing for employees and clean up the balance sheet. He was dealt a very ugly hand before he even got in the game.

GE needs an additional $5 billion per year minimum just to stave off the pension demon. That won’t make shareholders happy, but Culp is now in the business of survival, not happiness.

That is why GE wants to buy out its defined benefit plan beneficiaries. Right now, the company is on the wrong side of math. It doesn’t have anything like Hussman’s 31X the benefits it is obligated to pay. Nor do many other plans, both public and private. Nor does Social Security.

To be clear, I think GE will survive. Its businesses generate good revenue and it owns valuable assets. The company can muddle through by gradually bringing down the expected returns and buying out as many DB beneficiaries as possible. But it won’t be fun.

Pension promises are really debt by another name. The numbers are staggering even when you understate them. We never see honest accounting on this because it would make too many heads melt.

And again, a recession is probably coming in the next year or two. The Treasury yield curve has been inverted for three months now and Campbell Harvey, who pioneered that indicator, says it is “flashing code red.” This will further aggravate the pension problem.

If I am a GE employee who is offered a buyout? I might seriously consider taking it because I could then define my own risk and, with my smaller amount, take advantage of investments unavailable to a $75 billion plan.

We are like a football team facing a very tough schedule. Winning will take a solid team working together. Going it alone will be difficult in the 2020s.


Announcing “7 Deadly Economic Sins” Week

Regular readers know my “Things to Worry About” list is pretty long: unsustainable national debt, the fact that nearly 50% of all corporate bonds are teetering on the edge of the BBB cliff, power struggles between competing nations, the insanity of Modern Monetary Theory, a growing partisan split in the US and Europe, an exceedingly hostile US-China relationship, and the threat of negative interest rates.

I think all of these warrant taking a closer look, so October 14–20 will be “7 Deadly Economic Sins” Week at Mauldin Economics.

Seven of my closest friends and I will sit down for thoughtful conversations with our own Jonathan Roth. You probably already know them: Louis Gave, Grant Williams, Peter Boockvar, Lacy Hunt, George Friedman, William White, and Samuel Rines.

They’ll all give you their take on the root causes of the coming global economic crisis.

On Monday, we will start the week with me talking about the deadly economic sin of Lust. Please watch for my emails throughout the week so you won’t miss this special treat.

New York and Butterflies

Other than being in New York October 21 and thereabouts, I’m trying to stay close to home. And when I say home, I can now say that I have finally closed on my home here in Dorado Beach East, Puerto Rico. Getting a loan here is kind of like a Spanish soap opera unless you are willing to pay the going rates. I am paying close to 6%, a far cry from the 2.375% mortgage I had in Dallas. Seriously, there is an opportunity for a jumbo mortgage lender in Puerto Rico. Under 5%, you can sweep the market. Refi’s will line up. On solid loans.

The eye doctor says I am okay and so back to the gym tomorrow. Patrick Cox and Terry Coxon are coming this weekend to discuss funds focused on biotechnology investments. It will be a fascinating weekend of speculation.

And finally, one picture from the butterfly sanctuary my wife Shane has literally created in our home. Seriously, she is raising butterflies, mostly Monarch but also a few other species. It is fascinating to watch them go from eggs to caterpillars to cocoons to butterflies. Here is one of her babies…


 
And with that glorious image I will hit the send button. You have a great week while we all contemplate a lower-return future. And figure out how we beat the average.

Your creating a team to control our future analyst,



John Mauldin
Co-Founder, Mauldin Economics

Here’s one way to fix Brexit’s Irish border problem

The government has already conceded that some rules for Northern Ireland will be set by the EU

Martin Sandbu




Amid the fallout from the UK Supreme Court’s landmark decision on the suspension of parliament, it is easy to forget that Boris Johnson’s first significant engagement with Brexit as prime minister was in a letter to Donald Tusk, president of the European Council.

In it, he reneged on the UK’s December 2017 commitment to keep Northern Ireland aligned with the EU regulations and customs rules until other ways to avoid border infrastructure and controls could be agreed. This was formalised as the “backstop” for Northern Ireland only, later extended to an all-UK version at Britain’s behest.

The commitment, undertaken in the so-called EU-UK Joint Report, had been the EU’s precondition for entering talks on long-term trade relations. By reneging, the UK went back on something the EU took in good faith. From Mr Johnson, such behaviour is hardly shocking, even if it should be. More importantly, it is counterproductive. When the UK has asked to sort out border issues after Brexit, Irish leaders are at pains to emphasise that they cannot replace a legal guarantee with a promise. Given what happened to the earlier promise, who can blame them?

While not couched in these terms, the EU now insists on recommitting the UK government to the Joint Report. That is how we should read the overture by Jean-Claude Juncker, the president of the European Commission, to alternatives to the backstop if “all” its objectives can be met by other means than aligning with EU rules.

No such means have been identified. This reality is the same as that faced by Theresa May. So Mr Johnson’s premiership started by reverting to his predecessor’s late-2016 position only to turn into a fast-forward replay of her evolution towards a softer Brexit. The question is whether he will move far and fast enough towards EU demands in the limited time left and be able to sell the concessions this entails better than she did.

By accepting the notion of a single regulatory area for agrifood, Mr Johnson and his Democratic Unionist partners have already conceded that some rules for Northern Ireland will be set by the EU. That makes extending regulatory alignment to industrial goods a simple question of scope. There is no deep reason why Britain should refuse to accept for industrial goods what it accepts for agrifood — regulatory checks on boats crossing the Irish Sea — and the prime minister now hints he may do just that.

There is a problem of democracy, in that Northern Ireland will be governed by rules decided elsewhere. But this is a problem the EU is willing to ameliorate. The Joint Report explicitly provided for an economic border in the Irish Sea if Northern Ireland’s elected institutions agree. Mrs May’s withdrawal agreement includes a Joint Committee to oversee the backstop, on which those institutions could have representatives. And models exist: non-EU countries in the single market, such as Norway, have a system for adopting EU rules that preserves formal sovereignty while protecting the single market’s integrity.

Mr Johnson was therefore right to spot a “landing zone”. In substance, it looks much like where Mrs May ended up landing. (Northern Ireland will also have to stay in the EU’s value-added tax rules, but this is so technical as to escape politics.) The thorniest problem remains: customs.

Mr Johnson, like Mrs May, will accept regulatory differentiation but insists on one trade regime for the whole UK. For her, this meant an all-UK tie-in with the EU customs union. For him, it means Northern Ireland out of it. The customs border this entails is why customs is shaping up to be the one outstanding obstacle to a deal. Even accepting alignment on all other things would create two borders rather than just one.

The UK will not convince anyone that technology can substitute for border controls. But another rejected alternative may be worth revisiting. The “customs partnership” where the UK would have its own trade deals but enforce EU tariffs on imports destined for the single market was only ridiculed because it was unrealistic to identify which goods were headed for the EU when entering the UK customs area. But it is not quite as unrealistic to identify which goods cross into Northern Ireland and end up there or return to Great Britain.

The UK could offer to enforce EU customs rules on all goods crossing the Irish Sea, but where its own future tariffs were lower, it would rebate the difference for Northern Irish consumers — on the model of VAT refunds for travellers — or for re-exports back to Great Britain. Such tariff rebates could be managed via the tax system for individuals, so only Northern Irish residents would benefit, and via VAT tracking for re-exports. Since named individuals and firms would have to claim the rebate, fraud attempts could be detected.

While convoluted, such a system is not unworkable, and it would tick a number of important boxes. It would secure the correct tariff revenue for the EU and enforce its commercial policy. It would allow the government to promise — honestly — that Northern Ireland would share the benefits of trade deals. It would keep the Irish land border open.

The question for the UK government is not whether to concede but how to defend its concessions. A politically sellable customs solution is at the crux of whether it delivers a broken Brexit or an orderly one.

Explosive Silver Prices Will Be Mind Boggling

by: Bob Kirtley


Summary
 
- Gold has been ignored for 6 years and silver has been totally forgotten about by the majority of the investment community.

- This chart depicts the sudden rise in silver prices from around $14.50/oz to a high of $19.50/oz in just 4 months.

- Silver has been moving faster than gold as the gold/silver ratio shows that it now stands at a reduced level of 83.

All in all, the scene is set for an exodus from some of the large investment classes and into the precious metals sector, particularly silver.


Introduction

Gold has been ignored for 6 years and silver has been totally forgotten about by the majority of the investment community. This was evident when the gold/silver ratio rose to almost record levels at 95 which was reached in July 2019. The situation has started to change over the last few months as we have seen both gold and silver prices spring to life and increase in value. In particular, silver has been moving faster than gold as the gold/silver ratio shows that it now stands at a reduced level of 83.
 
This chart depicts the sudden rise in silver prices from around $14.50/oz to a high of $19.50/Oz in just 4 months. We can also glean that during that period of rapid movement, silver formed a number of higher lows which is usually a positive indication of a strong advance.
 
 
 
 
Gold/Silver Ratio chart
 
This chart shows that the gold/silver ratio rose to 95 when silver was out of favor and has subsequently reversed as silver prices gained some traction. Over the last 20 years, the average has been around 60 for this ratio so there is still room for silver to move to higher ground before it hits that average. There are some who are calling for the ratio to drop to around the 15 level.

These predictions generate vastly different prices for silver as per the following:
 
Gold at $1,500/Oz, the ratio at 83, Silver priced at $18.00/Oz. Gold at $1,500/Oz, the ratio at 60, Silver priced at $25.00/Oz. Gold at $1,500/Oz, the ratio at 15, Silver priced at $100.00/Oz.
 
The above calculations assume that gold will not increase in price, but we are firmly of the opinion that the new bull market in precious metals has started and will surpass previous all-time highs for both metals. If the price of gold continues to gain momentum, then the estimates shown for silver will be superseded by a considerable amount.
 
 
 
 
Reasons Behind This Move
 
There are a myriad of reasons that will drive this bull market, the two main reasons in our very humble opinion are the demise of fiat currencies and an economic recession which is long overdue.
 
A quick look at the currencies shows us that the central banks around the world are driving interest rates down to zero and in some cases negative territory, so there is no longer a return for savers who keep cash in a bank. They will need to do something else or sit and watch as their hard-earned wealth shrinks before their eyes.
 
We know that the European Central Bank has just re-introduced Quantitative Easing and we suspect it won’t be very long before other central banks follow suit. The constant printing of money only serves to weaken a currency and reduce its purchasing power.
 
The current economic recovery has been one of the longest in history and now looks to be exhausted as the S&P 500 struggles to retake the 3,000 level. The pullback could be severe as investors will move their funds out of the general markets in order to preserve their gains and avoid losses. Again, they too will be looking for a new home for their investment funds.

Other assets such as property have been in a bubble for some time in many parts of the world, and should that bubble burst, investors will look to liquidate their positions.
 
Conclusion
 
All in all, the scene is set for an exodus from some of the large investment classes as mentioned above and the precious metals sector has bottomed and is now heading for higher ground. The higher gold and silver go, the more airtime they will receive, and more and more investors will take an interest followed by taking an active part in this sector of the market.
 
Furthermore, it must be remembered that gold and silver and their associated stocks are tiny compared to the stock or bond markets, so even a small reallocation of funds will make a big impact on the demand side for these assets.
 
Silver prices will accelerate faster than gold prices so please give it some serious consideration along with the good quality silver producers that are due to experience a ballistic price rise before this bull market reaches its conclusión.

Free Exchange

Repo-market ructions were a reminder of the financial crisis

Soon enough post-crisis reforms will face serious tests

 

FOR ANYONE who lived through the global financial crisis, trouble in the market for repurchase agreements, or repos, induces a cold sweat. During the week of September 16th the repo market—the epicentre of the crisis 12 years ago—ran short of liquidity, forcing the Federal Reserve to intervene suddenly by injecting funds.

By the following week fears of a reprise of the global crisis were easing, though banks remained eager recipients of Fed liquidity. But the episode was a reminder that financial dangers lurk. At some point one will give post-crisis reforms a real-world stress test. It is unclear whether they are up to the challenge.

The financial crisis combined several storms into a single maelstrom. It was part debt-fuelled asset boom. A long run of rising home prices in America led to complacency about the risks of mortgage lending. Ever more recklessness fuelled the upward march of prices, until the mania could no longer be sustained. Borrowers began to default, saddling lenders with losses and creating a widening gyre of insolvency. Painful enough on its own, America’s housing bust became truly explosive thanks to an old-fashioned bank run.

Banks fund themselves on a short-term basis via demand deposits, but also on money markets, such as that for repos. Many bank assets, by contrast, are illiquid and long-term, such as loans to firms and homebuyers. This mismatch leaves banks vulnerable. During the Great Depression, many failed when nervous depositors demanded their cash all at once.

Though government-provided deposit insurance now protects against this hazard, it did not extend to money markets. In 2008, then, questions about the health of banks and their collateral triggered a flight from those markets, leaving healthy and unhealthy banks alike unable to roll over short-term loans and at risk of imminent collapse.

These twin woes were amplified by the global financial system’s interconnectedness. Cross-border capital flows soared in the years before the crisis, from 5% of global GDP in 1990 to 20% in 2007, spreading financial excess and outstripping regulators’ capacity for oversight.

Money from around the world poured into America’s mortgage market, and the resulting pain was correspondingly global. The Fed’s first crisis intervention, in August 2007, was in response to money-market turmoil prompted by financial difficulties at funds run by a French bank, BNP Paribas.

Chastened by the near-death experience, governments introduced regular stress-testing and made banks adopt “living wills”: plans to wind themselves down in the event of failure without endangering the system as a whole. Central banks added credit-risk indicators to their policy dashboards.

Regulators increased banks’ capital and liquidity requirements: bigger buffers against losses and liquidity droughts, respectively. In advanced economies bank balance-sheets look stronger than in 2007, and no obvious debt-fuelled bubbles have inflated.

Yet all that is less reassuring than might be hoped. Post-crisis, both governments and markets have proved surprisingly tolerant of risky borrowing. Despite household deleveraging, companies have taken on enough debt to keep private borrowing high; at 150% of GDP in America, for instance, roughly the level of 2004.

In America the market for syndicated business loans has boomed, to over $1trn in 2018, and loan standards have fallen. Many loans are packaged into debt securities, much as dodgy mortgages were before the crisis. Regulators have declined to intervene—remarkably, considering how recent was the crisis.

Just as the threat of bank runs migrated from depositors to money markets, so systemic risk may now be building up in non-bank institutions. Investment funds, pension managers and insurance companies have been eager buyers of securitised bank loans. As recently noted by Brad Setser of the Council on Foreign Relations, an American think-tank, some have begun to take on an ominously bank-like maturity mismatch.

Insurers in some countries, including Japan and Korea, have been hoovering up hundreds of billions of dollars of foreign bonds, hedging the exchange-rate risk on a rolling, short-term basis. If, in a crisis, these funds cannot renew their hedges, they could be exposed to significant losses. The vulnerabilities of supposedly staid firms may be an underappreciated source of risk for big banks.

These obscure dangers arise because finance remains extraordinarily globalised. Outstanding cross-border financial claims, though lower than just before the crisis, remain well above the historical norm. Money continues to slosh around the global economy, seeping into cracks beyond the reach or outside the view of national regulators. It is impossible to be sure that unanticipated turmoil in one corner of the financial system cannot spiral into something catastrophic.

The gyre next time

Troubles in repo markets illustrate the threat posed by this opacity. Market-watchers blamed the cash crunch on firms’ need to pay corporate-tax bills at the same time as sucking up more new government debt than usual. But banks were aware of these factors well ahead of time. Other, as yet poorly understood, forces seemed to have provided the nudge that tipped repo markets into disarray.

No obvious disaster looms. But the world did not appreciate the peril it faced in 2007 until too late. There are ways to keep financial risk in check. The Great Depression convinced many people that financial capitalism was inherently dangerous, but in the 40 years that followed, crises were infrequent—a testament to draconian financial regulation and capital controls.

Since the deregulation of the 1970s and 1980s, crises have been depressingly common. Just how far back the pendulum has swung will be clear only decades from now, when it becomes possible to look back and count the consequent misfortunes. Rattled once more by repo gyrations, it is tempting to say not far enough.

Over the line

America signs a limited trade agreement with Japan

The deal shows how hard it is for the Trump administration to rewrite the rules of world trade




PRESIDENT DONALD TRUMP teased trade-watchers on September 25th when he reannounced a deal with Japan (just weeks after announcing an agreement in principle). He promised it would mean “really big dollars for our farmers and for our ranchers”.

A White House press release boasted about the extra access American exporters of beef, pork and cheese would get to the Japanese market.

Robert Lighthizer, the United States Trade Representative, told journalists that American tariff reductions would arrive by January 1st. But despite all the fanfare, the text of the deal remained unpublished.

There had been hopes that Mr Trump might sign a mini-deal with India, too, during his meeting with the country’s prime minister, Narendra Modi, on September 24th. American companies complain that India’s price controls on heart stents and knee implants force them to sell at below cost price.

The hope was that, in return for a package that solved that problem, India might be reinstated as a member of America’s Generalised System of Preferences, which offers lower tariffs on some products. But negotiators failed to resolve their differences in time.

The mismatch between the demand for photo opportunities and the supply of worked-out trade deals explains both anticlimaxes. Such agreements are complex legal documents, and the language needs to be clear enough that neither side can squeeze out more concessions on the sly.

This is trickier when neither trusts the other. The deal with Japan was as difficult as any other, even though the negotiators had relatively recently sealed the Trans-Pacific Partnership (TPP), an agreement including America and Japan negotiated by the Obama administration, only to be rejected by Mr Trump.

Despite the lack of detail, one thing is clear: the deal will be narrow. Apart from some rules on digital trade, it seems to be focused on tariff barriers. It omits cars and car parts, even though these account for around two-fifths of Japanese goods exports to America. This has drawn criticism. Myron Brilliant of the US Chamber of Commerce, a lobby group, described the agreement as “not enough”.

The narrow scope is partly because the Trump administration wants to avoid having to seek full congressional approval. (American trade law allows small tariff concessions to be made without it.)

But it raises questions about whether the agreement complies with the rules of the World Trade Organisation, which say deals must include “substantially all the trade” if they are to withstand legal challenge.

The WTO does permit smaller interim agreements—and, mirabile dictu, that is how the Trump administration describes this one. The leaders’ joint statement said that within four months of the mini-deal coming into force, the two countries hope to finish consultations and “thereafter” start negotiating a deal that would address issues including barriers to trade in services and investment.

Some are sceptical. Wendy Cutler, a former negotiator on the TPP, fears “negotiating fatigue”.

Even with domestic pressure from American producers to whom the interim deal offered nothing, “it’s difficult to see how the second stage would be concluded on an expedited basis,” she says.

Further doubts stem from the leverage that has been granted to Japanese negotiators. They were brought to the table after America walked away from the TPP by the threat of tariffs on cars and car parts.

Now they have concessions they can roll back if the Trump administration enacts those.

Threats have worked once. But they could be less use in securing the big concessions needed if this supposed staging post is not to become the final destination.