Weapons of Economic Misdirection
By John Mauldin
“Measurement theory shows that strong assumptions are required for certain statistics to provide meaningful information about reality.
Measurement theory encourages people to think about the meaning of their data. It encourages critical assessment of the assumptions behind the analysis.
“In ‘pure’ science, we can form a better, more coherent, and objective picture of the world, based on the information measurement provides. The information allows us to create models of (parts of) the world and formulate laws and theorems. We must then determine (again) by measuring whether these models, hypotheses, theorems, and laws are a valid representation of the world.”
– Gauri Shankar Shrestha
“In science, the term observer effect refers to changes that the act of observation will make on a phenomenon being observed. This is often the result of instruments that, by necessity, alter the state of what they measure in some manner.
“It was, perhaps, the most unusual episode in the long running duel between the two giants of twentieth century economic thought. During World War Two, John Maynard Keynes and Friedrich Hayek spent all night together, alone, on the roof of the chapel of King’s College, Cambridge. Their task was to gaze at the skies and watch for German bombers aiming to pour incendiary bombs upon the picturesque small cities of England….
“Night after night the faculty and students of King’s, armed with shovels, took it in turns to man the roof of the ornate Gothic chapel, whose foundation stone was laid by Henry VI in 1441. The fire watchmen of St. Paul’s Cathedral in London had discovered that there was no recourse against an exploding bomb, but if an incendiary could be tipped over the edge of the parapet before it set fire to the roof, damage could be kept to a minimum. And so Keynes, just short of sixty years old, and Hayek, aged forty-one, sat and waited for the impending German onslaught, their shovels propped against the limestone balustrade. They were joined by a common fear that they would not emerge brave nor nimble enough to save their venerable stone charge.”
This week’s letter will deal with the problems of determining what GDP really is … and isn’t.
But first, I’m having a free online Q&A session on Tuesday, Aug. 23 at 2:00 PM Eastern time. We’ll discuss some of the macro issues I’ve been pondering in recent newsletters.
Joining me will be Patrick Watson, whose “World Gone Backwards” article I featured in this space two weeks ago, and our Mauldin Economics Senior Equity Analyst, Robert Ross. 
Patrick and Robert co-edit our Macro Growth & Income Alert premium service. As I’ve explained before, for regulatory reasons (since I am registered) I do not discuss specific stocks or other securities in this letter, tending instead to stick to macroeconomic and other big-picture concepts. Patrick and Robert face no such limitations, so after we discuss the macro world, I will drop off and they will talk about how to turn our macro views into real-world investment ideas. I am proud of the team we have assembled here at Mauldin Economics and appreciate the hard work and experience they bring to our readers.
You can register for the Q&A session and submit questions by clicking here. I hope you’ll join us. And now to the letter.
Weapons of Economic Misdirection
The problem we have today in economics is that many people, and not a few economists, seem to regard economics as “pure science,” as described above by Gauri Shankar Shrestha. If you delve deep into measurement theory, you find that all too often the way in which you measure something determines the results obtained from your experimental model. How you measure the effectiveness of a drug can sometimes determine whether it gets approved – apart from whether it actually does any good. The FDA actually works rather hard at measurement theory.
And if you’re using models, as we do in economics, to determine policies that govern nations, your efforts can result in economic misdirection that seems for a time to work but that all too often can lead to a disastrous Endgame. A shortsighted economic policy is not unlike a drug that makes one feel good for a period of time but ultimately leads to further weakness or collapse.
In this week’s letter we look at the construction of gross domestic product (GDP). As we will see, GDP is a relatively late-to-the-party statistic, thoroughly malleable in its construction and often quite contentious in its application. Yet the mainstream media regularly releases GDP numbers with the implicit assumption that they are in fact an accurate reflection of the general economy. We shall soon see that GDP is instead a fuzzy reflection of the economy, derived from a model that is continually readjusted in a well-intentioned effort to understand the scope of the economy.
GDP is one economic model among several that could serve the purpose, but its use conveniently leads to policies that reflect the thinking of a particular school of economic monetary and fiscal policy advocates.
We all know that in operating a business we need to be able to measure the profits of our company and then adjust our prices and production to make sure that there are enough profits to adequately fund the company. That is a relatively straightforward process, since the amount of money in the bank at the end of the month is a real number.
Hayek Versus Keynes
When most people see the release of the GDP number, they equate the precision of that statistic with the bottom right-hand number in their bank accounts. And news anchors and journalists rarely acknowledge the rather significant caveats that the Bureau of Labor Statistics publishes along with that data.
What we are going to find is that developing the concept of gross domestic product was more than a dry economic and accounting undertaking. At its very core, GDP is John Keynes versus Friedrich Hayek writ large. And their debate explains a great deal of the current tension between those who would make final consumption – or what we call consumer spending – the be-all and end-all of economic policy, and those who feel that productivity and income should instead be the focus. The very act of measuring GDP as we do gives the high and easy intellectual ground to those of the Keynesian persuasion.
Let me hasten to note that I have no problem with the concept or the calculation of GDP in general. It is absolutely a number that we need to have in order to understand the workings of a part of the economy. But it is just one tool in the economic toolbox. If the only tool you use to affect (determine, guide – choose your word) economic growth and the creation of jobs is the hammer of GDP, the world ends up being a very strange-looking, rather deformed nail, bent time and time again by the imprecise blows of those wielding the hammer.
GDP is an important concept, perhaps one of the more important that we have looked at in quite a few years. I urge you not to roll your eyes at the attempt to understand yet another dry economic statistic, but instead to look deeply at how the attempt to measure GDP affects everything in our lives.
GDP: A Brief But Affectionate History
The subtitle above is taken from the title of a recent book by Diane Coyle. (For economics wonks, she writes an interesting blog at http://www.enlightenmenteconomics.com.)
GDP: A Brief But Affectionate History is a fascinating 140-page book that I cannot recommend highly enough. This is simply the best book on GDP that I’ve ever seen. You can read it on a few hours’ plane ride or a lazy Sunday afternoon. And Ms. Coyle actually makes a relatively dry subject interesting and at times a page-turner. She has a true gift.
(Now that she has conquered the GDP mountain, might I suggest she move on to CPI?)
Ms. Coyle starts with the predecessors to Adam Smith and takes us through the 17th century right up until today with the development of GDP, so we see the ebb and flow of ideas through time. Who knew the early developers of the model did not want to include defense spending, as they saw it as a wasteful, nonproductive activity? Or that Adam Smith thought the inclusion of services in the concept was misleading. “The provision of more services was a cost to the national economy, in his view. A servant was a cost to his employer, and did not create anything. Importantly, money spent on warfare or the interest on government debt was also being used unproductively. The nation’s wealth was its stock of physical assets less the national debt. National income was what derived from the national wealth.”
(I read this book on my iPad using my Kindle app, an extremely useful tool. As it turns out, if you highlight passages in the book you read [and even make notes and comments], you can go to your Kindle web page and see all the passages you highlighted. I regularly do that now and find it an extremely useful exercise, one that I would suggest to any serious researcher, as notes in a book tend to get buried and lost; and often you just can’t quite (at least at my age) remember those connections five or ten years later, especially if you’re reading more than a few books a year. Now my notes are in the cloud. Wow. And when I access the notes, I can touch a link to go back to the original passage in the book, making sure I have the context. How cool is that?
I found myself highlighting more than the normal number of passages, as seemingly every page had something I wanted to be able to remember for future use. Just for fun I cut and pasted my highlights into a Word doc and found that they ran to some 15 pages, or more than 10% of the book.)
And while I would suggest you read Coyle’s book, I know that many of you don’t have the time or inclination, so I’m going to try to summarize the highlights and arguments and quote somewhat freely from the text here and there. (Unless otherwise noted, all quotations below are from the book.)
Will the Real GDP Please Stand Up?
Let me note up front that Ms. Coyle takes us through not just the development of GDP but also the problems inherent in the concept. She delves into its misses and its misfires, some regularly discussed in public circles and a few new to me.
There is no such entity out there as GDP in the real world, waiting to be measured by economists. It is an abstract idea…. I also ask whether GDP alone is still a good enough measure of economic performance – and conclude not. It is a measure designed for the twentieth-century economy of physical mass production, not for the modern economy of rapid innovation and intangible, increasingly digital, services. How well the economy is doing is always going to be an important part of everyday politics, and we’re going to need a better measure of “the economy” than today’s GDP.
GDP is a huge undertaking, full of rules, with almost as many exceptions to the rules, changes, fixes, and qualifications, so that, as one Amazon reviewer noted, GDP is in reality so complex there are only a handful of people in the world who fully understand it, and that does not include the commentators and politicians who pontificate about it almost daily. The quarterly release of GDP statistics is more akin to a religious service than anything resembling a scientific study. The awe and breathlessness with which the number is discussed is somewhat amusing to those who understand the sausage-making process that goes into producing the number. Whether the GDP reading is positive or negative, it often changes less in a given quarter than the margin of error in the figure itself, and it can be and generally is revised significantly – often many years later when almost no one is paying attention. When’s the last time the mainstream media reported a five-year -old revision?
If you pay someone to mow your lawn and report wages paid, that adds to GDP. If you pay that person under the table, it doesn’t. If you pay your maid to clean your house, it adds to GDP. Except if you marry her, then it doesn’t. Unless of course she gets access to the credit card, in which case spending probably increases GDP dramatically. In England, sex with your wife does not add to GDP, but sex with a prostitute does – even if it is unreported. Go figure. There are so many jokes and one-liners that I could add to this litany, but I’m going to resist. Okay, just one. Can you imagine the reception if you came home with a blonde hair on your dark suit and your excuse was, “Honey, I was just doing my bit for the national economy. We all have to make sacrifices.”
Housekeeping, cleaning, cooking, and other such duties do not get counted in GDP, although without them GDP would suffer significantly. Perhaps that is because when the original discussions about what constituted GDP were underway, “woman’s work” was significantly undervalued.
But we are getting ahead of ourselves. Before we discuss how GDP is constructed (and abused), let’s take a look at the history of how it came about. It will not surprise most readers to know that governments decided they need to know what the gross domestic product of the country was in order to be able to both tax that productivity and decide about a nation’s capabilities to wage (and pay the wages of) war.
Ms. Coyle starts her book with the rather dramatic story of the calculation (or rather the miscalculation) of Greek GDP upon that country’s entry into the European Union. The Greek group responsible for creating such numbers worked in a dusty old apartment without any computers and seemingly engaged in little activity. The real work was done by politicians, who did not appear to feel the need to be burdened by anything so aggravating as actual numbers. When the European Commission and the IMF decided to send someone to create an actual statistical agency in Greece, they selected a well-respected Greek economist, who within a year was charged by the Greek government with the crime of betraying the national interest, an offense that theoretically carries a life sentence. Essentially, he was charged for not cooking the books, which the Greeks had perfected as an art form.
Evidently, in Greece economics is a full-contact sport, and the “calculation” of G DP had real-world implications for whether the government would get desperately needed money from its Eurozone lenders and for how many government workers would lose their jobs, not to mention the impact it would have on the living standards of millions of Greeks.
GDP is the way we measure and compare how well or badly countries are doing. But this is not a question of measuring a natural phenomenon like land mass or average temperature to varying degrees of accuracy. GDP is a made-up entity. The [current] concept dates back only to the 1940s….
According to Benjamin Mitra-Kahn, “The Wealth of Nations introduced a new idea of the economy, and through the effort of Adam Smith’s students and admirers, it was adopted almost instantly.” In Smith’s own words: ‘There is one sort of labour which adds to the value of the subject upon which it is bestowed: There is another which has no such effect. The former, as it produces a value, may be called productive; the latter, unproductive labour.
Thus the labour of a manufacturer adds, generally, to the value of the materials which he works upon, that of his own maintenance, and of his master’s profit. The labour of a menial servant, on the contrary, adds to the value of nothing…. A man grows rich by employing a multitude of manufacturers: He grows poor, by maintaining a multitude of menial servants.’ The idea of a distinction between productive and unproductive activity, adopted by Adam Smith, dominated economic de bate and measurement until the late nineteenth century.”
(A side note: Karl Marx agreed with Adam Smith, and up until the collapse of communism in 1989, the Soviet Union’s economic statistics ignored service activities. Go figure.)
Simon Kuznets was a Russian-American economist and a true giant in the field.
Much of what we regard as economics today was developed under his aegis.
Wikipedia notes: “His name is associated with the formation of the modern economic science … as an empirical discipline, the development of statistical methods of research, and the emergence of quantitative economic history. Kuznets is credited with revolutionising econometrics, and this work is credited with fueling the so-called Keynesian revolution” (even though Kuznets had significant disagreements with Keynes). Kuznets himself was influenced by Schumpeter, Pigou, and Pareto; and he early on introduced Kondratiev to the West.
Kuznets, when he originally developed an approach for measuring GDP for the American economy, did not want to include expenses on “… armaments, most of the outlays on advertising, a great many of the expenses involved in financial and speculative activities, and much of government activity,” including the building of subways, expensive housing, etc.
Such thinking could not stand the scrutiny of politicians, however:
With this aim, in fact, Kuznets was out of tune with his times. Welfare was a peacetime luxury. This passage [and his early work on GDP] was written in 1937, when his first set of accounts was presented to Congress. Before long, the president would want a way of measuring the economy that did indicate its total capacity to produce but did not show additional government expenditure on armaments as reducing the nation’s output. The trouble with the prewar definitions of national income was precisely that, as constructed, they would show the economy shrinking if private output available for consumption declined, even if the government spending required for the war effort was expanding output elsewhere in the economy. The Office of Price Administration and Civilian Supply, established in 1941, found that its recommendation to increase government expenditure in the subsequent year was rejected on this basis. Changing the definition of national income to the concept o f GDP, rather than something more like Kuznets’s original proposal, overcame this hurdle.
There was a “heated debate between Kuznets and other economists, especially Milton Gilbert of the Commerce Department, about the right approach. The discussions were highly technical, but the underlying issue was profound: what was the meaning of economic growth and why were statisticians measuring it?
Gilbert and his colleagues were clear that the aim was to construct a measurement that would be useful to the government in running its fiscal policy.”
The inclusion of business taxes and depreciation [in GNP measured at market prices] resulted in a production measure that was more appropriate for analysis of the war program’s burden on the economy. Kuznets was highly skeptical: “He argued that Commerce’s method tautologically ensured that fiscal spending would increase measured economic growth regardless of whether it actually benefited individuals’ economic welfare.” In the policy tussle in Washington, Kuznets lost and wartime realpolitik won. [And that those arguing against Kuznets were heavily influenced by Keynes is rather difficult to deny. –JM]
… This decision was a turning point in the measurement of national income, and it meant that GNP (or later GDP) would be a concept strikingly different from the way the economy had been thought about from the dawn of modern industrial growth in the early eighteenth century until the early twentieth century. For two centuries, “the economy” was the private sector.
Government played a small role in economic life, and featured mainly because it looked to raise taxes to pay for wars. Its role expanded steadily over the centuries, however. In Victorian times this began to extend to the provision of other services, those we take for granted now such as roads and water as well as the historic government roles of defense and justice.”
Keynes himself, on the other side of the Atlantic, was arguing for an extended role for statistical analysis in government planning. He set forth his case in a 1940 pamphlet called How to Pay for the War.
Coyle notes:
Crucially, the development of GDP, and specifically its inclusion of government expenditure, winning out over Kuznets’s welfare-based approach, made Keynesian macroeconomic theory the fundamental basis of how governments ran their economies in the postwar era. The conceptual measurement change enabled a significant change in the part governments were to play in the economy. GDP statistics and Keynesian macroeconomic policy were mutually reinforcing. The story of GDP since 1940 is also the story of macroeconomics. The availability of national accounts statistics made demand management seem not only feasible but also scientific.
Understand what this means. One thing that Paul Krugman and I can agree on (and I say this with utmost confidence) is that we both believe that real economic growth is necessary to get us out of our current situation. (I am sure there are some other things that we could agree on, such as our mutual love for science fiction, but nothing else leaps to mind right now.)
However, if your measure of economic growth overweights the contribution of government spending to growth and underweights private production by focusing on final consumption, then when you are looking for “policy dials” to turn on the economic control panel in order to increase growth, the dials you reach for will be the two largest ones in your equation for measuring success: final consumption and government spending.
GDP Is a Political Construction
Coyle underlines the inherently political nature of GDP measurement:
We are now awash with macroeconomic models and forecasts, published by official agencies and central banks, by investment banks, by think tanks and researchers, as well as by commercial forecasters such as DRI’s successors. Indeed, the idea of the economy as a machine, regulated by appropriate policy levers, took firm hold….
Debate rages in particular about the multiplier, because the issue of whether extra government spending or tax cuts (a “fiscal stimulus”) will boost GDP growth turns on its size. If it is greater than one, a stimulus will help growth, while austerity measures will hurt it. Its actual size is hotly contested among macroeconomists, especially in the context of the present political debate about how much “fiscal stimulus” the government should be applying to get the economy growing faster.
There is an unsurprising alignment in the “multiplier wars” between macroeconomists’ answer to the technical question about the size of the multiplier and their political sympathies….
It will be clear by now that the ambition of measuring national income has a long history, with correspondingly many changes in how people have thought about it. As Richard Stone put it, national income is not a “primary fact” but an “empirical construct”: “To ascertain income it is necessary to set up a theory from which income is derived as a concept by postulation and then associate this concept with a certain set of primary facts.” There is no such entity as GDP out there in the real world waiting to be measured by economists. It is an abstract idea, and one that after a half century of international discussion and standard-setting has become extremely complicated. [emphasis mine]
Today, as Coyle notes, the process of comprehending GDP is somewhat akin to what happens when my kids play a videogame. The basic concepts are simple, but as you master each level and move on to the next, complexity increases almost ad infinitum. There is now an entire international community of statisticians (a surprisingly small one at that) that actually determine what is accepted as statistically relevant to GDP. The first United Nations guide on national accounts was 50 pages. The latest edition has 722.
It should not surprise readers that every few years new rules are created for the figuring of GDP. British statisticians just this year declared the UK economy to be 5% bigger than previously thought. What brought about this magical boost in productivity? There was no discovery of buried treasure hidden away in the vaults of the Bank of England. Instead, statisticians turned to counting the economic contribution of prostitution and illegal drugs (along with a few other odds and ends). If you are borrowing money and your creditworthiness depends on cash flow and your debt-to-GDP ratio, you tend to look for sources of income that weren’t previously accounted for.
Did the size of the US economy increase by 3% last summer? According to the statisticians it did. They decided to include music and entertainment and make adjustments to how we deal with investments. These changes were then calculated for all previous years, and suddenly the economy was 3% bigger! Small positive annual changes can add up over 40 years.
GDP has always been a political construction, subject to the ebb and flow of the intellectual and political climate, the need to raise taxes, and the military needs of the day. It is also a tool used to argue for or against income inequality (depending on what country you’re in).
GDP is particularly bad at detecting innovation, as George Gilder’s powerhouse work Knowledge and Power explains. There is a clear consensus emerging in economic circles about that weakness in the formula for calculating GDP, but there is nothing approaching consensus on how you might actually measure the contribution of innovation to GDP.
How do you measure the value of Google maps? The voice recognition software that I’m using right now has made me significantly more productive, but how do we measure that?
And somewhat provocatively, there is growing disagreement over the contribution of the financial services sector. Depending on how you measure it, you can even determine that the actual contribution of the financial services sector is negative, although I would not make that argument. But was the contribution of financial services in 2005-2006 as positive as their impact on GDP suggests? Or was it part of the destructive process?
If I purchase a solar energy system for my home, that purchased immediately adds its cost to GDP. But if I then remove myself from the power grid I am no longer sending the electric company $1000 a month and that reduces GDP by that amount. Yet I am consuming the exact same amount of electricity! My lifestyle hasn’t changed and yet my disposable income has risen.
Black markets? The sharing economy? The new gig jobs which are off the radar? So much of our economy doesn’t easily fit into neat financial models.
GDP is a financial construct at its heart, a political and philosophical abstraction. It is a necessary part of the management of the country, because, as with any enterprise, if you can’t measure it you can’t determine if what you are doing is productive. That said, the act of measuring GDP precipitates the observer effect writ large.
But as we will see next week, there are additional (note, I am not saying alternative) ways to measure growth and the size of the economy. Those measures would actually lead to policies more favored by Hayek, as the largest “dials” on the control panel would become productivity and income rather than consumer spending and government.
Stay tuned as next week we ponder the question of “How in the name of all that is righteous and holy could Hayek lose the argument?” His proponents are right to argue that the match was rigged and the judges were bought. If you have a few minutes, watch these two brilliantly done, hilarious, and instructive YouTube videos, here and here. I think you will come away smiling but also gain an understanding of the true terms of the debate. At the end of the day, I keep coming back to how central the arguments between Hayek and Keynes are to almost every economic discussion.
Denver, Denver, Dallas, and Writing
I will be in Denver on September 14 for the S&P Dow Jones Indices Denver Forum. If you are an advisor/broker and are looking for ideas on portfolio construction, I will be there along with some friends to offer a few suggestions. Then I will stay in Denver for the next few days to give the closing keynote at the Financial Advisor magazine’s 7th annual Inside Alternatives conference, where I will again share my thoughts on how to construct portfolios that are designed to have the potential to get us to the other side of the problems I see coming in the macro world. Bluntly, I think that portfolios constructed along the traditional 60/40 model are going to cause their owners significant pain in the future. And if you think the recovery has been slow this time, then you will not appreciate the snail’s pace of the n ext recovery.
Sometime in the fourth quarter I will go public with what I think is an innovative way to approach portfolio construction and asset class diversification.
I’ve been thinking about this new “Mauldin Solutions” portfolio model for a very long time, and now we are putting the final touches on the project. While the investment model itself is relatively straightforward, all of the details involved with making sure that the regulatory i’s and business t’s are crossed – the stuff that has to happen behind the scenes – are far more complex. Plus, as you might guess, there are white papers to write and web pages to construct.
It is a little ironic that I put together  this letter on productivity and GDP during a week when I have been about as unproductive as I have been in a very long time.
My computer crashed Monday morning while I was in Montana, and let us just say that the efforts to get it back up have been frustrating. I am operating in a very reduced and unproductive writing environment, which will hopefully change in the next day or so. It has allowed me to get a lot of reading done while people work on the computer and backups.
And with that I will go ahead and hit the send button. And hope that we are all more productive next week.
Your did not add much to GDP this week analyst,

John Mauldin

Record-breaking US stocks are a sideshow next to bond bonanza

John Authers

NEW YORK, NY - AUGUST 11: Traders applaud as the closing bell rings on the floor of the New York Stock Exchange (NYSE), August 11, 2016 in New York City. For the first time since 1999, the S&P 500 Index, Dow Jones Industrial Average and Nasdaq Composite Index all set record highs on the same day. (Photo by Drew Angerer/Getty Images)©Getty

It is not only in the Olympics that records are being broken. On Thursday, all the three indices of the US stock market that have traditionally been most widely quoted set a new all-time high.

It was the first time that each of the Dow Jones Industrial Average, the S&P 500 and the Nasdaq Composite were simultaneously at a high since the very top of the internet boom back in early 2000.

But the multiple Wall Street records do not tell us as much as might be hoped.

First, as with any market index, we need to be clear about what each represents. Even though they continue to be widely quoted in the press, neither the Nasdaq nor the Dow tells us much and they are little used by investors. Neither is representative of anything much.

The indices are right, however, to indicate that stocks are on a tear. After several doses of volatility in recent months, animal spirits are back. And they are a good indicator of how much money it was possible to make. Index funds, which merely track an index rather than attempting to beat it, are hugely popular. In the case of the S&P, the world’s most followed index, the administrative costs are tiny. The return on the headline index is almost exactly what you could indeed have received by investing in an S&P tracker.

But how far have stocks really come since the top in early 2000? This is where it gets interesting.

Over the long run, the bulk of return from stocks comes from dividends, so we need to look at the index on a total return basis. Judged that way, the S&P has doubled since the top in 2000. It would have made you money.

But we need to take inflation into account. Do this, by dividing the rise in the S&P by the rise in the US consumer price index, and the returns drop to 40 per cent. In real terms, the S&P was still lower than at its 2000 peak 11 years later. But the exceptionally low inflation of the last few years means that the recent rally has meaningfully increased the buying power of those who held the S&P.

Now we need to consider the opportunity cost of holding stocks. They are risky and inflict volatility on you. Twice since 2000, the main indices have taken a terrible beating, in the crashes that started in 2000 and 2007. What could have been achieved in the much safer equivalent of government bonds?

The answer is stunning. When compared with long-dated treasuries, as measured by the Bloomberg EFFAS indices, the S&P has underperformed by almost exactly 50 per cent. In other words, buying stocks in 2000 would have made you money, but you would have made twice as much from bonds, with a much less bumpy ride.

Bonds flourish in an environment of low inflation, as this allows their fixed income payments to hold their value. They are also flattered by the 2000 starting point, when stocks were historically overpriced. But the bonds story goes further than that.

Bond yields — the effective interest rate paid by bonds, which falls as bond prices rise — have fallen to fresh historic lows this year. UK gilts, helped by the response to the Brexit referendum and the Bank of England measures that followed it, are among the best performing securities anywhere.

German, Japanese and Swiss bonds carry negative yields. The records for stocks are impressive; those for bonds are extraordinary.

Bond markets have real-world economic effects. Lower yields for the safest government bonds mean that riskier companies, and countries, can borrow for less. They have taken the opportunity to do so.

Higher leverage, for companies, helps boost earnings but also enhances risk for the longer term.

Most importantly, strong bond markets encourage investment in stocks. Once bonds become expensive, as they are now, it is easier to justify the risk of stocks. That is in large part why the Federal Reserve resorted to a series of programs to buy bonds. The idea was that this would push up asset prices and in this, at least, it worked. Compare a chart of the increases in the total amount of bonds the Fed holds on its balance sheet since the market bottom in 2009 with a chart of how stocks have performed relative to bonds and they look almost identical.

Over the past seven years, stocks have rallied relative to bonds whenever the Fed was buying bonds and fallen back whenever the Fed desisted from buying. And since the Fed started to taper off its purchases of bonds, in December 2013, bonds have beaten stocks. This year, bonds have easily outpaced stocks.

So the headline record for the US indices begins to look more like an outcrop of the far more remarkable rally in bonds, and of central bank intervention. What does that mean for the future?

Look at the chart of the S&P and this looks like a peak, and a bad time to buy. Look at the chart of how stocks have performed relative to bonds, and it looks like stocks should be ready to shine. This illustrates the paradox that has also lasted for years that stocks look expensive by almost any sensible historical measure — except when compared to bonds, when they look cheap.

But there is a nasty problem with this. If bonds finally go into reverse, rates will rise, the support for stocks will be removed and the risk is more that stocks will start to fall. The bond market rally is extraordinary, it has gone on for a long time, defeating predictions by many (myself included) that yields had become unsustainable. US Treasury yields have been falling steadily for more than three decades.

If bonds can somehow continue this, then stocks will probably continue to prosper (although they may fail to outstrip bonds). If bonds go into reverse, it would be bad news for both stocks and bonds.

And either way, the record in the S&P 500, which has created genuine wealth for those who hold it, is a sideshow besides what is happening in bond markets.

Russia, Ukraine and Threats

Moscow appears to be setting up conditions to justify action against Ukraine but its goal is unclear.

By George Friedman

Tension between Russia and Ukraine is escalating. According to the Russians, a special operations team from Ukraine attacked Crimea. The Ukrainians denied the claim. The Russians appear to be moving forces around in Crimea and increasing the number and the posture of the forces in the area. More significant militarily, there are some reports of Russian troop buildups east of their border with Ukraine and an unconfirmed report of a brigade of Russian troops deploying in pro-Russian rebel-held territory inside Ukraine. The Russians have done nothing to tamp down tension. In fact, they have increased it by citing multiple Ukrainian provocations and insisting that they will not be allowed to persist.

Whatever the truth in the reports, it is obvious that the
Russians are establishing a justification for taking action against Ukraine. Our model predicts that the Russians will eventually move to change the situation in Ukraine, militarily if necessary. Ukraine is too important to them strategically to accept anything less than a neutral government in Kiev. A pro-Western government with close ties to the U.S. and other militaries can evolve dangerously from the Russian point of view. Therefore, we expect the Russians to take some significant action – diplomatically, economically and/or militarily.

However, our view is that for the moment the military option is likely off the table. Ukraine is a very large country and just occupying it against minimal resistance would require a force that Russia didn’t have a year ago. Given that the Russians couldn’t count on minimal resistance, their forces needed modernization, extensive training and a strong logistical base. Thus, we expected the informal truce that has been in place – with low-level fighting and an implicit commitment from the U.S. not to get directly involved in boosting Ukraine’s military position – to continue to the end of 2016 at least.

Therefore, our forecasting model says that an increase in tension will lead nowhere. But while models are nice, and we are proud of ours, the Russians are talking war, and we must consider why they are doing it now.

The Russian economy has declined precipitously and is still declining. This has to be hurting President Vladimir Putin’s political position, especially among senior officials and oligarchs who constitute the Russian elite. Putin has been increasing his power lately,
replacing some governors with his former bodyguards. But actions like that don’t make him appear powerful to us. On the contrary, it makes us think that he is extremely worried and trying to shore up his position.

The declining economy is one of the forces undermining his position. The other is his mishandling of Ukraine. While Westerners think of Putin as the aggressor, at the end of the day, Ukraine’s Russian-friendly government was replaced by a pro-Western government. All the Russians retained was Crimea, where they already had a massive force by treaty with Ukraine, and a presence in eastern Ukraine. There, the Russians tried to incite a broad uprising that never happened, and the rebel forces they supported were essentially fought to a standstill with the Ukrainians. An equivalent scenario in the United States would be if the U.S. simultaneously went into a massive depression and faced a pro-Mexican coup in Texas. Not being able to do much about the economy and the Ukrainian situation, Putin needs to do something. He needs to appear threatening, even if it’s a bluff.

Areas of Ukraine Under Rebel Control

The greatest challenge to a Russian military action would be a massive commitment of U.S. airpower in the region. The U.S.’ F-16s and F-15s (along with strategic bombers and newer if fewer fighters) were designed to stop a Soviet invasion, albeit a lot farther west. The U.S. still has the ability to impose severe attrition on Russian armor. The United States has close relations with Poland and Romania. It is interesting that the Russians have been creating problems on their border with Poland in Kaliningrad. The U.S. would base its aircraft in these countries, as well as Germany and other countries, if it were to confront Russia. But the needed force is not there yet, and any deployment will take a while. Assuming that diplomacy aligns with the best timeline, this leaves a window for the Russians.

The recent shifts in regional alignment also help them. The coup in Turkey has created what appears to be a massive rift between Turkey and the United States, and has drawn Turkey and Russia closer. Russia is withdrawing support from Armenia and forcing a settlement with Azerbaijan. This is valuable to the Turks. The Turks won’t join with the Russians over Ukraine, but hostility toward the United States and a debt to Russia will likely keep Turkey from helping the U.S. much. The air base at Incirlik might even be unavailable.

Russia has some advantages at this moment. But it is not clear that the Russian military is prepared to undertake an action that might bring it into a confrontation with the United States. While a rapid victory might boost Putin’s position dramatically, if Russia were to get bogged down or even lose, it would be his end. Such an action would also likely kill Putin’s attempt to separate Europe from the United States. It would be a Hail Mary and simply doesn’t seem worth it. Our model still seems correct.

So what is Putin doing? If Putin wanted a satisfactory political settlement, this would be the best strategy. He should create a crisis that makes it appear Russia is on the verge of attacking Ukraine. This would start massive shuttles of dignitaries traveling to and around the region, culminating with an effort to convince the Russians not to go to war. Putin would make absurd demands, enraged at the brutal aggression of the Ukrainians, and just as the talks appear to be collapsing, would generate a deal. Given the American sense of weakness after Ukraine, and Germany’s distraction, this would be the ideal time for this move.

However, the Russians would also use the same strategy if they made a decision to go to war. Before the Russians go to war, they engage in Maskirovka (a masquerade). They create a massive crisis, and then reach a very reasonable agreement. The Russians stand down, except for a few brigades or divisions that carry out exercises, and everyone relaxes. Then, the Russians strike. This is what the Soviets did in Hungary and Czechoslovakia and what Russia did in Georgia. And they blame the attack on some action by the now cocky target, who thinks the Russians have backed down.

The problem is that if the Russians wanted a negotiated settlement or if they were getting ready for war, they would act in exactly the same way. The negotiation requires an opening bluff, and war requires a final bluff. So, as much as I believe this is not going to end up in a war right now, we can’t ignore that this looks like the early stages of one. It also looks like the early stages of negotiation. This strategy branches out into two different results only at a later point.

There are those who believe that a weak economy precludes war. I will close by saying that generally that isn’t true, but with the Russians it certainly isn’t true. The Russians have fought all their wars from Napoleon on with an economy in shambles. It is their normal condition. And this would not be a world war, but a local conflict. It might have the Americans involved, but obviously not on a large scale. As for sanctions, they really aren’t a deterrent on a national security issue, and sanctions are rarely placed on a country that just won a major war and is now perched on the borders of Europe. And that’s one of the attractions. In that position, Russian can try to extract economic benefits.

I would not be surprised to see this in a year. I am surprised to see it now. But while we know what we are seeing, we don’t know what it means. The next thing to watch is whether the Russians increase or decrease their rhetoric. Whatever they are doing, they will either quiet down or get very scary indeed.

Why China Trade Hit U.S. Workers Unexpectedly Hard

A growing body of academic research shows as import competition surged, the U.S. labor force itself was becoming less adaptable

By Jon Hilsenrath and Bob Davis

Container trucks leave the Port of Shanghai's Wusongkou area. A 2016 paper found that adjustments in U.S. labor markets to China trade were unusually slow, with wages and labor-force participation rates remaining depressed and unemployment rates elevated for at least a decade after the China trade shock hit. Photo: JOHANNES EISELE/AFP/Getty Images)

A growing body of academic research shows the U.S. workforce was hit harder than expected by trade with China and was potentially unprepared for the shock. As import competition surged and displaced manufacturing workers, the U.S. labor force itself was becoming less adaptable, and political blowback was brewing.

Here is a summary of some of the most important new research in these areas:

Less Flexible Labor Markets

U.S. workers and firms have long been known among scholars and policy makers for being flexible and able to adapt to shocks and changes in the economy.

But some researchers suggest that labor markets have become less dynamic since 2000, and even more so since 2007, making them less adaptable just as the shock of trade with China hit and then worsened.

1. In “Understanding Declining Fluidity in the U.S. Labor Market,” written in March 2016, Raven Molloy, Christopher Smith, Riccardo Trezzi and Abigail Wozniak document declining dynamism in the job market. That means fewer people switching jobs, moving in and out of the labor force and moving from one state to another, and fewer companies creating and extinguishing positions.

The Fed analysts say the trend dates back to the early 1980s. Their measure of fluidity has dropped 10% to 15% since then. This is partly due to an aging population and two-worker families keeping people in place.

The trend also might be associated with fraying social fabric in communities. States with large decreases in the fraction of the population who report that strangers can be trusted tend to have large declines in labor market fluidity.

In other words, job searches and hires might be getting tangled up because people don’t trust each other. Workers also are renegotiating wages less often.

2. In “Labor Market Fluidity and Economic Performance,” delivered at the Federal Reserve’s Jackson Hole, Wyo., conference in August 2014, economists Steven Davis and John Haltiwanger find a shift away from young firms that create new jobs.

Firms no more than five years old accounted for 19% of employment in 1982, and then 14% in 2000 and 11% in 2011. In the 1980s and 1990s, the drop was dominated by young retail firms, likely being squeezed by big-box retailers.

After 2000, there was a switch: a large decline in high-tech startups. Those “young, entrepreneurial firms…were a major source of innovation and productivity growth for the economy as a whole in the 1980s and 1990s,” the economists said.

They found that lost labor-market dynamism has been hardest on younger and less-educated workers. The economists say regulations, including occupational-licensing rules and worker protections meant to prevent discrimination based on age, gender, race and religion, contribute to less-dynamic labor markets.

3. In “The Secular Decline in Business Dynamism in the U.S.,” from June 2014, Ryan Decker, John Haltiwanger, Ron Jarmin and Javier Miranda find that firms have become less responsive to outside shocks. “This has potentially adverse effects on industry-level productivity growth since there has been a slowdown in the pace at which resources are being reallocated from low- to high-productivity businesses,” they wrote.

4. In “Locate Your Nearest Exit: Mass Layoffs and Local Labor Market Response,” September 2015, authors Andrew Foote, Michael Grosz and Ann Stevens look at how workers respond to mass layoff events.

Since the Great Recession, a greater number of people have tended to drop out of the labor force in response to mass layoffs, while fewer people have moved to other places in search of new jobs, the researchers concluded.

Moreover, the percentage of the population that moved in response to mass layoffs in search of better jobs declined after the recession.

5. Kerwin Kofi Charles, Erik Hurst and Matthew Notowidigdo, in “The Masking of the Decline in Manufacturing,” find that the decline in U.S. manufacturing led to a reduction in demand for less-educated workers between 2000 and 2006.

For a few years, the housing boom masked the effects of the manufacturing decline for less-educated workers as men found jobs in construction. But when the housing market collapsed in 2007, there was a large, immediate decline in employment among such workers, who faced the sudden disappearance of jobs related to the housing boom and the fact that manufacturing’s steady decline in the early 2000s left them with many fewer opportunities in that sector than at the start of the decade.

China Shock

The shock of trade with China was different than the shock of U.S. trade with other countries such as Mexico, Japan and Asian “tiger” economies such as Taiwan and Hong Kong, research shows. The scale of import competition from China was immense, dislocating millions of U.S. manufacturing workers, who had trouble adjusting and finding new work.

1. In “The China Shock: Learning from Labor Market Adjustment to Large Changes in Trade,” in February 2016, authors David Autor, David Dorn and Gordon Hanson find that adjustments in local labor markets to China trade were unusually slow, with wages and labor-force participation rates remaining depressed and unemployment rates elevated for at least a decade after the China trade shock hit.

Exposed workers experience more job churning, reduced lifetime incomes and more dependence on disability benefits and other government assistance.

2. In “Important Competition and the Great U.S. Employment Sag of the 2000s,” August 2014, authors Daron Acemoglu, David Autor, David Dorn, Gordon Hanson and Brendan Price find that import competition from China between 1999 and 2011 led to an employment reduction of 2.4 million workers.

The decline came in industries directly hit by competition and among their suppliers and neighboring firms.

3. In “Trade Adjustment: Worker Level Evidence,” December 2014, authors David Autor, David Dorn, Gordon Hanson and Jae Song find that earnings losses for people exposed to trade with China are larger for people with low initial wages, low initial tenure and low attachment to the labor force.

Low-wage workers churn primarily among manufacturing sectors, where they are repeatedly exposed to subsequent trade shocks. High-wage workers are better able to move across employers with minimal earnings losses and are more likely to move out of manufacturing.

4. In “The Surprisingly Swift Decline of U.S. Manufacturing Employment,” April 2014, Justin Pierce and Peter Schott find a connection between U.S. manufacturing declines and China’s admission to the World Trade Organization in 2001. China’s accession to the WTO removed an uncertainty about tariff levels, increasing the incentive of firms to invest in China for export.

Political Blowback

The shock of trade with China also has had political repercussions. Those include polarizing congressional districts, increasing voter turnout and possibly helping Democrats.

1. In “Importing Political Polarization?,” April 2016, authors David Autor, David Dorn, Gordon Hanson and Kaveh Majlesi find that congressional districts most exposed to trade with China tended to remove moderate representatives from office in the 2000s and replace them with either more liberal Democrats or more conservative Republicans.

Voting also took place along racial lines. Districts with white populations tended to replace moderates with conservative Republicans, and districts with nonwhites tended to replace moderates with liberal Democrats.

2. In “Does Trade Liberalization with China Influence U.S. Elections?” April 2016, authors Yi Che, Yi Lu, Justin Pierce, Peter Schott and Zhigang Tao find that counties subject to greater competition from China tend to vote more often for Democrats and experience greater voter turnout.

In the past, Democrats benefited from taking positions that restrict trade and offer assistance to people exposed to trade shocks.

The researchers’ analysis didn’t include the results of the 2016 presidential primaries, which resulted in Donald Trump as the Republican presidential nominee. Mr. Trump has taken tough-on-trade positions.