Risk On/Risk Off Face-off

Doug Nolan

The DJIA rose 11 straight sessions (“longest streak since the Reagan administration”) to end the week at a record 20,822. The S&P500 gained 0.7% this week (up 5.7% y-t-d), its fifth consecutive weekly gain. The Morgan Stanley High Tech Index’s 0.5% rise increased y-t-d gains to 11.5%. Already this year the Nasdaq Composite has gained 8.6%. The Nasdaq100/NDX added 0.3% this week (up 9.9%). Bullish analysts continue to point to strong market momentum.

It’s an unusual backdrop where “Risk On” powers a U.S. equities markets melt-up, while safe haven assets trade as if “Risk Off” is lurking right around the corner. Ten-year Treasury yields declined 10 bps this week (to 2.31%) to the lowest level since November 29th. UK yields sank 14 bps (to 1.08%) to lows since October. Gold added $22 this week to $1,257, trading to the high since the election. Silver jumped 2.0% to $18.41, increasing y-t-d gains to 15%. The yen gained 0.6% this week, increasing y-t-d gains versus the dollar to 4.3% (and near a key technical level).

Elsewhere, it appears some favored trades are performing poorly – with popular longs lagging and popular shorts outperforming. The financials continue to lag, while the out-of-favor Utilities surged 4.1% this week. Defensive stocks outperformed this week, while “Trump reflation” wagers underperformed. Low beta outperformed high beta. The small caps underperformed again this week. Meanwhile, the Treasury bond bears are running for cover. All in all, it would appear Market Dynamics continue to frustrate many hedge fund strategies.

At this point, Europe remains at the epicenter of The “Risk On”/“Risk Off” Face-off. Major European equities indices reversed lower into this week’s close. After trading to the highest level since 2015, Germany’s DAX index dropped 1.6% during Thursday’s and Friday’s sessions. Italian equities fell 2.2% this week, and Spanish and French equities posted modest declines. The European Bank Stock Index (STOXX 600) dropped 3.2% this week, trading to the lowest level since early-December. Notably, Italian banks sank 5.8% this week, boosting y-t-d losses to 10.4%.

Through the eyes of the global bond market, something just doesn’t look right. And while this week’s Treasury and gilt yield declines were curious developments, the real action continues to unfold in Europe. German bund yields declined a notable 12 bps this week to 0.18%, the low since December 29th. Even more intriguing, German two-year sovereign yields sank 14 bps this week to a record low negative 0.96%.

The French versus German two-year sovereign spread traded as high as 49 bps this week, the widest since the tumultuous summer of 2012. This spread widened 11 bps for the week (to 43bps), and has doubled thus far in February. The Italian to German 10-year spread widened 12 this week, back to a two-year high 201 bps. The Spanish to German 10-year spread surged 18 bps this week to a seven-month high 151 bps. After beginning the year at 37 bps, the French sovereign Credit default swap (CDS) traded Thursday above 70 for the first time since August 2013.

Markets clearly fret approaching French elections (first round April 23, second May 7). National Front candidate Marine Le Pen is widely expected to win the first round but then lose in May’s two candidate runoff. After Brexit and Trump, markets this time around are less willing to take things for granted. Le Pen is running on a far right platform that includes exiting the EU, returning to the French franc and adopting various “France First” measures. Having watched post-Brexit and post-Trump non-turmoil, perhaps French voters will disregard what has become routine fearmongering.

While markets see a Le Pen Presidency as a relatively low-probability (Citigroup says 20%), there is recognition that such an outcome would be highly market disruptive. Many would view a National Front upset as the beginning of the end of the euro monetary experiment.

February 23 – Reuters (Brian Love and Michel Rose): “France's presidential race took a new turn on Thursday as independent Emmanuel Macron raised the curtain on a partnership with veteran centrist Francois Bayrou to help him beat the far-right's Marine Le Pen. ‘Political times have changed. We cannot continue as before. The National Front is at the gates of power. It plays on fear,’ Macron said… Opinion polls appeared to show the 39-year-old Macron, a political novice who has never held elected office but who has soared to become a favorite to enter the Elysee, was already benefiting from the new-born alliance announced on Wednesday.”
French (to German) bond spreads narrowed Wednesday on prospects for a Macron/Bayrou alliance to counter Le Pen. This development, however, didn’t slow the melt-up in German bund prices or, for that matter, the rally in Treasuries, gilts and safe haven bonds more generally. And it didn’t stop a sell-off in European bank stocks that seemed behind the late-week underperformance in U.S. and global financial stocks.

A Friday Reuters headline caught my attention: “Global Stocks Fall, Bond Markets Rally as Trump Optimism Pauses.” I have a difficult time with the notion of “Trump optimism” fueling international equities. Rather, it’s too much “money” (liquidity) chasing highly speculative markets in stocks, bunds, Treasuries, gilts, JGBs, corporates and EM debt. This same fuel has been behind gold and silver’s 9% and 15% y-t-d gains.

It’s a Theme 2017 that markets are unprepared for what would be a surprising change in the global monetary backdrop. I expect both the BOJ and ECB to at some point this year begin developing strategies for significantly reducing QE liquidity injections. Clearly, the Germans are contemplating a year-end conclusion to ECB QE operations.

February 23 – Reuters (Francesco Canepa): “Germany's central bank posted its smallest profit in more than a decade in 2016 as it set aside more money against potential losses on the bonds it is buying as part of the European Central Bank's stimulus programme… The Bundesbank recorded a net profit of 399 million euros, the lowest since 2004 and a sharp drop from the 3.2 billion euros bagged in 2015… Commenting on the results, Bundesbank president Jens Weidmann said it was right for the ECB to discuss closing the door to a further policy easing in the future.” February 23 – Bloomberg (Carolynn Look and Manus Cranny): “Investor expectations for an interest-rate increase by the European Central Bank in 2019 aren’t totally unjustified as downside risks to the economic outlook recede, according to Bundesbank President Jens Weidmann… Accelerating inflation and a strengthening economic outlook have fanned a debate in the 19-nation euro area about the appropriate degree of stimulus as central banks prepare for a policy shift. While officials including Weidmann are arguing that the time to talk about an exit is coming closer, ECB President Mario Draghi contends that record low rates and a 2.28 trillion-euro ($2.4 trillion) quantitative-easing plan are still necessary to produce a sustained pickup in inflation… While Weidmann conceded that the ECB is right to keep monetary policy accommodative, he criticized the Governing Council’s decision to extend QE through the end of 2017. ‘I was not very supportive of that step… The monetary-policy stance that I would have been willing to accept is less expansionary than the current one.’ One can certainly ask ‘when we might slow down monetary policy and whether the ECB Governing Council shouldn’t make its communication more symmetrical beforehand, for instance by not only pointing to the fact that monetary policy could be even more expansionary.’”
Angela Merkel appears increasingly vulnerable heading into October elections. Responding to criticism from a Trump advisor, Merkel this week commented: “We have at the moment in the euro zone of course a problem with the value of the euro. The ECB has a monetary policy that is not geared to Germany, rather it is tailored from Portugal to Slovenia or Slovakia. If we still had the D-Mark it would surely have a different value than the euro does at the moment.”

February 23 – Reuters (Francesco Canepa): “Exclusive: ECB seeks to lend out more bonds to avert market freeze – sources: The European Central Bank is looking for ways to lend out more of its huge pile of government debt to avert a freeze in the 5.5 trillion-euro short-term funding market that underpins the financial system, central bank sources told Reuters. The ECB has bought more than a trillion euros ($1.06 trillion) of euro zone government bonds in a bid to shore up economic growth and inflation in the euro zone… By doing so, it has taken away the key ingredient for repurchase agreements, or repos, whereby financial firms lend to each other against collateral, typically high-rated government bonds such as Germany's… Germany, the only large euro zone country with a top-notch credit rating, is where the problem is at its most severe.”
Will the Merkel government and Weidmann Bundesbank finally craft a more aggressive strategy for reining in Mario Draghi? Securities financing markets are already under heightened strain, as ECB purchases ensure an ever-dwindling supply of German debt in the marketplace. Again this week, there was talk of heightened stress and dislocation in the crucial “repo” marketplace. And while German influence over the ECB has waned throughout Draghi’s term, the Bundesbank holds a commanding position over the (by far) most dominant securities in the euro zone: “AAA” German debt. At this point, there’s a case to be made that German bunds are more critical to global securities funding, leveraged speculation and derivatives markets than even Treasuries.

ECB policymaking is increasingly at odds with German interests. I hold the view that German officials have more power to impose their will than is appreciated in today’s complacent markets. Perhaps it was no coincidence that Mr. Weidmann publicly voiced comments critical of ECB policy concurrent with a dislocation in bund trading and associated “repo” market stress. Moreover, I wouldn’t suggest owning risk assets anywhere in the world if European securities financing markets begin to malfunction.

Here at home, perhaps the markets will begin questioning the new Administration’s priorities (along with the ability to get those priorities through Congress). The markets are bullishly positioned in anticipation of a string of tax cuts, deregulation and infrastructure spending. I’m not sure how encouraging markets should find White House chief strategist Steve Bannon’s “three buckets” - “national security and sovereignty,” “economic nationalism” and the “deconstruction of the administrative state,” along with his comment “…one of the most pivotal moments in modern American history was [Trump’s] immediate withdraw from TPP. That got us out of a trade deal and let our sovereignty come back to ourselves.” It’s also worth mentioning that President Trump spent more time at CPAC trumpeting military buildup than offering details for tax reform and deregulation.

February 24 – Reuters (Emily Stephenson and Steve Holland): “President Donald Trump said he would make a massive budget request for one of the ‘greatest military buildups in American history’ on Friday in a feisty, campaign-style speech extolling robust nationalism to eager conservative activists. Trump used remarks to the Conservative Political Action Conference (CPAC)… to defend his unabashed ‘America first’ policies. Ahead of a nationally televised speech to Congress on Tuesday, Trump outlined plans for strengthening the U.S. military… and other initiatives such as tax reform and regulatory rollback. He offered few specifics on any initiatives, including the budget request that is likely to face a harsh reality on Capitol Hill… Trump said he would aim to upgrade the military in both offensive and defensive capabilities, with a massive spending request to Congress that would make the country's defense ‘bigger and better and stronger than ever before.’ ‘And, hopefully, we’ll never have to use it, but nobody is going to mess with us. Nobody. It will be one of the greatest military buildups in American history…’”

Trump, the Dollar and Trade – What’s Ahead



President Donald Trump’s early statements on international trade and currency valuations left many concerned about rocky times ahead: After winning the election, Trump continued to accuse key U.S. trading partners of unfair practices, following up on comments he made during the campaign. By making one of his first acts as president calling the Taiwanese president, Trump seemed to call into question the “one-China” policy (which entails diplomatic, official recognition of China, with an unofficial relationship with Taiwan), in an apparent snub to the mainland.

Mexico and Japan also came in for criticism for alleged manipulation of currency and trade regimes.

Even Germany was put in the cross hairs for carrying a perceived trade surplus deemed too large.

But more recently, in a phone call with China President Xi Jinping, Trump walked back any threat to abandoning the one-China policy. Then, his meeting with Japan’s Prime Minister Shinzo Abe last week seemed to suggest more cooperation than confrontation. That followed an announcement by Japan’s Government Pension Investment Fund, the world’s biggest, that it would invest in U.S. infrastructure projects that could create hundreds of thousands of American jobs. Still, trade tensions with Mexico and elsewhere remain unresolved.

To better understand how recent events could affect the U.S. dollar and international trade, Knowledge@Wharton spoke with Franklin Allen, an emeritus professor of finance at Wharton who is also a professor of economics and finance at Imperial College in London, where he is executive director of the school’s Brevan Howard Centre for Financial Analysis.

Knowledge@Wharton: I’d like to discuss the U.S. dollar, which could be used as a lens, in some ways, for analyzing some of the key issues in world markets. The value of the dollar, of course, has big implications for world growth, and very importantly, emerging market dollar-denominated debt. Also, many people view the dollar as a bit of a proxy for how the U.S. is performing overall, including the new administration. So, if people lose faith in the dollar, they might sell the dollar off and buy gold, or other currencies, or other investments.

At the same time, if the dollar appreciates too much, that can affect the level of growth here in the U.S. There was a recent Financial Times article that said if the U.S. dollar went up by 10%, that could knock a half percentage point (0.5%) off of GDP growth. There are a lot of pointers in the direction of the dollar getting stronger, such as: economic growth has been pretty strong, and it looks like it’s going to get stronger; especially if the administration passes a stimulus package. They’re also talking about deregulation, lower corporate and personal taxes and corporate tax forgiveness. All these things could put upward pressure on the dollar. The stock market has been doing well — that seems to draw money in and increase the dollar. And of course, the Fed has been talking about wanting to raise interest rates — that makes for a stronger dollar.

On the other side are the politics. President Trump has been talking about an interest in a weaker dollar. He is also saber-rattling about trade with some of the U.S.’s major trading partners; Mexico, China, Japan, Germany and other euro countries.

Given all of that, there’s a lot of contradictory stuff. What’s your view of the landscape? How important is it to look at the dollar, to figure out what’s happening in the world, and what’s likely to happen going forward?

Franklin Allen: I think it’s fairly important. I don’t think it’s hugely important, but it’s certainly one of the important things. Probably, the main driver is the difference in interest rates around the world, for the short run, at least. And, how things like a stimulus package, and so on, will play into that. If [the U.S.] does pass a big stimulus package, then my guess is that the Fed will raise rates faster than they otherwise would have done, and that will have an effect. We’ll see whether that gets passed; what the timing of that is, how the expectations for that play out.

The other thing, which I think is important, is what happens in the other countries, in terms of interest rates. In particular, in the Eurozone; whether that continues to stay where it is, or whether the growth that started to emerge leads to some ending of the quantitative easing, and raising of rates going forward. All of those, I think, will be very important for where the dollar ends up.

I think the trade policy of Trump will also play an important role. We’ve seen, clearly, some aggressive moves against Mexico, in particular, but also towards Germany, and to a lesser extent, maybe Japan. And then, of course, the big one is China. That’s been a little bit on the back burner, with everything that happened after he was elected; in particular, the call from the president of Taiwan, and the issue about the “one-China” policy, and whether it would be continued.

Hopefully, the talk [February 9] between President Xi and President Trump will mean that now that issue is off the table and we can focus on trade. I think there are lots of things going on, as your introduction indicated. But I would stress, most of all, the interest rate movements, and also the trade movements.

Knowledge@Wharton: One key thing is that if the dollar were to appreciate quite a bit, then there are a lot of emerging market countries out there that have a lot of dollar-denominated debt. We know that in the past, the Asian financial crisis of the late 1990s, and the Latin American crisis of the early 1980s — the dollar had a role in those problems. They had a lot of dollar-denominated debt, which suddenly became very expensive when they had big devaluations of their currencies. Could you talk about the risks in emerging markets right now?  
Allen: I think that potentially, is something to worry about. The key issue is the extent to which they have dollar-denominated income from exports, and various other sources, to offset their dollar debt. I think it’s the net positions, rather than the gross positions, that are important there.

A country like South Korea, I think it’s less of a problem than some of the other countries which are borrowing in dollars…. I would say there’s wide variation in that. But I think that’s something people need to keep an eye on over the next year or two.

Knowledge@Wharton: We’ve seen that President Trump is very concerned about trade with Mexico…. There’s talk of putting some kind of tax, or tariff, on imports. I’m wondering what effect this would have, both on Mexico and the U.S., and as a chilling effect on trade in general?

Part of what I’ve read suggests that it won’t be very effective, because the dollar may just adjust in a way that would have a zero-net effect in the long run.

Allen: That’s what people have argued, but that’s in an ideal world that it would adjust.

Whether or not that will happen in practice, I think, is still something that we don’t have a good sense of. I think if [the Trump administration does] something like that with Mexico, then it will potentially cause big problems because so much of world trade now is on supply chains.

Really, a lot of what’s happening in Mexico is supply chains. If they get disrupted, then people can be very reluctant to invest in those kinds of things again. That could potentially have a very big effect.

I guess it’s tied up with how they want to renegotiate the NAFTA agreement; and I think we still don’t have too much idea what exactly their tactics on that one are going to be. There’s also the [border] wall, and paying for the wall, and all those issues bubbling away underneath some of these things. So, I think it’s going to be a while before we know how that plays out. But it is potentially disruptive, not just for Mexico, but for many other countries where people are using them as part of a supply chain.

Knowledge@Wharton: China was a real whipping-boy for President Trump during the campaign. He talked about China’s currency being undervalued. Some analysts and critics said, well, that was true years ago, but it actually isn’t the case now. Although it is true, I think, that the Chinese currency has been depreciating somewhat against the dollar more recently, but probably for good, fundamental reasons. Can you talk about your view of how accurate the relationship between the dollar and China’s currency is now, and how much merit there is to what the administration has been talking about, regarding China?

Allen: My own view on the RMB-dollar exchange rate is that it depends a great deal on the capital account flows, as well as the current account flows. I think too much of the discussion focuses on the current account flows, and the deficit that the U.S. has with China. But what we’ve seen, as your question indicates, is that in fact in recent months there has been a weakening of the RMB as the dollar strengthened. So, the notion that they’re manipulating it is somewhat valid, but they’re manipulating to keep it valuable, rather than to keep it undervalued. I think that is, to a large extent, because of capital flows coming out of China. As long as that continues, it’s likely to be weak.

What we have to see is how capital account convertibility plays out in China. They’ve said they’ll do it, but the time frame is very important. And, as long as there’s money coming out in the kinds of quantities that there are, I think they’ll be reluctant to do it any time soon. So, my own view is that that’s the big issue on the RMB-dollar exchange rate.

Knowledge@Wharton: Also, with Japan, there’s been some jawboning by President Trump about the currency differences. And then, perhaps coincidentally, there was an announcement by Japan that it was willing to make certain investments in the U.S. that would create hundreds of thousands of jobs. What are the merits of the argument that Japan is still — I say ‘still,’ because this was an argument that goes back to the 1980s — manipulating its currency against the U.S. dollar?

Allen: They do intervene more than most countries in the foreign exchange market, but I think this is more to smooth the movements, rather than to have a fundamental effect. The one major achievement of Abenomics was to move the exchange rate so that the yen did effectively devalue against the dollar. But I think that they really are trying to stimulate the economy, and that this was a side effect, rather than the main reason for doing it.

I would say that they aren’t manipulating their currency, and that the charges that the Trump team is making are not particularly valid, with respect to Japan.

Knowledge@Wharton: I think back when Japan first instituted some of those changes, under Abenomics, that the International Monetary Fund (IMF) actually gave them the blessing to go ahead and do that.

Allen: Yes. I think the view was, they’ve had such a bad time for such a long time, that we should give them a free pass on that. But it’s an interesting one, because Brexit basically does the same thing for the pound. The pound has devalued substantially, and the economy’s now doing quite well — partly as a result of that, I think. So, these movements in exchange rates are driven by a wide range of things, and I think that the notion that countries are doing these things on purpose is probably not a valid one, in most cases.

Knowledge@Wharton: The final case I wanted to chat about is Germany. I didn’t expect to be talking about Germany until President Trump came out and accused them of undervaluing their currency, which, of course, is the euro, which, of course, most of the continent uses. There have been criticisms that Germany has benefited from a relatively low euro, because it’s a big exporter, one of the biggest in the world. And so, if it had its own currency, that currency would have gone up a lot. And that would have balanced out its trade with the rest of the world.

But also, Germany has been criticized for not spending more within the EU to take some of those gains, and to spread it around, as it were, and try to stimulate the rest of the EU.

But in any case, Germany doesn’t totally control the euro. So, what’s going on when you actually go head-on against Germany, and accuse it of manipulating its currency?

Allen: I think this is one of the most interesting questions — not just in this aspect, but also, of course, if you look at some of the other things that the Trump administration has been stressing. Like, spending at least 2% of GDP on defense for NATO members. Germany is also one of the biggest violators of that. They’re having a tremendous amount of pressure put on them, I would say.

In terms of the economic aspect, I guess I would be more sympathetic to them in the sense that the euro is not controlled by them. That’s controlled by the European Central Bank (ECB).

And I would think, if they could do anything, they would want the ECB to raise rates. They’ve been complaining bitterly about the penalty that German savers have been facing because of the low interest rates the ECB is setting. And, of course, if they were to raise interest rates, the euro would probably appreciate significantly. So, I think it’s a misplaced charge.

My own view on, should they be spending more? I guess that’s a sort of a macroeconomic view, based on inflexible prices, and whereas there’s some merit to that in the short run, in the long run, I don’t think it’s particularly valid. The one thing we know is that Germany has been running surpluses, in the long run, for many decades now. They’re incredibly competitive. People love their goods. And so, whatever the exchange rate is, they seem to do well. So, I think in this case, the issues raised by Trump are not particularly valid.

Knowledge@Wharton: What do you think is going to happen to the dollar over the next year or two, given pressures I mentioned, at the outset, that suggest that the dollar would go up, at least somewhat? And then, the opposite pressures, at least so far, of the new administration, suggesting they want a softer dollar, and also kind of saber-rattling against our trading partners, when it comes to the currency, in the hopes of improving the U.S. trade position.

Allen: I think a lot of things are already priced in, that you’ve discussed. The one thing that we do definitely know is that forecasting exchange rates is one of the most difficult things to do.

And there are not many people that can do it very well, and I’m certainly not one of them. I wouldn’t be surprised if the dollar strengthened, but I also wouldn’t be surprised if it weakened. I think there’s just so many things that can happen, in terms of the Trump program, that can make it move either way. There are some trade issues that we haven’t seen play out very much yet, particularly with China.

But there are also a number of other things, like security issues, and so on, and how Congress reacts.

What they do about these border taxes that we talked about, and so forth. There are just so many things. It would be very difficult to project what’s going to happen.

Knowledge@Wharton: Is there’s anything else you want to bring up in connection with all of this?

Allen: This issue about the border tax — of making exports non-taxable, and imports non-deductible — is potentially a big thing. Republicans seem to be pushing that hard in Congress, but it’s not quite clear what Trump thinks about it. But that could drastically change a number of things. One would be the dollar, but also, the relative positioning of firms will change quite a lot, I think, if anything like that happens. We’ll see whether it does. How the World Trade Organization will react to that is also up in the air, I would say. But I think that’s a big issue.

Knowledge@Wharton: When you say it could bring big changes for firms, could you describe, just in broad strokes, what some of them are?

Allen: Well, the exporters, like Boeing, and so forth, are going to do wonderfully well. And the importers, like Walmart, are going to do pretty badly, in terms of their taxes. So, that’s one aspect.

Whether or not it will change how they proceed, in terms of importing less and exporting more, I think, is an open question. I’m not sure how much of the effect there will be.

Trump, Islam and the clash of civilisations
The hostility to Muslims is finding adherents across the western world
by: Gideon Rachman

Donald Trump’s travails with his “Muslim ban” make it easy to dismiss the whole idea as an aberration that will swiftly be consigned to history by the judicial system and the court of public opinion. But that would be a misreading. The ban on migrants and refugees from seven mainly Muslim countries was put together clumsily and executed cruelly. But it responded to a hostility to Islam and a craving for security and cultural homogeneity that is finding adherents across the western world — and not just on the far right.

Even if Mr Trump’s ban is withdrawn or amended, it will probably be just the beginning of repeated efforts — in the US and Europe — to restrict migration from the Muslim world into the west.

There certainly should be no doubt about the radicalism of the thinking of some of Mr Trump’s key advisers. Michael Flynn, the president’s embattled national security adviser, and Steve Bannon, his chief strategist, believe that they are involved in a struggle to save western civilisation. In his recent book, The Field of Fight, General Flynn insists that: “We’re in a world war against a messianic mass movement of evil people, most of them inspired by a totalitarian ideology: Radical Islam.” Mr Bannon holds similar views. In a now famous contribution to a seminar at the Vatican in 2014, he argued that the west is at the “beginning stages of a global war against Islamic fascism”.

The fact that Mr Trump’s closest advisers believe they are engaged in a battle to save western civilisation is a key to understanding the Trump administration. It helps explain why the president, in his inaugural address, pledged to defend the “civilised world” — not the “free world”, the phrase that would have been naturally used by a Ronald Reagan or a John F Kennedy.

This tendency to conceive of the west in civilisational or even racial terms — rather than through ideology or institutions — also helps explain the Trump team’s sympathy with Vladimir Putin’s Russia and hostility to Angela Merkel’s Germany. Once the west is thought of as synonymous with “Judeo-Christian civilisation” then Mr Putin looks more like a friend than a foe. The Russian president’s closeness to the Orthodox church, his cultural conservatism and his demonstrated willingness to fight brutal wars against Islamists in Chechnya and Syria cast him as an ally. By contrast, Ms Merkel’s willingness to admit more than a million mostly Muslim refugees into Germany make America’s alt-right regard her as a traitor to western civilisation. President Trump has called the German chancellor’s refugee policy a “catastrophic” error.

Through his Breitbart news service, Mr Bannon forged close ties with the European far-right, who share his hostility to Islam and immigration. The belief that the west is engaged in a mortal struggle with radical Islam clearly animates Marine Le Pen, leader of France’s National Front, who recently argued that: “Washington, Paris and Moscow must form a strategic alliance against Islamic fundamentalism . . . Let us stop the quarrels and unnecessary polemics, the scale of the threat forces us to move fast, and together.”

These views are not confined to the political extremes in France. François Fillon, the centre-right’s candidate in the presidential election, recently published a book called, Conquer Islamic Totalitarianism, which contains the Flynn-like declaration that: “We are in a war with an adversary that knows neither weakness nor truce.” Pierre Lellouche, France’s former Europe minister, has also just brought out a book called War without End, which argues that Islamism is the 21st-century equivalent of Nazism.

Far-right parties with a Trumpian view of Islam are also prospering in the Netherlands and in Germany. The Freedom party led by Geert Wilders is set to top the polls in next month’s Dutch elections — although it is unlikely to enter government. In Germany, the Alternative for Germany party has surged in response to the refugee crisis, and is likely to become the first far-right party to enter the country’s parliament since 1945. Some in the British government believe that hostility to immigration from the Islamic world — more than Europe — lay behind the discontent that triggered the Brexit vote last year.

Sympathy for the Bannon-Flynn-Trump view of Islam extends beyond the US and Europe. A belief that their nations face an elemental threat from radical Islam is also an animating force on the rightwing of Indian and Israeli politics.

Even if Mr Trump loses the battle over his executive order on refugees and immigration, he is likely to return to the fray with further measures. That is because his closest advisers and many of his strongest supporters will remain driven by a deep suspicion of Islam and a determination to stop Muslim immigration.

There will also, almost inevitably, be further jihadist attacks in both the US and Europe that will feed this fear and hostility. Meanwhile, the long-term demographic trends that create pressure for migration from Muslim countries to the US and Europe will only increase in the coming years. The population of impoverished, largely Muslim, north Africa is much younger than that of Europe, and growing fast.

The polemic over Mr Trump’s “Muslim ban” will not be an isolated event. On the contrary, it is a foretaste of the future of politics in the west.

Make Big Banks Put 20% Down—Just Like Home Buyers Do

Financial CEOs say capital requirements are already too high, but the facts suggest otherwise.

By Neel Kashkari

There’s a straightforward way to help prevent the next financial crisis, fix the too-big-to-fail problem, and still relax regulations on community lenders: increase capital requirements for the largest banks. In November, the Federal Reserve Bank of Minneapolis, which I lead, announced a draft proposal to do precisely that. Our plan would increase capital requirements on the biggest banks—those with assets over $250 billion—to at least 23.5%. It would reduce the risk of a taxpayer bailout to less than 10% over the next century.

Alarmingly, there has been recent public discussion of moving in the opposite direction. Several large-bank CEOs have suggested that their capital requirements are already too high and are holding back lending. As this newspaper reported, Bank of America CEO Brian Moynihan recently asked, “Do we have [to hold] an extra $20 billion in capital? Which doesn’t sound like a lot, but that’s $200 billion in loans we could make.”

It is true that some regulations implemented after the 2008 financial crisis are imposing undue burdens, especially on small banks, without actually making the financial system safer. But the assertion that capital requirements are holding back lending is demonstrably false.

How can I prove it? Simple: Borrowing costs for homeowners and businesses are near record lows. If loans were scarce, borrowers would be competing for them, driving up costs. That isn’t happening. Nor do other indicators suggest a lack of loans. Bank credit has grown 23% over the past three years, about twice as much as nominal gross domestic product. Only 4% of small businesses surveyed by the National Federation of Independent Business report not having their credit needs met.

If capital standards are relaxed, banks will almost certainly use the newly freed money to buy back their stock and increase dividends. The goal for large banks won’t be to increase lending, but to boost their stock prices. Let’s not forget: That’s the job of a bank CEO. It isn’t to protect taxpayers.

So if capital requirements aren’t the problem, why does it feel so hard to get a loan today? I can speak from firsthand experience. Last year my wife and I decided to buy a house. We applied for a loan with a bank where I have been a customer for many years. I assumed that my long record with the bank and our good credit would make it easy. With the required 20% down payment, we were prequalified for a mortgage with a rate of 3.375% fixed for the first 10 years. That was an attractive rate, suggesting capital was not holding back lending.

The prequalification was easy. Then the frustration began. The mortgage banker asked for myriad documents: bank statements, 401(k) statements, brokerage statements, tax returns, W-2s, insurance records and so on. That all seemed reasonable, but as the weeks rolled on, the requests for more documentation kept coming. After a month or so, I couldn’t believe what I was being asked for. Despite having all the records of my on-time monthly rental payments in my checking account, the bank demanded a copy of my lease and to speak with my landlord.

The banker called me to apologize, admitting that the requests were ridiculous but saying that there was no reasoning with the underwriting department. As we waited, we began to wonder if we wanted to buy the house at all. Wouldn’t continuing to rent be so much easier?

In the end, the bank funded the loan. I felt bad for the underwriters, who seemed unable to exercise judgment or use common sense. The impression I got was that people at the bank were simply paralyzed by fear—that they might make a mistake, that regulators would be breathing down their necks.

I have spoken to many borrowers at other banks, and they tell me similar stories. It has become needlessly difficult for qualified borrowers to get loans. But again, the problem isn’t the capital requirements—it’s everything else.

Capital is the best defense against bailouts. Although capital standards are higher than before the last crisis, they are not nearly high enough. The odds of a bailout in the next century are still nearly 70%. Large banks need to be able to withstand around a 20% loss on their assets to protect against taxpayer bailouts in a downturn like the Great Recession, according to a 2015 analysis by the Federal Reserve. Unfortunately, regulators have taken it easy on the large banks, which today have only about half of the equity they need.

There is a simple and fair solution to the too-big-to-fail problem. Banks ask us to put 20% down when buying our homes to protect them in case we run into trouble. Similarly, taxpayers should make large banks put 20% down in the form of equity to prevent bailouts in case the financial system runs into trouble. Higher capital for large banks and streamlined regulation for small banks would minimize frustration for borrowers. If 20% down is reasonable to ask of us, it is reasonable to ask of the banks.

Mr. Kashkari is president of the Federal Reserve Bank of Minneapolis and a participant in the Federal Open Market Committee.

The European Unraveling?

Ana Palacio

 EUprotest poland


MADRID – After years of intensifying fragmentation and tension, the European Union may be on the verge of losing its most precious assets: peace, prosperity, freedom of movement, and values such as tolerance, openness, and unity. Will Europeans unite in time to save them?
The danger facing the EU became starkly apparent last June, when the United Kingdom voted to leave. And Donald Trump’s election as US president has made matters far worse. The United States, Europe’s closest and most powerful ally – a crucial security partner and bearer of shared values – is now headed in a very different direction, and threatening to leave a shaken and divided Europe alone in a harsh world eager to tear it apart.
This might sound hyperbolic. Many in the US political class remain convinced – at least in public – that US foreign policy under Trump will be reined in by the more level-headed heavyweights in his cabinet, such as Secretary of Defense James Mattis and Secretary of State Rex Tillerson. “Don’t worry,” they say, “the worst will not happen.”
But, in my experience, the person who really counts is the one who has the president’s ear. And, so far, all signs indicate that Trump’s inner circle is driving policymaking. In fact, the pronouncements and executive orders of Trump’s first weeks in office convey a singular ideological perspective – the one long espoused by White House Chief Strategist Steve Bannon, an ultra-nationalist, acolyte of the Italian fascist philosopher Julius Evola, and long-time enabler of America’s white-supremacist “alt-right.”
As if to underscore his Rasputin-like influence, Bannon has now secured a seat on the National Security Council Principals Committee, which includes the secretaries of state and defense, but not the director of national intelligence or the chairman of the joint chiefs of staff. No surprise, then, that #PresidentBannon has been trending on Twitter.
Ordinarily, I would not pontificate on the structure of another country’s foreign-policy apparatus. But Trump’s is no ordinary US presidency, so we all have a responsibility to consider the implications of the White House’s ideological about face from traditional democratic and Western thinking for our own countries. For Europeans, this responsibility is particularly urgent, because America’s new driving ideology emphasizes the traditional Westphalian nation-state, with its insistence on sovereignty, strong borders, and nationalism.

The EU – built on the idea of strength, peace, and prosperity through cooperation – is anathema to it.
The problem for the EU is no longer the indifference that marked the worst elements of President Barack Obama’s approach to Europe. It is outright US hostility. Trump’s praise of Brexit, which emphasized the British people’s “right to self-determination,” and his belittling reference to the EU as “the Consortium” in his appearance with British Prime Minister Theresa May, underscores his hostility.
Europe is now stuck between a US and a Russia that are determined to divide it. What are we Europeans to do?
One option is to pander to Trump. That is the approach May took on her visit to Washington, DC, when she stood by silently as Trump openly declared his support for the use of torture at their joint press conference.
But, for the EU, such appeasement would be counter-productive. It is our values, not our borders, that define us. It makes little sense to abandon them, especially to ingratiate ourselves with a leader who has shown himself to be capricious and utterly untrustworthy.
Another option is to find a new savior – perhaps a country like China, which not only is America’s closest analogue, in terms of economic impact, but also has attracted substantial attention lately, owing to its president’s robust defense of globalization.
But we should beware of false messiahs. The global vision promoted by China focuses almost entirely on economic relations – precisely the soullessness that got the liberal world order into trouble in the first place. A sense of common purpose, not just the operation of the market, binds humanity together. Were it otherwise, the EU’s single market would have been enough to protect it from the existential threat it now faces.
The third option – and the only viable one for the EU – is self-reliance and self-determination.
Only by strengthening its own international positions – increasing its leverage, in today’s jargon – can the EU cope effectively with America’s wavering fidelity to its allies and the values they share.
Pursuing this option implies that the EU should push for progress in trade talks with Japan, negotiate an investment agreement with China, modernize the EU-Mexico Global Agreement, and position itself as a world leader on tax reform. Moreover, Europe should take greater responsibility for its defense, both by increasing spending and by pursuing continental cooperation aimed at using resources and capabilities more efficiently.
To address the migration challenge it faces, Europe should craft a policy guided by its values, as well as its security and economic interests. That means distinguishing between economic migrants and refugees, strengthening border controls, and boosting cooperation with third countries.
In all that it does, from this moment on, the EU must affirm and advance the values – openness, human rights, knowledge, and the rule of law – that have enabled Europe to recover, grow, and thrive for more than seven decades. French President François Hollande and German Chancellor Angela Merkel’s recent call for a “clear, common commitment” to the EU is a good start.
But such calls must now be backed by action. That may be difficult for the next nine months, as the Netherlands, France, and Germany hold national elections. It will be even more difficult if an extremist candidate in one or more of these countries achieves a surprise victory. But if Europe’s political center holds, as expected, the EU will be in a strong position to confront increasingly hostile external forces and move forward with purpose.

Something Rotten in the State of Russia?

By George Friedman and Jacob L. Shapiro

Geopolitical Futures’ forecast for 2017 says the following: “In hindsight, the coming year will be an inflection point in the long-term destabilization of Russia that we predict will reach a boiling point by 2040.” This may seem counterintuitive in light of the Russia hysteria following the US presidential election. Yet in the first six weeks of 2017, it is already possible to observe indicators that this forecast is on track.

These indicators fall roughly into four separate categories of instability: the distribution and prevalence of wage arrears, pressure on the Russian banking system, low-level social and economic unrest, and government purges. The map below summarizes these developments.

Before we get started…

It is our pleasure to invite you to Geopolitical Futures’ inaugural conference, The Next 4 Years: The Role of the United States in the World. This exclusive April 5 event at the Army and Navy Club in Washington, DC will bring together brilliant minds to tackle today’s critical geopolitical issues and help you plan for the coming years.

In addition, you will have the opportunity to meet and talk with George and Meredith, GPF analysts Jacob L. Shapiro, Kamran Bokhari, and Antonia Colibasanu, and several of the other panelists. Our elite list of speakers includes Harald Malmgren, former adviser to four presidents; Theodore Karasik, senior adviser to Gulf State Analytics; Ariel Cohen, director of the Center for Energy, Natural Resources, and Geopolitics; and Stephen Blank, senior fellow at the American Foreign Policy Council… with more to be added to the event page  in the coming weeks.

Attendance is strictly limited to 80 guests, so there’s no time to waste. To ensure your place at this important conference, please reserve your ticket today. We hope to see you there.
Show Me the Money

The bottom part of the Russia map shows wage arrears as reported by region. “Wage arrears” is a fancy term for workers not being paid. In December 2016 (the last month for which Russia’s Federal State Statistics Service has data), total wage arrears amounted to 2.7 billion rubles (roughly $46.4 million in USD).

The regions with the largest wage arrears can be divided into two categories. The first is port regions. Primorsky region, whose capital Vladivostok is Russia’s largest port on the Pacific, has by far the worst incidence of wage arrears. It accounts for 21.2% of the country’s total. The area where it is the second most prevalent is Siberia (in places like Irkutsk and Novosibirsk).

The importance of these wage arrears is not their size in absolute figures. It is where Russian workers are not getting their paychecks. Russia’s economy is highly regionalized. More than a fifth of Russia’s wealth is generated in Moscow and its surrounding areas. The central government keeps the Russian Federation together by redistributing wealth to interior regions.

The first places to expect economic trouble are port and interior regions. The port regions will struggle because trade is the oxygen that port cities need to breathe, and Russia’s main export, oil, is facing prolonged low prices. The interior will struggle because the central government will have less money to allocate. This forces a lose-lose choice between austerity and cutting military spending

The wage arrears map is an indication that GPF’s model for Russia is accurate. If the model is accurate, the probability of the forecast coming to fruition greatly increases.
Russia’s Banking System

The decline in the price of oil has had a predictably negative effect on the Russian banking system. Incidents of Russian depositors applying for deposit insurance have increased markedly.

Some regions are suffering from banking crises. In Tatarstan, for example, the region’s leading bank suspended operations in December, depriving both individual depositors and businesses of access to funds. This led to workers not being paid and to bankruptcies. It also required intervention from the central government.

The above map identifies regions where over 100 banks have had their licenses revoked. By itself, this indicator does not present a clear picture. Russia’s banks could be under severe pressure. The fact that the main fund used by Russia’s Deposit Insurance Agency has decreased in value by 75% in two years gives this argument some weight. Russia could also be cleaning up its banking system and shutting down banks involved in illegal or irresponsible activity. In view of the other negative indicators about the current state of Russia’s economy, the former is a more likely explanation.
Protests in the Countryside

The logical consequence of economic difficulty is social unrest. The world is not always logical, but in this case, what logic would dictate appears to hold true. Small-scale protests have been observed throughout the Russian countryside. Small incidents have also occurred in major cities like Moscow and St. Petersburg. The map plots areas where protests have been observed.

It is important to note two things. First, none of these protests have indicated any sort of wider national organization. Second, they are relatively small (often in the low hundreds). They are important, but they should not be over-exaggerated. The Russian countryside is not singing the songs of angry men, nor is it close to doing so.

There are, though, concrete signs of dissatisfaction bubbling to the surface. These are tangible indicators of frustration with salary cuts, unpaid wages, and social services reduced by Moscow. These small events are the canary in the coal mine and spell trouble down the line for the Russian government.

The remaining two items on the map show political and security purges ordered by President Vladimir Putin. Russian media have described these moves as a “major political reshuffle.” That is a euphemism for what it really is.

The point of a purge is to get rid of potential challengers and install loyalists in their place. On Feb. 6–7, two governors from Perm and Buryatia regions were forced to resign. Vedomosti, a leading Russian-language business daily, reported that additional resignations and removals are expected in the regions identified in the map.

Unlike wage arrears, these purges are not confined to any one geographic area. Some are in Siberia to the east, some are in the regions toward the Caucasus, and others are in the immediate vicinity of Moscow. That Putin feels unsure enough of his own position to carry out these kinds of political changes reveals a great deal about the position in which he currently stands.

Presidential elections are coming for Russia. They will likely be held in 2018 (though there have been rumors they could happen in 2017). Like President Xi Jinping in China, who is using “anti-corruption” as a pretense to remove rivals ahead of his reappointment at this fall’s Communist Party Congress, Putin is securing his political position in the name of fighting corruption.

The purges are not limited to governors who have significant powers in the Russian Federation’s political system. Putin has also removed generals from the Interior Ministry as well as the Ministry of Civil Defense, Emergencies and Elimination of Consequences of National Disasters. These ministries are responsible for forces that are used to control domestic social order and quell protests. Ensuring the loyalty of such ministries is essential and must be done before serious problems emerge. A total of 16 generals have been removed, according to RIA Novosti, and two of those were also removed from military service.
Writing on the Wall?

This report is not meant to be alarmist. It is not GPF’s forecast that the Russian Federation is in danger of imminent collapse. None of these data points by themselves indicate that GPF’s forecast has been confirmed. They simply highlight Russia’s underlying weakness and explain why Putin, who just a few months ago was strutting on the world stage, has gone somewhat quiet. Important things need to be done at home. This is where Moscow’s focus is right now, and in choosing that focus, GPF and Russia have something in common.

“Trump-O-Nomics” – An exploration of the proposals

As readers know, I have been doing a multipart series on the proposed tax reforms for the last three weeks in Thoughts from the Frontline. My intention is to finish this week. In part two I talked about what I like about the Better Way proposal, and in part three I pretty much eviscerated the border adjustment tax (BAT), which I think has the real potential to create a global recession. You’ll need to read the series to see why, but a lot of it has to do with simple game theory, which the measure’s Republican proponents are ignoring. If you upset the equilibrium, the other partners at the table will change their strategies, too.

Let me repeat that what I find encouraging about the proposed tax reforms is that they are fairly radical in the sense that there is not an obvious constituency for much of what is proposed, and it will require some real leadership in Congress to get them passed. In the past I have proposed a series of tax reforms (sometimes with my friend and fellow economist Steve Moore, in op-eds around the country) that are pro-business/entrepreneur, but we have always constrained our proposals by what we saw as political reality.

If the Republican leadership thinks they can get the BAT through Congress, then I’m going to take the constraints off my thinking and propose something that is even more radical but much more workable and would not come with the negatives that the current Republican proposal does. (It is also something that most economists would agree with, at least in theory.) It would unloose a massive amount of entrepreneurial spirit and free up capital to go where it can be most productive, AND it will balance the budget. My proposal will makes the United States heads up more competitive vis-à-vis the rest of the world world and yet allow other countries to respond in a similar fashion, making their own economies more competitive but without their having to try to outcompete with us and thereby hurt global trade. But that’s all for this weekend…

Today I want to offer as your Outside the Box an analysis of the current tax proposal from my friend Constance Hunter, who is the chief economist at KPMG and wicked brilliant. We spent some time in the Caymans last week talking about these issues, and she graciously allowed me to send this internal KPMG document to you.

She analyzes the entire proposal and tries to be fair but comes up with many of the same negatives that I do and a few more besides. One of the things that Constance and a few readers have noted is that the real, forceful change that is required to get this reform through Congress will mean that, without Democratic support in the Senate, there will be an automatic sunset provision in 10 years that would be devastating to the economy. There needs to be a real effort to figure out how to create something bipartisan.

Further, in a conversation yesterday at lunch with a large family farmer, he casually noted how farmers have to borrow money in the spring and pay it back in the fall. This has been going on for hundreds of years and is actually a quite well-documented phenomenon of banking cash flows. In the 1800s, New York bankers would game this dollar flow, but that’s a story for another day.

By not allowing any interest-rate deduction, as the tax-reform proposal seeks to do, you will simply destroy the family-farming community nationwide. I think when farm-state Republican Senators realize what this proposal will do, they will line up to oppose it. Which is good, because I would really prefer not to see us plunged into a global recession.

One thing that Constance does well is to bring in other economists and their papers and really get into how the economics community is thinking about some of the major consequences of this tax plan. Again, it is not that the current proposal doesn’t have many good features; it is that the bad ones – which actually allow you to pay for the good tax cuts – go about it in the wrong way and create serious problems.

Why is this so important? Because if we don’t come up with a tax proposal that can get through Congress this year, then we’re looking at 2018; and do you really think the stock market is going to levitate, waiting until 2018 for a tax proposal that’s not even on the table yet? Congress needs to focus clearly and figure out what they’re going to do – and not do things that would make the US and global economic situation even worse.

As investors and portfolio managers, we need to be paying attention to what Congress is saying and doing and figure out how their actions are going to affect the economy and our portfolios. The right policies and programs could be very good for the markets. The wrong ones? You’d want to get out of the way of that train.

As much as I enjoy traveling and the Caymans in particular, it is good to be back in Dallas for a few weeks and trying to catch up. As I’ve been hinting, we are getting close to announcing our new approach to portfolio design and management. It will be available to everyone, but we are especially looking to make it available to brokers and advisers to use with their own clients. The team we have put together is actually quite large, and there are a lot of moving parts to handle to make sure we’re ready for what I hope will be a strong response when we launch. But getting all the materials and contracts and agreements and compliance done in advance has been a bigger project than I realized.

But then, that has been the story of my life. My friends and partners can tell you that I start projects not realizing how huge they are going to be until I’m in the middle of them. Kind of like my book on how the next 20 years will look. What I thought was going to be a fairly straightforward book is now massively complex, and part of the challenge is to make sure it’s not a five-volume set but is actually a fairly thrifty overview of the Age of Transformation.

And with that I will hit the send button and try to get back to my inbox, plus take care of a lot of writing and research that I need to do. You have a great week, and remember that no matter what the politicians do to us, we’ll all figure out how to Muddle Through together.

Your appreciating the reality of complexity analyst,

John Mauldin, Editor
Outside the Box

“Trump-O-Nomics” – An exploration of the proposals

By Constance Hunter and Jennifer Dorfman
KPMG US Economic Update

As Donald J. Trump begins the presidency with promises of greater GDP growth and job creation, this report examines both the cyclical and structural backdrop that could impact the efficacy of his plans. The report will also discuss the border adjustable tax proposal and some possible implications. The analysis takes into account the more than 20 percent of U.S. imports that are priced in dollars, a unique situation that alters the normal currency adjustment assumptions economists make when assessing the impact of such a tax.

It is debatable how much influence presidents can have over near-term, cyclical, economic growth. Certainly expansionary or contractionary fiscal policy has some influence, but in the United States, discretionary government spending is a relatively small percent of GDP so this influence is minimal. Presidents have more influence over structural aspects of GDP via changes to regulation, changes to the tax code, and changes to total government spending and resulting debt levels.

In terms of the cyclical prospects for the UnitedStates, the recovery appears to be in about the 7th inning. The Federal Reserve Bank (the Fed) is hoping its policies can create some overtime innings and a soft landing; however, this is often the hope of central banks, yet few are lucky enough to achieve such feats. The largest constraint to the Fed’s goals is apparent tightness in the U.S. labor market. For example, the National Federation for Independent Business1 reports that the number of respondents who say there are few or no qualified applicants for job openings exceeds the long-term average of 42 percent. This suggests that even if the participation rate rose, the lack of labor market depth would still pose constraints for business expansion despite any new incentives from tax changes or other stimulative measures.

In addition to relatively tight labor supply, the Fed has just raised rates for the second time in the current cycle. Since the election, long-term interest rates have risen more than short-term ones due to anticipation of more frequent rate increases in 2017 and some possible increase in risk premia due to fiscal policy uncertainty. However, we believe the biggest contributor to higher rates is the stronger U.S. economy that was in train before the presidential election. In addition to cyclical momentum seen in jobs and consumption growth, higher oil prices are supporting a return of oil and gas investment. Our base forecast for growth in 2017 is now higher than before the election due to strong growth momentum.

Therefore,Trump enters his presidency at the end of a long, if tepid, expansion with little capacity for faster growth in the near term.

Nevertheless, during the first 100 days, the Trump administration will want to achieve some quick wins. One way to start this would be to streamline regulation. A study from the conservative think tank, Heritage Foundation2 found the cost of new regulations implemented since 2008 amount to an average of $15 billion a year spent on compliance. The argument suggests this is money not spent on generating economic activity and it reduces productivity. Even if this number is off by 50 percent, given that U.S. corporate investment has averaged $130 billion a year since 2010, even $7 billion of extra investment could add up to 50 basis points a year to investment’s contribution to GDP.

In terms of fiscal stimulus from Trump’s tax policies, it is important to remember that in addition to lower personal and corporate taxes, there are proposals that would create offsets to pay for the cuts. At the moment, Republicans are united in saying that the tax cuts and offsets are part of the same proposal and cannot be separated. Therefore, their economic impact must be assessed in concert.

There is a good reason for the insistence by many Republicans that spending not simply stay the same while tax revenue declines due to tax cuts, as this would increase our already high 102 percent general government debt to GDP levels. Here one can turn to a well-established phenomenon in economics, the Ricardian Equivalence Theorem.3 Ricardian Equivalence states that the economic outcome between debt financing and increased private spending is equal.

Or put another way, there is no free lunch. If tax cuts cause the federal debt to rise, then companies and households spend and invest less than the amount of the cut. The greater the debt level at the initiation of the tax cut the smaller the portion that is spent or invested.

The first offset is a change to the deductibility of interest. Under the current House Republican proposal,4 interest would no longer be deductible unless it could be claimed against interest income.

While this is neutral for banks, in isolation it could hurt heavily indebted industries, many private equity structures, and companies that rely on debt versus equity financing. Proponents of the tax change argue that reducing the tax benefits of debt financing would allow better allocation of capital and would normalize the U.S. tax code with the rest of the world. Nevertheless, most U.S. companies will see an increase in their weighted average cost of capital (WACC). According to outside estimates of the GOP proposal, this would raise more than $1 trillion in additional tax receipts.5 However, this change comes at a price. A November 2015 paper by RLG Forensics in association with the Association for Corporate Growth predicts that “revenue neutral” in terms of the federal budget is not the same thing as “impact neutral” in terms of equity valuations or economic impact.6 Proponents of the change argue that investment expensing and the reduction of the overall corporate tax rate to 20 percent will offset the increase of the cost of WACC in many cases. While this may be true eventually, the transition period is likely to cause lumpiness in investment spending, which could well translate into some quarters of negative growth.

The second offset, implementing a border adjustable tax, is estimated to raise $1.2 trillion in tax revenue over 10 years. One main motivation for this tax appears to be that it would discourage corporate inversions. As A Better Way7 notes, “Taken together, a 20 percent corporate rate, a switch to a territorial system, and border adjustments will cause the recent wave of inversions to come to a halt.” However, other claims that the change will now favor exports over imports ignores linkages between imports, exports, and foreign exchange values. Perhaps more importantly, if the tax changes did reduce our imports, it would also reduce our standard of living, as more goods and services would be sent to foreigners while receiving fewer goods and services from them in return.8

Indeed the fact that in any given year 20–30 percent of U.S. imports are priced in dollars means the J-curve effects of the currency adjustment would likely take longer and could be adverse for importers of commodities in the short term. Additionally, the linkages in global value chains where many goods are priced in dollars, the long-term nature of contracts, and general price stickiness throughout the value chain mean the transition between implementation and complete currency adjustment could disrupt U.S. and global GDP growth.

Nevertheless, many economists make several arguments in favor of a border adjustable tax system.9

1.    It would align more closely with the VAT system in most of our trading partners where exports are not taxed but imports are.

2.    Border adjustments reduce the incentive to manipulate transfer prices by shifting to lower tax jurisdictions based on tax policy alone.

3.    Border adjustments reduce the incentive to shift profitable production activities abroad simply for tax benefits of lower tax jurisdictions commonly known as corporate inversions.

4.    Proponents argue that border adjustments are not trade policy, but rather create a level playing field between domestic and overseas competition.

5.    Border adjustments do not distort trade as exchange rates should react immediately to offset the impact of these adjustments.

Many economists agree with most of these points. We concur largely with points 1-3 and in the long run with point 5, although the implementation phase could cause disruption that may have a significant near-term impact on GDP. On point 5, the reserve currency status of the United States blunts this negative impact. Our research suggests that the reserve currency status of the United States and integrated global value chains could slow the rate of currency adjustment with adverse unintended consequences for world and U.S. growth. The stronger U.S. dollar will raise prices of dollar priced goods for the rest of the world which will, at some point, if not immediately, lower demand for these goods. No immediate adjustment will take place on the 20–30 percent of imports priced in U.S. dollars, and it will raise prices and lower demand of these goods worldwide.

Raising $1.1 trillion in taxes means that cost must be borne by some part of the economy either domestically or by trading partners. In the example below, the tax law change simply shifts the burden of the tax to different types of businesses.

Auerbach and Holtz-Eakin assume that the world price of the goods remains the same and that the dollar appreciates to offset the border adjustment. They also appear to assume that the good is priced in foreign currency and no long-term contracts or integrated value chains are in place. Economic theory suggests that the higher import tax cost in the example below does not mean that the firm does worse after tax under the new system once the currency adjustment is completed and the cost of imports falls due to the higher value of the U.S. dollar. Under the new law, the firm in the example below can deduct only 20 of its purchases rather than 30 because 10 represents the imported amount. However, as Auerbach and Holtz- Eakin’s paper explains, the import costs will adjust to be 8 in dollar terms, rather than 10, if the tax rate is 20 percent. This means that the firm’s after-tax cash flow will be the same in the two cases; 80 percent of 15 = 12 under the current system, and 80 percent of 25 = 20 – nondeductible expenses of 8 = 12 under the new system.

We worry that this assumption is a bit too neat and the real-world adjustment will be less smooth and not immediate. As the home of the reserve currency, U.S. importers have the significant advantage of never having to worry about currency price fluctuations (in particular a devaluation of the dollar) impacting the purchase cost of commodities and many other goods that are part of the global value chain. There are other advantages such as significant demand for U.S. Treasuries keeping U.S. borrowing costs lower than they otherwise would be. But the chief advantage for the purpose of analyzing the border adjustable tax is that commodities trade in U.S. dollars.

The example put forth by Auerbach and Holtz-Eakin assumes the exchange rate absorbs the tax change and the cost evaporates in currency fluctuations. The tax law change would then encourage investment as its full expensing regime makes this activity more attractive; it would also blunt the impact from the import tax. It is implicitly assumed that this greater investment will translate into greater economic activity and yield a higher growth rate. One may also assume one has a can opener.10

Over the long term, it seems reasonable that the proposed tax law change would simplify the code, which in and of itself could allocate scarce resources to better use thereby improving GDP. However, the transition to the new system as laid out in A Better Way does raise some questions, a few of which are outlined below.

1.    The assumption that all traded goods are priced in foreign currency is a key part of most exchange rate models that one can apply to this situation. Examples such as the Bickerdike-Robinson-Meltzer Model assume the supply and demand schedules shift downward by the same proportion as the appreciation.11 It also assumes the good is priced in foreign currency terms, which for the United States is not the case for 20–30 percent of its imports in a given year.

2.    The demand elasticity is not the same for each imported product so the currency adjustment on a good-by-good basis may not be equal to the tax change. Therefore, some importers would be more or less advantaged as would some exporters.  

3.    With no offsetting tax cut, a rise in the value of the dollar would hurt exports. With the reduced corporate tax, exporters would presumably have room to lower the price of their goods in line with the amount of the appreciation of the currency. However, this transition is likely to be “lumpy” and could reduce exporters’ revenues during the transition period and beyond.

4.    Not all importers are engaging in corporate inversion or are importing goods because of tax reasons. Global value chains (GVCs) have become increasingly integrated. In 2011, nearly half of world trade in goods and services took place within GVCs, up from 36 per cent in 1995.12 This is due in part to labor cost differentials, in part to sourcing of raw materials, and in part to expertise in certain products and services. Thus, changing the way imports are taxed for U.S.-domiciled companies is likely to cause disruption to globally linked supply chains many U.S. multinational companies have in place.  

5.    The J-curve effect means that there is a lag between when a currency change takes place and the physical change in imports or exports is realized in the current account balance. Usually orders that existed before the currency move have yet to be paid for, thus the J-shaped change in the trade balance immediately following a substantial currency move. A stronger dollar should increase the current account deficit over time as U.S. dollar exports become more expensive to our trading partners. Additionally, the immediate effect would be a reduction in the current account deficit. This would be an addition to GDP but it would also correspond to a significantly smaller capital account surplus and would likely negatively impact the U.S. equity market and increase U.S. interest rates, all other things equal.

6.    The idea of wanting to stimulate exports, reduce imports, and reduce our current account deficit ignores the other side of this accounting identity, the capital account. As Ruddy Dornbusch wisely noted, “The flow of investment and the changes in the value of real capital potentially dominate the effects of current account imbalances. A good week on the stock market produces a change in wealth that is several times the magnitude of an entire year’s deficit in the current account. Although it is true that the current account is important because persistent current imbalances accumulate, exactly the same argument can be made for investment.” A persistently lower current account deficit would equal a persistently lower capital account surplus and over time higher interest rates and lower stock market returns. Conversely, a high current account deficit means there is a higher capital account surplus and an abundance of capital in the U.S. market. This is also a function of our reserve currency status; foreign holders of U.S. dollars need to invest their holdings in U.S. assets. Therefore, one can argue that the benefit to the economy overall of running a current account deficit and a capital account surplus not only outweighs the costs, but is a corollary to reserve currency status.

7.    While it is commonly known that commodities trade in U.S. dollars, it is likely less widely known that much of the global value chain of intermediate goods also trades in dollars. This is in part because the U.S. consumer base is the largest in the world which reinforces the United States’ reserve currency status. If at the margin a border adjustable tax caused fewer goods to be priced in dollars, it could have the unintended consequence of pushing the U.S. dollar further from reserve currency status.

There are of course other aspects of the A Better Way blueprint that could have unintended consequences. The list above is meant to stimulate thought and improvement of the plan and its implementation.

While some theory does support the idea that it would improve U.S. GDP, there are a lot of assumptions that cannot be counted upon. It cannot be overstated that while a major tax overhaul of this kind could in the long run benefit the U.S. economy, the transition is likely to be lumpy and could even see some quarters of negative growth as adversely impacted firms or industries suffer or go out of business.

The comprehensive and sweeping nature of the proposed tax changes and the fact that they will be much more effective if they are permanent means that the GOP will want to be strategic in the way they pass the bill.

There are two options that would eliminate the need for a sunset provision. The first would require at least eight Democrat senators to sign on. This means that compromise will alter the current proposal. It also means that passage before the end of 2017 will be difficult. Reagan’s 1986 tax law change took three years to negotiate and this tax bill will take time as well. The second way the GOP could make the law permanent is the so-called reconciliation process. This is only possible if the law does not increase the deficit in any year beyond the official 10-year budget window. Some believe this is their current plan—to construct the bill in such a way to be revenue neutral or positive in years 11 and beyond. This too would require significant changes to the current law. The Tax Policy Center assumes the current plan adds to current deficit levels by $3.3 trillion over the first decade.

In the meantime, it is expected the U.S. dollar to be the most immediate asset to anticipate this change in policy over the course of 2017. Any move in the dollar will be buttressed by the interest rate differential between the U.S. and other high- grade government debt markets. Higher interest rates will put pressure on Trump to achieve GDP wins early as it will reduce U.S. exports, increase imports, and have a negative effect on GDP. Therefore, as stated above, regulatory changes are expected to be sweeping withinTrump’s first 100 days. However, even this is not a panacea as many of these changes will be seen in the energy space where the value of a barrel of oil will be just as important in determining investment levels as regulatory changes. Remember, a stronger dollar reduces the demand and price for oil in foreign currency terms, all things being equal.

Therefore, it is fair to say that Trump’s 4 percent growth target faces challenges from both structural and cyclical factors. Streamlining regulation is Trump’s best bet for a quick win on increasing GDP. __________

1  NFIB, Haver Analytics
2  Gattuso & Katz, (2016) “Red Tape Rising,” Heritage Foundation
3  Buchanan, James M. (1976) “Barro on the Ricardian Equivalence Theorem,” Journal of Political Economy
4  A Better Way (2016) Better.gop
5  Nunns, Burman, Page, et al (2016) An Analysis of the House GOP Tax Plan, TaxPolicyCenter.org
6  Morris, (2015) Eliminating the CIT Deduction: Valuation Implications for Middle Market Enterprises. RLG Forensics
7  A Better Way (2016) Better.gop
8  Viard,(2009) Border Tax Adjustments Won’t Stimulate Exports, AEI.org
9  Auerbach and Holtz-Eakin, (2016) The Role of Border Adjustments in International Taxation, AAF.org
10  A can of soup washes ashore. The physicist says, "Lets smash the can open with a  rock." The chemist says, "Let's build a fire and heat the can first." The economist says, "Let’s assume that we have a can opener.” Crickets.
11  Bickerdike-Robinson-Meltzer (1975), Vol 65, no 5 American Economic Review
12  Trade in value-added and global value chains: statistical profiles, WTO, wto.org