More on Complexity Economics

John Mauldin


In last weekend’s Thoughts from the Frontline, I talked about how the economics profession in general and central bankers in particular have consistently failed with their economic projections, and I pointed to the need to deepen our understanding of complex systems behavior. I said that we need to marry complex systems theory and information theory in order to establish a new basis for analyzing the economy and creating economic policy.
I couldn’t have been happier, then, when the new issue of Michael Lewitt’s The Credit Strategist popped into my inbox this morning and I found him addressing the same issue. Michael leads off with a discussion of the views of William White, formerly with the Bank for International Settlements (BIS) and now chairman of the Economic and Development Review Committee at the OECD in Paris. (He also spoke at our Strategic Investment Conference last year.)
White, too, has argued that “the fundamental analytical mistake has been to model the economy as an understandable and controllable machine rather than as a complex, adaptive system,” and Lewitt certainly concurs.
OK, so we all agree. But I have to confess, I wasn’t quite satisfied with my own attempt last week to point to a new path forward for economics. It’s one thing to say the economy is complex and nonlinear and another to translate that fundamental understanding into actionable analysis.
And in today’s Outside the Box, I find both Lewitt and White struggling similarly.
Consider these sentences from Lewitt, for instance:
The failure to recognize markets as complex systems led policymakers to adopt the wrong approach to healing the global economy after the crisis. Giving credence to the adage that a hammer views every problem like a nail, they clung to the misguided belief that “growth and job creation deemed to be inadequate are solely due to inadequate demand and that this can always be remedied with expansionary monetary policy.”
Notice how he has immediately jumped from his prescription for complex systems thinking to an entirely mundane statement about the failings of Keynesian economics. You may have found me copping out the same way last weekend!

Lewitt does this more than once. Here’s another example:
Understanding what to look for requires the proper intellectual frame of reference, which Mr. White correctly argues requires an understanding of complex systems, which require digital not analogue and non-linear rather than linear thinking. The global economy lacks a common anchor of value, leading the value of all financial instruments to be based on a structure of reference rather than relation; in other words, assets are valued based not on their inherent characteristics but on their relative worth compared to other assets.
Well, in the first place, what the heck does it mean to engage in “digital not analogue” thinking? How exactly is digital thinking more nonlinear or better aligned with complexity? What I suspect is going on here is that all of us – Lewitt, White, me, and many others – are just beginning to come to terms with this complexity business. We start to talk about it, and then two seconds later we’re using same tired old economics language we have used for decades. It’s the only language we have! Complexity economics, at this stage, is just very fancy algorithms in very fast computers; it’s not something we can fruitfully chew over and do anything with in our daily work as analysts and investors.
But we’ll get there, and that’s why I’m sharing this piece with you today. I hope you’ll read it, mull it over, and get back to me about it. Let’s share other resources on complexity economics and figure out together how to put it to work.
This week, I find myself deep in the jungle of trying to figure out what the new federal tax policy will be. My fellow explorer Patrick Watson and I have been on numerous conference calls with various people, most of whom are willing to provide background but not actual quotes, although Congressman Kevin Brady (of Texas), the chair of Ways and Means, the House committee where all tax bills must originate, was gracious enough to go on the record. To say this bill is complex is an understatement. It touches EVERYTHING.
I have been in jungles on several continents. Let me just say that this tax jungle is not as breathtakingly inspiring as the Amazon jungle.
Still, There are a quite a number of proposed changes in the bill that give this conservative economist warm fuzzy feelings. Lower and simpler taxes, immediate expensing of equipment, etc. But (you knew there was a but coming) I am having a hard time wrapping my head around the core of the bill. Well that and...
Several things actually. The whole idea is to create jobs, which no one can be against, but what jobs and where?  Rather than do the “reveal” on these thorny questions today, they will be the topic of this week’s letter, coming to your inbox over the weekend. The whole jobs question is a big part of my thinking in “The Future of Work,” which I keep saying has been the most difficult chapter to write in my upcoming book on the next 20 years. Are we conservatives like the generals who are always planning to fight the last war? Or are positive human responses to proper incentives part of our core DNA, so that getting the incentives right will work? Are we fighting the future, or making it? Big questions.
They are giving me the signal to get ready to go on stage, so I will hit the send button. Shane and I are throwing a Super Bowl party on Sunday and I will simply say that I want to see a good game that is close, talk with friends and family, and enjoy my chili and Shane's beans and some of the best BBQ in Dallas – and of course guacamole. No diets on Super Bowl Sunday. Have a great week.
Your loving complexity but still stumped by it analyst,

John Mauldin, Editor
Outside the Box

Objects In Mirror Are Closer Than They Appear

By Michael Lewitt
Excerpted from The Credit Strategist

“The fundamental ontological error has been to model the economy as a relatively simple machine, whose properties can thus be known and controlled by its policy operator. In reality, it is an evolving system, too complex to be either well understood or closely controlled. Moreover, it is a system in which stocks and ‘imbalances’ build up over time in response to monetary stimulus. This reality makes future prospects totally path dependent, and we are on a bad path.”

William White1

William White is one of the few policymakers who foresaw the 2008 financial crisis. Understanding the pathologies that led to the global financial crisis, Mr. White today rejects the intellectual errors that mislead so many mainstream economists, pundits and officials regarding the current state of the global economy. In a recent speech, he criticized consensus economic thinking and warned that, for all the hoopla surrounding Donald Trump’s ascension to the presidency, insufficient attention is paid to the precarious state of global finances.
Mr. White argued that “the fundamental analytical mistake has been to model the economy as an understandable and controllable machine rather than as a complex, adaptive system.” As a result, the decision to solve a debt crisis by printing tens of trillions of dollars more debt2 means that “the situation we face in late 2016, both in the advanced economics (AMEs) and the emerging market economies (EMEs ), is arguably more fraught with danger than was the case when the crisis first began.” He added, “(b)roadly speaking, the levels of prices in financial markets today look as stretched as they did in 2007 just before the crisis erupted.” The global economy is much more leveraged today, central banks’ are running out of policy responses, and the geopolitical landscape is more stressed than at any time since the end of the Second World War. I would go further than Mr. White’s warning, however; global bond markets are in an epic bubble and stock markets are quickly catching up.

The failure to recognize markets as complex systems led policymakers to adopt the wrong approach to healing the global economy after the crisis. Giving credence to the adage that a hammer views every problem like a nail, they clung to the misguided belief that “growth and job creation deemed to be inadequate are solely due to inadequate demand and that this can always be remedied with expansionary monetary policy.” This is the wrong lesson gleaned from reading John Maynard Keynes though certainly the most politically palatable one since monetary stimulus delays the necessary (and painful) cleansing of excesses that economies require to move forward. Policymakers also developed an excessive fear of deflation and failed to distinguish between deflation caused by positive factors such as higher productivity and technological innovation, on the one hand, and deflation caused by too much debt suppressing economic growth and ultimately inflating asset values bey ond sustainable levels on the other hand, such as the type we saw during the financial crisis. As a result, any time they see low inflation (as they measure it, which has little relationship to reality), they expand credit with little regard for the consequences. The result is an increasingly over-leveraged economy whose growth prospects are suppressed by the very debt- driven policies employed to stimulate economic growth.

Mr. White also makes the extremely important point that “one characteristic of complex systems is that precise forecasting is literally impossible.” We rarely hear market pundits say they don’t know where the market is going despite the fact that nobody knows where the market is going. Complex systems are non-linear and experience discontinuous change when forces build up to the point where current conditions can no longer be sustained. These forces often accumulate gradually and unseen and render the system more fragile and more vulnerable to abrupt change or crisis. Economic policymakers are particularly poorly equipped to identify the types of changes that render economies unstable and vulnerable to crisis because, for the most part, they are not educated in how complex systems work but are beholden to static economic models that ignore concepts such as path dependency, non-linear change and instability.3 

The question that all market observers ultimately have to answer today is whether the epic accumulation of global debt is sustainable. If it is not, as I believe, the next question is how to identify the signs indicating that excesses are becoming unsustainable and leading to breakage. Understanding what to look for requires the proper intellectual frame of reference, which Mr. White correctly argues requires an understanding of complex systems, which require digital not analogue and non-linear rather than linear thinking. The global economy lacks a common anchor of value, leading the value of all financial instruments to be based on a structure of reference rather than relation; in other words, assets are valued based not on their inherent characteristics but on their relative worth compared to other assets. This is what gave rise to a $600 trillion derivatives infrastructure that prices the risk of all types of financial instruments based on binary contracts between counterparties rather than reference to any independently verifiable indicia of value (and also requires the ability of contracting parties to perform their obligations). It also divorces market values from fundamental economic values based on the inherent qualities of financial instruments.

Complex systems are also self-adaptive, which means they are capable of adjusting to changing conditions. But these adjustments are often sudden and violent and systems don’t return to their previous state, leaving those trying to manage them with a new reality for which old models and modes of thinking are inadequate. This is precisely what happened after the 2008 financial crisis, when policymakers were left facing a much more leveraged world but failed to adapt their tools to new conditions. Whether the global economy is capable of adapting to an unsustainable state of over-indebtedness is dubious; the only question is the timing and severity of the coming adjustment. As Mr. White warns, we risk learning the answers to those questions before we are prepared to withstand the consequences. As we are reminded every time we look in the mirror of our automobile, objects are closer than they appear. In this case, the forces destabilizing financial markets and rende ring them fragile and vulnerable to another crisis are staring us right in the face.
But in order to see them, we have to learn to see markets for the complex and unpredictable systems they are.
Stocks Are Very Expensive

Markets are chasing the highest valuations in history. And as usual, they are cheered on by an increasingly puerile mainstream media. Barron’s didn’t even wait for the ink to dry on the Dow Jones Industrial Average’s 20,000 print before declaring in a new cover story: “Next Stop Dow 30,000.” Barron’s argues that “[t]he Dow hitting 20,000 was no fluke. Today’s stock prices are well supported by corporate earnings and economic growth. In fact, if President Trump can avoid stumbling into a trade war – or a real war – the Dow could surpass 30,000 by the year 2025.” Leaving aside that this National Enquirer-style headline is a desperate attempt to pump up readership and is followed by an article lacking a modicum of analytical substance, let’s take a serious look at claims that corporate earnings and the economy are strong. The facts tell a different story than the one Barron’s tries to sell.

Corporate earnings have been weak for the last two years. According to Factset, estimated non- GAAP earnings growth for S&P companies in 2016 was a paltry +0.1% (and GAAP earnings growth was negative). Revenues were up roughly 2.0%, which is zero growth once you back out phony government inflation data and negative if you use real world prices. In 2015, S&P 500 earnings declined year-over- year on both a GAAP and non-GAAP basis. But even these figures really don’t tell how poorly businesses are performing because GAAP and non-GAAP earnings are inflated by low effective corporate tax rates, low interest rates on the money borrowed to buy back stock and pay higher dividends, and sluggish wage growth.
US corporations are significantly more leveraged than they were on the cusp of the financial crisis in 2007, a condition disguised by record low interest rates that are now rising. So-called non-GAAP S&P 500 earnings (which are best considered “earni ngs as we would like them to be” rather than as they actually are) are more than $20 per share higher than GAAP earnings. With almost half of companies reporting so far for 4Q16, the full year estimate for 2016 S&P 500 non-GAAP earnings is $108.66 and GAAP earnings is $97.98 This puts the market multiple at 21.1x trailing non-GAAP earnings and 23.4x GAAP earnings.4 By way of comparison, this multiple was 24x non-GAAP earnings during the Internet Bubble. Other valuation metrics such as the Shiller Cyclically-Adjusted P/E at 28.4x (versus a mean of 16.7x) and the S&P Market Cap/GDP Ratio of 125% are also at extreme levels. There are other signs of excess as well such as margin debt running above $500 billion compared to $380 billion at the market top in 2007. Wall Street strategists trying to tempt investors into buying more stocks at these levels are playing with fire.

And Dow 20,000 isn’t what it seems. Drawing historical comparisons between index levels is an inexact science due to the fact that the composition of these indices changes over time. The composition of the Dow Jones Industrial Average has changed over time. As economist extraordinaire David Rosenberg points out, if the eight companies that were replaced in the Dow since April 2004 had remained in the index, we would be reading about Dow 12,886, not Dow 20,000.5 Also, as a price-weighted index, moves in certain stocks have an outsized impact on the Dow, creating false impressions about the overall strength of the market. For example, moves in Goldman Sachs Group (GS) have eight times the impact on the Dow as those of General Electric (GE), a factor that contributed to the index’s post-election rally. Tracking the Dow may make for good financial television (actually, nothing makes for good financial television today other than Realvision TV, bu t that’s a topic for another day), but it is comparing apples and oranges and means little analytically. All Dow 20,000 accomplishes is getting investors all stirred up that they are missing a rally. They should be careful what they wish for.

The chase to peak valuations is occurring in a weak economy. Barron’s claim that economic growth justifies not only Dow 20,000 today but Dow 30,000 in eight year is malarkey. Barron’s ignores the fact that fourth quarter GDP sputtered to 1.9% and kept full year 2016 growth at a disappointing 1.6%, the slowest since 2011 and down sharply from 2015’s 2.6% pace. Last year marked the 11th consecutive year that America failed to reach 3% growth, the longest period since the Bureau of Economic Analysis started reporting GDP. U.S. industrial production has declined on a year-over-year basis for 15 consecutive months and the capacity utilization rate is a disappointing 75% (a level considered contractionary). And let us not forget that this tepid growth was boosted by eight years of zero interest rates and trillions of dollars of QE; without that support, the economy likely would have shrunk. Claiming that robust economic growth supports hi gher stock prices is nonsense. Stock prices are primarily supported by cheap money and, as we will see in a moment, important structural forces in the markets.

Stocks enjoyed quite a run since Election Day. But even before Donald Trump surprised the world and won the U.S. presidency, stocks were on an epic run that began in March 2009 at the depths of the Great Financial Crisis. The most impressive aspect of this bull market is that it defied the worst economic recovery in the last century and survived eight years of Obama administration policies that were hostile to economic growth and markets.6 As noted above, rather than based on a solid economic foundation, the bull market benefitted from zero interest rates, lower corporate tax payments, wage suppression and financial engineering in the form of epic levels of debt-funded M&A, stock buybacks and dividend increases. These factors have little to do with the fundamental financial condition of American corporations (in fact, some of these factors weaken their condition). Eight years later, this leaves the markets (and the individual companies comprising them) overva lued and overindebted.

But the important question for investors is not where the market has been but where it is going. Right now, it would be imprudent to fight the sentiment pushing stock prices higher. Donald Trump’s presidency represents a sharp break not only with the awful Obama years but the Bush II administration as well. The new president is laying waste to decades of failing domestic and foreign policies. It is hardly surprising that investors are willing to ignore serious structural impediments to growth in order to give the new president the benefit of the doubt. This sentiment will likely calm down once the realities of governing within the American constitutional system set in, but for the moment fighting the tape is a tough gig.

There are also important structural forces pushing stock prices higher without regard to fundamentals. The question the market will have to answer is whether the serious valuation, growth and debt headwinds facing stocks are more powerful than these structural forces that developed over the past two decades that contributed to stock prices trading today near their highest valuations of the century. The most powerful structural force at work is an unprecedented amount of money pursuing a diminishing number of U.S. stocks. There are roughly half as many publicly listed companies trading on U.S. stock exchanges today than 20 years ago. The peak of 7,322 public stocks was reached in 1996; by late 2015 the number was down to 3,700.7 The primary reason for the decline is massive M&A activity that removed many public companies from the mix; lesser reasons include the cumulative effects of private equity firms buying public companies (a subset of the M&A boom) an d a steady slowing of IP0 activity. Heavier regulation such as the Sarbanes-Oxley Act passed in the wake of the Enron scandal significantly increased the costs of being a public company and contributed to more companies staying private. All of these factors caused the number of publicly listed companies to shrink significantly over the last twenty years.

While the number of listed companies dropped sharply, thousands of new ETFs sprang up to take their place. But ETFs do not create new investment opportunities; they merely repackage existing ones. As a result, they magnify the shrinkage of available stocks by funneling more money into the limited number available. Stocks included in the most popular and largest ETFs attract more capital than those excluded from such ETFs without regard to their investment fundamentals. This inflates their values beyond what fundamentals justify. This is how the market became as overvalued market as it is today. And it is also how markets can stay overvalued for long periods of time.

But this is only half of the picture. The other half involves the fact that there is much more money in the world today chasing this diminishing number of investment opportunities. While the number of stocks dropped in half over the last twenty years, the global stock of money available to invest in them exploded as a result of unprecedented efforts by central bankers to revive economic growth.
These efforts accelerated after the 2008 financial crisis to the point where the world is now home to more than $200 trillion of debt. In addition, there are tens of trillions of dollars of equity on top of this figure to bring the total stock of money to somewhere in the $250 trillion range (my very rough estimate). Obviously all of this money is not chasing equities, but the world is flooded with capital seeking a positive return, a challenge exacerbated by the imposition of historically low interest rates by central banks. With bonds reduced to certificates of confiscation t hat guarantee negative real returns for years to come, money is naturally drawn to stocks that at least offer the chance of higher returns.

While a more economically enlightened policy environment may offer a reasonable basis for buying stocks, more money chasing fewer stocks is arguably a more powerful force. Even if U.S. stocks struggle with higher interest rates and a strong dollar under the new administration, the gravitational pull of tens of trillions of dollars of capital looking for decent returns within a shrinking pool of stocks may make it much more difficult for a sharp sell-off to occur, certainly one that would last very long before all that money would come back into the market looking for “bargains.” This is particularly true in a world where investors are trained to buy on dips like Pavlov’s dogs.

Right now, the biggest danger to stocks appears to be higher interest rates. Most observers (at least the ones I respect) put the danger zone at the 10-year Treasury hitting 3%. I actually think the yield could hit 3.25-3.5% without sinking stocks if higher rates are seen as a sign of better economic growth. The Fed is telling people it plans to raise rates three times in 2017, an aggressive stance to which it is unlikely to stand up. But even 50 basis points of hikes before year end (my expectation) would push 10-year yields to 3% (assuming the curve doesn’t flatten or invert due to recession) and closer to the day of reckoning. With American corporations carrying more debt than ever before, higher rates should worry investors.

But until rates hit the danger zone, the enormous amounts of money chasing a diminishing number of stocks will remain a strong force supporting the market.
That doesn’t mean stocks are guaranteed to produce positive returns in 2017, just that the odds of anything worse than a garden variety bear market (down 10%) are limited. Further, all that money chasing the limited number of stocks would likely render any bear market short-lived. This also doesn’t mean a lot of stocks won’t go down – there are many lousy companies trading at unsustainable levels. But it remains a stock picker’s market on both the long and short sides.
President Trump

There is little question that Donald Trump’s presidency introduces an unusual degree of uncertainty into markets. The fact that liberals purport to be shocked that Mr. Trump is fulfilling his campaign promises confirms their cynicism and inauthenticity. The Trump administration represents a sharp break not only with the disastrous domestic and foreign policies of the Obama years but the failures of the Bush II administration. Mr. Trump is an ideological hybrid, borrowing ideas from both progressives on trade and foreign policy and conservatives on the economy, the Supreme Court and social issues like abortion and gun control. He is uniquely positioned to run against both establishment political parties and, most important, to take aim at the entrenched and corrupt government bureaucracy. He is considered unpredictable but in fact he is quite the opposite: he does what he says and he says what he does. If this is considered unpredictable, it is only because recen t presidential candidates misrepresented their true colors (Obama and Bush II campaigned as moderates but governed from the far left and far right, respectively).

The unhinged reaction of the mainstream media, which Mr. Trump correctly describes as corrupt and dishonest, only confirms their attempt to disguise rank political partisanship behind a phony First Amendment curtain. The fact that so many of the so-called journalists who were actually working behind the scenes for Hillary Clinton and writing false stories about Mr. Trump and the election are still on the job is inexcusable (when, for example, is CNBC going to fire John Harwood?). I certainly do not agree with everything Mr. Trump says or does (though I agree with much of it), but at least he speaks his mind and backs it up with action. Our country is now run by generals and businessmen, not by the types of academics and politicians who made a shambles of foreign and domestic policy over the last two decades. Before we judge Mr. Trump too harshly, we should give him a chance to implement the policies that he was elected to implement. The fact that a biased liberal medi a and half the country doesn’t like him or his policies is irrelevant. By the time Mr. Trump’s first term is over, the media is going to be a shadow of its former self if it doesn’t start telling the truth and behaving like the Founders envisioned, not like a bunch of political operatives.

1 William R. White, “Ultra-Easy Money: Digging the Hole Deeper,” Adam Smith Priwe Lecture, National Association for Business Economics, Atlanta, Georgia, September 11, 2016, money-digging-hole-deeper. I strongly recommend this paper as a balanced and sobering analysis of the current state of the global economy from one of the smartest and most well-informed policymakers in the world.

2 Friedrich Hayek famously warned that, “To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about.” Friedrich A. Hayek, Monetary Theory and the Trade Cycle, Martino Fine Books, 1933, p. 21.

3 The work of Nassim Nicholas Taleb speaks to the tendency for systems to become unstable (he uses the word “fragile”) based on human failures to think properly about them. See Nassim Nicholas Taleb, Antifragile: Things That Gain From Disorder, New York, Random House, 2012. On complex systems, see also Marten Scheffer, Critical Transitions in Nature and Society, Princeton, Princeton University Press, 2009.

4 Peter Boockvar points out that non-GAAP earnings grew by 10.7% in the last four years beginning in 2013 while the market multiple expanded by 47% (from 14.4x non-GAAP and 15.9x GAAP earnings in 2013). The reason for this is that central banks reduced the price of money to zero through QE and ZIRP (zero interest rate policy), radically affecting the discount rate used to calculate the price at which equities “should” trade. Rather than being supported by earnings, stock prices are levitated by cheap money and an absence of intellect on the part of investors. Money is becoming less cheap but investors are not becoming smarter, a potentially deadly combination.

5 David Rosenberg, Gluskin Sheff, Weekly Buffet with Dave, January 27, 2017, p. 13. The eight companies dropped from the Dow and their successors are Alcoa/Nike (2013), Altria Group/Chevron (2008), AIG/Kraft Foods (2008), Citigroup/Travelers (2009), General Motors/Cisco Systems (2009), Hewlett-Packard/Visa (2013), Honeywell International/Bank of America (2008), and SBC Communications/Apple (2005).

6 While nobody should be surprised that Barack Obama never saw 3% GDP growth during his tenure as the economy recovered from a serious financial crisis, his policies made things worse than they needed to be. Rather than prioritize economic growth, he pursued policies to more heavily regulate the economy and redistribute income. In doing so, he failed to help the very disenfranchised constituencies that voted for him and that he claimed to champion because he failed to understand the devastating effects of activist monetary policy and refused to promote pro-growth fiscal policies. While Mr. Obama will no doubt blame George W. Bush and Republicans for his failures, the blame lies with him.

7 Craig Doidge, Andrew Karolyi and Rene M. Stulz, “The U.S. Listing Gap,” NBER Working Paper No. 21181, May 2015.

Gloom Descends on Mexico’s Nafta Capital

President Trump’s threat to renegotiate the free-trade agreement and build a wall has created anxiety in Monterrey, where foreign investment lifted thousands of workers into the middle class and further enriched the city’s mighty industrialists

By Robbie Whelan

       A view of Monterrey, Mexico. Photo: Daniel Becerril /REUTERS

MONTERREY, Mexico—The road from the airport to the center of this city, Mexico’s bustling industrial hub, is lined with factories and warehouses bearing familiar American corporate names that churn out some of the world’s most recognizable products: Whirlpool Corp. washing machines, Mondelez International Inc. cookies and Mary Kay Inc. makeup.

At an industrial park in the city’s outskirts that includes General Electric Co. and DuPont Co. facilities, one street is named Nafta Avenue, while another is called TLC Boulevard, the Spanish-language acronym for the North American Free Trade Agreement that binds the economies of the U.S., Canada and Mexico.

A flood of Nafta-inspired foreign investment has helped turn Monterrey into Mexico’s Free Trade capital, lifting tens of thousands of workers into the middle class and making this city’s mighty industrialist families even richer. These days, people at both ends of the economy are scrambling to figure out what to do now that the new U.S. president, Donald Trump, appears to be following through on vows to renegotiate Nafta and build a wall between the two countries.

Just Thursday morning, President Trump threatened to cancel a scheduled meeting next week with Mexican President Enrique Peña Nieto, during which both sides were expected to agree on a framework to renegotiate the pact, if Mexico refuses to pay for the wall. Mr. Peña Nieto responded by calling off the trip.

“Free trade is crucial to Mexico’s growth,” said Alberto de Armas, president of the Monterrey chapter of the American Chamber of Commerce of Mexico, a pro-trade business association. “When I first came to Monterrey in the 1980s, it was a sleepy town. It was all glass factories and cement and beer. Now you can go to the opera.”

While American political leaders ranging from Mr. Trump to Democratic Sen. Bernie Sanders have blamed Nafta and free trade more broadly for job losses in the U.S., it has turned exports into the engine of Mexico’s economy. Nafta helped a wide swath of the country develop, helped end the country’s chronic boom and busts, and ushered in a fivefold rise in annual foreign direct investment—mostly by U.S. companies. Mexico’s largest private employer is Bentonville, Ark.-based Wal-Mart Stores Inc.
      A worker assembles a vehicle at the Kia Motor Corp. assembly plant in Pesqueria, Mexico. Photo: Susana Gonzalez/Bloomberg News

For Mexico, the rise of Mr. Trump is seen as the country’s biggest threat from its northern neighbor since World War I, when U.S. Marines briefly occupied the city of Veracruz. It also upends six decades of U.S. policy that placed stability in Mexico as a key priority.

The national currency, the peso, has already weakened by about 13% since the election and foreign direct investment, which had already tumbled 23% in the first nine months of 2016, appears to have dried up altogether since the U.S. election. Last Friday, economists surveyed by Mexican bank Citibanamex cut their growth forecast for 2017 to 1.5% from 1.7%. They also raised expectations of steeper inflation and a fresh round of interest rate increases by Mexico’s central bank.

Mexican business leaders are trying to come up with ways to soften the blow. On a recent Thursday, around 50 executives from Mexico’s largest companies met privately in Mexico City with Luis Videgaray, who was appointed foreign minister by President Peña Nieto earlier this month.

The purpose was to brainstorm ways to approach the Trump administration, a task that has been delegated to Mr. Videgaray, who previously served as finance minister before resigning from the cabinet in September over fallout from Mr. Trump’s campaign visit to Mexico.

Business leaders suggested that Mr. Videgaray propose that Nafta add tighter rules-of-origin, which would require that products assembled in Mexico have increased levels of North American components in order to be exported duty free to the U.S. In the car industry, for example, some auto makers such as Mazda Motor Corp. import motors directly from Japan to assemble a car in Mexico for export to the U.S. Under revised rules, those cars might be subject to a tariff unless the motors were made in the region.

Tighter rules of origin would likely prompt a shift toward greater U.S. content, but it would also likely raise costs and reduce the region’s competitiveness versus the rest of the world, trade advocates say.

Mr. Videgaray approved of the strategy and said it sounded like the “most logical” negotiating tactic, according to several executives who attended the meeting. The office of Mr. Videgaray, who is meeting with representatives of the Trump administration in Washington this week, didn’t respond to calls seeking comment.

While much of Mexico remains poor, parts of the country have leveraged trade to begin to develop. The economy in Nuevo León, where Monterrey is located, grew by 67% between 2004 and the middle of 2016, according to Mexican government data—a yearly average of more than 4%.

Likewise, the 12 Mexican states that rely most on export industries governed by Nafta—clustered mostly along Mexico’s northern border and in the central auto-manufacturing region known as the Bajio—saw an average annual rate of economic growth of 3.7% since 2004, according to a Wall Street Journal analysis of government data. The 20 Mexican states that don’t rely heavily on Nafta had an average annual GDP growth of 2.8% since 2003.

Nafta Boost

The 12 Mexican states whose economies depend heavily on export industries have seen an average annual GDP growth of 3.6% since Nafta was implemented, compared to 2.7% for the 20 that don’t.


Average annual GDP growth since Nafta was implemented*
3.61% to 4.5%
2.7% or less
2.71% to 3.6%
More than 4.5%
States depending heavily on export industries
Distrito Federal
*As of the end of the second quarter of 2016
Sources: WSJ analysis of INEGI data (map); Labor Department (manufacturing employment)

Even if Nafta can be successfully renegotiated, Mexico appears in for a rough ride given how Mr. Trump has called out U.S. firms that try to open a new factory south of the border.

Concern grew to near panic in recent weeks after Ford Motor Co. canceled a planned $1.6 billion assembly plant in the industrial city of San Luis Potosí after Mr. Trump criticized the move. That followed a similar cancellation by Indiana-based Carrier Corp. A big U.S. home improvement chain has suspended its plans to expand in Mexico, worried about the negative publicity, according to people familiar with the matter.

Some in Mexico say it’s difficult to imagine when a big U.S. company will announce a new factory in Mexico anytime soon. “We have no new information about new investments in plants since the U.S. election,” said Ricardo Cantú, president of Index Nuevo Leon, an exporters’ trade group.

The CEO of Fiat Chrysler Automobiles said his firm could pull out of Mexico entirely if the Trump administration follows through on a pledge to impose tariffs on imported cars, and Mr. Trump has in recent weeks put General Motors Co., Toyota Motor Corp. and BMW AG in the crosshairs over their investments in Mexico.

Mexicans are dismayed and, increasingly, angry. One state government, a municipal government and several Mexican firms responded to Ford’s announcement by launching a boycott of the auto maker’s products.

If Nafta were scrapped entirely, the U.S.-Mexico trade relationship would revert to World Trade Organization rules, experts say, which would likely result in average tariffs of only about 5% for Mexican goods going north. The impact would be slightly worse for American goods going south, since the old WTO arrangement allowed for some protectionism by Mexico.

But the impact on the investment climate would be hard to predict. Nafta enshrined legal protections for U.S. firms investing in Mexico, protecting them from punitive Mexican regulation or confiscation. The pact also established a mechanism to adjudicate complaints.

Even more worrisome for the Monterrey elite are other possible import tariffs under discussion in the U.S. Republicans in the U.S. House of Representatives have floated the idea of “border adjustment tax” that would bar American firms from taking a tax exemption on imported goods.

“The idea of a border tax is a huge problem,” said Enrique Zambrano Benítez, chief executive of Grupo Proeza, a holding company that owns steel producer Metalsa, a large auto supplier based in Monterrey.

If a border tax happens, Mr. Zambrano said his firm would likely shift some of its Mexican production to its five U.S. plants and buy more raw materials from U.S. producers, which would result in job losses in Mexico. He also said it would likely force his firm to charge higher prices in the U.S.

    A man walks near the Whirlpool Mexico SAB facility in Monterrey. Photo: Susana Gonzalez/Bloomberg News

Stabilit SA, a construction materials company, said such a tax might force it to lay off hundreds of Mexican workers, while trying to focus more on selling to customers in Mexico, Europe and Asia, according to company chairman Fernando Canales Clariond, a third-generation industrialist who served as Mexico’s secretary of economy and of energy.

Mr. Canales said the company spends about $350 million per year on raw materials, including running up large tabs buying plastic resins and fiberglass from U.S. companies including PPG Industries Inc. Imposing a border tax would mean a lot of lost jobs in U.S. factories, too, Mr. Canales said.

With six major manufacturers of industrial vehicles, trucks and cars and more than 200 first-tier suppliers, Nuevo León, and especially Monterrey, is a major economic center for the Mexican auto industry. Roughly 84,000 people work in the local auto industry, accounting for a third of every sales dollar gleaned from exports, according to Manuel Montoya Ortega, the head of a local auto industry group.

“These are the most formal, most stable jobs in the region, from factory positions to designers and engineers,” Mr. Montoya said. “Everyone is very worried.”

For Monterrey, the embrace of free trade and Nafta didn’t come naturally. For decades, Mexico had a closed economy, and many of the country’s national champion firms were based in Monterrey. When Nafta was being negotiated in 1993, many firms in Monterrey thought they would simply disappear under the onslaught of U.S. firms.

Not everyone in Mexico thinks that free trade has been an unequivocal success. Mexico’s annual GDP growth since 1994, the year the treaty took effect, has averaged 2.57%, according to the World Bank, compared with 4.18% per year during the previous two decades—a time when Mexico made major oil discoveries.

Wage growth has also fallen short of what Nafta’s early champions had hoped, partly due to a bulge in young Mexicans entering the workforce during the 1990s and early 2000s. Average daily wages in dollar terms have risen by just 18% since 2000, to $16.70 per day, according to Mexican government statistics. Tens of thousands of Mexican small-plot farmers were forced to find work after Nafta exposed them to competition with more technologically adept U.S. factory farms.

Nafta “has not been a silver bullet,” said Fernando Turner, Nuevo León’s secretary of economic development and owner of Katcon Global, a manufacturer of automotive exhaust systems.

Despite those reservations, few in Mexico think the country would have been better off without the trade pact. Nafta and open trade in general introduced competition to an economy that had been closed off for decades, with coddled public and private monopolies making low-quality goods at uncompetitive prices.

Mr. Canales, whose family used to run the conglomerate Industrias de Monterrey SA, says that before Nafta, galvanized steel produced in Mexico was so flimsy that it broke under the pressure of stamping presses. Only after the markets opened up to American competition did the quality of his family business’s products improve.

“I lived through Mexico’s period of closed borders, and the products we had were lousy,” he said. “I remember being worried when Nafta started, thinking, ‘How can we compete with American steel producers?’ My uncle used to tell me, ‘When you go to bed, pray for your company, but pray more for your competitors, because good competition is the best pressure a company can ask for.’”

Workers watch as a large stamping press, used to shape steel pieces in chassis for Dodge and Toyota pickup trucks, is moved inside the Metalsa factory in Monterrey. Photo: Robbie Whelan/The Wall Street Journal

Metalsa’s factory in the Monterrey suburb of Apodaca offers a glimpse into how free trade has helped support the creation of a blue collar labor force here. The plant employs some 3,600 people and produces about 680,000 steel frames for Dodge Ram, Toyota Tundra and Toyota Tacoma pickup trucks each year. The company buys 56% of the steel and other components to produce the truck chassis from Mexican suppliers, 21% from U.S. suppliers, and 22% from Asian companies.

Alexander Calderón, 46, grew up the son of a farmer in a rural part of the Mexican state of Veracruz. He started working at Metalsa welding frames for Chrysler trucks in 1993, initially earning 600 pesos, or about $194 at the time, per month. He now earns 40,000 pesos, $1,860, per month as a supervisor in the plant’s steel hydroforming division, owns a house in the Monterrey suburb of Guadalupe, and sent his oldest son to study accounting at the state of Nuevo Leon’s public university.

“For me, I really started to notice the development of industries here in the last 15 years as companies from other countries came here. That’s when my salary started to go up,” Mr. Calderón said. “It’s gotten very competitive.”

Most workers at the Metalsa plant earn much less, but their lives have improved. Alfredo Treviño, 30, has been with the company 11 years, and has seen his salary grow from 50 pesos, or $13.76, per day to 360 pesos, or $16.74. He spends about a quarter of his paycheck to pay the mortgage on the two-bedroom house he shares with his wife and two children. The Volkswagen Lupo hatchback he bought in 2005 is paid off.

“In my circle, everyone has a house and a car,” Mr. Treviño said.

China’s Big Sticks

Stephen S. Roach

Year of rooster in Chengdu China

NEW HAVEN – US President Donald Trump’s administration is making a major miscalculation by going after China. It appears to be contemplating a wide range of economic and political sanctions – from imposing punitive tariffs and designating China as a “currency manipulator” to embracing Taiwan and casting aside some 40 years of diplomacy framed around the so-called One-China policy.
This strategy will backfire. It is based on the mistaken belief that a newly muscular United States has all the leverage in dealing with its presumed adversary, and that any Chinese response is hardly worth considering. Nothing could be further from the truth.
Yes, the US is one of China’s largest export markets – and thus a central pillar of its spectacular 35-year development trajectory. Closing off the US market would certainly crimp Chinese economic growth.
But the US has also become heavily dependent on China, which is now America’s third largest and fastest-growing export market. And, as the owner of over $1.25 trillion in Treasuries and other dollar-based assets, China has played a vital role in funding America’s chronic budget deficits – in effect, lending much of its surplus saving to a US that has been woefully derelict in saving enough to support its own economy.
This two-way dependency – the economic equivalent of what psychologists call codependency – has deep roots. Back in the early 1980s, in the wake of the Cultural Revolution, which left its economy in shambles, China was desperate for a new source of economic growth. Coming out of a destructive bout of stagflation in the late 1970s and early 1980s, the US also needed a new economic recipe. The hard-pressed American consumer solved both problems, by becoming a powerful source of external support for Chinese growth and by benefiting from the lower prices of products made in China.
The two countries thus entered into an awkward marriage of convenience that served each other’s needs. China built an increasingly powerful economy as the Ultimate Producer while the US embraced the ethos of Ultimate Consumer.
As mirror images of each other, interactions between the two economies became increasingly comfortable and ultimately addictive – so much so that these codependent partners were keen to enable each other’s economic identities. The US opened the door to China’s accession to the World Trade Organization in 2001 – a milestone in China’s ascendancy as the Ultimate Producer. And China’s voracious appetite for Treasuries in the early 2000s helped keep US interest rates low, sustaining the froth in asset markets that allowed the Ultimate Consumer to live well beyond its means – until the music stopped in 2008.
As in the case of humans, economic codependency is ultimately a very destructive relationship.
Blinded by the gratification phase of codependency, both the US and China lost their way. Each became so caught up in its role of serving the other that both effectively repressed their economic sense of self. Therein lies the ultimate twist of codependency: one partner invariably looks inward and turns on the other, in order to recapture that missing piece of its identity.
That’s where Trump enters the equation, by targeting China as the villain that purportedly prevents America from being great. Trump has assembled a team of like-minded senior trade advisers to plan the attack. From Peter Navarro as Director of the National Trade Council, to Wilbur Ross as Commerce Secretary, Robert Lighthizer as US Trade Representative, and Rex Tillerson as Secretary of State, the new administration’s anti-China biases are without modern precedent.
Yet their battle plan overlooks a critical risk: codependency is a highly reactive relationship.

When one partner changes the terms of engagement, the other, feeling scorned, usually responds in kind. In the aftermath of the provocative December 2 phone call between Trump and Taiwan President Tsai Ing-wen, stunned Chinese officials said little at first. But as Trump’s China-bashing strategy started to crystalize around the advisers he appointed and the issues he raised, China’s official media finally warned that “big sticks” would be used in defense, if need be.
This is very much in keeping with what could be expected from the reactive phase of a destabilized codependency. The scorned partner, China, is threatening to hit back. And now America will have to face the consequences.
Smugly confident that the US has nothing to fear, the Trump administration could quickly feel the full wrath of Chinese retaliation. If it follows through with its threats, expect China to reciprocate with sanctions on US companies operating there, and ultimately with tariffs on US imports – hardly trivial considerations for a growth-starved US economy. Also expect China to be far less interested in buying Treasury debt – a potentially serious problem, given the expanded federal budget deficits that are likely under Trumponomics.
But the greatest tragedy for the US may well be the toll all of this takes on the American consumer. “America first” – whether it comes at the expense of China or via the so-called border-tax equalization that appears to be a central feature of proposed corporate tax reforms – will unwind many of the efficiencies of global supply chains that hold down consumer-goods prices in the US (think Wal-Mart).
With their incomes and jobs under long and sustained pressure, American consumers count on low prices for their economic survival. If Trump’s China policy causes those prices to rise, the middle class will be the biggest loser of all.
Sino-American codependency poses a formidable challenge to Trump’s strategy of China bashing. It frames the ominous prospect of a rupture in the world’s most important economic relationship, with potentially devastating spillovers on the rest of the world.

China Bids for the Philippines

There is a strategy behind Beijing’s recent investments in the Philippines.

By Jacob L. Shapiro

On Jan. 24, an official Philippine delegation wrapped up a visit to China. The previous day, both countries issued statements saying they reached an agreement that China would provide the Philippines with $3.7 billion to fund 30 projects. The Philippine finance secretary said in a statement that the projects would include infrastructure schemes, such as irrigation systems, power plants and railroads. This is a small part of a much larger development: China is attempting to buy an alliance with the Philippines. China gets a huge amount of attention for its saber-rattling in the South China Sea. But the possibility that China could secure an alliance with the Philippines is much more important because it would significantly improve China’s strategic position in the region.

(click to enlarge)

China is currently hemmed in by a group of islands, referred to as the first island chain, off its coast. In a serious military conflict between China and the United States, or even China and a regional power with a formidable navy such as Japan, these islands would become a distinct weakness. The map above clearly shows why China would want to build an alliance with the Philippines. A Chinese-Philippine alliance would remove a key partner in the U.S. alliance structure. It also would secure Chinese access beyond the first island chain and allow China to base military assets at an important strategic location in the Pacific.

This photo taken on Jan. 2, 2017 shows Chinese J-15 fighter jets being launched from the deck of the Liaoning aircraft carrier during military drills in the South China Sea. The aircraft carrier is one of the latest steps in China's military buildup, as Beijing seeks greater global power to match its economic might and asserts itself more aggressively in its own backyard. STR/AFP/Getty Images

China faces two key challenges to successfully close the deal. First, China must entice the Philippines into an alliance – it cannot force Manila to bend to Beijing’s will. China’s navy is vastly superior to the Philippines’ navy, but as long as the Philippines’ mutual defense treaty with the U.S. is in place, China cannot conquer the Philippines or attempt to hold it for a meaningful period of time. That means China has two options: covertly work to destabilize the domestic situation in the Philippines, or attempt to use the promise of aid and development to buy Philippine allegiance. These are not mutually exclusive options.

China does not need to work hard on the first option. The Philippines has a populist president, who is attempting major domestic changes and is open to a different relationship with China.

The issue China faces in pursuing the latter option is twofold. First, China’s economic influence in the Philippines currently is relatively limited. China is one of the Philippines’ most important trading partners – but so are the U.S., Japan, South Korea and Taiwan, none of which would be pleased by a Chinese-Philippine alliance. China also is not currently a major investor in the Philippines. As the graph below shows, China’s investments in the Philippines over the last three years pale in comparison to those by Japan, the U.S. and Singapore – all countries that are diametrically opposed to a change in the balance of power in the Pacific.

Approved Foreign Investments in the Philippines by Country
(click to enlarge)

China, however, is trying to change this. In October 2016, China and the Philippines reportedly signed deals worth $24 billion during Philippine President Rodrigo Duterte’s visit to China.

This includes $15 billion in investment and $9 billion in credit facilities. This week’s announcement of $3.7 billion is the first chunk of that much larger investment to be doled out.

Foreign investment in the Philippines totaled $4.9 billion in 2015 (data for all of 2016 is not yet available). Thus, just this first installment is equivalent to 75 percent of the Philippines’ foreign investment in 2015. China’s investment and credit offers are a significant tactical move to gain a source of leverage in the Philippines. The Center for China and Globalization reported that Chinese foreign direct investment in 2015 totaled $145 billion. Considering the Philippines’ strategic importance to China, and considering how much less expensive throwing money at Manila would be than building five carrier battle groups or developing sophisticated anti-submarine capabilities, China has both the ability and the will to use economic heft to try to secure a better relationship with the Philippines.

However, when it comes to the impact of investment on the relationship between two countries, the devil is always in the details, and so far, the details on these deals are lacking. China’s commerce minister declined to provide details about the initial batch of projects and noted that they still need to be finalized.

This leads to China’s second challenge in developing closer ties with the Philippines: Its friendship comes with strings attached, which may deter the Philippines. China’s endgame is to secure a relationship that would allow it to station military assets in the Philippines. This would be a major reversal of Philippine policy and would face strong opposition there, both from the broader population and institutions such as the military that are more wary of China than Duterte.

There is a deeper problem and a major conflicting imperative: China wants the Philippines to drop its claims in the Spratly Islands and recognize Chinese sovereignty in the South China Sea. China has already taken some of the Spratly Islands from the Philippines and can limit access for Philippine fishermen at will, and it has shown no hesitance in doing so when unhappy with Manila’s moves. Part of the Philippines’ frustration is it views the United States as not adequately defending Philippine territorial claims and therefore not living up to their treaty’s terms. If the U.S. had honored the treaty, from this perspective, the U.S. would have made sure China could not take Scarborough Shoal or any other island and “maritime feature” on which China is building runways and stationing missile batteries.

The potential economic volatility that would result from putting all its eggs in Beijing’s basket and China’s desire to assert sovereignty over territory the Philippines considers its own are the major stumbling blocks to a Chinese-Philippine alliance. This is true regardless of what Duterte says or how much China invests in the Philippines. It is premature to view China’s investment deals in the Philippines as consequential because the Philippines has been vocal in protesting Chinese moves in the South China Sea in recent weeks, filing a diplomatic protest, hosting Japan’s prime minister and having key government officials critique Chinese actions in the region. If China goes ahead with the investment, the Philippines will be able to have its cake and eat it too: It will get money from China and won’t have to give up its claims. However, if China demands changes in Philippine behavior or territorial claims, or becomes too heavy-handed in what it is offering currently, it could push the Philippines away. In the meantime, at least Manila will have attracted some more attention from regional powers and the U.S. during its flirtation with China.

These are major challenges, and overcoming them will be difficult. The likelihood is that the Philippines will remain in the American sphere of influence, even if the Philippine president despises the U.S. on an ideological level. Even so, the challenges to securing a strategically significant relationship with the Philippines are more manageable for China than attempting to fight the U.S. Navy or attempting an amphibious invasion of Taiwan. China is making a move in the South China Sea, and it has nothing to do with Fiery Cross Reef or its rudimentary aircraft carrier crossing the Taiwan Strait. Watching whether these investments come to fruition and whether China can increase its influence over the Philippines will be important in benchmarking China’s strategic position in the next few years.