The Geopolitics of Fire and Ice

On April Fools' Day, Geopolitical Futures presents an analysis of the fictional world of Westeros.


On this auspicious April Fools’ Day, Geopolitical Futures presents a net assessment of Westeros, the fictional world at the center of the novels written by George R. R. Martin and the hit HBO series it has spawned. This piece applies GPF’s methodology to the Game of Thrones universe and makes predictions about what the year holds in store for the upcoming seventh season of the show.

The Geography of Westeros

Westeros is a large landmass, roughly the size of South America or triple size of Great Britain.

It has eight distinct geographical regions: the Reach, the Riverlands, the Stormlands, Dorne, the Westerlands, the Vale of Arryn, the North (which includes the Gift) and the Iron Islands.

The Crownlands, shown on the map below, is technically a constituent region. But as a geographic entity, it is part of the Stormlands, though power over the Crownlands often changes hands.

The Reach and the Riverlands are the most densely populated and agriculturally fertile regions of the realm, but also its most indefensible. Both have large river systems. The Mander River flows through the Reach. The Trident River passes through the Riverlands and is formed by three major tributaries: the Green Fork, the Blue Fork and the Red Fork. Each of these two major population centers and food-producing regions are located on flat plains that are highly susceptible to both invasion from outside powers and power contests between local political communities. Sometimes these regions are controlled by a single ruler, as the Reach is currently by House Tyrell, which governs from its seat at Highgarden. Even so, these breadbaskets of Westeros are always in danger of attack from bordering regions.

To the east, the Stormlands and the Crownlands are located on wooded uplands, making them vulnerable to conquest. But they are still considerably more defensible than the Reach and the Riverlands. The Stormlands’ and Crownlands’ eastern coasts boast some of the realm’s best ports, most notably the city of King’s Landing, Westeros’ royal capital and largest city. King’s Landing, a walled city home to 500,000 souls, is beset with many chronic issues, including low food supply, crime and corruption. The city is located on a raised upland and is an ideal port for travel across the Narrow Sea to Essos. Whoever controls King’s Landing is in an ideal position to deal with the Iron Bank of Braavos, which funds most of the Crown’s activities and plays a key role in Westeros’ economy.

To the south of the Reach and the Stormlands is Dorne. Dorne is a resource-poor region and the least integrated into the rest of Westeros. It is separated from the rest of Westeros by mountains, making it almost impossible for outside forces to dominate the region. Dorne has little commercial value because its ports are located farther away from Essos than others in Westeros and it can only support a limited population. Dorne’s ruling families are the most diverse in Westeros, having integrated refugees from Essos (the Rhoynar) and the North (the First Men) into its society. Thus, Dorne’s culture is both cosmopolitan and unique compared to the rest of Westeros.

North of the Stormlands is the Vale, another mountainous region with a limited population. It is an extremely advantageous defensive point from which to launch attacks into the Riverlands.

To the west, the Westerlands are rocky and blessed with abundant mining resources, especially gold. The region has a highly defensible staging ground for aggressive attacks, especially into the Riverlands.

North of the Riverlands, the geography of Westeros changes. The continent narrows considerably at what is called “the Neck,” a region beset with marshes and swamps that make the movement of large-scale troop formations extremely vulnerable to enemy attack. The only passable point in the Neck is marked by Moat Cailin, the boundary separating northern and southern Westeros for millennia. This is also the area in which ethnicity begins to change on Westeros, as the North is populated by the descendants of the First Men and the area south of Moat Cailin is populated by the descendants of the Andals. The Andals invaded Westeros thousands of years ago, but even they could not assert power past Moat Cailin. The North is a vast land, making up almost half of Westeros, and its population has its own unique religion and dialect. Direct control of the North, even by its native population, is extremely hard because it is such a wide expanse. No foreign power in Westeros’ recorded history has managed to subdue the North, though the Targaryens were able to keep the region under submission for a few centuries.

The two remaining regions are geographical outliers. The first is the area beyond the Wall, home to untold numbers of Wildlings who are separated from Westeros by a massive wall of ice and magic many times higher than any wall ever constructed in modern human history. The second is the Iron Islands, a dank and wet batch of relatively small islands to the west of the Riverlands that can support a limited population, albeit one that is highly skilled when it comes to naval warfare. At various points in Westeros’ history, the Iron Islands’ rulers have asserted control over the Riverlands and even parts of the North. Due to being disconnected from the main continent, the Iron Islands have developed a distinctive culture and religion.

Political and Religious Transformation

Having laid out the basic geography of Westeros, it is now necessary to examine its history.

Before the Targaryens crossed the Narrow Sea and asserted control over Westeros through their possession of an almost invincible technology (dragons), the continent was divided nominally into Seven Kingdoms – some highly fractious – each with its own king. The continent was also divided on religious grounds. The North continued to worship the Old Gods, while the rest of Westeros, except for the Iron Islands, was converted to the Faith of the Seven, brought over by the conquering Andal race thousands of years ago.


The Targaryen conquest of Westeros set in motion a series of conflicts on both political and religious fronts, which led directly to the War of the Five Kings. After the Andals invaded Westeros, a feudalistic system was set up throughout the continent. The basis of this system was the personal relationship between a liege lord and his subjects. The best evidence for this is how various Westeros regions are associated with different Houses. For example, House Stark rules the North and derives its power from the various lesser houses and communities that pledge allegiance to the Stark banner.

House Stark’s bannermen, however, can transfer their allegiance if they choose, as the Karstarks did after Robb killed Rickard Karstark, the head of the House.

The Targaryens sought to impose a different system in which all of Westeros’ land was owned by the Crown and various Crown-sanctioned Houses were assigned Stewardship of those lands.

The Targaryens wiped out Houses that did not bend the knee to Targaryen rule, and replaced them with Targaryen-sanctioned stewards. (House Tyrell, which governed the Reach, is the most prominent example.) The Targaryen monarchy managed to keep this system together for hundreds of years, though not without various rebellions and wars that challenged Targaryen rule. The Targaryen Crown could do this because the Targaryens had dragons. The United States’ development of nuclear weapons before any other country at the end of World War II is an apt analogy. House Targaryen could annihilate its enemies. This cowed many into submission; those who didn’t go along with the new system were wiped out.

But the dragons died out, partly because of constant Targaryen civil wars. The result was House Targaryen had to rule through prestige alone. This worked for a time, but required extremely deft political leadership. When the aptly named Mad King ascended to the throne, the result was catastrophe for the Targaryens. A rebellion against the Targaryens ensued that put House Baratheon on the throne. But a rebellion to King Robert Baratheon’s rule was inevitable, because House Baratheon could no more control the monarchy than could House Targaryen without its strategic weapon. During the War of the Five Kings, the old feudal system, developed over thousands of years, reasserted itself against the Crown’s authority, which is presently tenuous at best.

As the situation currently stands, a Lannister sits on the Iron Throne, and the Lannisters control the Westerlands, the Riverlands and much of the Stormlands, as well as the capital. But their control is maintained by a force that is spread far too thin and is facing rebellion against the Crown’s authority on all sides.


In Westeros, where nationhood as an organizing political principle does not exist, religious conflict remains of geopolitical consequence. Official history would have us believe that the Andals brought over the Faith of the Seven as conquerors and that over time most of Westeros adopted it. It is too convenient, however, that the Faith of the Seven would have existed before it encountered the Seven Kingdoms. More likely, the Andals sought a way to consolidate their hold over their new possessions and modified their religious beliefs to make them more acceptable to Westeros’ population (though the new religion never took hold in the North).

When the Targaryens arrived, they saw a ready-made lever they could use to install a new centralized monarchy. An alliance was forged between Aegon the Conqueror and the Faith of the Seven’s religious militia, the Faith Militant. The Faith thought it could manipulate the conquering Targaryens, and once it became clear that the Targaryens intended to rule, not to pray, the Faith turned against them, fighting a series of bloody conflicts against the Targaryen House. An agreement eventually was reached between the two sides: The seat of the High Septon, the Faith’s essential pope, was moved to King’s Landing, and the Crown pledged to protect the Faith at all costs.

After the War of the Five Kings, Cersei Lannister reached an agreement with the Faith. Cersei gained a militia to help her defend the Crown’s power. The Faith got their militia back. Instead of adhering to the desires of the Crown, the Faith decided to assert their own beliefs, even holding Cersei hostage.

House Lannister has now crushed this rebellion and Cersei has been crowned Queen, but did so by wiping out all of the Faith’s fighters and most of the Septons in King’s Landing. News of this will travel far throughout the south, including in the Riverlands and even in Casterly Rock, the seat of House Lannister. In the North, the Old Gods continue to reign, and the coming of Winter has only reasserted their long-held influence.

Not coincidentally, other various religious movements have also begun to arise, the most prominent being the cultish, monotheistic faith imported from Essos that believes there is only one God, the Lord of Light. A band of vigilantes called the Brotherhood and a political adviser to one of the five kings known as the Red Priestess both subscribe to this faith, and have already shaped the political conflict in Westeros. The approaching Targaryen host also has ties to this faith; the Targaryens used the Faith of the Seven in their initial conquest of Westeros, but the approaching host has associated itself with the Lord of Light cult. The destruction of the Faith of the Seven’s leadership will reverberate throughout the realm. It will weaken House Lannister’s claim to the throne, be a rallying cry against the Crown, and lead to the proliferation of various groups seeking power amid chaos.

The inclusion of religion in politics and the rise of other religious movements were set in motion when the Andals first supplanted the native religion of the population they conquered. These issues were accelerated when House Targaryen attempted to impose a centralized monarchy on the Seven Kingdoms and saw fit to use the Faith for worldly issues. Westeros now faces invasion from two forces: a supernatural army from north of the Wall, and a Targaryen host seeking to reinstall a Targaryen upon the throne. But Westeros was already tearing itself apart before either of those forces were assembled. The most important, if less obvious, issue in Westeros will continue to be defining political power and the relationship between religious and political authority.

The Current Situation

Having defined the major political fault lines of the realm, we turn now to the present.

King’s Landing

House Lannister has taken control of King’s Landing and the Riverlands. House Lannister boasts a maximum of roughly 50,000 men at arms and a small naval fleet, but House Lannister’s strength has been significantly curtailed by two factors. The first is that its armies have been constantly at war for many months. In the war of the Five Kings, House Lannister called roughly 35,000 bannermen to arms, but thousands of those soldiers died, and many others returned to the Westerlands or were dispatched to King’s Landing or other places. The second factor is that House Lannister is financially broke; its Westeros mines have not produced gold for over a year.

Thus, House Lannister is highly indebted to the Iron Bank of Braavos. We estimate the ratio of non-performing loans to total loans the Iron Bank of Bravos issued to the Crown has ballooned to over 45 percent. House Lannister has also lost its most important alliances. In taking the throne for herself, recently anointed Queen Cersei destroyed the alliance with House Tyrell, the current rulers in the Reach. The Reach had provided King’s Landing with much-needed food and soldiers for defense, and without either it will be hard for the Lannisters to hold King’s Landing by any other way than brute force. Meanwhile, the Vale has, for now, sent the bulk of its fighters to the North to back a budding Stark restoration in the Northern stronghold of Winterfell. There are no sides unspoken for that the Lannisters can call for help.

The Lannister armies currently occupy the Westerlands, the Riverlands, the Stormlands, the Crownlands, and King’s Landing itself, but they are spread too thin, and their control over the Riverlands will dissipate from the strain of attempting to hold them. King’s Landing is in a highly defensible position, as it is a walled city surrounded on one side by water. An invasion of King’s Landing would require either an amphibious landing, which Stannis Baratheon learned the hard way is extremely difficult, or a direct assault on a walled city. Even if the walls were breached, the battle for King’s Landing would be a classic case of urban warfare, where the casualty rate for an invading force can easily reach 50 to 60 percent of total forces. The Lannister position is extremely weak from a power projection point of view, but uprooting the Lannisters by force from King’s Landing will be extremely difficult without the deaths of tens if not hundreds of thousands of civilians.

A Targaryen Invasión

While the Lannister position in King’s Landing is extremely weak, it is not threatened by any of the other regions in the realm. The most serious threat is from an emerging alliance between the Reach and Dorne, but it is very difficult for Dorne to project force over such long distance and harsh geography. The Reach’s armies have been bloodied and lost some of their best fighters and commanders in King’s Landing. The Reach’s real power lies in its ability to cut off food and other supplies from King’s Landing and its ability to stage attacks in the Riverlands to cut off Lannister supply chains. The Reach cannot launch a full-scale invasion against King’s Landing, but it could invade the Riverlands and challenge Lannister dominion in the region. If successful, this would worsen the economic situation in the capital.

What King’s Landing does not expect is that a large and capable force armed with newly discovered dragons is about to make landfall in Westeros. Daenerys Targaryen, the last full-blooded member of her once-illustrious house, is sailing for Westeros at the head of a massive host. Her armed forces number roughly 20,000, not including Dothraki light cavalry, but all told her numbers swell to between 80,000 and 100,000 souls. This means that Daenerys cannot attempt a direct amphibious assault against King’s Landing. Daenerys needs food and supplies, as well as local Westerosi support and a safe place to land her forces. Dorne is too far removed from the action, but the Reach, with its combination of ample supplies and hatred for the Crown, is an ideal place for Daenerys to make landfall and plot her assault on King’s Landing.

Daenerys comes equipped with three flying weapons of massive destruction. No other force in the entire Seven Kingdoms contains anything like Daenerys’ dragons. This new technology gives Daenerys a great deal of power, but this power also has its limits. Daenerys has no interest in razing King’s Landing and its civilian population to the ground – she wants to conquer the city with popular support. Her dragons are only effective as a potential threat, if the goal is to conquer King’s Landing without killing most of the civilians living there. House Lannister has no reason to negotiate with Daenerys, and will turn the entire population of King’s Landing into a human shield. Daenerys’ dragons help very little in a direct assault on King’s Landing itself.

It is unlikely then that Daenerys will begin by waging a full-scale assault on King’s Landing.

Daenerys’ dragons are highly effective in projecting both prestige and power to would-be allies, many who are dissatisfied with the Crown, especially in the regions below the Neck. Daenerys’ dragons also give her a far greater ability than any other force to project across distance. It so happens that the North, which has rallied behind a Stark restoration, is facing a massive invasion of the Army of the Dead, a military force without peer in the realm. Even the fresh 45,000 troops of the Vale, the main reason the Starks were able to retake Winterfell, stand little chance against the Army of the Dead, which likely numbers in the hundreds of thousands and is marching south toward the Wall.

Daenerys can offer two things to House Stark.

First, she can offer fighters and troops of unquestionable loyalty. The Knights of the Vale currently swear allegiance to a pathetic, inbred, halfwit of a child who is as lame as he is unpredictable. But often this child-lord of the Knights of the Vale listens to the council of Petyr Baelish. Baelish seeks to divide the two Stark children currently ensconced at Winterfell against each other, which makes the Stark position extremely vulnerable. It also so happens that one of those Stark children is half Targaryen, though he is not aware of it yet. Bran Stark is en route south and has discovered the truth of Jon Snow’s identity. As soon as Bran relays this information to Jon, a potential alliance between House Stark and Daenerys will emerge.

Second, Daenerys’ dragons are needed more in the North than anywhere else in the realm.

Daenerys’ dragons are the only weapon the human populations living south of the Wall have to resist the Dead force of the Night King. By dispatching her dragons to the North, Daenerys will solidify an alliance with the North and will also become its savior. This will significantly increase Daenerys’ prestige, and will make any House or region thinking of resisting her invasion of Westeros extremely wary of doing anything except pledging fealty to the new superpower of the realm. Daenerys is already in negotiations with the Reach and Dorne for an alliance. Once her position in the North is secure, Daenerys’ forces will be able to approach the Riverlands from both the north and south. This will enable her forces to cut King’s Landing off from all supplies and carry out a siege operation to force the Lannister’s hand. All of this also assumes that Daenerys’ host crosses the Narrow Sea mostly intact, which is not a foregone conclusion considering the dangerous nature of seaborne travel in this world.


Two disruptive events are about to change the course of Westeros’ history: Daenerys Targaryen will arrive in Westeros with three dragons, and the Night King will begin to push south of the Wall. These two forces will fight at some point – the only question is when the conflict will occur. This is the second time a Targaryen at the head of a mighty army and with vastly superior technology has set out to conquer Westeros, but the Westeros Daenerys is reaching has only just begun to tear itself apart. Geography is reasserting itself on the continent, and both political and religious authority is up for grabs. Daenerys’ dragons lend her significant but not absolute power, and Daenerys has been insistent that she intends not to resort to the type of tactics of her ancestors. It is a noble aim, but the road to the Red Waste is paved with noble aims, and if Daenerys means to succeed in her task, she will do so only because she lives long enough to see herself become the villain.

Getting Technical

Is Gold’s Comeback Real, Or Just Another Tease?

Global tensions combine to push the precious metal higher. But the rally may be short-lived.       

By Michael Kahn 

Gold has been languishing for several years in the absence of inflation. Yet the yellow metal quietly reached a five-month high and vaulted a few technical barriers in the process. While the long-term picture is still rather unconvincing on gold – and silver – the short term is looking much better.
Gold and silver stocks continue to lag the metals themselves, but they too have been on the move higher for the past month. Current geopolitical issues help gold and silver as a hedge against uncertainties in the world, and investors should consider modestly increasing their allocations to the sectors. 
Gold bottomed last December, but the current leg higher began March 15 after the Federal Reserve announced it was raising short-term interest rates by one-quarter percentage point to 0.75%-1% (see Chart 1). Gains stalled when the SPDR Gold Sharesexchange-traded fund (ticker: GLD) reached resistance in its chart.

Chart 1

The launch of 59 tomahawk missiles at Syria ahead of the April 7 trading day couldn’t punch gold through to new highs. It proved to be a temporary setback, and two days later the ETF did break out.
The move was confirmed the next day when the U.S. dollar was knocked down by a tweet from the president saying the greenback was “getting too strong.” The dollar and gold often move in opposite directions.
For now, with the ETF above its major moving averages, it appears the top of its four-year trading range in the 131 area is the next target (the ETF traded at $122.72 Monday afternoon). We can’t forecast what will happen if and when the market gets there (see Chart 2).

Chart 2

For comparison, the top of gold’s long-term range is close to $1,383 per ounce; on Monday, it was trading at $1,291. That would be about a 7% gain.

The VanEck Vectors Gold Miners ETF (GDX) has a bit more work to do before scoring its own short-term breakout (see Chart 3). It still trades just below resistance from its February (and November 2016) highs. It is also still below its flat 200-day moving average. Yet for the first time since its 2016 peak, it is now outperforming the broad market, even if by only a small amount.

Chart 3

The long-term range here is not as well-defined as it is for gold itself. If the gold-mining ETF can make it back to last year’s high of $31.79, it would be tempting to label the entire 2013-2017 pattern as an inverted or upside-down head-and-shoulders pattern. (The ETF traded at $24.56 Monday afternoon.) That would carry long-term bullish implications. but we are getting way ahead of ourselves. There is a lot of price movement and time ahead before the market gets to that crossroads.

Still, a short-term breakout would be a good sign and a reason to increase allocation – at least a little bit – to precious-metals miners.

Consider South African gold miner Gold Fields (GFI), which jumped higher last Thursday as gold moved to within striking distance of the $1,300 level (see Chart 4). This formed an “upside breakaway gap” on its chart – usually a powerful bullish signal, especially when accompanied by strong volume.

Chart 4

A gap is an area on the chart where no trading takes place, as demand swamped supply before the trading session began. The price had to jump, rather than trade smoothly, to restore equilibrium. On a more pragmatic level, it represents a sea change of sentiment from the uncertainty of a trading range to the bullishness of a rising trend.

Gold Fields has a solid market value of $3.3 billion, but its American depositary receipt trades near $4 per share. Investors should be forewarned that such low-priced stocks carry higher risk as well as higher profit potential.

Caution Signals Are Blinking for the Trump Bull Market


Photo Credit Chris Koehler 

Despite an eight-day losing streak that ended on Tuesday, the stock market has generally been buoyant in the opening weeks of the Trump administration. The bullish mood could be a self-fulfilling prophecy and lead to continuing gains for a while.

Yet important measurements — some of which I developed — tell us that the market is quite expensive and that investor optimism is tinged with plenty of worry. None of this tells us where the market is going tomorrow, but it suggests that some caution is advisable, and that returns over the next decade or so are likely to be constrained.

Consider first the evidence from what is often called the Shiller CAPE ratio.

What is CAPE, or the cyclically adjusted price-earnings ratio, exactly? Bear with me. This is a bit technical: It is real, or inflation-adjusted, stock price divided by a 10-year average of real earnings. It is usually measured using the price and earnings of the Standard & Poor’s 500-stock index, adjusted for inflation with the Consumer Price Index. In 1988, John Y. Campbell (now at Harvard) and I showed in a joint article that such a ratio has, since 1881, forecast returns somewhat well in the stock market. That “somewhat” is important because the ratio has its limits as a forecasting tool.

We found back then that averaging earnings over 10 years smoothed short-run or cyclical fluctuations, providing a better indicator of fundamental value. The CAPE ratio has successfully explained about a third of the variation in real 10-year stock market returns in United States history since 1881.

This is the important point: In 1988, we found that CAPE had averaged about 15 since 1881. In years when CAPE was lower than that, subsequent 10-year returns for the stock market tended to be good.

In years when it was higher, the 10-year returns tended to be bad.

That’s why today’s CAPE is sending a troubling message. The ratio is now almost 30. Using monthly data, it has been higher only in 1929, when it reached 33, and in the few years around 2000, when it reached 44. In both instances, sharp market declines followed those very high readings. The current level of CAPE suggests a dim outlook for the American stock market over the next 10 years or so, but it does not tell us for sure nor does it say when to expect a decline. As I said, CAPE is useful, but it does not provide a clear guide to the future.

Investor sentiment is another factor, and current readings also give us cause for concern.

I have been involved in regular opinion surveys of institutional and individual investors in the United States since 1989. These surveys are undertaken and published online by the Yale School of Management. From these data, I created a Valuation Confidence Index, which is the percent of respondents who think the domestic stock market is not overvalued; a Crash Confidence Index, which is the percent who think that a 1929- or 1987-style crash in the next six months is highly unlikely; and a One-Year Confidence Index, which is the percent who think the stock market will go up in the next year. The indexes are measured in six-month intervals, and our latest data are for the six months through February, which includes the election of President Trump on Nov. 8, 2016.

Valuation confidence in February was quite low. The only time it has been lower was in the years surrounding the market peak of 2000. In February, crash confidence was quite low too, though it has been slightly lower on a number of occasions since 1989. These two indicators might seem to confirm the apparent signal of the CAPE ratio: trouble ahead. They are certainly saying that investors aren’t confident that current prices are reasonable or that the market is stable.

But one metric went the opposite direction. One-year confidence is at a record high for institutional investors, and it is at the highest level since 2007 for individual investors. (That means, by the way, that in 2007, the eve of the Great Recession and financial crisis, most people had no clue that big problems were imminent.)

It is hard to reconcile these results. One possible interpretation might be that respondents perceive a stock market bubble: They think valuations are high and there is a non-negligible probability of a crash. At the same time, they are hanging in because they think the Trump boom will probably last for at least another year.

That doesn’t provide much reassurance. The high fraction of our survey respondents who think that the stock market is unlikely to fall in the next year may simply reflect a failure of imagination about how a Trump bull market could suddenly end. There are scores of ways, of course. Just because people can’t picture a big decline doesn’t mean that they won’t react very badly if the market comes under real stress.

Many people appear to believe that a business-oriented president will preside over a long stock market boom. At a glance, there appears to be some precedent for this, first with the 1920 election that brought in President Warren G. Harding and Vice President Calvin Coolidge (who took over when Harding died in 1923) and then with the 1980 victory of Ronald Reagan. These elections were followed by the Roaring Twenties of 1921 to 1929 and the Millennium Boom market of 1982 to 2000.

But in both cases, during the initial election campaigns the economy was in recession and the CAPE ratio was extremely low — around 5 in 1920 and 9 in 1980.

We are in a very different situation now. The economy has largely recovered from the last recession, and CAPE shows us that stocks are now relatively expensive.

There is no clear message from all of this. Long-term investors shouldn’t be alarmed and shouldn’t avoid stocks altogether. But my bottom line is that the high pricing of the market — and the public perception that the market is indeed highly priced — are the most important factors for the current market outlook. And those factors are negative.

We don’t know where the market will go this month or this year. It could well rise a lot. But investors should not let themselves be tempted to bet aggressively on the Trump bull market.

Robert J. Shiller is Sterling Professor of Economics at Yale.

Up and Down Wall Street

Dr. Doom’s Diagnosis of the Banks, the Fed, and the Economy

Former Salomon bond maven Henry Kaufman has a new book. His argument: The Fed has grown more essential as its policies have failed.     

By Randall W. Forsyth                

There was a time when markets moved not on the televised utterances of Federal Reserve officials or billionaire money managers, but on a small printed report with the unassuming title “Comments on Credit.” That was because it contained the latest insights from Henry Kaufman, Salomon Brothers’ chief economist and head of the firm’s nonpareil research efforts.
Some readers may not recognize the name of the man or the firm, since they were toddlers (or perhaps not yet born) in Salomon’s heyday of the 1970s and ’80s. During that time, Kaufman earned the sobriquet of Dr. Doom for his consistently downbeat—but consistently prescient—forecasts of inflation and interest rates rising to unprecedented levels well into the double digits. Anyone younger than 35 years old has lived only in a period of disinflation and generally falling interest rates.
So it was enlightening and enjoyable to catch up with Henry via telephone on the occasion of the publication of his latest book, Tectonic Shifts in Financial Markets: People, Policies, and Institutions. At my end, his voice sounded the same as it did when he addressed a New York City hotel ballroom packed with clients and media 3½ decades ago to outline his eagerly anticipated forecast for the coming year. But his weekly “Comments” carried as much clout as his annual predictions did during those days of soaring bond yields and extreme volatility.
He later parted company with Salomon over disagreements about the risky tack the firm had taken and formed his own consultancy. Solly would later be hit by the infamous Treasury auction scandal, after which it was folded into various firms that were melded by Sandy Weill into what ultimately became Citigroup (ticker: C).
Kaufman’s book offers a valuable history of how we got to the state we’re in, most notably the follies of policy makers and market participants that led to the financial crisis and its aftermath. What stands out, even as the markets’ attention has been shifted to Trump administration policies and promises, is that the Federal Reserve has attained an unprecedented prominence—precisely because of its past policy failures.
The central bank under its previous chairmen, Alan Greenspan and Ben Bernanke, failed to grasp the changes in the structure of finance, Henry argues. Securitization, which allowed subprime (and frequently fraudulent) mortgages to be repackaged into investment-grade securities, was one.
Another was the repeal of the Depression-era Glass-Steagall Act, which drastically increased the concentration of the markets and left a handful of megabanks to dominate Wall Street.

That, in turn, reduced the breadth and depth of market makers that provide liquidity, leaving only the Fed as a liquidity provider in times of stress.
The reforms of Dodd-Frank have only exacerbated the concentration of financial power, he notes in the book. The result is a far more fragile financial system than in the past, and one more dependent on the Fed.
That said, Henry writes that the secular lows of long-term interest rates already have been seen, with the 30-year Treasury bond touching 2.1% last July (compared with about 3% as we chatted). But, he emphasizes, a secular rise in interest rates similar to what was seen in the post–World War II era, which took long-term bond yields from 2.5% in the 1950s to a peak of 15.25% in 1981, is unlikely to recur.
Henry could foresee a return to 4% to 5% for the Treasury long bond. That range was last visited in 2011—before the collapse in yields following Congress’ game of chicken over the federal debt ceiling that threatened default and (ironically) resulted in a flight to quality into U.S. debt. The 5% mark was last touched in August 2007—just before the financial crisis that would culminate in Lehman Brothers’ collapse a little over a year later.
As for the Fed today, the current economic expansion is “getting on in age,” he says, with utilization of labor reaching a ceiling (notwithstanding what he calls the secular problem of the depressed labor force participation rate). That implies a continued rise in the Fed’s target for the federal-funds rate, which was lifted last month to 0.75%-1%.
But the frailties of the financial system limit how far the central bank can raise the fed-funds rate, which Henry says will force it to consider new, non-interest-rate tools to meet its objectives. This fragility is already evident in other sectors of the credit markets, and he singles out automobile loans as a key area of weakness (about which more to follow).
Curbs or greater scrutiny on lending practices might be employed. In other words, qualitative, rather than quantitative, restraint could be used. That’s because interest rates wouldn’t have to rise to historically high levels to cause a financial accident. Recall that the Fed pushed the fed-funds rate to what seemed like a benign 5.25% before fissures in the financial structure appeared ahead of the 2008 crisis.
This is the flip side of Kaufman’s key observation of the 1970s—that interest rates would have to rise far higher than ever before in order to stop inflation. Previous restraints on credit, such as interest-rate caps, had put a brake on the system. Deregulation did away with that.
Now, a frail financial system can’t take a rise in interest rates, as in past periods. The lack of a robust roster of market makers results in the system being ever-more dependent on the Fed, he emphasizes.
Which, in turn, makes the central bank more politicized than ever. During the election campaign, President Donald Trump made no bones about not reappointing Janet Yellen as Fed chair when her term expires in early 2018. Presumably also on the way out is Vice Chair Stanley Fischer, who like Yellen was appointed by former President Barack Obama. Among the Fed’s board of governors, there will be three vacancies when Daniel Tarullo steps down this week. So, of the seven board members, Trump potentially could name five in the next year.
His nominees are likely to be more “liberal,” Henry says, in the sense that they are apt to follow more expansionary policies to accommodate the administration’s fiscal plans. That would be the opposite of what the critics—many of them Trump supporters—charge, namely that the Fed has done more harm than good by keeping rates too low for too long, thus boosting asset values for the rich and hurting small savers.
His new book ends on the note that “you can’t go home again,” in the sense that the clock can’t be turned back to a simpler time. Ideally, he says, it would be better for smaller firms to specialize in their own niches: Investment banks should stick to investment banking, asset managers to managing assets, rather than having all of those functions under one roof, with inevitable conflicts of interest.
That would leave a more interventionist Fed presiding over a small roster of mega-banks that may be turned into quasi-utilities, he concludes.
Henry’s great strength has always been to present things as they are, not the way we may want them to be.
AS KAUFMAN ASTUTELY OBSERVED, credit distress is becoming visible in the auto-loan sector, with the asset-backed securities market once again playing the role of enabler, just as it did in the housing debacle last decade. 

Over lunch a couple of years ago, a money manager described why it was different this time with auto ABS.

Unlike houses, on which foreclosures literally take years, the collateral for auto loans can be retrieved overnight by the repo man and his tow truck. The seized car then could be readily resold and financed by a new loan, because the demand for quality used cars was strong and so were their prices. So auto loan defaults were no problem—then.

Things have changed. There’s a glut of relatively young used cars coming back on the market, now that leases of three-year-old models are up. That’s pushing down used-car prices, to the detriment of CarMax    (KMX), as described fully in ”CarMax Could Stall as Risky Loans Rise.”

“After inflating like crazy, the auto-loan bubble has at last gone bust,” MacroMavens’ Stephanie Pomboy writes. Lenders provided lengthy deals, seven years and more, to get buyers into pricey sport-utility vehicles and pickups, while keeping the monthly nut affordable. The loans can be securitized into ABS, which investors gobble up in the low-interest-rate world.

“These practices are bearing their inevitable fruit,” she continues. Auto inventories are bulging, resulting in stepped-up incentives for new cars, which is driving down used-car prices.

The ripple effects are apt to spread far beyond the manufacturers, as they will have to pare payrolls and hours, resulting in lower spending by their workers, reduced tax revenue, and higher outlays by state and local governments. This, at a time when defaults on credit cards and home-equity loans are at three-year highs, Steph notes.

And it comes just as Greenlight Capital’s David Einhorn is cajoling General Motors (GM) to create two classes of stock, one to pay rich dividends to income investors, another for capital gains. (See my recent online column “What’s Good for Einhorn Isn’t Good for GM or U.S.,” March 30.) Moody’s and Standard & Poor’s criticized the scheme, saying it imperiled GM’s credit rating.

As Kaufman explained, the implications of market innovations, such as securitization of auto loans or financial engineering, have been poorly understood. To put it in ancient terms, in the Old Testament, Joseph advised gathering grain in good harvests to prepare for the inevitable drought. Einhorn’s plan would squander GM’s surplus, rather than save it for tougher times, which auto-loan stresses suggest lie ahead. 

Rising Anxiety Fuels Market About-Face

Many investors worry that markets are entering a treacherous period amid soft economic data and global conflicts

By Corrie Driebusch and Sam Goldfarb

The Chicago Board Options Exchange’s volatility index pit in March. The VIX is up 24% since April 7. Photo: Getty Images

Signs of a slowdown in the U.S. economy and rising anxiety in markets are prompting many investors to reassess their portfolios and prune risky positions.

On Friday, the consumer-price index, which measures what Americans pay for goods and services, declined. It was the first monthly decline for core prices, which exclude the often-volatile categories of food and energy, since January 2010. The data came a week after the Labor Department said U.S. employers added far fewer jobs in March than economists had expected.

The declines, which helped push the WSJ Dollar Index to its fourth retreat in five sessions, amplify the concern among many investors that markets are entering a treacherous period as lackluster economic fundamentals collide with unpredictable domestic and international politics.

The S&P 500 is down about 3% from its record hit in March, within the range many analysts have said they expect the stock market to end 2017. The CBOE Volatility Index, or VIX, climbed every trading day this past week, rising 24% since April 7 to its highest level since November. Bond yields have fallen to their lowest level since just after the November elections, reflecting the retreat of expectations that a White House policy onslaught would spearhead a rise in economic growth and inflation.

In recent weeks, Erik Knutzen, multiasset class chief investment officer at Neuberger Berman, said he reduced exposure to large-company stocks and instead put that money into European and emerging-market stocks in some of the portfolios he manages, citing more-favorable valuations overseas.

“We were concerned a lot of optimism and good news was already priced in, and we wanted to take some chips off the table,” he said. “We do expect an increase in volatility, but we’re not expecting a 20% drawdown in markets.”

Potential pitfalls for markets are numerous. President Donald Trump this past week reversed several positions that had defined his campaign. In an interview with The Wall Street Journal, he said he supported the Export-Import Bank and declined to label China as a currency manipulator. At a news conference Wednesday, he said the North Atlantic Treaty Organization is no longer “obsolete,” as he said repeatedly during the campaign.

On Thursday, after the Pentagon said the U.S. dropped one of its largest nonnuclear bombs on Afghanistan, U.S. stocks fell further.

The perception of policy volatility is among the reasons that some investors are increasing holdings of cash, at least for the near term.

“The realization is it’s going to be bumpy the next six, nine or 12 months,” said Mr. Knutzen.

Bond investors have scored gains amid the turmoil. Over the past four trading days, the yield on the benchmark 10-year Treasury note registered its largest one-week decline since last June, settling Thursday at 2.237%, its lowest close since Nov. 16. Yields fall when bond prices rise.

Over the past month, one development after another has led investors to rethink assumptions that had previously caused them to sell bonds.

Against this backdrop, one argument for higher yields that has remained intact has been a trend toward higher U.S. inflation. But that also suffered a setback Friday with the release of the CPI report.

While many bond investors had already started to scale back bets on inflation, the report confirmed suspicions “that inflation is not as big of an issue as we thought it was,” said George Rusnak, co-head of global fixed-income strategy at Wells Fargo Investment Institute.

One area where U.S. investors might shift money to protect their portfolios: Europe. Demand for European stocks has risen this year thanks to relatively low valuations, data pointing to an improving eurozone economy and polls suggesting far-right candidate Marine Le Pen’s odds of winning the French presidential elections have moderated.

Investors poured $1.8 billion into European equity funds in the week through Wednesday, according to data from EPFR Global, the biggest inflows for those funds in 68 weeks.

Meanwhile, investors put just $400 million into U.S. equity funds. The prior week, they had withdrawn $14.5 billion, the largest outflow for U.S. equities in 82 weeks.

The moves mark a reversal from the period between Election Day and year-end, when bets that the Trump administration’s agenda would supercharge economic growth in the U.S. led investors to pour $57.7 billion into U.S. equity funds while withdrawing $1.1 billion from their European counterparts, according to EPFR data.

While the VIX remains well below its 10-year average, its revival has marked a sharp move relative to the S&P 500 index, which fell about 1% since April 7. The VIX is based on options prices on the S&P 500 index and tends to rise when stocks fall.

Investors also drove up the price of April futures contracts on the VIX relative to contracts that expire in May, signaling heightened anxiety around the near term.

“There’s some nervousness in the marketplace that’s not reflected in the S&P 500 index,” John-Mark Piampiano, head of equity derivatives strategy at Seaport Global Securities, said.

—Gunjan Banerji and Akane Otani contributed to this article.

Delivering on Promises to the Middle Class

Michael Spence, David Brady
. Newsart for Delivering on Promises to the Middle Class

MILAN – US President Donald Trump owes his electoral victory largely to the older white middle- and working-class voters who have missed out on many of the benefits of the economic-growth patterns of the last three decades. Yet his administration is preparing to pursue an economic program that, while positive in some respects, will not deliver the reversal of economic fortune his key constituency was promised.
Trump gave voice to a group of voters who had long faced worsening job prospects and stagnant or even declining real incomes – trends that have accelerated since 2000. As the number of middle-class jobs fell, the middle-income group shrank, exacerbating income polarization. This phenomenon, while particularly severe in the United States and the United Kingdom, can be seen in various forms throughout the developed world.
The economic challenges facing developed-country middle classes are largely the result of two factors: the rapid loss of white- and blue-collar routine jobs to automation, and the shift of middle and lower value-added jobs to countries with lower labor costs. The latter pattern depressed income and wage growth not only in the tradable sector directly, but also in the non-tradable service sectors, owing to the spillover of displaced labor.
The result was surplus labor conditions in the middle- and lower-middle-income ranges, not dissimilar to the surplus labor in early-stage developing countries, where it suppresses income growth (for a period of time) even as the economy expands. A decline in the bargaining power of labor and a falling real minimum wage may have also contributed to income polarization, though these are probably secondary factors.
Though the challenges facing the middle class are well documented, US leaders have largely failed to recognize fully the struggles of middle-class households, much less implement effective countermeasures. This has contributed to a growing sense of hopelessness – particularly among men – which has manifested in rising non-participation in the workforce, aggravated health problems, drug abuse, elevated suicide rates, and anti-government sentiment.
Countries that experience high and rising economic inequality often face political instability and policy dysfunction. As policymaking becomes erratic, loses credibility, and becomes choked by gridlock, growth suffers, and the chances of achieving a prosperous form of inclusiveness decline.
The result is a vicious circle, in which government finds it increasingly difficult to do what is needed.
But government intervention is crucial to tackle the problems facing developed-country workers today, which markets can’t address alone. Whether by renegotiating trade arrangements, investing in infrastructure and human capital, or facilitating redistribution, government must work proactively to achieve a rebalancing of growth patterns.
The Trump administration now faces at least two major challenges. The first is to steer the political process away from paralyzing polarization, toward some vision of an achievable and more inclusive growth pattern. The second challenge – conditional on achieving the first – is to respond to the legitimate concerns of the voters who helped Trump reach office.
On the first challenge, the signs so far are not encouraging. The electoral process is essentially a zero-sum game for the participants. But governance is not a zero-sum game. Treating it that way produces gridlock, political fragmentation, and inaction, undermining efforts to address critical challenges.
To be sure, elements of the Trump administration’s proposed economic policy, if implemented, would surely have a positive impact. For example, with the support of a Republican-dominated Congress, the Trump administration could finally be able to end America’s excessive reliance on monetary policy to support growth and employment.
Moreover, the public-sector investment in infrastructure and human capital that Trump has promised, if properly targeted, would raise returns on – and thus the level of – private-sector investment, with tax and regulatory reform providing an additional boost. Some renegotiation of trade and investment agreements could also help to redistribute the costs and benefits of globalization, though any changes should fall well short of protectionism. And the impact of the Trump administration’s economic policies is likely to be buoyed by the economy’s natural structural adaptation to technological development.
But this will not be enough to combat the forces that have been squeezing American workers. Even if the Trump administration manages to boost economic growth, thereby diminishing the “surplus labor” effect and generating jobs, the labor market will struggle to keep up. At a time of rapid and profound technological transformation, the US also needs a strong commitment from the public and private sectors to help workers adapt.
A useful first step would be substantially increased support for training, retraining, and skills upgrading. In his book Failure to Adjust, Ted Alden, a fellow at the Council on Foreign Relations, observes that the US spends just 0.1% of its GDP on retraining, compared to 2% in Denmark. And Denmark and its Nordic counterparts seem to have done better than most in balancing imperatives like efficiency, dynamism, structural flexibility, competitiveness, and economic openness with the need for social-security systems that support adaptation to a shifting employment environment.
Furthermore, some income redistribution will be needed, in order to enable low-income workers to invest in themselves – which is impossible when they have just enough to cover their basic needs.
Here, conditional cash transfers for training and skills acquisition could be beneficial.
Universal access to high-quality education is also critical. Right now, when some part of the US educational system fails, the well-off bail out to the private system, and the rest are left behind.
That’s individually rational, but collectively suboptimal. Indeed, without high-quality education at all levels – from preschool through university or the equivalent professional training – it is nearly impossible to achieve inclusive growth patterns.
Finally, the Trump administration should rethink its proposed deep cuts to funding for basic research, which would undermine innovation and economic dynamism down the road. While weeding out less promising programs is certainly acceptable, as is fighting vested interests, the money saved should be redirected to more promising areas within the sphere of basic research.
The Trump administration’s current economic plan may be pro-growth, but it is incomplete on inclusiveness. Shifts in trade policy cannot be depended on to rebalance growth patterns in favor of middle- and lower-income households. They may even pose a risk to growth.

Americans Owe Other Countries Far More Than They Owe Us—And It’s Getting Serious

Two former U.S. Treasury officials argue the historic gap may require a weaker dollar

U.S. Treasury Secretary Steven Mnuchin and Federal Reserve Chairwoman Janet Yellen, seen here at the March G-20 finance ministers meeting in Germany, may soon face dollar headaches as national borrowing hits record levels. Photo: Thomas Niedermueller/Getty Images

Unprecedented U.S. borrowing from other countries compared with what they borrow from the U.S. is fast approaching danger levels, former U.S. Treasury officials warn.

“Never in history has one country owed so much to the rest of the world,” says Joseph Gagnon, a senior fellow at the Peterson Institute of International Economics.

The U.S. is borrowing to finance America’s trade deficit, pushing the country deeper into the red.

Mr. Gagnon and Peterson colleague Fred Bergsten say the Trump administration may have to push down the value of the dollar to cut an expanding U.S. trade gap.

Foreign ownership of U.S. debt such as Treasury and corporate bonds outpaced American claims on foreigners by $8.4 trillion in the last quarter of the year, new data posted this week by the Bureau of Economic Analysis shows. That’s a deficit worth 45% of America’s gross domestic product.

It is projected to hit 53% by 2021, but could accelerate if the Trump administration cuts taxes and Congress expands the budget deficit.

It is also nearing a zone that few countries have survived unscathed.

No economies of even a modest size have had a borrowing deficit above 60% of GDP without a major reversal in their trade balance, “often accompanied by severe financial stress,” Gagnon says.

The data–officially called the net international investment position–can act as an indicator of excessive and unproductive borrowing in an economy.

Borrowing itself isn’t a problem, especially if a country has major commodity reserves sought by global buyers, such as Australia.

But an unhealthy portion of U.S. borrowing from abroad finances consumption instead of investment in new domestic production that can fuel economic expansion.

At some point, credit bubbles pop, which can trigger turmoil in housing, financial, labor and other markets.

Because the U.S. borrows entirely in its own currency—averting an exchange-rate mismatch that hurts many countries–it will likely avoid a worst-case scenario, Mr. Gagnon says.

But the U.S. and foreign economies still face serious adjustment costs, he warns, that only rise as a needed shrinking of the trade deficit is delayed.

He estimates that to stabilize the borrowing deficit at 50% would require halving the trade gap to 2% of GDP by 2020 from its current projected path towards 4%. Such a feat would require a 14% depreciation in the dollar, he says.

The Trump administration says it plans to cut deficits by negotiating better trade terms with other countries, including by using higher import tariffs and investment restrictions as leverage.

But raising trade barriers would likely be economically harmful and have little effect on the trade deficit, Mssrs. Gagnon and Bersten argue.

Instead, the U.S. should encourage an orderly decline in the foreign exchange value of the dollar, they say. Other countries may not initially be keen to join a coordinated intervention because it would mean their currencies would appreciate.

That’s why the U.S. may need to act unilaterally to get the process started, the Peterson economists say, replacing a decadeslong “strong dollar policy” with an “appropriate dollar” policy.


Stockmarkets give up some of their Trump bump

The president’s promises look less plausible; his threats more menacing..

HONEYMOONS don’t last for ever. Having been a reluctant bride to President Donald Trump when courted in the run-up to November’s election, the American stockmarket quickly melted into a mood of romantic euphoria. Shares rose by 12% between election day and March 1st (see chart). But in recent days, sentiment has dimmed. There is talk of the “Trump-disappointment trade”.

For the markets to experience some kind of sell-off is hardly a surprise. The S&P 500 index had gone more than 100 days without a 1% decline, the longest such streak since 1995. And the setback should not be exaggerated. The S&P 500 remains well above its pre-election level, compared with the dollar, which has given up around half its gains. The ten-year Treasury-bond yield, which hit 2.62% on March 13th, has dropped back to 2.38%.
The immediate cause of the retreat seemed to be the failure of Mr Trump to repeal his predecessor’s health-care bill. That logic was hardly a great advertisement for capitalism, implying that the fewer Americans had access to health insurance, the happier investors would be. But the broader rationale seemed to be that, if the Republicans could not meet this campaign promise, then they also would struggle to push through the tax cuts which investors were counting on to push up corporate profits and improve economic growth. A basket of shares of firms that pay the highest tax rates as a proportion of profits, compiled by Goldman Sachs, an investment bank, is now lower than it was before the election.

On its own this change of mood made investors look naive. Mr Trump came to office as a political neophyte with a reputation for being sketchy on policy detail. His differences with the congressional Republican Party were made clear throughout the campaign. No one should have expected a smooth roll-out of policy. Nor is a lower corporate-tax rate a sure route to growth.

Britain has cut its marginal rate from 28% to 20% since 2010, without sparking a runaway boom.

In any case, given the lengthy negotiations needed to create a tax package, and the inevitable lag before the policy has an effect on the economy, it would probably be 2018 before the impact of a fiscal stimulus became clear. And if any pickup in growth is delayed, then the Federal Reserve may have less need to push interest rates up as rapidly, weakening the appeal of the dollar for international investors. The latest forecast from the tracking model of the Atlanta Fed suggests that first-quarter growth in America may have been only an annualised 1%.

With analysts forecasting 12% growth in S&P 500 companies’ profits this year, in other words, there was scope for disappointment for the stockmarket. That was especially so since American shares are trading on a cyclically adjusted price-earnings ratio of 29, a level exceeded only in the booms of the late 1920s and 1990s.

Globally, however, stockmarkets are not dependent on Mr Trump to push through his agenda.

Their mood started to brighten last spring as concerns about “secular stagnation” and a hard landing for the Chinese economy began to dissipate. By the end of 2016 Asian exports were picking up, commodity prices were rebounding and growth forecasts for 2017 were being revised higher.

So investors started the year in optimistic mood. A recent survey of fund managers by Absolute Strategy, a research firm, found that 74% expect global equities to produce better returns than government bonds over the next 12 months and 70% expect global profits to rise.

Recent positive data have included the German Ifo survey of business confidence, which was its strongest since 2011; a rebound in euro-zone consumer confidence; and Chinese industrial profits, which were 31.5% higher in January and February than in the same period a year ago.

Emerging markets have risen much faster than the S&P 500 this year, gaining 12%, and trade on an historic price-earnings ratio of less than 14, according to Société Générale, a French bank.

So the markets might have been doing very well even if the presidential election had produced a different outcome. Indeed, the Trump agenda could well be more of a threat than a promise for international investors, particularly if the administration pursues a more protectionist line or makes a blunder in its approach to flashpoints with China, Iran or North Korea. Markets turned round so dramatically on the morning after Mr Trump’s election that investors may yet have cause to remember the old saying: “Marry in haste; repent at leisure.”