Recovery is Not Resolution

Carmen Reinhart
Samsung store US

CAMBRIDGE – Earlier this year, the consensus view among economists was that the United States would outstrip its advanced-economy rivals. The expected US growth spurt would be driven by the economic stimulus package described in President Donald Trump’s election campaign. But the most notable positive economic news of 2017 among the developed countries has been coming from Europe.
Last week, the International Monetary Fund revised upward its growth projections for the eurozone, with the more favorable outlook extending broadly across member countries and including the Big Four: Germany, France, Italy, and Spain. IMF Chief Economist Maurice Obstfeld characterized recent developments in the global economy as a “firming recovery.”

Growth is also expected to pick up in Asia’s advanced economies, including Japan.
As I noted in a previous commentary, Iceland, where the financial crisis dates to 2007, has already been dealing with a fresh wave of capital inflows for some time, leading to concerns about potential overheating. A few days ago, Greece, the most battered of Europe’s crisis countries, was able to tap global financial markets for the first time in years. With a yield of more than 4.6%, Greece’s bonds were enthusiastically snapped up by institutional investors.
Greek and European officials hailed the bond sale as a milestone for a country that had lost access to global capital markets back in 2010. Greek Prime Minister Alexis Tsipras said the debt issue was a sign that his country is on the path to a definitive end to its prolonged crisis.
In the US, the Federal Reserve’s ongoing exit from ultra-easy post-crisis monetary policy adds to the sense among market participants and other countries’ policymakers that normal times are returning.
But are they? Do recent positive developments in the advanced countries, which were at the epicenter of the global financial crisis of 2008, mean that the brutal aftermath of that crisis is finally over?
Good news notwithstanding, declaring victory at this stage (even a decade later) appears premature.
Recovery is not the same as resolution. It may be instructive to recall that in other protracted post-crisis episodes, including the Great Depression of the 1930s, economic recovery without resolution of the fundamental problems of excessive leverage and weak banks usually proved shallow and difficult to sustain.
During the “lost decade” of the Latin American debt crisis in the 1980s, Brazil and Mexico had a significant and promising growth pickup in 1984-1985 – before serious problems in the banking sector, an unresolved external debt overhang, and several ill-advised domestic policy initiatives cut those recoveries short. The post-crisis legacy was finally shaken off only several years later with the restoration of fiscal sustainability, debt write-offs under the so-called Brady Plan, and a variety of domestic structural reforms.
Since its 1992 banking crisis, Japan has suffered several false starts. There were recoveries in 1995-1996 and again in 2000 and 2010; but they tended to be cut short by the failure to write down bad debt (the so-called zombie loans), several premature policy reversals, and an increasingly unsustainable accumulation of government debt.
The eurozone emerged from the financial crisis in 2008-2009 with some economic momentum. Unlike the Federal Reserve, however, the European Central Bank hiked interest rates in early 2011, which contributed to the region’s descent into a deeper crisis.
History, therefore, suggests caution before concluding that the current recovery has the makings of a more sustainable and broad-based variety. Many of the economic problems created or exacerbated by the crisis remain unresolved.
All of the advanced economies (to varying degrees) have significant legacy debts (public and private) from the excesses that set the stage for the financial crisis, as well as from the prolonged impact of the crisis on the real economy. Low interest rates have eased the burden of those debts (in effect, negative real interest rates are a tax on bondholders), but rates are on the rise.
Political polarization in the US and the United Kingdom is at or near historic highs, depending on the measure used. As a result, many critical but politically sensitive policies to ensure future fiscal sustainability remain unresolved in both countries.
The UK’s withdrawal from the European Union – and Brexit’s medium-term impact on the British economy – is another source of risk that has yet to be tackled. How Japan will resolve its public and private debt overhang is yet to be determined. I have argued elsewhere that inflation will likely be part of that resolution, as it is improbable that an aging population will vote to raise its tax burden and reduce its benefits sufficiently to put Japan’s debt trajectory on a sustainable path.
In Europe, the high level of non-performing loans continues to act as a drag on economic growth, by inhibiting new credit creation. Furthermore, these bad assets pose a substantial contingent liability for some governments. Target2, the euro’s real-time gross settlement system, has emerged as the eurozone’s mechanism for financing the emergence of widening structural balance-of-payments gaps, whereby capital flows out of southern Europe into Germany. For Greece, Italy, Portugal, and Spain, public-sector debt must now also include the central bank’s sharply rising debts.
Perhaps the main lesson is that even more caution is warranted in deciding whether the time is ripe to “normalize” monetary policy. Even in the best of recovery scenarios, policymakers would be ill-advised to kick the can down the road on structural reforms and fiscal measures needed to mitigate risk premia.

The Sinking Dollar Has Not Reached Its Bottom

by: Andrew Hecht

- A fall from the highest level since 2002.

- A bull market in jeopardy.

- The rise of the euro follows a familiar pattern.

- The administration wants the dollarlower.

- Where is the bottom?

The dollar is the reserve currency of the world, which makes it the benchmark pricing mechanism for raw materials. The United States' long reputation as the richest and most stable nation on earth is the reason that central banks all over the world hold dollars as reserve assets.
The dollar embarked on a bullish run starting in May 2014. Over a ten month period, the U.S. currency rallied by over 27% from under 79 to over 100 on the dollar index. The dollar appreciated against almost all other currencies during that period. The greenback then spent the next twenty months consolidating near its highs trading in a range from 91.88 to the 100.60 level on the dollar index until November 2016 when it moved above the top end of its trading range. The dollar reached a peak at 103.815 on the index at the beginning of January 2017 which was the highest level since 2002.
The decade and a half high in the dollar index was a technical breakout, but it turned out to be a pinnacle for the currency which has since turned lower, and over recent months the currency has made lower highs and lower lows with the downside action picking up a head of steam over recent weeks.

A fall from the highest level since 2002

The descent of the dollar has been almost as impressive as its ascent from May 2014 through March 2015, and it may not be over yet.
Source: CQG
As the weekly chart highlights, the dollar index has dropped from 103.815 in early January to lows of 93.00 on July 27, a decline of 10.4% in a little under eight months. A ten percent move in a currency is a significant move, and it is now approaching a level that puts the long-term bull market in the greenback in jeopardy.

A bull market in jeopardy

The technical line in the sand for the dollar index now stands at the May 2016 lows of 91.88.
Below there, the dollar could find itself in a technical free fall as it is the only standing level left from the long consolidation period that occurred from March 2015 through the January 2017 highs.
An end to the bull market in the dollar will have far reaching implications for markets across all asset classes. When it comes to stocks, a lower dollar will support earnings for multinational companies as it makes U.S. exports more attractive on global markets. In the bond market, the lower dollar represents a total lack of sensitivity to rising short-term interest rates as a result of Fed rate hikes. Moreover, the Fed's plans to tighten credit by allowing the legacy of QE to the tune of $50 billion per month in debt to roll off its balance sheet. As foreign exchange markets tend to be highly sensitive to interest rate differentials, the price action in the dollar reveals the underlying weakness in the U.S. currency.
In the world of commodities, a lower dollar usually is bullish for raw material prices, and we have seen some commodities begin to move to the upside as the value of the dollar has declined.
A fall below technical support in the dollar index at 91.88 could trigger market adjustments across all asset classes. Meanwhile, the weakness in the dollar is a result of strength in the euro currency after elections that solidified the European Union and future of the euro in 2017.

The rise of the euro follows a familiar pattern

The elections in the Netherlands and France this year did not follow the trend of a rejection of the status quo that began in 2016 with the Brexit referendum and U.S. election. The future of the Union and euro currency survived as pro-EU candidates were victorious. The next election in Germany seems to be a fait accompli with German Chancellor Angela Merkel apparently coasting to an easy victory and fourth term in September.
With politics out of the way for the European Central Bank, President Mario Draghi has been hinting to markets that QE will come to an end soon and the ECB will begin to taper bond purchases. At the same time, with interest rates at negative forty basis points in Europe, the path of least resistance is logically higher. The rally in the dollar began in May 2014 when the Fed began to taper QE and began to hint about interest rate hikes. In many ways, Europe is now in the same position as the United States was in back in May 2014. The euro found a bottom in December of 2016 and has been rallying since.
Source: CQG
As the weekly chart of the euro versus dollar currency relationship illustrates, the euro hit a low of $1.03675 in December 2016 and has rallied to highs of $1.1808 on Thursday, July 27. The currency is up 13.9% since last December. Moreover, the euro rose above its line in the sand on July 25, which was critical technical resistance at $1.1718, the August 2015 highs in the euro and now the sky appears to be the limit for the European currency when it comes to the charts.
The next stop for the euro could be the $1.20 level, which would likely put the dollar index at or below the 91.88 support level and could lead to a massive currency adjustment between the two foreign exchange instruments. The dollar index closed near the lows last Friday at 93.114 on the September futures contract and the euro was trading at the $1.1778 level.

The administration wants the dollar lower

President Donald Trump and his Treasury Secretary Steve Mnuchin have made no secret of their desires to see the dollar move to a lower level. To "Make America Great Again" and improve trade deals with other nations, a lower dollar will make U.S. exports more attractive on world markets, which will lead to a more favorable balance of trade for the United States.
The weak dollar policy is a departure from past administrations who advocated for just the opposite as a strong dollar represents American stability and fosters the illusion of the U.S. as the world's richest and most powerful nation.
However, President Trump campaigned on a platform of a wholesale overhaul of all existing trade agreements, and a lower dollar would put him in a better position when it comes to negotiating with other countries around the world. China had been devaluing their currency, and the President has often threatened to label the Chinese government as currency manipulators. A lower dollar plays right into the President's hands when it comes to negotiating trade. Therefore, with the trajectory of the technical trend in the dollar pointing lower, a rising euro currency, and an administration that favors letting the greenback fall, it may be that 91.88 will be just the first stop for the dollar as the over three-year bull market comes to an end.
Where is the bottom?
It is currently challenging to project a bottom for the dollar or a top for the euro currency. The euro has moved above its technical resistance area, and on the charts, it looks like there are more gains on the horizon. The dollar has not yet broken to the downside, but it is likely just a matter of time before a test of the 91.88 level. The dollar moved 27% from its lows in May 2014 in ten months. The euro is now in its eighth month of a rally, and a 27% rise would take the currency all the way up to the $1.3167 level against the dollar which seems unlikely. While economic conditions have improved in Europe, the southern countries like Italy and Greece remain financial nightmares, and many of the problems that led to Brexit like immigration issues and terrorist threats remain factors that weigh on the European economy.
I believe that the current adjustment in the currency markets will find a level where stability returns to exchange rates, and that may be somewhere around the $1.20 to $1.25 level on the euro versus dollar exchange rate. At that level, the dollar index will find itself below support at 91.88 and possibly under the 90 level for the first time since 2014. While commodities prices are currently watching both the dollar and the prospects for higher interest rates in the future, I believe that it will be a weak dollar that causes the path of least resistance for many raw materials to move higher causing inflationary pressures to increase in late 2017 and into 2018.
The dollar continues to sink against other world currencies, much to the delight of the U.S. President. The bottom for the world's reserve currency is not yet in sight, and it may wind up finding its nadir under 90 on the dollar index. Fasten your seat belts because a break in technical support for the greenback will likely reverberate across all asset classes over the coming months.

Why Tax Cuts for the Rich Solve Nothing

Joseph E. Stiglitz

Investment business

NEW YORK – Although America’s right-wing plutocrats may disagree about how to rank the country’s major problems – for example, inequality, slow growth, low productivity, opioid addiction, poor schools, and deteriorating infrastructure – the solution is always the same: lower taxes and deregulation, to “incentivize” investors and “free up” the economy. President Donald Trump is counting on this package to make America great again.
It won’t, because it never has. When President Ronald Reagan tried it in the 1980s, he claimed that tax revenues would rise. Instead, growth slowed, tax revenues fell, and workers suffered.

The big winners in relative terms were corporations and the rich, who benefited from dramatically reduced tax rates.
Trump has yet to advance a specific tax proposal. But, unlike his administration’s approach to health-care legislation, lack of transparency will not help him. While many of the 32 million people projected to lose health insurance under the current proposal don’t yet know what’s coming, that is not true of the companies that will get the short end of the stick from Trump’s tax reform.
Here’s Trump’s dilemma. His tax reform must be revenue neutral. That’s a political imperative: with corporations sitting on trillions of dollars in cash while ordinary Americans are suffering, lowering the average amount of corporate taxation would be unconscionable – and more so if taxes were lowered for the financial sector, which brought on the 2008 crisis and never paid for the economic damage. Moreover, Senate procedures dictate that to enact tax reform with a simple majority, rather than the three-fifths supermajority required to defeat an almost-certain filibuster by opposition Democrats, the reform must be budget-neutral for ten years.
This requirement means that average corporate-tax revenue must remain the same, which implies that there will be winners and losers: some will pay less than they do now, and others will pay more. One might get away with this in the case of personal income tax, because even if the losers notice, they are not sufficiently organized. By contrast, even small businesses in the United States lobby Congress.
Most economists would agree that America’s current tax structure is inefficient and unfair.

Some firms pay a far higher rate than others. Perhaps innovative firms that create jobs should be rewarded, in part, by a tax break. But the only rhyme or reason to who gets tax breaks appears to be the effectiveness of supplicants’ lobbyists.
One of the most significant problems concerns taxation of US corporations’ foreign-earned income. Democrats believe that, because US corporations, wherever they operate, benefit from America’s rule of law and power to ensure that they are not mistreated (often guaranteed by treaty), they ought to pay for these and other advantages. But a sense of fairness and reciprocity, much less national loyalty, is not deeply ingrained in many US companies, which respond by threatening to move their headquarters abroad.
Republicans, partly out of sensitivity to this threat, advocate a territorial tax system, like that used in most countries: taxes should be imposed on economic activity only in the country where it occurs. The concern is that, after imposing a one-off levy on the untaxed profits that US firms hold abroad, introducing a territorial system would generate a tax loss.
To offset this, Paul Ryan, the speaker of the US House of Representatives, has proposed adding a tax on net imports (imports minus exports). Because net imports lead to job destruction, they should be discouraged. At the same time, so long as US net imports are as high as they are now, the tax would raise enormous revenues.
But there’s the rub: the money must come from someone’s pocket. Import prices will go up. Consumers of cheap clothing from China will be worse off. To Trump’s team, this is collateral damage, the inevitable price that must be paid to give America’s plutocrats more money. But retailers such as Walmart, not just its customers, are part of the collateral damage, too. Walmart knows this – and won’t let it happen.
Other corporate tax reforms might make sense; but they, too, imply winners and losers. And so long as the losers are numerous and organized enough, they are likely to have the power to stop the reform.
A politically astute president who understood deeply the economics and politics of corporate tax reform could conceivably muscle Congress toward a reform package that made sense.

Trump is not that leader. If corporate tax reform happens at all, it will be a hodge-podge brokered behind closed doors. More likely is a token across-the-board tax cut: the losers will be future generations, out-lobbied by today’s avaricious moguls, the greediest of whom include those who owe their fortunes to scummy activities, like gambling.
The sordidness of all of this will be sugarcoated with the hoary claim that lower tax rates will spur growth. There is simply no theoretical or empirical basis for this, especially in countries like the US, where most investment (at the margin) is financed by debt and interest is tax deductible. The marginal return and marginal cost are reduced proportionately, leaving investment largely unchanged. In fact, a closer look, taking into account accelerated depreciation and the effects on risk sharing, shows that lowering the tax rate likely reduces investment.
Small countries are the sole exception, because they can pursue beggar-thy-neighbor policies aimed at poaching corporations from their neighbors. But global growth is largely unchanged – the distributive effects actually impede it slightly – as one gains at the expense of the other. (And this assumes that the other does not respond and fuel a race to the bottom.)
In a country with so many problems – especially inequality – tax cuts for rich corporations will not solve any of them. This is a lesson for all countries contemplating corporate tax breaks – even those without the misfortune of being led by a callow, craven plutocrat.

One Way Russia Can Retaliate Against US Sanctions

By George Friedman, Xander Snyder, and Ekaterina Zolotova

The US Congress has passed new sanctions targeting Russia’s energy companies. Among the other notable aspects of the sanctions is that they take some authority away from the US president (who used to be able to implement some measures but not others at his discretion) and give it to Congress.

Recognizing that a vital sector in its economy has even less chance of relief than it once had, Russia has retaliated. It has reduced the number of diplomats it has in the US and has seized property used in Russia by US diplomats.

Energy sales are an important source of revenue, of course, but for Russia they are more than that: They are an instrument of geopolitical power. They give Moscow considerable influence over the countries whose energy needs are met by Russian exports. If Russia intends to retaliate further against the US, its energy supplies, especially those it sends to Europe, may be its best option to do so.
Deliberate Dependence

But exactly how much oil does the rest of the world import? How can Russia use this to its advantage?

Collectively, the European Union imports 53% of the energy it consumes. This includes 90% of its crude oil and 66% of its natural gas—a higher percentage than most other regions of the world, including North America, East Asia (but not Japan), and South Asia. All told, energy accounts for 20% of all EU imports.

Individually, some countries rely more on energy imports than others. Most European countries import more than 30% of the energy they consume. Norway provides roughly 35% of these imports, while Russia provides roughly 40%. Germany, which boasts the largest economy in the EU, imports more than 60% of the energy it consumes, and France, which boasts the third-largest economy, imports about 45%.

Some Eastern European countries are even more dependent on foreign energy. Hungary, Austria, and Slovakia import approximately 60–65% of their energy needs. Bulgaria, the Czech Republic, and Romania, however, import less (37%, 32%, and 17%, respectively). In the Baltics, Lithuania imports roughly 75% of the energy it consumes. Latvia imports 45%, and Estonia imports 9%.

Most of this energy comes from Russia. In fact, Russia provides more than 70% of the oil and natural gas used in Bulgaria, Latvia, Lithuania, Hungary, Slovakia, and Finland. It provides 62% of the natural gas and 56% of the oil used in the Czech Republic, and 53% of the natural gas and 90% of the oil used in Poland.

Cultivating this dependency is a conscious move on behalf of Russia. Russia’s core security imperative is to maintain a buffer space between it and Western Europe that would help it repel any invasion, which it accomplished during the Soviet era by invading and occupying countries. Russia is not as powerful as it used to be, but it has developed economic leverage that enables it to exert pressure over countries that could pose a danger to it by threatening their energy security.

Aware of how dangerous a dependence on Russia can be, these countries are trying to diversify their energy sources accordingly. Poland and Lithuania, for example, have begun to import liquefied natural gas from the United States. This is a longer-term solution, however, since importing LNG requires the development of specialized infrastructure to receive and transport it.
The Best Bet

France and Germany—the de facto, if often irreconcilable, leaders of the European Union—illustrate how Russian energy can shape foreign policy. France may rely heavily on foreign energy, but most of its oil and natural gas comes from Algeria, Qatar, Saudi Arabia, and Libya—not Russia. France can therefore afford to be more aggressive and supportive of sanctions against Russia.

Not so with Germany, which receives 57% of its natural gas and 35% of its crude oil from Russia. Berlin must therefore tread lightly between its primary security benefactor, the US, and its primary source of energy, Russia.

This is one reason Germany has been such an outspoken critic of the recent US sanctions, which penalize businesses in any country that collaborate or participate in joint ventures with Russian energy firms. Germany supports the construction of Nord Stream 2, a pipeline that would run through the Baltic Sea, circumventing Ukraine—the transit state through which Germany currently receives much of its energy imports. The pipeline would help to safeguard German energy procurement, since it would allow Russia to punish Ukraine by withholding shipments of natural gas without punishing countries such as Germany further downstream.

Of course, Germany may try to diversify its energy sources, which include Libya, Nigeria, Kazakhstan, Norway, and the Netherlands, but it would struggle to do so. Germany relies heavily on pipelines for its energy, particularly Russian natural gas. It has four cross-border crude oil pipelines, four domestic pipelines, and three oil ports in the North and Baltic seas. But Germany has fewer options for natural gas and no major LNG facilities. Simply put, Germany is beholden to the countries with which its pipelines have a connection—something that makes it vulnerable to retaliation.

But there is only so much Russia can do. Its geopolitical interests in Ukraine, for example, align with Germany’s energy interests. Germany would benefit from Nord Stream 2 by getting a new natural gas route, and Russia would benefit by gaining more leverage over Ukraine. But Washington wouldn’t want Moscow to halt energy flows through Ukraine at its leisure. The US needs to try to manage the Ukraine situation in a way that prevents a greater general German-Russian alignment.

Russia, moreover, cannot bully the United States with its energy exports. Washington doesn’t need them. But Russia could influence US allies if it chose to retaliate more than it already has. Since the US is far more powerful than Russia, divide and conquer may be Moscow’s best bet.