Hoisington Quarterly Review and Outlook, Third Quarter 2017

By Lacy Hunt and Van Hoisington, Hoisington Investment Management

The worst economic recovery of the post-war period will continue to be restrained by a consumer sector burdened by paltry income growth, a low and falling saving rate, and an increasingly restrictive Federal Reserve policy. Additionally, with the extremely high level of U.S. government debt and deteriorating fiscal situation, the economy is unlikely to benefit from any debt-financed tax changes. Finally, from a longer-term perspective, the recent natural disasters are an additional constraint on economic growth.

Nominal GDP has expanded by $712 billion over the past four quarters. Consumer spending, which was up $552 billion, represented 77% of this growth. For the past five years, consumers have accounted for about 68% of GDP, which is nearly identical to the average over the past 20 years. Clearly, consumer spending is a crucial component of maintaining growth in GDP. Consumer spending is funded either by income growth, more debt or some other reduction in saving. Recent trends in each of these categories, as outlined below, do not bode well for this critical sector of the U.S. economy.

First, in the past five years real disposable income growth (DPI) has averaged a disappointing 2%. Real DPI has been flat over the last three months and has risen only 1.2% over the past year. On a per capita basis over the past year, the growth rate is one-half of 1%, which is one-quarter of the historic growth rate. In nominal dollar terms, DPI has risen a paltry 2.7% over the past year. Consumer spending, in contrast, has risen much faster over the past year, growing by 3.9%.

Second, in an effort to maintain their standard of living in the face of slowing income growth, consumers stepped up their borrowing and significantly reduced their savings.

In national income accounting, personal saving is calculated by subtracting personal outlays, including interest and transfer payments, from disposable personal income. As an example, in the past month personal income was $14.4 trillion (SAAR), with personal outlays of $13.9 trillion, resulting in total personal saving of $523 billion, or 3.6% of income. That is about three-fifths less than the 8.5% saving rate level that has existed since 1900 (Chart 1). As recently as five years ago the saving rate was 7.6%.

An increase in borrowing was the major factor behind the recent slide in the saving rate.

Consumer credit over the past year has risen by $208 billion, or 5.9%. Interestingly, without the drawdown in the saving rate, real consumer spending over the past two years would have been reduced by more than half. Considering the slow and declining rate of growth in income as well as the low saving rate, it appears that the current spending level cannot be sustained.

Historically there has been an important relationship between the saving rate and economic growth. A high initial saving rate has been associated with subsequently stronger economic growth, while a low saving rate produces a lower growth pattern. This observation can be confirmed by observing year-over-year growth in GDP plotted against the average of the current saving rate, with lags in the rate of one, two and three years (Chart 2). Since 1930 the regression coefficient indicates that a 1% drop in the personal saving rate in the current and prior three years will lower the real GDP growth rate by a substantial 0.65%. Considering that the present 3.6% saving rate is lower than all of the initial starting points of economic contractions since 1900, the outlook for ebullient growth is problematic particularly in the context of slow and diminishing income growth.

Fed Tightening

The prospect for stronger economic growth in the economy is clouded further by restrictive actions previously taken by the Federal Reserve (the effects of which are still being felt) along with the promise of further rate hikes, and by the coming reduction in the Fed balance sheet, or quantitative tightening (QT).

The massive balance sheet expansion recorded during the three separate quantitative easing (QE) episodes did not produce significant growth in the money supply (M2) or in nominal GDP, despite predictions to the contrary. Indeed the expansion has been the slowest in the post-war period. Thus it is perceived, and the Fed has assured the public, that a modest reduction in the balance sheet will have only a benign impact on the economy. This presumed symmetry in monetary actions may exist in certain economic circumstances, but in a heavily indebted society Fed actions are highly asymmetric. The current evidence of this is that the mere four small 25 basis point increases in the federal funds rate over the past year and a half, and resultant lowering of excess reserves, have produced a noticeable slowing in the growth of M2. Additionally, credit aggregate growth has slumped. The application of widely accepted monetary theory and history implies that QT will further reduce excess reserves and the monetary base, and this will have a profound slowing effect on money and credit. Therefore, the growth of nominal GDP and inflation will be headed lower.
Theoretical Model

The math and the relationship of the monetary base to other monetary factors have been well established and tested. Therefore, these relationships can be used to estimate the impact of QT as follows:

  1. M2 equals the monetary base (MB) times the money multiplier (m or little m).

  1. Little m is greater than one whenever the banks operate under a fractional reserve requirement system.

  1. GDP equals M2 times the velocity of money (V), which is the same as saying that M2 and V determine aggregate demand (AD).

The U.S. operates with a fractional reserve system, thus the money multiplier (m) is greater than one, and a dollar decrease in the base will lower M2 by more than a dollar (Chart 3). Currently, little m is 3.6, an amount determined by dividing M2 of $13.7 trillion thus far in 2017 by $3.8 trillion for the monetary base.

Little m is primarily determined by swings in currency held by the public, the Treasury’s deposits at the Fed, excess reserves of the depository institutions and the ratio of demand deposits to time and savings deposits. Prior to the announcement of the first round of QE the level of m was generally consistent with the 8.1% average that prevailed since the start of the Fed in 1913. Presently, however, m is greatly depressed (Chart 3).

However, assuming m holds at this depressed level of 3.6, QT as announced by the Fed ($30 billion in the fourth quarter) is tantamount to a $105 billion decrease in M2. M2 increased by 5.1% in the latest 12 months, or an average monthly increase in M2 of $55 billion. The math means that M2’s annual rate of growth will recede to 4.2% by the end of 2017. This is a sharp slowdown from the near 7% growth in 2016, owing to the previous interest rate increases and resultant decline in bank reserves. The effect on bank loans and other short-term credit aggregates would be similar, reducing the 12-month increase from 3.8% to about 2.5% by the end of the year.

If the Fed were to continue reducing the base for the first nine months of 2018, the annual rate of growth in M2 would fall to negative 2.8%, applying the same calculation. Using the Fisher equation of exchange, where M2 times its turnover (velocity) equals nominal GDP (M2*V=GDP), it is possible to see the incredible negative impact if M2 declines by that much, assuming that velocity remains stable at 1.43, its lowest level since 1949.
Incidentally, velocity has been declining at a 2.5% rate over the past five years. Given the math outlined above, the probabilities are high that QT will not be sustained for the duration of 2018, or that substantial offsetting purchases of securities (repo or outright) will be necessary to offset the existing maturities.
Tax cuts

Negative existing federal fiscal conditions strongly suggest that any benefit of the proposed debt-financed tax cut is likely to be very muted, if it is positive at all. The U.S. budget deficit, according to the non-partisan Congressional Budget Office (CBO), surged to an estimated $693 billion in the fiscal year that ended September 2017, up from $585 billion and $438 billion, respectively, in fiscal 2016 and 2015. Deterioration in the budget deficit of this magnitude is unprecedented in a late-stage business cycle expansion. In the late-stage expansions of both the 1990s and early 2000s, the deficit was reduced significantly. Indeed, late in the 1990s’ expansion, budget surpluses were registered.

Unfortunately, the deficit doesn’t capture an accurate picture of the federal financial situation. An increasing number of items have been taken off the expenditure accounts and re-categorized as “investments.” This accounting gimmickry has artificially reduced deficits for the past three fiscal years relative to the actual amount of debt that was incurred. For example, the increase in federal debt for the three years ending September 30, 2017 totaled $3.2 trillion, or almost twice the $1.7 trillion cumulative deficit for these three years.

It appears that gross U.S. government debt will very shortly reach a new record of 110% of GDP. At the end of calendar 2016, this ratio was 106.1% of GDP. Econometric studies indicate that such high levels of U.S. debt reduce the trend rate of growth in economic activity and quite possibly at a non-linear pace. One major study found that when this debt ratio exceeds 90% for five consecutive years, the economy loses one-third of its trend rate of growth. The U.S. government debt ratio has exceeded 100% for each of the past six years.

When the 1981 Reagan and 2001 Bush tax cuts were implemented, U.S. government debt was 32% and 55%, respectively, of GDP. Further, the Reagan and Bush tax cuts were supported by a sharply falling federal funds rate, much stronger monetary growth and significantly higher level of money velocity. In the first three years of the 1981 and 2001 tax cuts the federal funds rate fell by 960 and 500 basis points, respectively. Since the federal funds rate is currently 1.00% to 1.25% and rising, such previous rate reductions are in sharp contrast to today’s monetary environment. A host of other critical initial conditions - including favorable demographics, debt and productivity - were also much more supportive of economic growth then than now. Therefore, the combination of existing large deficits and record debt levels with a restrictive Federal Reserve will mean any tax cuts will have only a muted impact at best on economic growth.
Natural Disasters

The recent natural disasters have been viewed as providing a potential boost to economic activity. This is an incorrect assessment. If a natural disaster destroys viable homes, businesses and infrastructure, then more of current household and corporate saving (income less spending) will be diverted from normal spending to disaster spending. Hence, disaster recovery spending will benefit some while hurting others. For example, funds would likely be diverted from new business ventures, research and development or household formation and various other consumer/ government goods and services.

Savings, which is defined as accumulated saving or wealth, must be liquidated in order to restore functionality. A reduction in savings will lead to an impairment of balance sheet wealth. In spite of a transitory boost to GDP after the end of the disruptions, two measures - income allocation and reduction of savings - indicate society is worse off, meaning over time that growth and prosperity will be reduced.

The unseen or unintended consequence of a natural disaster is to weaken an economy over the course of time. U.S. government action to cover the losses of a disaster leads to larger budget deficits and additional debt financing, but the increased expenditure financed in this manner results in a decline in private expenditures that is greater than the increase in debt financing. The action may be socially responsible and politically necessary, but at the end of the day the economy’s growth trend will be reduced, regardless of the possible short-term effect of additional deficit financing. For state and local governments that typically lack the option of additional deficit spending, the trade offs are serious and direct. If a state or local government raises taxes to cover disaster relief, this may cause firms to shift operations elsewhere in the state or to some other state entirely. In short, the opportunity cost of natural disasters is far larger than any immediate benefit that accrues from a short-term rebuilding effect on GDP, resulting in another drag on future growth.
Treasury Bonds

With monetary restraint continuing to weigh on economic growth for the remainder of 2017 and 2018, inflation, which receded sharply this year (PCE is up 1.2% year-to-date and 1.4% year-over-year), will continue on a downward path. Coupled with extreme over-indebtedness, these factors are the dominant factors causing both cyclical and secular growth to weaken. Additionally, these negative impulses are presently being reinforced by the problems of poor demographics and productivity. Population growth in 2016 was the slowest since 1936-37 - roughly half of the post-war average - and the fertility rate in 2016 was the lowest on record. These trends have contributed to the declining growth of household formation, which is now less than one-half the rate of increase that has been experienced since 1960. Productivity in the eight years of this expansion was the lowest for any eight-year period since the end of World War II.

These existing circumstances indicate that a Fed policy of QT and an indicated December hike in the federal funds rate will put upward pressure on the short-term interest rates. At the same time, lower inflation and the resultant decline in inflationary expectations will place downward pressure on long Treasury bond yields, thus causing the yield to curve to flatten. Continuation of QT deep into 2018 would probably cause the yield curve to invert. Short-term interest rates are determined by the intersection of the demand and supply of credit that the Fed largely controls by shifting the monetary base and interest rates. Changes in long-term Treasury bond yields are primarily determined by inflationary expectations. Inflationary expectations will ratchet downward in this environment, pushing the long Treasury bond yields lower.

Van R. Hoisington
Lacy H. Hunt, Ph.D.

Arms Race

Doug Nolan

Bloomberg: “Treasuries Surge as December Hike Odds Drop After CPI Miss.” Year-over-year CPI was up 2.2% in September, with consumer inflation above 2% y-o-y for six of the past 10 months. The Producer Price Index gained 2.6% y-o-y in September. Yet, apparently, the focus will remain on core CPI (along with core personal consumption expenditure inflation) that, up 1.7% y-o-y, missed estimates by one tenth and remained below 2% for the sixth straight month. 

Notably – analytically if not in the markets – the preliminary October reading of University of Michigan Consumer Confidence jumped six points to the high since January 2004. Or taking a slightly different view, Consumer Confidence has been stronger for only one month in the past 17 years. Current Conditions rose to the highest level since November 2000.

Data notwithstanding, from Bloomberg: “Bond Shorts Experience the Agony of Defeat Yet Again.” Ten-year Treasury yields declined nine bps this week to 2.27%, though I’m not sure this qualifies as a “defeat.” In stark contrast to the fanatical gathering on the opposing side of the field, not a single central banker was spotted on the bond bears’ sideline.

October 12 – Financial Times (Sam Fleming): “Worries about the risk of stubbornly low inflation hung over the Federal Reserve’s most recent policy meeting, even as the central bank held its course for a further rate rise as soon as the end of the year. Many of the US central bank’s policymakers declared at its latest rate-setting meeting that a further increase is likely to be needed ‘later this year’ as long as the economy stays on track. But minutes of the Fed’s gathering on September 19-20 revealed a body of policymakers who are troubled by this year’s doggedly weak inflation readings and divided over how best to respond. Many expressed worries that poor price growth could reflect entrenched factors following a half-decade of sub-target readings on the Fed’s favoured measure of core inflation. Several insisted they wanted to see economic data that ‘increased their confidence’ that inflation would move towards the Fed’s 2% objective before they acted again.”

October 13 – Reuters (Balazs Koranyi): “European Central Bank policymakers are homing in on extending their stimulus programme for nine months at their next meeting while scaling it back, five people with direct knowledge of discussions told Reuters. The ECB’s asset purchases are due to expire at the end of the year, and policymakers are set to decide on Oct. 26 whether to prolong them. They will have to reconcile the bloc’s best growth run in a decade with an inflation rate expected to undershoot the bank’s target of almost 2% for years. The next move is still up for discussion, but there is a consensus that it should signal both the need to cut support in light of strong economic growth, while also committing to an extended period of monetary accommodation…”

October 13 – Reuters (Leika Kihara): “Bank of Japan Governor Haruhiko Kuroda on Thursday stressed the central bank’s resolve to maintain its ultra-loose monetary policy, even as its U.S. and European counterparts begin to dial back their massive, crisis-mode monetary stimulus. Kuroda offered an upbeat view of Japan’s economy, saying it was expanding moderately with rising incomes leading to higher corporate and household spending. But he said inflation and wage growth were disappointingly low, despite such improvements in the economy.”

Goldman Sachs reduced the probability of a December Fed rate hike to 75%, as dovish comments from Fed officials and dovish minutes from the September FOMC meeting allay concerns that the Fed was leaning “normalization.” So global markets take comfort that the Fed is largely on hold with rate hikes; a rate hike may be at least a year away in the euro zone as the ECB sticks to its max leisurely path to winding down QE; and, best yet, the Bank of Japan is gratified to wait and see how the others get along without aggressive stimulus before contemplating its own course.

The S&P500 gained 0.2% this week to new record highs, increasing y-t-d gains to 14%. Indicative of the froth that has taken hold throughout EM, bastions of stability South Korea (up 22% y-t-d) and Turkey (up 36%) gained 3.3% and 2.0%, respectively. Meanwhile, Bitcoin (U.S. spot) surged $1,275 this week (29%!) to $5,615, with 2017 gains of a cool 480%. If central bankers have any concern with acute asset price inflation and speculation it was not apparent this week. And, sure enough, no sooner than Fed officials reiterate below-target inflation angst the commodities pop. The GSCI Commodities index jumped 2.8% this week to a six-month high. Copper rose 2.8% this week, increasing y-t-d gains to 25%. Crude jumped 4.4%, silver 3.7% and Gold 2.2%.

Markets these days have attained that late-nineties feel. Manic 1999 had those crazy Internet stocks. Manic 2017 has the even crazier cryptocurrencies – with biotech (up 39% y-t-d) and semiconductor (up 35%) stocks straining to keep up with the insanity. In the face of conspicuous speculative excess, the Fed in 1999 held firm with its baby-step “tightening” approach that worked only to promote a further loosening of financial conditions. The 1998 crisis was fresh in central bankers’ minds, while markets delighted in the fear central bankers harbored over Y2K. As for central banks here in 2017, apparently the 2008 crisis will remain forever top of mind. Markets have never been as reassured that central bankers are loving the party.

By 1999, a policy-induced prolonged technology boom had fostered a veritable arms race, especially in anything Internet and PC. Finance was flooding into the sector, ensuring massive mal- and over-investment. The upshot was the rapid propagation of negative cash-flow enterprises that would turn unviable the minute the Bubble burst. The New Age hype had one thing right: Exciting new technologies changed the world. This did not, however, prevent painful busts and a pair of powerful financial crises.

There’s complacency along with a lack of appreciation for the long-term structural impact associated with late-nineties excesses. I continue to read of the “mild recession” after the bursting of the “tech” Bubble. Collapse ensured depression throughout a segment of the economy. Let’s also not forget the 2002 corporate debt crisis.

The Fed held powerful reflationary tools at its discretion. Rates were slashed from 6.5% in December 2000 all the way to 1.00% by June 2003. There was also a strong inflationary bias throughout mortgage finance and housing. This provided the Federal Reserve a robust avenue in which to promote record Credit growth and an attendant Bubble of sufficient scope to more than emerge from the technology bust. No nineties boom and bust then no mortgage finance Bubble reflation and resulting 2008 collapse – and no ongoing global government finance Bubble. Open the central bank crisis-fighting tool kit today and there’s a single slot for QE. 

Markets are elated with the virtually barren apparatus.

The current “tech” Bubble absolutely dwarfs the late-nineties period. Arms Races now proliferate across various industries, technologies and products on a global basis. Recalling 1999, media these days are filled with ads from scores of upstarts promoting new products and services. How many will ever generate positive cash-flow and earnings? The big global tech firms – flush with extraordinary boom-time profits – spend lavishly in an Arms Race for primacy over the cloud, artificial intelligence and myriad new services. Alternative energies, another Arms Race. Media, telecom, entertainment and programming – more Arms Races. Pharmaceuticals, biotech and biopharma…

And then there’s the massive Arms Race gathering momentum in electric vehicles. “British Vacuum Maker Dyson Plans Electric Car Assault” – with, it’s worth noting, a $2.0 billion investment. From the Seattle Times, “In Race for an Electric-Car Future, China Seeks the Lead.” With a blank checkbook and the power to ban the combustion engine, China will invest hundreds of billions in electric car and battery development. Will anyone ever earn a profit?

One can do worse than ponder the work of the great economist Joseph Schumpeter. Known most for the concept “creative destruction,” Schumpeter was an eminent thinker on economic development and Credit. He believed innovation often evolves in “swarm like clusters,” where development in one sector spurs innovation and development in other areas. Entrepreneur success in one field motivates entrepreneurship more generally. Moreover, innovation fuels - and is fueled by - Credit. The interplay of the entrepreneur and finance plays a fundamental role in boom and bust cycles. Eventually over-production, waning profits and Credit issues lead to cyclical downturn.

Schumpeter’s analysis would occasionally enter the discussion back in the late-nineties. Some of us would compare the proliferation of new technologies to that of the “Roaring Twenties” period (automotive, production line, electricity, radio & entertainment, refrigeration, household appliances, science & medicine, etc.). There’s no doubt that innovation and speculation tend to become kindred spirits.

The Greenspan Fed, Wall Street strategists and most economists argued during the nineties that new technologies had raised the economy’s “speed limit.” This meant less impetus to tap on the monetary brakes to subdue the boom. I saw things differently: Periods of breakneck innovation, technological advancement and resulting economic transformation beckon for a commitment to sound “money.” Especially in our age of unbounded market-based finance, captivating innovation in the real economy over time spurs precarious self-reinforcing excess in “money,” Credit, the securities markets and derivatives.

It’s my view that prolonged cycles of economic and financial innovation turn progressively more perilous. The key analysis from the “Roaring Twenties” period was one of spectacular economic and financial innovation commencing even before the outbreak of the first World War. As the Twenties progressed, our fledgling central bank misread the downward pressure on consumer prices. Technological advances, new production methods, a proliferation of new products, and booming international trade – all empowered by loose finance - were generating downward pressure on prices.

The Fed accommodated escalating financial excess and was later unwilling to risk bursting the Bubble (in the face of mounting late-cycle fragilities). At the heart of financial and economic excess was the prevailing view that the Federal Reserve possessed the tools to underpin uninterrupted financial and economic prosperity. The perception of adept central banking had become integral to a transformative change in inflation dynamics – massive investment spurring disinflation in the real economy in the face of powerful inflation dynamics raging in asset markets. What was viewed as an extraordinarily favorable fundamental backdrop was in reality an unsustainable boom, with an acutely unsound financial Bubble at its core. The many parallels to today are too obvious to ignore.

October 12 – ANSA: “European Central Bank President Mario Draghi defended quantitative easing at a conference with former Fed chief Ben Bernanke, saying the policy had helped create seven million jobs in four years. Bernanke chided the idea that QE distorted the markets, saying ‘It's not clear what that means’.”

October 11 – Financial Times (Chris Giles): “Central bankers usurped the titans of Wall Street as the masters of the universe almost a decade ago. They rescued the global economy from the financial crisis, flooding the world with cheap money. They used their powers effectively to get banks lending again. Their actions raised asset prices, keeping business and consumer confidence up. Financial markets and populations hang on their words. But never have they been so vulnerable. As they gather in Washington for the annual meetings of the International Monetary Fund, there is a crisis of confidence in central banking. Their economic models are failing and there are doubts whether they understand the effects of interest rates and other monetary policies on the economy. In short, the new masters of the universe might not understand what makes a modern economy tick and their well-intentioned actions could prove harmful. While there have long been critics of the power of central bankers on the left and the right, such profound doubts have never been so present within their narrow world.”

Uncle Sam’s Unfunded Promises

Here’s a surprisingly profound question: What is a promise? Dictionaries offer various definitions. I like this one: “An express assurance on which expectation is to be based.”

That definition captures the two-sided nature of a promise. One party offers an assurance, which the other converts into an expectation. You deposit money in your checking account, and the bank assures you that you can have it back on demand. You expect that the bank will fulfill its promise when you visit an ATM.

Governments likewise make promises, but those are different. Government is the ultimate enforcer of promises, but we have no recourse if it chooses to break them – except at the ballot box. As we’ve seen in recent weeks regarding public pensions, that’s ineffective when the promises were made long ago by officials who are no longer in office.

The federal government’s keeping its promises is important for everyone in the US, because almost all of us are part of the largest public pension system: Social Security. We pay taxes our whole working lives and expect the government to give us retirement benefits. But what happens if it can’t?

Three weeks ago we visited the problems with local and state pensions. Last week we looked at European pensions. This week we are going to take a hard look at the unfunded liabilities and debt of the US government. And even though the federal unfunded pension liabilities dwarf those of state and local pensions, I want to make it clear that I believe the state and local problems will be far more intractable.

I have to warn you: You may be hopping mad when you finish reading this.

Doubled Debt

In the United States we have two national programs to care for the elderly. Social Security provides a small pension, and Medicare covers medical expenses. All workers pay taxes that supposedly fund the benefits we may someday receive. That’s actually not true, as we will see in a little bit.

Neither of these programs is comprehensive. Living on Social Security benefits alone is a pretty meager existence. Medicare has deductibles and copayments that can add up quickly. Both programs assume people have their own savings and other resources. Nevertheless, the programs are crucial to millions of retirees, many of whom work well past 65 just to keep up with their routine expenses. This chart from my friend John Burns shows the growing trend among generations to work past age 65. Having turned 68 a few days ago, I guess I’m contributing a bit to the trend:

Limited though Social Security and Medicare are, we attribute one huge benefit to them: They’re guaranteed. Uncle Sam will always pay them – he promised. And to his credit, Uncle Sam is trying hard to keep his end of the deal. In fact, he’s running up debt to do so. Actually, a massive amount of debt:

Federal debt as a percentage of GDP has almost doubled since the turn of the century. The big jump occurred during the 2007–2009 recession, but the debt has kept growing since then. That’s a consequence of both higher spending and lower GDP growth.

In theory, Social Security and Medicare don’t count here. Their funding goes into separate trust funds. But in reality, the Treasury borrows from the trust funds, so they simply hold more government debt.

The Treasury Department tracks all this, and you can read about it on their website, updated daily. Presently it looks like this:

• Debt held by the public: $14.4 trillion

• Intragovernmental holdings (the trust funds): $5.4 trillion

• Total public debt: $19.8 trillion

Total GDP is roughly $19.3 trillion, so the federal debt is about equal to one full year of the entire nation’s collective economic output. In fact, it’s even more when you consider that GDP counts government spending as “production,” even when Uncle Sam spends borrowed money. Of course, that total does not count the $3 trillion-plus of state and local debt, which in almost every other country of the world is included in their national debt numbers. Including state and local debt in US figures would take our debt-to-GDP above 115%. And rising.

You can quibble over the calculations, but there’s no doubt the numbers are astronomically huge and growing. And we haven’t even mentioned the huge and growing private debt.

Just wait. We’re only getting started.

Yes, Trillions

We in the business world put a lot of faith in accountants. We trust them to count the beans honestly and give us accurate reports. We may not like the numbers (I was certainly distraught with my final tax numbers this year!), but we mostly believe them. Nothing will make a company’s stock drop faster than accounting irregularities will.

Government accounting is, well, different. The government doesn’t need to make a profit, but we expect it to spend our tax money wisely and to deliver services efficiently. That’s not possible unless there is reliable accounting. But reliable accounting is the last thing most politicians want – it constrains them from promising things they can’t deliver. So we have to take all government numbers with many grains of salt.

However, there is one chink in the politicians’ armor. An old statute requires the Treasury to issue an annual financial statement, similar to a corporation’s annual report. The FY 2016 edition is 274 enlightening pages that the government hopes none of us will read.

Among the many tidbits, it contains a table on page 63 that reveals the net present value of the US government’s 75-year future liability for Social Security and Medicare. That amount exceeds the net present value of the tax revenue designated to pay those benefits by $46.7 trillion. Yes, trillions.

Where will this $46.7 trillion come from? We don’t know. Future Congresses will have to find it somewhere. This is the fabled “unfunded liability” you hear about from deficit hawks. Similar promises exist to military and civil service retirees and assorted smaller groups, too. Trying to add them up quickly becomes an exercise in absurdity. They are so huge that it’s hard to believe the government will pay them, promises or not.

Now, I know this is going to come as a shock, but that $46.7 trillion of unfunded liabilities is pretty much a lie. My friend Professor Larry Kotlikoff estimates the unfunded liabilities to be closer to $210 trillion. When presidential candidate Ben Carson last year quoted Kotlikoff’s numbers, the Washington Post, New York Times, and other mainstream media immediately attacked him. Of course, the journalists doing the attacking had agendas, and none of them were economists or accountants. None. Zero. Zip.

Larry responded in an article in Forbes, since Carson was using his data:

The fiscal gap is the present value of all projected future expenditures less the present value of all projected future taxes. The fiscal gap is calculated over the infinite horizon. But since future expenditures and taxes far off in the future are being discounted, their contribution to the fiscal gap is smaller the farther out one goes. The $210 trillion figure is based on the Congressional Budget Office’s July 2014 Alternative Fiscal Scenario projections, which I extended beyond their 75-year horizon.

The journalists used a very poorly researched analysis, which fit their political bias (shocking, I know). Apparently they take that fabricated analysis more seriously than they do the views of 17 Nobel Laureates in economics and over 1200 PhD economists from MIT, Harvard, Stanford, Chicago, Berkeley, Yale, Columbia, Penn, and lesser known universities and colleges around the country. Each of these economists has endorsed The Inform Act, a bi-partisan bill that requires the CBO, GAO, and OMB to do infinite horizon fiscal gap accounting on a routine and ongoing basis.

Now why would 17 Nobel Laureates and over 1200 US economists, all listed by name at www.theinformact.org, including many, like Jeff Sachs, who lean to the left, and others, like Glenn Hubbard, who lean to the right, endorse infinite horizon accounting. Because they understand something that I told Michelle repeatedly and have also told Bruce Barlett repeatedly. The fiscal gap is the only measure of our fiscal position that is mathematically well-defined.

Every other fiscal measure, including fiscal gaps calculated over any finite horizon, such as the CBO’s 25-year fiscal gap Michelle references, are not mathematically well defined. The infinite horizon is mathematically well defined because it is the same number no matter what choice of internally consistent fiscal words we use to label government receipts and payments. Moreover, the infinite horizon fiscal gap is the only measure of our fiscal policy’s sustainability that puts everything on the books. It is also the only measure of our fiscal policy’s sustainability that is invariant to the choice of words.

Congress’s choice of fiscal labels determines what gets put on and what gets kept off the books. I told Michelle that her grandparents’ Social Security benefits, for which she is now paying taxes, are not on the books because the government chose to call those payments “transfers” paid in exchange for “FICA contributions” not “return of principal plus interest” paid in exchange for “purchase of government bonds.”

Every mathematical model of the economy’s dynamic transition path incorporates the infinite horizon fiscal gap, which is called the government’s infinite horizon intertemporal budget constraint. This constraint has to hold, which means the infinite horizon fiscal gap must be zero. Our country’s infinite horizon fiscal gap is far from zero. It would take an immediate and permanent 59 percent increase in all federal taxes or an immediate and permanent 33 cut in all federal expenditures (including official debt service) to eliminate our fiscal gap. The longer we wait to fix our fiscal system, the larger the adjustment needs to be. This means that (the journalist), and others her age, will need to pay even more for all the “assets,” including my own Medicare and Social Security benefits that have been left off the books.

Yes, something will have to give. 

The $210 Trillion Gap

I will admit that I’m not worried about the $210 trillion in unfunded liabilities. Long before we ever get to having to fund those liabilities, the country will be in a massive crisis.

Using the CBO’s own numbers, the projected total US debt will be $30 trillion within 10 years, but the CBO also makes the rosy assumptions that there will be no recessions and that GDP will grow at a 4% nominal rate. Now, that’s possible; but I’m inclined to haircut it a bit.

If you asked me to bet the “over/under” on the debt in 2027, I would bet the over at $35 trillion. After the next recession the deficit will be $30 trillion within 4–5 years and then grow from there at a rate of anywhere from $1.5 to $2 trillion per year. Note: That is not the CBO’s projected debt. It does not count the off-budget deficit that still ends up having to be borrowed. Last year the deficit was well over $1 trillion – but we were told it was in the neighborhood of $600 billion. If any normal company tried to use accounting like the US Congress does, the SEC would rightly declare it fraudulent and shut it down immediately. .

Here’s another chart from the Treasury’s annual financial report, projecting government receipts and spending:

Note that this chart expresses the various items as percentages of GDP, not dollars. So the relatively flat spending categories simply mean they are forecasted to grow in line with the economy, or just a little faster. But the space representing net interest grows much faster than GDP does – fast enough to make total federal spending add up to one-third of GDP by 2090.

Obviously, this chart is based on all kinds of assumptions, and reality will be far different. I doubt we will make it to 2090 (or even 2050) without at least one global depression or other calamity that radically resets all the assumptions. Beneficial changes are also possible – biotech breakthroughs that reduce healthcare expenditures, for instance.

Still, looking at the demographic reality of longer lifespans and lower birthrates, it’s hard to believe Social Security can survive over the long run in anything like its present form. But any major change will mean that the government is breaking its promise to workers and retirees.

Well, guess what: They backtracked on that promise decades ago. Few people noticed it at the time, and even fewer remember it now.

A Tax, Not a Promise

There’s a big difference between that federal government financial statement and similar ones from private companies. “Liabilities” for a business represent contracts it has signed – the long-term lease on a building, for instance. The company agrees to pay so many dollars a month for the next 20 years. That obligation is enforceable in court. Even if the company enters bankruptcy, the court will award creditors damages from whatever assets it can recover.

The federal government doesn’t work that way. It signs contracts all the time – but often with escape clauses that private businesses could never get away with. Social Security is a good example.

Many Americans think of “their” Social Security like a contract, similar to insurance benefits or personal property. The money that comes out of our paychecks is labeled FICA, which stands for Federal Insurance Contributions Act. We paid in all those years, so it’s just our own money coming back to us.

That’s a perfectly understandable viewpoint. It’s also wrong.

A 1960 Supreme Court case, Flemming vs. Nestor, ruled that Social Security is not insurance or any other kind of property. The law obligates you to make FICA “contributions.” It does not obligate the government to give you anything back. FICA is simply a tax, like income tax or any other. The amount you pay in does figure into your benefit amount, but Congress can change that benefit any time it wishes.

Again, to make this clear: Your Social Security benefits are guaranteed under current law, but Congress reserves the right to change the law. They can give you more, or less, or nothing at all, and your only recourse is the ballot box. Medicare didn’t yet exist in 1960, but I think Flemming vs. Nestor would apply to it, too. None of us have a “right” to healthcare benefits just because we have paid Medicare taxes all our lives. We are at Washington’s mercy.

I’m not suggesting Congress is about to change anything. My point is about promises. As a moral or political matter, it’s true that Washington promised us all these things. As a legal matter, however, no such promise exists. You can’t sue the government to get what you’re owed because it doesn’t “owe” you anything.

This distinction doesn’t matter right now, but I bet it will someday. If we Baby Boomers figure out ways to stay alive longer, and younger generations don’t accelerate the production of new taxpayers, something will have to give.

If you are depending on Social Security to fund your retirement, recognize that your future is an unfunded liability – a promise that’s not really a promise because it can change at any time. 
How Will We Fund the Deficit?

And now we come to the really uncomfortable part. Notice that Larry Kotlikoff said we would need an immediate approximately 50% increase in taxes to fund our future deficits. That’s what we would need to create a true entitlements “lockbox” with the funds actually in it. But surely everybody knows by now that there is no lockbox with Social Security funds in it. That money was spent on other government programs and debts. And so when the CBO doesn’t count the trust funds as part of the national debt, they are not only being disingenuous, I think they are committing financial fraud. The money that will actually pay for Social Security and Medicare down the road is going to have to come out of future taxes, just as for any other debt of the US.

So at some point – even though Republicans are jawboning hard about cutting taxes now – we are going to have to raise taxes in order to fund Social Security and Medicare. I personally think it will have to be done with a value-added tax (VAT), because the necessary increase in income taxes would totally destroy the economy and potential growth.

(And yes, I know some of you will write back and say we had much higher tax rates in the 50s and we had good growth then, but our demographics and productivity levels were completely different in that era. Plus, nobody actually paid the highest tax levels. I remember that in the 80s, before Reagan cut the tax rate, I had so many deductions that my effective tax rate was about 15%. The irony is that after the Reagan tax cuts, my total tax payments went up, not down – I lost all of my cool deductions! Aaah, the good old days…)

But the simple fact of the matter is that no Congress is going to fund Social Security and Medicare through tax hikes. Before they ever go there, they will means-test Social Security and increase the retirement age – which they should.

Of course, Congress could always authorize the Treasury Department to authorize the Federal Reserve to monetize a certain amount of the Social Security and Medicare debt, which is essentially what Japan is doing (and seemingly getting away with it). I think we should all be grateful to the Japanese for being willing to undertake such a fascinating experiment in monetary and fiscal policy.

Let me close with a quick sidebar note. I think the Fed’s mad rush to raise rates and reduce its balance sheet at the same time is unwise. I mean, seriously, is the Federal Reserve balance sheet making that much of a difference to the US economy? Perhaps when that extraordinary balance was created, it did – but not today. This is one of those times when I think our policy makers should go slowly and tread carefully. Just saying…

San Francisco, Denver, Lugano, and Hong Kong

My few days in Portugal were not long enough. My hosts, the Soares dos Santos family, showed me a marvelous time. The conference I participated in was truly mentally exhilarating, but I came back exhausted and have picked up some bug that has given me a low-grade fever and stomach issues. I’m sure I’ll kick it soon. The good news is, it has also killed my appetite, so I am working off some of the calories that I picked up in Portugal.

I will be going to San Francisco (technically, to Marin County) to visit the Buck Institute, which is the premier antiaging research center in the world. I have been invited join their Buck Advisory Council, which will afford me the privilege of receiving once or twice yearly updates on where antiaging research is going. I will give you a report when I return. Then on November 7 I will be speaking to the Denver CFA Society. A week later I will fly to Lugano, Switzerland, for a presentation to a conference – and I’ll try not to push myself quite so hard on this next trip across the Pond. I will also be in Hong Kong for the Bank of America Merrill Lynch conference in early January.

I come back from Lugano the day before Thanksgiving, when in theory I will be cooking for 40–50 friends and family. And I will again be making my special prime rib. Recently I’ve been cooking it regularly when I host dinners for brokers and advisers who are interested in my new Mauldin Smart Core Program. I also make chili. And while people often say it’s the best chili they’ve ever had, trying to claim you make the best chili in Texas will get you into trouble. There is really only very good chili; there is never the best. Chili is a very personal, very subjective taste experience.

Prime Rib: The Recipe

On the other hand, there is universal acclaim that my prime rib is the best ever. Over the years, I’ve had hundreds of people ask me for the recipe; and so today, well in advance of Thanksgiving, I’m going to share it with you. Those of you who are not interested should just stop right here, because this is about 20% of the letter; and while I’ve been told I need to write shorter letters, you cannot abbreviate a great recipe. The details are critical.

First, the most crucial ingredient is a great piece of meat. You simply cannot skimp on the quality. And this is going to surprise people, but I have found that the best-quality prime rib comes from Costco. You can get a delicious 12- to 13-pound, already boned prime for about $120–$130. Which is about 40% of what it costs at Whole Foods or Central Market. And frankly, the quality is better and more consistent. I was on a plane with the national food buyer for Walmart and asked him about that, and he claimed that Walmart has stepped up its game in order to compete with Costco. I have never put that claim to the test, but if any of you do, let me know how it turns out.

About four hours before you’re going to cook the prime, take it out of the refrigerator and bring it up to room temperature. And then make the hand rub. Finely chop up two onions and place in a fairly large bowl. Then grab some fresh rosemary. It’s best if you can actually pick it off a plant somewhere near you, but most good Whole Foods or other organic grocers have relatively fresh rosemary. Take off the leaves and discard the stems. Chop the rosemary finely. I probably use six to eight long stems of rosemary. Honestly, don’t worry about using too much rosemary – just make sure to chop it finely.

Add some form of coarse salt. At least one cup. More if you like your meat a little salty. Remember, this rub is going to go mostly on the outside. Then add 6–8 ounces of coarse-ground pepper. Lately, I have found smoked coarse-ground pepper at Whole Foods. It really does seem to add a little extra kick. Then throw in a generous amount of Cavender’s Greek Seasoning. I might use 1/3 of one of their larger containers. Now slowly add a decent-quality olive oil to the bowl and stir until you get a consistent paste. (Over the course of time, you will develop your own sense of how you want your ingredients combined, and how much of what.)

And now we have to prepare the prime itself for seasoning. Take a sharp knife and essentially butterfly the prime, leaving maybe a 1-½ inch connection at the back. Then score the meat on both the inside and the outside every inch and and a half or so with a ½-inch-deep cut. Then take the rub and apply it on first the inside of the prime, working the rub into those scores you have made, so that more of the flavor can seep into the meat. Then fold the prime back together, and repeat the process on both the top and bottom of the meat. Place the prime in a roasting pan that has a grill that stands at least about ½ inch off the base of the pan. You want to convection cook the roast, not the metal of the pan.

Now, this is important. Get a good meat thermometer, preferably one that is electronic and that will alert you when the meat is at the proper temperature. (You can get a really good electric cordless meat thermometer at Bed, Bath & Beyond for under $40.) Have your oven preheated to 200° – yes, we are going to slow-cook it. Cooking a prime too fast will end up making it not as tender.

When the prime is not bone-in, it will generally take about two to three hours to cook, depending on size. When the meat gets to 120°, take it out of the oven. That should mean it is about medium rare on the inside. If it will be more than 30 minutes before you eat, put it in an oven that is at about 100°, just to keep it warm (but not to cook it further). Fifteen minutes before you are ready to serve it, put the prime back into the oven, which has now been preheated to 500°. We are going to sear the outside of the meat to hold in the flavor and to have it at the perfect temperature for eating. Leave it in there for 10 minutes, then take it out of the oven, put it on your large wooden chopping board, cut it into the sizes you want to serve, and take it immediately to the table. And be prepared for people to tell you that you’re a culinary genius. You don’t even have to tell them you got the recipe from a financial newsletter.

If I get a sufficient response from this, next week I will even lay out my mushroom recipes. (Yes, there are two of them, and I generally make about 10 pounds of mushrooms to accompany the prime.)

And with that, I will hit the send button. Have a great week and start planning your Thanksgiving dinner early. And yes, ours does include several different types of turkeys, not to mention cakes and pies (I make the cakes if I have the time) and all the usual trimmings. Remember, there are no calories on Thanksgiving Day.

Your thinking he is going to see Blade Runner 2045 tonight analyst,

Biting the bullet

China sets its sights on dominating sunrise industries

But its record of industrial-policy successes is patchy

IN RECENT days China set the record for the world’s fastest long-distance bullet train, which hurtled between Beijing and Shanghai at 350kph (217mph). This was a triumph of industrial policy as much as of engineering. China’s first high-speed trains started rolling only a decade ago; today the country has 20,000km of high-speed track, more than the rest of the world combined. China could not have built this without a strong government. The state provided funds for research, land for tracks, aid for loss-making railways, subsidies for equipment-makers and, most controversially, incentives for foreign companies to share commercial secrets.

High-speed rail is a prime example of the Chinese government’s prowess at identifying priority industries and deploying money and policy tools to nurture them. It inspires awe of what it can accomplish and fear that other countries stand little chance against such a formidable competitor. Yet there have also been big industrial-policy misses, notably the failure to develop strong car manufacturers and semiconductor-makers. China is rolling out a new generation of industrial policies, directed at a range of advanced sectors, raising worries that it will dominate everything from robotics to artificial intelligence. That result is far from preordained.

Industrial policy is a touchy topic. In continental Europe and, especially, Asia, many have faith in the government’s ability to steer companies into industries they might otherwise shun. In America and Britain, faith tends to be supplanted by deep doubts. Governments, after all, have a lousy record in picking winners in fast-evolving markets. Yet most countries try to support some industries, usually through a mixture of infrastructure, tax breaks and research funding. What differs is the stress they lay on such measures.

China is unique in the breadth and heft of its industrial policy. For years the government concentrated on modernising what it classified as nine traditional industries such as shipbuilding, steelmaking and petrochemical production. In 2010 seven new strategic industries, from alternative energy to biotechnology, also became targets. And two years ago it announced its “Made in China 2025” scheme, specifying ten sectors, including aerospace, new materials and agricultural equipment, which are now at the heart of its planning. The various plans overlap; cars, for example, have appeared in every iteration. The result is a wide-ranging approach in which the government tries to shape outcomes in important parts of the economy, new and old.

The “Made in China” plan, its latest industrial-policy craze, is derived in part from Germany’s “Industry 4.0” model, which focuses on creating a helpful environment through training and policy support but leaves business decisions to companies. China’s version is much more hands-on. By the start of this year, officials had established 1,013 “state-guided funds”, endowed with 5.3trn yuan ($807bn), much of it for “Made in China” industries. In August the Ministry of Industry and Information Technology unveiled a manufacturing-subsidy programme, spread across as many as 62 separate initiatives. Most contentiously, the government has laid out local-content targets for the various “Made in China” sectors (see chart). One plan features hundreds of market-share targets, both at home and abroad. “Clearly, this is no mere domestic exercise,” the EU Chamber of Commerce in China warned in a report this year.

The targets also illustrate one of the facets of Chinese industrial policy that has so angered foreign companies and governments: the disguising of state support. The World Trade Organisation (WTO) strictly limits local-content rules. But China’s market-share targets are primarily contained in semi-official documents, such as a blueprint published by the Chinese Academy of Engineering. So the government can claim that these are simply industry reports, not official targets. But in the Chinese system the line between government-backed industry estimates and official guidelines is easily blurred.

Similarly, foreigners have long complained that China hides much of its illegal state aid. Since 2011 America has formally requested information about more than 400 unreported Chinese subsidies. “China learned how to game the system,” says Tim Stratford, a former American trade official responsible for dealings with China. “The WTO is not designed to deal effectively with a huge economy that has, as the core of its development strategy, industrial policies across a wide range of sectors.” Frustrations at the WTO’s inadequacy in restraining China have led the American government to look at other mechanisms.

Foreign competitors see China as a well-oiled machine and worry that they will lose business not just in China but around the world. Export powerhouses such as South Korea and Germany feel most exposed (see chart). But in fact the Chinese government’s record in promoting specific industries is patchy. Since the 1970s it has tried to develop semiconductors.

But of the $145bn-worth of microchips China consumed in 2015, only a tenth were truly domestic; foreign technology remains superior. The car industry, too, has disappointed. To manufacture in China, foreign firms must take local partners. The government hoped this would lead to knowledge transfers. Instead, local firms, insulated from head-on foreign competition, have milked the joint ventures for profits and innovated Little.

Moreover, in their zeal, local governments can go overboard. Some worry that “Made in China” sectors will end up facing gluts, like “old” industries where China is now cutting overcapacity, such as steel and coal. The Mercator Institute of China Studies, a Berlin-based research group, counted that, by late 2016, nearly 40 local governments had opened or planned robotics parks. The central government estimates that China will need nearly 150bn yuan-worth of robots over the next few years. According to the Mercator tally, local targets add up to roughly five times as much.

Yet when four factors—foreign technology, domestic abilities, market demand and government money—come together, Chinese industrial policy can be ruthlessly effective. The boom in high-speed rail began in 2004 when the government offered lucrative contracts to foreign engineering companies such as Germany’s Siemens and Japan’s Kawasaki so long as they shared their know-how. Some resisted at first, but eventually the lure of China’s vast market won them over, especially when they saw competitors getting a slice of it. With their prodigious engineering skills, born from years of trying to develop high-speed rail themselves, Chinese companies soon absorbed the technology. After a decade of laying tracks on an unprecedented scale, they have improved on it.

That success cannot be replicated in all ten of the “Made in China” sectors, not least because foreign companies are more guarded about sharing their secrets. But it would be rash to bet against China’s succeeding in at least a few of them.

France and Germany: The Arbiters of European Peace


The European Union, for all its ambition and inclusivity, is a function of relations between its most important members: France and Germany. It was an experiment meant to test the limits of their animosity. If France and Germany were bound together in such a way that prosperity for one meant prosperity for the other, then perhaps they would not rip the Continent apart again as they had in World War I and World War II. It was a noble experiment, and for a long time it worked. So effective were the European Union and its precursor institutions that the era in which they were formed is often called the Long Peace – a term that ignores the dissolution of Yugoslavia but largely captures the essence of the period.

But can the EU continue to keep the peace? If the bloc reflects the ways in which France and Germany tried to pursue certain national interests, what happens when French and German strategies change? Already there are signs that EU institutions – and therefore the strategic pursuits that led to their formation – are either failing or becoming ineffective, and so there are signs that France and Germany will undertake new strategies.

The following report explains the strategies available to them – and how these strategies work with and against each other – amid the transformations underway on the Continent. It shows how decades of peace belie the fact that French and German interests, despite small areas of mutuality made manifest by the EU, are fundamentally different. And it is the differences between them, not the results of the recent elections in France or the upcoming elections in Germany, that will shape the fates of these nations, and therefore the fate of Europe.
The Story of Germany
Germany as we know it didn’t form until 1871. It had been composed of smaller states and territories for centuries. But the story of Germany’s place in Europe, and Europe’s behavior toward Germany, really begins during the Thirty Years’ War, which lasted from 1618 to 1648. It started as an internal conflict that pitted Protestant German states against the Catholic and increasingly fragmented Holy Roman Empire, which was controlled by the Habsburgs. But in chaos there is opportunity, and major European powers soon joined the fray. Throughout the previous century, for example, Protestant German states had slowly gained greater independence from the Holy Roman Empire, and now that they were somewhat more independent, they could be used against their former overlords by enemies of the empire. France liberally played German territories off the Holy Roman Empire throughout the war, taking advantage of their status as buffer states.
The devastation of the fighting during the Thirty Years’ War cannot be overstated. Newly organized armies – modernized, using new military doctrines such as the new massed firing techniques developed by Gustavus Adolphus, and much larger than anything Europe had seen since the decline of the Roman Empire in the 5th century – fought each other fiercely, and when they fought, they usually did it on German soil. Most estimates put the death toll at around 8 million people, roughly 8 percent of the entire population of Europe. (World War I, by comparison, killed off 4 percent of the European population.) And since Germany was where the fighting happened, Germany was also where most of the casualties were incurred. Foreign armies replenished their stocks by ransacking nearby villages and towns, some of which lost as much as 75 percent of their population.

That this destruction occurred on German territory and not elsewhere is unsurprising, given European geography. Much of this territory sits on the North European Plain, a flat area prone to invasion from two directions. The plain, which is part of the larger Great European Plain, is widest in the east where it spans from Germany’s northern tip on the Baltic Sea to the modern southern border with the Czech Republic. While the Alps sit to Germany’s south, it has no natural borders to either the east or the west.
The Ore Mountains in the south of Germany narrow the plain until the country juts south in the state of Bavaria, where it becomes more mountainous. Near the center of the country are the Harz Mountains, which lay south of Hamburg. To the west of the Harz Mountains is the Teutoburg Forest, where the Roman conquest was halted and turned back by Germanic tribes 2,000 years ago, marking the northernmost point of the Roman Empire. Farther west, in the Rhineland-Palatinate region, are the Eifel Mountains, which curve southwest into Belgium and Luxembourg and lead into the Ardennes. Although these mountains offer some protection, they are less difficult to pass than, say, the Alps and Carpathians.
Though most of modern Germany’s population lives in the west, which is where much of its industrial base is located, Berlin, its most populous city, is located midway on the eastern portion of the plain, making it strategically valuable as a way to block an oncoming attack from the east. Still, its lack of natural barriers in the surrounding region also makes it vulnerable to encirclement. Hamburg, in the center northern portion of the country and Germany’s second most populous city, lies at the southern end of Schleswig-Holstein, the southern half of the Jutland peninsula on which Denmark also sits and an important element of protecting Germany’s access to the Baltic and North seas.
Germany has a set of navigable rivers – several of which are connected by extensive canal systems – that enable trade to the Atlantic and inland along the Danube, although those that flow to the Atlantic can be blocked in the North Sea by the United Kingdom and in the Baltic by potential enemies.
Germany’s Imperatives
It was with the historical memory of the devastation caused by the Thirty Years’ War that compelled Otto von Bismarck, who guided Prussian and, later, German strategy in the second half of the 19th century, to seek German unification, forming a single national entity that could defend itself at the center of the flat European Plain. Since then, Germany’s core security imperative has been to remain united and prevent a two-front war from emerging. Germany cannot protect itself when it is not united. Its fate was determined by outside powers in the Thirty Years’ War, just as it was during the Cold War, when it was bifurcated into East Germany and West Germany. This is precisely what governed Bismarck’s stable border strategy. From 1871 to 1890, when he was fired by Kaiser Wilhelm II, Bismarck largely abstained from grabbing territories and colonies so that other countries would not perceive Germany as an expansionist power in need of curbing. It was the exception to Bismarck’s stable-border strategy – the creation and subsequent acquisition of Alsace-Lorraine from France in 1871 – that helped fuel the onset of World War I.
And herein lies the paradox of German foreign policy. Germany must avoid two-front wars, but if it believes one to be unavoidable, as it did twice in the early 20th century, its conditional imperative is to dominate Europe as quickly as possible. It is strong enough to defend one of its flanks but not both. So the only way it can win is to knock out one of its enemies first, a strategy that requires pre-emptive attack. (In both world wars, it attacked France.) Yet it is this pre-emptive strategy that leads the rest of Europe to see Germany as a major threat to the balance of power – therefore, once this first strike is launched the only way to secure its homeland is by building strategic depth to the west and east. Germany avoided a two-front war in the 1870-71 Franco-Prussian War (which led to the unification of Germany) because the European balance of power at the time precluded a Franco-Russian alliance – Russia was more focused on the Balkans and, therefore, the Ottoman Empire. Further, Bismarck manipulated the situation such that France declared war on Prussia, rather than the other way around, making Germany appear defensive, not aggressive.
Notably, Germany has never been able to dominate the Continent militarily. Doing so butts up against the interests of too many other strong powers, which, when threatened, band together to defeat Germany. During World War II, for example, the United States and the United Kingdom employed strategies meant to prevent any country from growing strong enough to threaten their respective navies. (The U.K. was forced to subordinate its strategy to the U.S. at the end of the war.) Russia, meanwhile, feared that if Germany defeated France it could focus that much more of Europe’s considerable resources against Russia.
A second imperative for Germany is securing access to the Atlantic Ocean. Without access to the Atlantic its economy – which is heavily dependent on the export of high value-added industrial products – is threatened, so easily can it be blockaded by foreign naval powers. An effective blockade of Germany’s access to the Atlantic would let an adversary – if allied with the appropriate land powers – starve it out. In World War II, Germany controlled the Baltic Sea, and while the British navy attempted to block its access to the North Sea, it was still able to send its U-boats out undetected to assault the Allied supply lines and provide support to Japan. This imperative was also one of Germany’s major motivations for the 1864 Second Schleswig War and the 1866 Austro-Prussian War. In the first, Prussia and Austria took possession of the Schleswig-Holstein region from Denmark, and two years later Prussia blocked Austria’s access to the region, defeated it in a war, and annexed the territory, giving it greater access to the seas and unifying the northern German states into a confederation.
The Story of France
Unlike Germany, France is a Mediterranean power. It is much more preoccupied with the affairs of the south and so feels a greater need for a navy. In contrast to the United Kingdom, France is also a continental power that lies on the southern reaches of the North European Plain. It must therefore also divert resources to developing an army, since it must defend itself from any state that becomes powerful enough to its north to challenge it. Over time, this has created circumstances in which the United Kingdom has managed to repel French crossings of the English Channel and to launch its own invasions into French territory despite France’s superior army.

France has a protective barrier that Germany does not: the Pyrenees. Though this mountain chain is passable – it has been traversed by Hannibal, Napoleon and warriors in the Umayyad Caliphate – it is difficult to scale and so discourages land invasion from the south. The Alps protect France’s eastern flank, but, as with Germany, they leave France exposed to the northeast.
The French core is in the region of Beauce, where the seat of French power, Paris, can be found. It lies on the confluence of the Seine and Marne rivers, a position that provides access to the Atlantic Ocean but is far enough inland to give it space against amphibious assaults. The Seine flows close enough to the Loire to provide transportation farther south.
In fact, all of France’s navigable rivers – the Seine, the Loire, the Somme and the Garonne – converge in the Beauce. Over the years, they have fed commerce and have enabled the government in Paris to accumulate enough capital to industrialize quickly. (Paris industrialized the north more quickly than it did the south, and the north-south divide is evident even in contemporary politics.) The Beauce also contains France’s most arable land, the fruits of which were easily transported by its river network.
French Imperatives
Since the government cannot rightly control all of France without first controlling the Beauce, its first imperative is to secure this important region. It must be defended from northern attacks and Atlantic assaults alike. Once the Beauce is secure, France must also ensure open access to its rivers that provide it access to both the Mediterranean and the Atlantic, without which its trade is imperiled and its inner regions can become threatened by outside intervention.

In the event that the north can’t be defended – if, say, a coalition of countries aligns against it – France would need to dominate Western Europe to ensure its survival – not unlike Germany. It must push out far enough to prevent such a coalition from materializing or, if it has materialized already, to destroy it. France has only come close to achieving this imperative once, during the Napoleonic wars. The French Revolution created fear among European monarchs that the Republican cause would spread to their own countries and overthrow their governments. As Napoleon was increasingly harassed by foreign powers to undo the outcomes of the French Revolution, he realized that such a coalition could easily come about. If an anti-French European alliance attacked France, France could be overrun.

This was primarily why Napoleon brought war to the rest of the Continent. While Europe recognized Napoleon’s war as offensive, France saw it as defensive. Napoleon was taking the fight to his enemies. The Napoleonic wars were the only time France has come close to fulfilling this imperative, and was ultimately beaten back by a coalition of Russian, Prussian and British allies. Just as with Germany’s need to dominate the Continent when confronted with a two-front war, France needs to try to dominate if confronted with a coalition that can overpower it from the north. And, as with Germany, this imperative necessarily conflicts with the needs of others.

France’s other imperative is domination of the Mediterranean. Controlling the Mediterranean would not only allow France to project power throughout the waters to its south – securing its supply lines to North Africa and giving it the ability to threaten its continental neighbors from their southern flank if necessary – but also to protect its own eastern flank from an amphibious invasion. But it is an imperative France has never achieved. Though in the 16th century its alliance with the Ottoman Empire gave the Ottomans access to Mediterranean ports and military help against naval rivals such as Venice, France has never been an exclusive power on the Mediterranean. Perhaps the closest it came to being one was when Napoleon invaded Egypt in 1798. Shortly thereafter, however, the United Kingdom destroyed the French fleet, stranding Napoleon and his army.
Strategies Diverge
The pursuit of all these imperatives brings France and Germany into conflict – an eventuality that explains their behavior toward each other.

To protect its core, France must ensure that no state emerges that can challenge its border on the North European Plain. This means that France must keep its northern neighbor either distracted, divided or weak. Before the German states gained greater independence from the Holy Roman Empire, France kept them distracted through frequent alliances with the Ottoman Empire, which forced the Holy Roman Empire to focus a substantial amount of its military resources east. After the German states became more independent, France kept them divided by allying with whichever ones opposed the Holy Roman Empire. During the Cold War, France supported the division of Germany into two states – again to keep it divided.

After the Cold War, Germany reunited and, as in prior times in its history, surprised its neighbors with how quickly it regained its economic strength. This worried France, but Paris understood that the best way it could manage a newly resurgent Germany, knowing that it could not contain its economic growth, was to at least manage its growth so that it didn’t threaten France. By working from within the institutions that would become the EU, France could exert greater pressure on German policies, and it could contain German military expansion without obstructing German economic growth. Charles de Gaulle recognized as much after World War II, and although he at first opposed the creation of the EU’s precursor institutions because, he believed, they relied too much on the U.S., he became convinced that the institutions would be created with or without his consent. France supports NATO in large part because it allows Germany to choose to be militarily weak.

This dynamic became more pronounced after Germany reunified in 1990 – and caused unforeseen problems. The past few decades generally worked out: France has kept Germany militarily weak, and Germany, which relies on selling exports, has had guaranteed customers with strong enough currencies to buy its goods. But this required the strengthening of multilateral institutions such as the EU and therefore required Paris to surrender some of its sovereignty, which has spurred the rise of nationalist parties bent on leaving the EU. This is France’s dilemma. It must maintain the strength of the EU to keep Germany in check, but maintain sufficient autonomy – and therefore limit the EU’s reach – to prevent it from losing self-determination.

For its part, Germany must maintain a balance of power on the Continent, and ensure that all major powers – especially Russia and France – are closer to it than they are to one another. It pursued this strategy throughout the 19th century with different institutions that all had the same aim: the Holy Alliance – born from the Congress of Vienna – that tied Prussia, Russia and the Austro-Hungarian Empire together with the concept of shared legitimacy of monarchs, and after that the multiple iterations of the Three Emperors League.

The situation is much the same today. Germany knows that if the EU fails it will have a much more difficult time exporting what it produces. But it would also eliminate France’s ability to influence German policy from within the EU framework, which, paradoxically, would not be in Germany’s interest. Maintaining a united country is Germany’s first imperative, and therefore failure of the EU would represent an existential threat to Germany as France would be forced to pivot to a new strategy. Germany, therefore, runs a grave security risk if the EU fails. Germany must do everything it can to keep the EU intact.

If the EU weakens further, and if Germany fears its dissolution, it will be forced to form a closer relationship with Russia to prevent Russia from getting too close to France. It is this dynamic – and the need to hedge for both outcomes – that in part explains the cooperation between German and Russian companies on oil and gas infrastructure projects. Germany realizes it needs a backup plan for its security if the EU breaks down entirely, and part of the plan is to build dependencies on Russia so that, if need be, it can claim to be in Russia’s camp. It also explains why Poland, sandwiched between Germany and Russia, will be compelled to accumulate greater military power and establish relations with other Intermarium countries. When Poland has found itself trapped between German and Russian collaboration, it has faced utter destruction, and it will not be able to defend itself from these two regional powers on its own.

The things that drive German strategy should be kept in mind during the upcoming elections. Europe is at risk of fraying not because one leader or another decides to implement some new policy, but because the strategies that France and Germany must pursue to achieve their imperatives conflict with the imperatives of the other. This tension is pushing Europe to a point where the existing set of institutions may no longer present opportunities to successfully conduct strategies that support a unified Europe in its current state.

If the EU fails, France and Germany could, once again, find themselves facing the risk of conflict. The bloc is simply a means to an end, and not an end in itself. Although their grand strategies have overlapped for the last several decades – and proved successful in the sense that war has been avoided – there is no guarantee that this will continue to work.