The finance industry ten years after the crisis

Buddy, can you spare a Daimler?

MANY people complain that the finance industry has barely suffered any adverse consequences from the crisis that it created, which began around ten years ago. But a report from New Financial, a think-tank, shows that is not completely true.

The additional capital that regulators demanded banks should take on to their balance-sheets has had an effect. Between 2006 and 2016, the return on capital of the world’s biggest banks has fallen by a third (by more in Britain and Europe). The balance of power has shifted away from the developed world and towards China, which had four of the largest five banks by assets in 2016; that compares with just one of the biggest 20 in 2006.

The swaggering beasts of the investment-banking industry have also been tamed. The industry’s revenues have dropped by 34% in real terms, with profits falling by 46%. Return on equity has declined by two-thirds. Staff are still lavishly remunerated, but pay is down by 52% in real terms. (Perhaps it is time for a charity single: “Buddy, can you spare a Daimler?”) The relative importance of different divisions has also shifted, with the revenues of the sales, trading and equity-raising departments shrinking more than the merger-advice or debt-raising divisions.

This last change reflects market developments. In 2016 stockmarkets were smaller, as a proportion of GDP, than they were in 2006, despite the record highs on Wall Street; that was because Europe and Asia have not performed as well. Both government- and corporate-bond markets were bigger than they were a decade earlier. Although the crisis started because of overindebtedness, corporate-bond issuance has doubled in real terms over the decade, while the volume of stockmarket flotations has fallen by half.

Meanwhile the game of “pass-the-parcel” of assets around the markets has speeded up; trading volumes in equities, foreign exchange and derivatives have increased in real terms. In the corporate-bond market, trading in American securities has grown but trading in European debt has declined.

In the midst of the crisis, central banks stepped in with quantitative-easing programmes to buy financial assets. This has had profound effects, most notably in the bond markets, where yields have fallen to historic lows (and hence prices have risen). In contrast to equities, the value of both corporate and government bonds is significantly higher, relative to GDP, than it was ten years ago.

This has proved to be a pretty decent climate for money managers, who earn fees based on a percentage of the assets they invest. The industry’s pre-tax profits rose by 30% between 2006 and 2016, despite the growing market share of low-cost index-tracking funds at the expense of actively managed ones. At the other end of the cost spectrum, hedge funds, private equity and venture capital have all increased their assets, relative to GDP. The asset-management industry has become more concentrated. The 20 largest firms control 42% of assets, up from 33% a decade ago.

Overall, the authors of the report remark that “it is perhaps surprising how little has changed”.

It may be less surprising if you consider that finance has two faces: first, as a driver of the economic cycle via credit expansion; and second, as an instigator of crises when creditors lose confidence. If markets are plunging and banks failing, as they were in 2008, it is understandable that the authorities do all they can to stabilise markets and rescue banks. As Tim Geithner, a former treasury secretary in America, put it: “The truly moral thing to do during a raging financial inferno is to put it out.”

By making the banks take on additional capital, the authorities have at least made the system less likely to suffer an exact repeat of the last crisis. But the world is still marked by a combination of high asset prices and high levels of debt. Outside the financial sector, there is even more debt than there was ten years ago; the combined total of government, household and non-financial debt levels are 434% of GDP in America, 428% in the euro zone and 485% in Britain.

In other words, the borrowing has been shifted to other parts of the economy; but that makes the finance industry no less vulnerable. A sudden fall in asset prices, or a sharp rise in interest rates, would reveal the jagged rocks beneath the surface. Central banks know this; that is why they are so cautious about unwinding monetary stimuli. At the heart of the next economic crisis will be the finance business; that is something that has not changed in the past decade.

The International Consequences of U.S. Tax Reform

Martin Feldstein

CAMBRIDGE – The United States Congress is likely to enact a major tax reform sometime during the next six months. Although the new rules will apply only to American taxpayers, they will have important consequences for companies and markets around the world.       

The most important changes will apply to US corporations rather than to individual taxpayers.
Of these reforms, the one with the most obvious and direct international impact will be the change in the taxation of US corporations’ foreign subsidiaries.
The current US rule is unique among all major advanced economies. Consider the example of a subsidiary of a US corporation that earns profits in Ireland. That subsidiary pays the Irish corporate tax at Ireland’s low 12% rate. It is then free to reinvest the after-tax profits in Ireland, in financial securities, or in operating businesses anywhere in the world – except the US.
If the foreign subsidiary’s parent company brings the after-tax profits back to the US to invest or distribute to its shareholders, it must pay the current US corporate tax rate of 35% on its original pre-tax Irish profits, with a credit for the 12% that it has already paid.
Because of this 23% penalty on repatriation, US companies generally choose not to repatriate the profits of their foreign subsidiaries. The Treasury Department estimates that these subsidiaries have accumulated $2.5 trillion of offshore profits.
Congress is now likely to adopt the “territorial” method of taxing the profits of US corporations’ foreign subsidiaries. Under the territorial method, which virtually every other advanced economy uses, US corporations will be able to repatriate their foreign subsidiaries’ after-tax profits with little or no extra tax.               
Congress is also likely to enact a “deemed repatriation tax” on the $2.5 trillion of profits that have been accumulated abroad but never subject to US tax. Although the details of this provision have not been decided, the basic idea would be to levy a tax of about 10% on the untaxed overseas profits, to be paid over a period of years. In exchange for this new tax liability, a US corporation could repatriate those accumulated profits whenever it wanted to do so.
The shift to a territorial tax system is likely to have important effects on US corporations’ behavior. A large share of their foreign subsidiaries’ future profits, which would be retained abroad under current law, are likely to be returned to the US, reducing investment in Europe and Asia. A portion of the $2.5 trillion of past profits now held abroad would be repatriated as well.
Moreover, US corporations will no longer have an incentive to shift their country of incorporation to other countries in order to be able to distribute their foreign-earned profits to their shareholders. At the same time, foreign companies will have an incentive to shift their headquarters to the US, where they could enjoy the advantages of being a US corporation without incurring the current tax penalty.
Although the shift to a territorial system of taxation would have the most obvious foreign impact, the planned reduction in the corporate tax rate may have an even larger effect. The 35% statutory tax rate on corporate profits is one of the highest among all developed countries.
The congressional proposal would reduce the corporate rate to 20%. President Donald Trump has called for a 15% rate.
A lower corporate tax rate and the shift to a territorial system would increase the flow of capital to investment in US corporations from abroad and from capital investments in owner-occupied housing and in agriculture. This would raise productivity and GDP, leading to increases in tax revenue that would partly offset the direct effect of the corporate rate reduction.
But, because corporate tax revenue is now about 1.6% of GDP, the direct effect of halving the tax rate would reduce revenue by about 0.8% of GDP, or $160 billion a year at the current level of output.
The US cannot afford such a large increase in the fiscal deficit. And, because few features of the corporate tax law can be changed to reduce that revenue loss, I think the corporate tax rate will be reduced to about 25%. That would still be substantially less than the current rate and in line with the OECD average.
Corporate tax rates have been declining around the world in recent decades. The US rate was previously 50%, and rates in the other OECD countries were substantially higher than the current 25% average. It is certainly possible that the reduction of the US rate will cause other developed countries to reduce their corporate tax rates to improve their relative attractiveness to internationally mobile capital.
In short, the congressional legislation that is likely in the months ahead will change the tax rules for US companies, but it will also have important effects on international capital flows. It could also have significant effects on tax rules around the world.
Martin Feldstein, Professor of Economics at Harvard University and President Emeritus of the National Bureau of Economic Research, chaired President Ronald Reagan’s Council of Economic Advisers from 1982 to 1984. In 2006, he was appointed to President Bush's Foreign Intelligence Advisory Board, and, in 2009, was appointed to President Obama's Economic Recovery Advisory Board. Currently, he is on the board of directors of the Council on Foreign Relations, the Trilateral Commission, and the Group of 30, a non-profit, international body that seeks greater understanding of global economic issues.

Playing the Part in NAFTA Negotiations

By George Friedman and Allison Fedirka

As the fourth round of NAFTA negotiations comes to an end, the agreement’s survival has once again been brought into question. US President Donald Trump has threatened to strike a new deal with just Canada. Mexico downplayed the threat, saying it would walk away from negotiations if the new terms brought by the US put it at a disadvantage. For their part, the Canadians have been quiet, keeping their cards much closer to their chests.

All this commotion belies the fact that no NAFTA member is likely to walk away from the deal. The economic realities and commercial interests that led to its formation in the first place still incentivize cooperation, no matter how much any side postures.

An Apparent Advantage

Still, at first the glance, the United States appears to have the upper hand. It boasts the largest economy in the world and accounts for about a quarter of global gross domestic product. Exports account for only roughly 12% of its GDP, according to the Department of Commerce, so the US has the benefit of a strong consumer class to boost economic activity when international demand is low. Easy access to such a large and vibrant consumer market has enabled Mexico and Canada to build up their economies without having to trade much with each other. In Mexico, on the other hand, exports account for about 38% of GDP, and about 81% of those go straight to the United States. Exports account for 31% of Canada’s GDP, according to the World Bank, about 76% of which go to the US. Exports are simply more important to the Canadian and Mexican economies than they are to the US’s.

In keeping with this apparent advantage, there are a few areas in which the United States could hurt Mexico if Washington decided to restrict trade or impose tariffs.
These include gasoline, steel, agriculture, and automobiles. Though Mexico produces crude oil, it relies on imports for most of its refined gasoline. Last year, according to Pemex, Mexico imported 62% of its gasoline, mostly from the US. Mexico is a net consumer of steel, importing about 40% of it from the US. (By comparison, the US sells just 4% of its steel to Mexico.) Mexico relies on the US for 85% of its total soybean supply and almost exclusively on the US for corn—a staple of the Mexican diet—accounting for a third of the country’s total supply. In automobile production, Mexico and the US have very integrated supply chains such that either one has the potential to disrupt the other.

Canada’s major vulnerability is in oil. Oil is Canada’s most important export, and the US is practically Canada’s only customer. Meanwhile, some 40% of the oil the US imports comes from Canada, but that number is declining. Over the past 20 years or so, Canada has been developing oil production capabilities as manufacturing fell. For a few years, before the US shale revolution and the fall of oil prices, oil production was a boon to the Canadian economy. Since around 2014, however, the oil sectors in Alberta, Saskatchewan, and Newfoundland and Labrador have declined dramatically.

A Closer Look

At a national level, the US dominates its northern and southern neighbors. But a closer look at state economies shows a different dynamic. California, Arizona, New Mexico, and Texas, for example, rely heavily on trade with Mexico. They have a combined GDP of $4.5 trillion, or roughly a quarter of the country’s GDP, according to the US Bureau of Economic Analysis. Mexico, moreover, is among the top three export destinations for 33 of the 50 US states. Canada is the main destination of exports for 35 states and a vital source of oil to the US Midwest.

Similarly, the US business community has warned that major changes or dissolution of the trade agreement would be disruptive. Leading the charge is the US Chamber of Commerce, which has said that a US withdrawal from NAFTA would have catastrophic economic consequences for businesses. The American Farm Bureau Federation, meanwhile, acknowledges that despite competition of some products among the three nations, US farmers still rely heavily on trade for the sale of their goods. US agriculture exports to Mexico have nearly quintupled since NAFTA started, amounting to $17.9 billion last year. Even some members of the US automotive industry have urged caution in the renegotiations and that major changes are unnecessary.

NAFTA is going to be renegotiated, of course. Such agreements tend to be modernized to reflect new business practices, technological changes, different investment policies, and amendments to intellectual property law. But the consequences of walking away from the agreement entirely outweigh the political and economic benefits from staying in. As talks address the more contentious topics, the rhetoric surrounding the negotiations will likewise become more vitriolic. But this is just one act in the theater of negotiations, and all sides are playing their part.

The World Is Waiting for Inflation to Kick In

If economic growth keeps accelerating, it could finally push inflation higher

By Ben Eisen

Investors wondering whether inflation will pick up soon should keep an eye on the outlook for global growth.

The economy, sluggish in the years after the financial crisis, has accelerated this year. The International Monetary Fund projected global growth of 3.6% this year and 3.7% in 2018. The latest projections, released last week, raised estimates by 0.1 percentage point from the July forecast and would be faster than 2016’s 3.2% rate.

The lack of growth in many parts of the world since the financial crisis hampered the demand that tends to push up prices. In turn, inflation has remained low across developed economies, failing to pick up as much as central banks would like. But now, as noted in the Journal’s Morning MoneyBeat newsletter Monday, some policy makers are citing growing demand around the world as one factor that could push up consumer prices.

“Inflation will start to come in that environment,” Bank of England Gov. Mark Carney said in a television interview Friday. “It is not surprising given the big shock we have all been through and the coordinated opening up of output gaps that it is taking a little longer, but we are moving in the right direction.”

Some economists say that the spread of globalization in recent decades means inflation is determined at a more global level than it used to be. For example, companies can go further afield in search of cheap labor, giving them more options to make their products without paying higher wages. In this environment, it would take a pick-up in growth across the world to cause a sustained lift in prices.

Low inflation has confounded economists and stymied efforts to unwind years of easy-money central bank policies. The Federal Reserve targets a 2% annual inflation rate but prices have only briefly risen by that much or more.

An index of U.S. consumer prices, excluding volatile food and energy categories, rose just 0.1% in September from a month earlier and 1.7% from a year earlier, data showed Friday. Gasoline prices jumped after recent hurricanes but much of that is expected to be temporary.

Expectations for future inflation are also flagging. Consumers in a University of Michigan sentiment survey said they expect inflation of 2.3% annually over the next year, according to data released Friday, the lowest level of the year and down from 2.7% in September’s reading.

Over the weekend, Fed chairwoman Janet Yellen said the “biggest surprise in the U.S. economy this year has been inflation.” And outside of the U.S., European Central Bank president Mario Draghi warned Friday that inflation remains too low.

But some measures of consumer prices have started to pick up. A gauge of U.S. business prices, the producer-price index for final demand, rose 0.3% in September from a month earlier, topping expectations, data showed last week.

If economic growth keeps accelerating, it could push inflation higher. That would be a welcome occurrence for the many economists and policymakers who have been waiting for it to happen.