Little interest

American banks pay depositors less than online accounts

They seem to be relying on the power of inertia to retain their customers—a risky strategy

EVERYONE knows that interest rates are rising—except, perhaps, one group: American savers who have put $12trn in bank accounts. They have seen the government’s deposit guarantee, purportedly designed to protect them, become a ticket for banks to receive free money. For evidence, look no further than the ubiquitous bank branches dotting America’s high streets.

Those seeking a home for their money find that, unlike petrol stations or grocers, banks are not required to post their most important price, the interest rate. Ask and you will be referred to a specialised member of staff. After a wait, numbers are typed into a computer, followed by pauses for thought, a bit of throat clearing and, often, comments that the current rates on offer may not exceed inflation. Then come hints, doubtless filtered through a compliance department, of the higher returns available on the bank’s investment offerings, which, of course, carry risks (and fees).

Only then is the diligent customer told the rates on offer, ranging from almost nothing to almost nothing at all. A knowledgeable saver might then ask about certificates of deposit, guaranteed securities with maturities of up to five years. Here too the banks’ offerings often carry meagre rates. The exception may be a promotional deal—a slightly higher rate with an expiry date, intended to draw in new customers.

The high levels of deposits the big banks are sitting on suggest that many give up at this point, despairing of earning any return on their money. They would be wrong, however. Should they look online, at, for example,, a common reference point, they would find lists of rates provided nationally on deposits (up to 1.6% per year) and certificates of deposits (3%). These rates have been rising, in line with the broader bond markets.

You would expect the gap between what is offered to savers in banks and what can be earned online and in the money markets to close. Not so. In 2014 Gary Zimmerman launched a web-based financial link,, that enabled customers to transfer funds smoothly between their usual banks and higher-yielding online accounts (also government-guaranteed).

At the time, banks paid on average 0.11% on savings accounts. Online his clients could receive 0.87%. Since then, his online rates have risen to an average of 1.52%, compared with 0.09% paid to high-street bank depositors.

If banks bother to defend their low rates, it is to point to an expanding range of associated benefits that they offer: automated banking, bill payment, credit cards, an ability to consolidate all of this easily online, and so on. This has sparked debate about “deposit beta”, or how much of an interest-rate rise banks can afford not to pass on to savers (short answer: a lot).

Jason Goldberg, an analyst at Barclays, has compiled data stretching back to 1934 on the spread between how much banks have to pay for money and what they receive (see chart).

After the financial crisis, low prevailing rates compressed this margin. But its recent widening has lasted unusually long—the first three-year streak since the 1970s is expected. And Mr Goldberg thinks more is to come as rate rises by the Federal Reserve continue to exceed what filters down to depositors. That will play a critical role in strong bank profits.

Given the upheaval and price-cutting that online shopping has brought to the rest of the retail world, this is at the very least odd, and seems unsustainable, were it not for the power of inertia. But relying on inertia is a dangerous strategy. At some so far undiscovered tipping-point, customers may wake up abruptly, shift their money and never come back.

An Eventful Week in the Syrian War

By George Friedman and Xander Snyder

Turkey’s invasion of Afrin in northern Syria has redrawn the established lines of battle.

Turkey proposed cooperation with the United States in Afrin and Manbij, both of which are held by Syrian Kurds—whom the US has been supporting and the Turks consider hostile.

Though no formal agreement has been reached, US Secretary of Defense James Mattis said the US would work with Turkey to coordinate their actions in Syria. Then, the Syrian Kurds apparently invited pro-regime forces into Afrin to help fight back against the Turkish assault.

Joining the Fray

With Turkey joining the fray in Afrin and inching closer to Aleppo, a critical city over which Syrian forces have already fought a bloody battle, Bashar al-Assad has a choice: either escalate his military conflict with Turkey and its proxies or come to a settlement. To win a military victory in the region, Assad would need to move his forces along the southern edge of Afrin until they reach the Turkish border in the west and then turn farther south until pro-Turkish forces in Idlib—a region largely controlled by another Turkish proxy, Hay’at Tahrir al-Sham—are surrounded. Assad will try to encircle Turkish proxies in Idlib and cut off their supply routes to Turkey.

Source: Geopolitical Futures (Click to enlarge)

From the regime’s perspective, therefore, working with the Kurds makes sense. It can use the 8,000–10,000 Kurdish fighters from the People’s Protection Units (YPG) in Afrin to repel the Turkish invasion and avoid expending its own resources. It also makes sense for the Kurds, who are facing a Turkish assault with few allies, since the US has said it will not support the YPG in Afrin.

But Turkey has its own plans to surround the YPG and cut off access to its allies. On Feb. 20, Erdogan announced that the Turkish military would attempt to envelop Afrin in the next several days, blocking the YPG from receiving support from pro-Assad forces. Turkey and Assad are therefore applying the same strategy to different regions, while trying to avoid a confrontation that could draw in more outside powers and escalate the conflict.

This situation could give rise to a tactical settlement in Afrin. Faced with the risk of a far bloodier battle than it anticipated, Turkey may be willing to halt its advance if the Syrian regime—and by extension, Iran and Russia—agrees to move the Kurds out of Afrin and Manbij to an area east of the Euphrates, and if it could also guarantee to control the Kurds’ actions thereafter. The Syrian government could then take control of areas that have been held by semi-autonomous Kurdish entities for several years. The Syrian Kurds might also agree to this arrangement—it would allow them to avoid even more bloodshed, and they could negotiate a role for themselves in the Syrian government. Iran, an Assad ally, might also accept an agreement because it would reverse Turkey’s advance east. Such a settlement wouldn’t end the Syrian war, but it would help temper the conflict in Afrin.

It remains unclear whether the pro-regime forces that were deployed to Afrin have made much progress. Turkey said it halted their advance by shelling them as they entered the province, promising to engage directly if the fighters helped defend the YPG.

Fierce Bombardment

Meanwhile, over the weekend, some 600 special forces from the Free Syrian Army, which Turkey supports, were sent to Afrin, as a probable response to the deployment of pro-regime forces. This came at roughly the same time as a UN Security Council resolution was unanimously passed calling for a 30-day cease-fire across all theaters in Syria. Turkey supported the measure but said that the resolution would not affect its operations in Afrin.

Farther south, an area east of Damascus known as Eastern Ghouta underwent some of the fiercest bombing of the entire Syrian civil war. Reports estimate that more than 500 people were killed in just a few days. Syrian army commanders have said that the bombing campaign will precede a ground offensive meant to retake the pocket of rebel resistance, which has held out in Eastern Ghouta for several years despite the Syrian army maintaining a siege and blockade of most food and aid.

The regime’s behavior in Eastern Ghouta serves two strategic purposes. First, it eliminates the risk posed by rebel-held territory on the outskirts of the country’s capital. Second, it eliminates the risk quickly so that Assad can concentrate his forces to the north, adding to the defensive capabilities that the regime can deploy to block and prevent Turkey from moving too far inland.

The Ghost of Inflation Reappears

By Randall W. Forsyth

The Ghost of Inflation Reappears
Photo: iStockphoto 

“And things are going up/ and up and up and up/ And my check remains the same/ That’s why I got the blues/ Got those inflation blues.”

Wall Street seems to be singing along with B.B. King’s lament, although it isn’t feeling the squeeze like the hoi polloi. The moneyed crowd worries that the gravy train of cheap money from the Federal Reserve will come to an end. Main Street, however, soon may be feeling B.B.’s blues, as its denizens see any uptick in their paychecks eaten up by the increased cost of living.

“Inflation Blues” dates back to the bad old days of stagflation, that ugly term from an ugly time decades ago of simultaneously rising prices and high unemployment. And while we’re far from those Carter-era readings that sent the so-called Misery Index—consisting of inflation plus the jobless rate—soaring, recent data belie the bullishness that, until a couple of weeks ago, prevailed on Wall Street and Main Street alike.

The consumer-price index jumped 0.5% in January, the Bureau of Labor Statistics reported last week. The core rate that conveniently strips out food and energy prices rose 0.3%. Both of those readings were above forecasts, but also flattered by the conventions of rounding to one decimal place. Before rounding, the overall CPI was up 0.54%, while the core measure was up 0.349%. With just a few hundredths more of a percentage point (that’s basis points to financial folks), the total jump would have been 0.6%, while the core increase would have come in at 0.4%.

Leaving aside the month-to-month squiggles, the real story is that inflation is closing in on the Fed’s 2% target. Former Fed Chair Janet Yellen had been nonplussed by inflation’s failure to move up to the central bank’s standard for “price stability,” and was cautious in increasing the Fed’s key policy interest rate, which currently is targeted in the 1.25%-to-1.50% range. Low interest rates, of course, have been an important prop to the stock market and to asset prices in general.

Yellen’s recently installed successor, Jerome Powell, won’t have the same confusion about falling short on inflation. The stock market’s recent paroxysm of volatility was set off a couple of weeks ago when the BLS showed that average hourly earnings in January were up 2.9% from the level a year earlier. The consumer-price data also indicated an acceleration in price trends over shorter periods. For instance, the overall CPI increased at a 4.4% annual clip over the latest three months, lifting its year-over-year rate to 2.1%, according to the calculations from Michael Lewis’ Free Market Inc. consultancy. Core CPI, meanwhile, increased at a 2.9% yearly pace in the past three months, and was 1.8% above its year-earlier reading. 
In other words, the much-bruited 2.9% annual rise in hourly earnings reported for January is just keeping ahead of inflation. But there also was a drop last month in hours worked, which meant total earnings actually were down 0.1% in a month when pay packets supposedly were increasing at last for working men and women. (Could those hours lost be a result of the widely reported flu outbreak? JPMorgan economist Daniel Silver considered that possibility. He wrote in a report that the flu season could have affected the workweek, but the impact would seem to be small.)

In any case, the effects of the flu and any seasonal aberrations in the recent numbers will pass.

And even if January’s rise in the CPI was overstated, a real cyclical uptrend is under way.

Those rising prices, moreover, have been eating away at pay gains and have forced consumers to dip further into already meager savings to maintain their spending.

Looking more deeply at the January jump in CPI shows definite trends, according to Steven Blitz, chief U.S. economist at TS Lombard. Deflation in the prices of consumer goods we like to buy is ending; the rate of increase in the cost of things we have to buy either is rising, as for food and energy, or remains high, as for services or rent.

Goods inflation has been held down since the mid-1990s by increased low-cost imports, technology, or slowing spending by “aging baby boomers” (or should that be “aged”?). The dollar’s weakness is boosting import prices (up 1% in January and 3.6% from its level a year earlier), which should pass through to consumer prices this year and into the next.

As for technology, the magic of hedonic adjustments produces deflation, although the real world sees mobile phones costing a grand or more. Meanwhile, the cellphone price wars of last year lowered the inflation measures back then and, in turn, will boost the year-over-year increases in price gauges in 2018. (To paraphrase the song from a few years ago, it’s all about that base.)

Consumers’ paychecks had been keeping up with rising rents and services costs, while prices of goods have been falling, Blitz continues. “With goods prices set to rise and rent showing no signs of slowing down (in the aggregate), consumer finances are set to be squeezed further,” he writes.

That vise has been visible for some time. To keep up their spending, Americans cut their savings to just 2.6% of income in the fourth quarter.

But that’s not a new phenomenon, according to Stephanie Pomboy of MacroMavens. Nondiscretionary outlays—for food, energy, housing, and medical expenses—have accounted for 55% of the increases in household spending over the past two years. During that same period, savings have been “pillaged,” she writes in a recent missive to clients. “The ineluctable conclusion is that the decline in saving is occurring out of necessity, not choice.”

One cost of living that doesn’t get counted directly is debt service. In another note, Pomboy points out that the cost of paying back debt jumped by $62 billion through the third quarter—which predates the most recent rise in interest rates. Given the increase in rates since then and the Fed hikes likely this year, she conservatively estimates an additional $75 billion jump in debt service in 2018. “That alone would wipe out nearly all of the $80-to-$100 billion boost to growth forecast from the tax cuts,” she observes.

As for drag from the fiscal side, President Donald Trump’s suggestion last week of a 25-cent-per-gallon tax would wipe out 60% of the benefit of the tax cuts to individuals, according to Strategas’ Washington team lead by Daniel Clifton. No wonder this trial balloon was made of lead.

It’s too early to tell, but the unexpected drop of 0.3% in January retail sales was consistent with consumers being squeezed by higher prices. Don’t pin too much on one month, since retail sales are among the data series most prone to revision; December’s preliminary 0.4% increase was revised away to no change, for example. And sales of more costly gasoline provided a big boost; gas sales grew at a 23% annual rate in the past three months, while overall sales expanded at a 2.1% annual clip.

Inflation is depicted by optimists as a sign of the economy’s robustness, which will justify both higher stock prices and higher interest rates. On the latter score, the New York Fed’s Underlying Inflation Gauge rose to 3% in its latest reading, half again the central bank’s inflation target.

If inflation is sapping consumers’ spending power, even after employment gains and tax cuts, it could be seen as a harbinger of diminishing strength, especially as borrowing costs climb.

SO, TO CONTINUE THE song lyrics theme, last week wasn’t the end of the world as we know it. Depending on which index you cite, stocks had their best week since Nov. 11, 2016, with the Dow Jones Industrial Average up 4.25%; or since Jan. 4, 2013, with the Standard & Poor’s 500 index up 4.3%; or since Dec. 2, 2011, with the Nasdaq Composite up 5.31%.

More to the point, last week’s rebound sprang the market from the so-called correction, as the S&P 500 halved its drop from its Jan. 26 peak to 4.90% by week’s end. The real question is why the equity market pulled out of its nose dive. None of the fundamental reasons for the correction had changed.

If anything, the worries about inflation were confirmed by the aforementioned CPI and New York Fed data, which makes another quarter-point hike in the federal-funds rate a 100% certainty at the March 20-21 Federal Open Market Committee meeting, according to Bloomberg’s analysis. The odds of a second hike this year, in September, and a third, in December, were solidly better than even money, after having wavered during the stock market’s slide the previous week.

The plunge was so powerful that it set up for a spring back, comments Doug Ramsey, chief investment officer at the Leuthold Group. But that doesn’t imply that the selling is over, he adds in an email.

There was no real sign of panic in the selloff, outside of speculators who had shorted the Cboe Volatility Index (or certain quarters of the financial media), which typically indicates that retreats are overdone. Surges in other pessimism indicators, such as put/call ratio in options or swings in timing-oriented mutual funds or exchange-traded funds, also were absent.

Bulls’ demises typically are preceded by a period of narrowing participation of at least three to four months, and more typically twice that, he continues. “The latest high, which was only three weeks ago, wasn’t accompanied by the usual weakness in breadth, small-caps, and cyclicals—market signals which indicate that Fed tightening has really begun to bite,” Ramsey adds.

That process still lies ahead, according to him. But he also first sees a renewed rally—starting from lower levels. While the bull market isn’t over, he concludes, neither is the correction.

Private equity chiefs face conversion dilemma

Groups agonise over whether to follow Ares to become a corporation and pay less tax

Javier Espinoza

The US government's recent tax overhaul has potentially major consequences on how private equity firms choose to structure themselves © FT montage / AP

Private equity bosses are facing an uncomfortable choice: do they seek to benefit from US president Donald Trump’s tax cuts with a corporate rejig that would potentially boost valuations? Or do they stay as partnerships, which have proven a reliably lucrative means of keeping taxes lower on earnings?

The dilemma comes at a time of a wider change at private equity groups, where ageing founders at Blackstone, KKR and Carlyle are looking to anoint the next generation of leaders.

Private equity bosses have long complained that their stocks are undervalued, in part because of the lack of inclusion in big indices that would be solved through the shift in structure.

Only one firm has so far made its choice. Los Angeles-based Ares Management said last week it would be the first major private equity group to switch from a partnership tax structure to become a corporation. This means it can benefit from the Trump administration’s tax cut for corporations from 35 per cent to 21 per cent.

Apollo and KKR said they would consider the switch, which would allow them to join major stock indices that block the sort of publicly traded partnerships typically used by buyout groups.

“There is potential for increased ownership because the additional red tape and costs under a partnership structure is prohibitive for some investors,” says Jerry O’Hara, a private equity analyst at Jefferies in San Francisco.

“Ultimately if Blackstone wants to be eligible for inclusion in an index like the S&P 500 it would mean a broader investor base and ultimately a higher multiple on its share price.”

But the partnership structure — which has been used for more than a decade as private equity groups sought to list their shares — has proven lucrative. As partnership structures, companies such as KKR and Blackstone benefit from lower tax rates than a standard corporation.

Crucially, it allows them to shield their performance fees, known in the industry as “carry”, from corporate taxes, passing them all the way to shareholders.

If private equity firms convert to a corporation from listed partnerships, their performance fees are suddenly subject to a 21 per cent tax charge.

Last year Blackstone, the largest alternative asset manager in the world with more than $400bn in assets under management, made $3.7bn in performance fees, representing more than half of total fees. Rival Carlyle took $2.2bn in such fees for 2017 — or about 65 per cent of overall fees.

Ares has become the industry’s first test case. Mike McFerran, Ares’s chief financial officer, says the conversion “will simplify our structure, broaden our potential investor base, improve our liquidity and trading volume and provide a more attractive currency for strategic acquisitions”.

But it relies less on performance fees than some larger groups, which means that its shift is regarded with some scepticism among rivals. A conversion makes more sense for alternative asset managers where a large portion of earnings comes from management fees, which face the statutory tax rate.

The stock jumped as much as 14 per cent after the announcement.

Executives at the largest listed private equity groups have said they are taking their time to understand the implications.

“[These large private equity groups] need additional data points. Having one of their peers make the jump first would help,” says Jefferies’ Mr O’Hara. “Everybody is waiting for somebody else to do it so they can sit back and watch.”

KKR said this month that its management was “seriously considering” the switch and would update the market in three months’ time.

But it warned that had it been organised as a corporation last year under the new 21 per cent tax rate, its net profits last year would have been 17 per cent lower. In order for its stock price to have stayed constant then, its price-to-earnings valuation multiple would have needed to expand from 10 times to 12 times.

Despite this, some analysts expect KKR will be next to convert. And that might lead to Blackstone making the move. Following Ares’s announcement, analysts at Credit Suisse said “if Ares and KKR’s valuations improve meaningfully under the C-corp structure . . . this would increase the probability of Blackstone converting too”.

Blackstone’s vice-chairman Tony James says there would be “tax leakage” if the firm chose to convert, however. And his company is still not certain on whether the share price will rise sufficiently to make the conversion worth it.

“This is a decision we can make once,” he says, “and we want to make it deliberately.”

The advantage of converting to a corporation comes down to being able to access equity indices that have deemed listed partnerships are off-limits because of the bookkeeping burden they create. Partnership tax forms sent to investors called K-1s are complex enough that institutional investors cannot easily process them.

The corporation change also opens share ownership to foreign investors, says Christopher Schenkenberg, a tax partner at Grant Thornton. “Under the partnership structure an investor sitting in London that owns units in a listed private equity group needs to file a US tax return. That is not the case in a corporation.”

Credit Suisse said in a note that the Russell, the FTSE and the MSCI indices could also add alternative asset managers, triggering “significant passive buying (and active buying from investors who are benchmarked to these indexes)”.

Leon Black, chief executive of Apollo, described the decision to switch as “classic game theory”, whereby the actions of each player affect the rest.

Private equity can also look at other alternative asset managers for guidance, as their share prices have benefited from being in a corporate structure. An analysis by Credit Suisse showed companies such as Partners Group in Europe, Brookfield in Canada and Hamilton Lane in the US appear to have thrived. Their stocks trade at about 25 times earnings per share compared with listed partnerships in the US, which trade at roughly 11 times on average, the bank estimated.

But others have decided against converting to corporations for now. Lazard, the global investment bank headquartered in New York but domiciled in Bermuda, said in its recent earnings call that switching status would lead to its tax rate jumping roughly 10 percentage points. Other aspects of the new tax law related to taxation of foreign earnings were also unfavourable to Lazard.

Even with clear benefits from the conversion there is little advantage in moving quickly, multiple industry executives have said.

As Glenn Youngkin, co-chief executive of Carlyle, puts it, converting “is a no-going-back kind of decision”.

How China Could Freeze the US Military

by Nick Giambruno

Last April, President Trump launched 59 Tomahawk cruise missiles into Syria.

He was responding to an alleged chemical weapons attack by Bashar al-Assad’s Syrian government.

It was Trump’s most dramatic military move since he became president. It was also the United States’ first deliberate attack on the Syrian government.

At the exact moment he ordered the strike, Trump was also hosting China’s president, Xi Jinping, for dinner at Mar-a-Lago, Trump’s Florida resort. Xi’s wife was also there.

Trump said:

I was sitting at the table. We had finished dinner. We are now having dessert. And we had the most beautiful piece of chocolate cake that you have ever seen. And President Xi was enjoying it. And I was given the message from the generals that the ships are locked and loaded. What do you do? And we made a determination to do it. So the missiles were on the way. And I said: ‘Mr. President, let me explain something to you… we’ve just launched 59 missiles… heading toward Syria and I want you to know that.’

When asked how President Xi responded, Trump claimed: “He paused for 10 seconds and then he asked the interpreter to please say it again.”

The timing of the attack was meant to intimidate Xi and send China a message.

You see, China and Syria are allies. The Chinese give Assad’s government diplomatic, military, and economic support. China has also used its veto power at the UN several times to support Syria.

Essentially, Trump invited President Xi and his wife to his home for dinner. Then, over cake, he bombed one of Xi’s friends.

Trump hoped his hardball diplomacy would encourage China to tighten the screws on North Korea. He also wanted China to make changes in other areas like trade. He explicitly told Xi as much.

However, on closer look, Trump’s Syrian fireworks show was nothing but a hollow gesture.

That’s because, without China, Trump would have no missiles to launch at anyone.

The guidance systems on the Tomahawk cruise missiles Trump launched at Syria depend on special materials that China has a near monopoly on producing. Surely, Xi knew this. Though Trump probably didn’t at the time.

And it’s not just the missiles...

If China decided to cut off these special materials, the entire US military would cease to function in short order.

Not surprisingly, Trump’s display of machismo did not impress the Chinese. Nor did it make them change their approach to North Korea.

A few months later, North Korea tested both an intercontinental ballistic missile capable of hitting the continental US and a thermonuclear weapon for the first time. Both might’ve been prevented if China had pushed harder to reign in North Korea.

So eventually—and likely soon—the US government will try to force China’s hand through trade and economic means.

Trump already threatened to cut off trade with any country that does business with North Korea. He was talking about China.

And Trump’s Secretary of the Treasury threatened to kick China out of the US dollar if it doesn’t crack down on North Korea. That would be akin to dropping a financial nuclear bomb on Beijing.

Sure, these seem like exaggerated threats. But it shows Trump’s frustration. It also means trade penalties against China could be imminent.

I think a full-blown trade war is coming soon.

But China has a big card to play. It could restrict access to that special material I just mentioned—the material used to make advanced electronic components, like the Tomahawk cruise missile guidance system.

China has used this strategy before. About six years ago, it restricted exports during a spat with Japan. The supply crunch caused a veritable mania in the special material’s industry.

Almost overnight, the price of this special material went up over 10 times.

Companies in the industry went up many times higher.

That’s why you should position yourself now.

The US and China are in the early stages of a trade war. It’s only a matter of time before it escalates.

That will probably happen soon. The perilous situation with North Korea guarantees it.

The next time China restricts access to this special material, I think the industry will explode… just like it did the last time.

Even a whiff of the possibility that China could restrict supplies again would send these stocks soaring.

Loan Shark Nation: Forcing Our Kids To Choose Between Student Loans And Everything Else

It’s mid-winter, which means millions of high school seniors are winding up their childhoods and planning for what comes next. For many this next stage is college.

But in yet another example of how we baby boomers have rigged the system in our favor at the expense of pretty much everyone else, student loans – barely necessary when most boomers graduated 40 years ago – have become a life-defining problem for our kids and grandkids.

A college degree is now so expensive that for most students it requires massive borrowing. But the starting salary in most fields has risen so slowly that growing numbers of indebted grads can’t reduce – let alone pay off – their loans. From today’s Wall Street Journal:

Jumbo Loans Are New Threat in U.S. Student Debt Market 
During the housing boom of the 2000s, jumbo mortgages with very large balances became a flashpoint for a brewing crisis. Now, researchers are zeroing in on a related crack but in the student debt market: very large student loans with balances exceeding $50,000.
A study released Friday by the Brookings Institution finds that most borrowers who left school owing at least $50,000 in student loans in 2010 had failed to pay down any of their debt four years later. Instead, their balances had on average risen by 5% as interest accrued on their debt. 
As of 2014 there were about 5 million borrowers with such large loan balances, out of 40 million Americans total with student debt. Large-balance borrowers represented 17% of student borrowers leaving college or grad school in 2014, up from 2% of all borrowers in 1990 after adjusting for inflation. Large-balance borrowers now owe 58% of the nation’s $1.4 trillion in outstanding student debt. 
“This is comparable to mortgage lending, where a subset of high-income borrowers hold the majority of outstanding balances,” write Adam Looney of Brookings and Constantine Yannelis of New York University.
“A relatively small share of borrowers accounts for the majority of outstanding student-loan dollars, so the outcomes of this small group of individuals has outsized implications for the loan system and for taxpayers,” the authors say. 
The problem is particularly acute among borrowers from graduate schools, who don’t face the kinds of federal loan limits faced by undergraduate students. Half of today’s big balance borrowers attended graduate school. The other half went to college only or are parents who helped pay for their children’s education. 
Grad school borrowers tend to be among the best at paying off student debt because they typically earn more than those with lesser degrees. But the rising balances unearthed in the latest study suggest that pattern might be changing. 

Overall across the U.S., one-third of borrowers who left grad school in 2009 hadn’t paid down any of their debt after five years, compared to just over half of undergraduate students who hadn’t, federal data show. 
The findings on graduate schools are particularly noteworthy because the government offers little information on the loan performance of grad students, who account for about 14% of students at universities but nearly 40% of the $1.4 trillion in outstanding student debt.

Now, a 25-year-old with massive student debt probably doesn’t qualify for a mortgage. But they might be able to get a car loan, which partially explains why auto loans are rising right along with student loans. A car is necessary to get to work, and borrowing is the only way to get a car if a big piece of your income is going towards student loan interest.

So that’s our world: Stocks, bonds and real estate – long since acquired by baby boomers who graduated college with minimal student debt and therefore had the cash flow to invest – are way up, making us the richest generation ever. Meanwhile our kids and grandkids are going ever deeper in debt with no apparent way out.

Of course there is an eventual way out: Someday they’ll inherit our manipulated wealth. But in the meantime their inability to cover our Social Security and Medicare is forcing the government to pick up the slack with trillion-dollar deficits as far as the eye can see, more or less offsetting the value of our estates.

The only real solution? A massive devaluation that shifts resources away from owners of financial assets like bonds and towards debtors who get to discharge their loans with cheaper currency. All roads, in short, lead to currency crisis — and soaring gold and silver.

State of Inflationary Confusion

“Nobody knows anything.... Not one person in the entire motion picture field knows for a certainty what’s going to work. Every time out it’s a guess and, if you’re lucky, an educated one.”

– William Goldman, Oscar-winning screenwriter
On the surface, the film industry and central banking have little in common. Each does its own thing with little regard for the other. But in fact, they’re more alike than either cares to acknowledge.

Film executives must analyze the vast, constantly shifting data surrounding public preferences, make long-term financial commitments that aren’t easy to reverse, and then live with the consequences. Central bankers must do the same. Hollywood execs dress more fashionably, but otherwise they have a lot in common with Fed governors.

There’s one big difference, though: Hollywood’s financial mistakes hurt mainly Hollywood, but the Fed’s mistakes hurt almost everyone. Hollywood executives have their own skin in the game. They live with the financial consequences of their decisions. The members of the Federal Open Market Committee not only have no skin in the game; if something goes wrong, they will blame capitalism and free markets and thereby relieve themselves of the consequences of their own decisions and manipulations. And then they will go on manipulating the markets to far more applause than they deserve, in the attempt to clean up the consequences of their own mistakes.

Let’s be clear. The financial crisis of 2007–08 was the result of Federal Reserve errors and the regulatory failures of government agencies.

When William Goldman wrote, “Not one person in the entire motion picture field knows for a certainty what’s going to work,” he could just as easily have been talking about monetary policy. Nobody really knows what’s going to work, for the reasons we covered last week in “Data-Dependent on Imaginary Data.”

However, if we ask who makes more blockbusters while operating on flawed and limited information, Hollywood wins easily. It has the occasional Gigli or Heaven’s Gate, but the Fed remakes Ishtar every few years and thinks everything is fine.

Today we’ll extend last week’s discussion by considering how twisted inflation data leads to less-than-ideal policies. But first, let me again suggest that you get a Virtual Pass to my upcoming Strategic Investment Conference. We’ve added several new features this year.

• (New) 20+ hours of video recordings: Fine-tune your portfolio for 2018 and beyond with the help of 20+ hours of video recordings from the SIC. The video recordings of each session will be uploaded to the buyers-only website within 24 hours after the event.

• (New) Live video stream from SIC 2018: For the first time ever, you can watch the 20+ hours of presentations and panels LIVE from the conference.

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• Transcripts: You will also get transcripts of all presentations and panels taking place. With the transcripts, you can quickly find the key points you are looking for in a presentation.

I wish you could all join us in San Diego March 6–9; but if you can’t, the Virtual Pass will give you some of the same valuable (and fun!) experience. Click here to learn more.
No One Is Average
In the US we have two different inflation measures, produced by agencies of two different cabinet departments. The Federal Reserve prefers to look at the Commerce Department’s Personal Consumption Expenditures (PCE) Index, because they believe it is more comprehensive and nuanced than the Labor Department’s Consumer Price Index (CPI).
Are they right? In a moment I will talk about the differences, which are important; but I think the Fed is exactly backwards here. Neither measure is particularly foolproof, but the flexibility and adjustments that make the Fed prefer PCE also take the index further from reflecting the average citizen’s economic condition. This bias shows up in Fed policy, and not in a good way.
That doesn’t mean the CPI is wonderful, though. Unlike some, I don’t believe it is intentionally manipulated. I think the wonks (and I say that in a complimentary way, as a fellow wonk) who compile price data do a nearly impossible job as well as anyone can.
Browse through the methodological explanations on the CPI home page and you’ll quickly see how much effort goes into that work. They have a whole “data available” shopping list:

• Price indexes are available for the US, the four Census regions, nine Census divisions, two size of city classes, eight cross-classifications of regions and size-classes, and for 23 local areas. Indexes are available for major groups of consumer expenditures (food and beverages, housing, apparel, transportation, medical care, recreation, education and communications, and other goods and services), for items within each group, and for special categories, such as services.

• Monthly indexes are available for the US, the four Census regions, and some local areas. [You can see those indexes here.]  

• More detailed item indexes are available for the US than for regions and local areas.

• Indexes are available for two population groups: a CPI for All Urban Consumers (CPI-U) which covers approximately 94 percent of the total population and a CPI for Urban Wage Earners and Clerical Workers (CPI-W) which covers 28 percent of the population.

• Some series, such as the US City Average All items index, begin as early as 1913.

All that data gets worked into “baskets” that try to match the spending habits of typical consumers. That’s where the effort starts going wrong. The problem is quite simple and beyond anyone’s control: None of us are average.

We all spend our money differently, for an endless variety of reasons that change all the time. When you say inflation is higher than CPI shows while your neighbor says inflation is no big deal, you can both be right. Worse, even someone with spending patterns identical to yours can experience an entirely different inflation rate simply because they live in a different city or state. Or they choose to send their kids to a more expensive school. Or they spend a larger amount on health care and less on goods but more on services. It can get quite nuanced.

Reducing this complexity to one number and then using that number to guide monetary policy is asking for trouble. And trouble is what we get.
Hedonic Guesswork
CPI isn’t entirely useless. It can show us broad price trends over long periods. Those trends can reveal some things, as shown in this 20-year American Enterprise Institute chart that’s making the rounds this month.
What jumps out to me is that the highest inflation is in the goods and services over which people have the least discretion. This is particularly burdensome to lower-income Americans. The disinflation that so vexes the Fed impacts more optional purchases. Here’s how my friend Barry Ritholtz describes the pattern:

It is notable that the two big outliers to the upside are health care (hospital, medical care, prescription drugs) and college (tuition, textbooks, etc.).

Clothes, cars, TVs, cell phones, software – technology in general – showed disinflation or outright deflation in prices. (Housing and food & beverage have been right at the middle of inflation levels.)

Wages have barely ticked over the median inflation measure, but that did not stop some people from blaming the correction on rising wages.

Reading the pundits, I cannot tell which fate awaits us: the robot-driven apocalypse where we are all out of work, or the inevitable spike in wages that sends rates much higher and kills the market. Perhaps both – higher wages sends employers into the waiting arms of our automated future.
You can quibble with this data. Have TV prices really fallen 99%? No, unless you hedonically adjust, because today we can buy TVs of a quality that didn’t exist in 1997. If you use hedonic prices, adjusting for quality and technological sophistication, then you can argue that the price of TVs is down 99%. But we all know that we are paying less for TVs.
Same for other technology goods. But you simply cannot argue that we are paying the same now for new vehicles as we did 20 years ago, even though the cars we buy today are technologically vastly superior to what we could buy back then. These hedonic price adjustments are guesswork.

Still, the broader point seems right. Inflation is a real problem for some people and no big deal for others, yet the Fed uses inflation measures to impose a single monetary policy on everyone. Is it any wonder that policy doesn’t work for many of us?
PCE Versus CPI

The Federal Reserve prefers to use core PCE rather than core CPI. The Cleveland Fed has a very good basic explanation of the differences between the two indexes. A glance at their charts, below, will show that core PCE (Personal Consumption Expenditures) is significantly lower than core CPI (Consumer Price Index). After the charts, I will quote a few paragraphs from the Cleveland Fed.
What accounts for the difference between the two measures? Both indexes calculate the price level by pricing a basket of goods. If the price of the basket goes up, the price index goes up. But the baskets aren’t the same, and it turns out that the biggest differences between the CPI and PCE arise from the differences in their baskets.

The first difference is sometimes called the weight effect. In calculating an index number, which is a sort of average, some prices get a heavier weight than others. People spend more on some items than others, so they are a larger part of the basket and thus get more weight in the index. For example, spending is affected more if the price of gasoline rises than if the price of limes goes up. The two indexes have different estimates of the appropriate basket.
The CPI is based on a survey of what households are buying; the PCE is based on surveys of what businesses are selling.

Another aspect of the baskets that leads to differences is referred to as coverage or scope. The CPI only covers out-of-pocket expenditures on goods and services purchased. It excludes other expenditures that are not paid for directly, for example, medical care paid for by employer-provided insurance, Medicare, and Medicaid. These are, however, included in the PCE.

Finally, the indexes differ in how they account for changes in the basket. This is referred to as the formula effect, because the indexes themselves are calculated using different formulae. The details can get quite complicated, but the gist of the matter is that the PCE tries to account for substitution between goods when one good gets more expensive. Thus, if the price of bread goes up, people buy less bread; and the PCE uses a new basket of goods that accounts for people buying less bread. The CPI uses the same basket as before (again, roughly – the details get complicated).

Now, in conversations with my friend and fellow wonk Peter Boockvar, he has pointed out other, more nuanced differences. The inclusion of government-priced medical care, such as Medicare, where the government manipulates what they will pay, significantly reduces the healthcare inflation of the PCE. And as noted above, the PCE assumes that if the price of something – beef, for instance – goes up, consumers will buy less beef and more chicken, which is cheaper.

You can make the argument that the PCE is biased toward returning lower inflation numbers, but that tendency is almost beside the point. The technical differences between the two indexes make for extraordinarily economically dense discussions, and I’m sure the issues are debated heatedly at certain conferences that focus on such things, but both measures are honest attempts to understand what inflation is and how it affects us. Neither index necessarily reflects the inflation that you are personally experiencing, or the inflation of your particular area or region. And similar differences pertain in every country of the world.

But in most countries, inflation affects the bottom 50% more than it does the top 50% by income. Because there are certain necessities of life that must be purchased, and because many of those goods and services (such as housing, and health care) have higher than average inflation, the bottom half suffers a much higher inflation rate than the overall national average.

And yet, a national inflation policy geared to the lower 50% would aggressively skew monetary policy in a negative fashion.

Sidebar: PCE and CPI use different measures and percentages for housing costs. CPI uses something called Owner’s Equivalent Rent, which is a hypothetical number based on certain assumptions. Here’s a thought project. At one time the US used actual house prices to measure inflation, as Europe does today. If we had been using actual house prices during the period 2000 to 2008, the Fed would have been raising rates aggressively, trying to lean into the inflation caused by the increase in house prices, thereby likely avoiding the housing bubble but creating a recession earlier than 2008, for entirely different reasons.

Tell me again why 12 people sitting around a table should set interest rates based on data they don’t understand, in a market that is way too complex? More loans are based on LIBOR than anything else. And we trust a rather complicated market process, which can somewhat be manipulated, to set the price of LIBOR. Manipulating interest rates in the broader market would be far more difficult and would lead to interest rates that are more reflective of what is going on in the marketplace. Just saying…
Disinflation Fixation
In theory, we want “price stability,” which would mean the absence of either inflation or deflation. When Greenspan was asked, when he was chairman of the Fed, what is meant by price stability, he answered “Zero.” None of this 2% inflation target. “Price stability” is the obsession of central bankers everywhere, and in some places is their legal mandate. They currently like having just a little inflation but not too much. The Fed wants 2% and can’t even deliver that, if you define inflation by CPI or PCE. People think that 2% coming. Maybe so.

However, maybe we should all think about this issue differently. Last week I ran across a December 2017 Project Syndicate article by good friend William White, formerly Bank of International Settlements chief economist and now with the OECD.
Bill is my favorite central banker in the world. (The full article is well worth reading.)

White says central banks rightly responded to 1970s inflation by clamping down hard, but then failed to adjust when conditions changed. That oversight led directly to some of today’s problems.
From the late 1980s onward, low inflation was largely due to positive supply-side shocks – such as the Baby Boomer-fueled expansion of the labor force and the integration of many emerging countries into the global trading system.
These forces boosted growth while lowering inflation. And monetary policy, far from restricting demand, was generally focused on preventing below-target inflation.

As we now know, that led to a period of easy monetary conditions, which, together with financial deregulation and technological developments, sowed the seeds of the 2007 financial crisis and the ensuing recession. The fundamental analytical error then – as it still is today – was a failure to distinguish between alternative sources of disinflation.

The end of the Great Moderation should have disabused policymakers of their belief that low inflation guarantees future economic stability. If anything, the opposite has been true. Having doubled down on their inflation targets, central banks have had to rely on an unprecedented array of untested policy instruments to achieve their goals.

The fixation on keeping inflation low, according to White, has driven up global debt ratios, squeezed lender margins, and forced lending activity into an opaque shadow banking sector. All these effects raise systemic risks that will probably bite us eventually.
Here’s Bill again.
These developments constitute a threat not just to financial stability, but also to the workings of the real economy. Moreover, one could argue that easy money itself has contributed to the unexpectedly strong disinflationary forces seen in recent years. Owing to easy financing and regulatory forbearance, aggregate supply has risen as “zombie” companies have proliferated. Meanwhile, aggregate demand has been restrained by the debt headwinds – yet another result of easy monetary conditions.
This insight isn’t intuitive to many economists. Easy credit – as the Fed gave us for the last decade – should raise inflation, not reduce it. Bill says no; it allows zombie companies to survive and overproduce, while putting consumers in so much debt that their spending gets constrained. So it pushes inflation down instead of up.

Wrap your head around that thought. It answers some riddles that otherwise make little sense. But it also highlights the difficulty of formulating sane policy. Yes, it’s important to let zombie companies die. Creative destruction and all that. But real people work for the zombies, earning real money that lets them buy goods and services and keep the economy moving. So what do you do? None of the choices are painless.

Too often, we simply redistribute the pain to those least able to bear it, who are understandably unhappy – hence the present social and political tensions. They all trace back to economics.

Is data boring? Yes. It’s often wrong and misleading, too. But ignoring it to fly by the seat of our pants isn’t the right response, either. We need much better understanding and application of all these numbers, and I see very few economists trying to deliver either. That’s the core problem.

I am getting close to going on too long here, so the prescription for what we should be doing will come in future letters. Suffice it to say that using data that is fundamentally flawed as a “guide” to monetary policy creates the rather strange outcomes that we see. I get extraordinarily angry when central banks and big government proponents argue that it is capitalism and free markets, rather than manipulation and inappropriate regulation, that are the problem. The monetary policymakers never see themselves as the problem. This blind spot is just a corollary to one of my favorite Paul Simon quotes: “A man hears what he wants to hear and disregards the rest.”
Dallas, SIC, and San Diego

This last week was rather exhausting, with late planes and long flights. But I am now back in Dallas and think I will take a little time to relax before plunging into the week on Monday morning. With the exception of speeches and business all day Tuesday, my focus will be on the final plans and my topics for the Strategic Investment Conference in San Diego March 6–9. The conference will be well attended, and as usual almost half of the attendees have been to more than a few SIC conferences, so I will be among old friends. I will spend much of the week talking with the speakers and getting a sense of what they will say, so that I can make sure that I have everything and every topic in its proper order. I must say, what I have heard so far has shown me a surprise here and there, as it seems many are expecting changes and adapting their own businesses and outlooks. If nothing else, it promises to be a week of revelation.

I know my editors are working to pare back my letter, as we are trying to keep it shorter, so I’m going to help them this week by limiting my personal comments to wishing you a great week and hoping that you will find time to be with friends and family.

Your ready for a little rest analyst,

John Mauldin

Tales from the crypto-nation

A banking centre seeks to reinvent itself

Switzerland embraces digital currencies and crypto-entrepreneurs

ON A clear day, sunset over Lake Zug is magnificent. Snow-dusted mountains cut through the orange glow above and are mirrored in the lake below. “Zug is our spiritual home,” says Jeremy Epstein, from Washington, DC, who has just taken 40 foreigners to tour the small Swiss town south of Zurich. They came not for sunsets, though, but to find out how Zug has become known as “crypto-valley”—meaning the home of many firms dealing in crypto-currencies and related activities.

Switzerland’s famous banking secrecy is falling to a global assault on money-laundering and tax evasion. But financial security remains in demand. The country should seek to become the “crypto-nation”, said the economy minister, Johann Schneider-Ammann, last month. Zug aims to be the capital of that nation.

To that end, Switzerland is maintaining loose rules for crypto-businesses, even as other countries are tightening theirs. An industry is developing to store tangible crypto-assets, such as the hard drives on which cryptographic keys are stored, offline in cold, dry, secret sites complete with rapid-response teams. Where better than a decommissioned military bunker in the Swiss Alps? In Zug, friendliness to crypto-currencies is in evidence all around. “Bitcoin accepted here” stickers adorn the city hall and several shops, including the wine merchant’s. In 2016 Zug became the first place in the world to accept bitcoin for some public services. Residents can get a blockchain-based digital identity.

About a quarter of last year’s global total of $5bn in initial coin offerings (ICOs, a form of crowdfunding whereby investors are issued with digital tokens) was raised in Switzerland, estimates PwC, a consultancy. Of the ten largest ICOs, four were in part based in Zug.

The town decided early on to attract crypto-entrepreneurs, for example by allowing companies to incorporate based on bitcoin wealth, rather than insisting that it be converted into fiat currency. Taxes have long been low. After the second world war the former fishing village cut its corporate-tax rate to 8.5%. The rate is still competitive, at 14.6% compared with Zurich’s 21%.

Snowball effect

The crypto-chapter of Zug’s history began in earnest in 2013 when the Ethereum Foundation, a non-profit to support the development of the eponymous blockchain, based itself there. More crypto-firms followed. Now, having dealt with 150-odd of them, the local tax authorities are experts, as are the accountants and lawyers.

Two years ago Lakeside Partners, which runs a business centre in Zug, housed just five blockchain-related companies, of a total of 30. Now the number is 70 out of 90. “They landed like flying saucers,” says the mayor, Dolfi Mueller. At first he was unsure that the invaders would benefit the town, but “curiosity and being open to the world have brought us much wealth in the past.”

Switzerland’s decentralised government, direct democracy and history of libertarianism are all essential to Zug’s success. These contrast with rival hubs such as Hong Kong and Singapore, and appeal to fans of blockchain technology, which underlies most crypto-currencies and is essentially a distributed ledger maintained collectively by some users. There are practical benefits for crypto-entrepreneurs, too. The federal government takes a light approach to regulation in general, and to new technologies in particular. Cantons have wide latitude in how they deal with companies. A fintech licence, expected to become available next year, should make life even easier for fintech startups.

A final draw is a reputation for security and safety—including from governments. “You can have all the armoured walls in the world, but if your vault is in China or Singapore and the government says, ‘I’m seizing your assets’, there’s nothing you can do,” says Niklas Nikolajsen of Bitcoin Suisse, a financial-services provider. “That would never happen in Switzerland.”

Regulators elsewhere see it as their job to protect consumers from dubious new crypto-currencies. But Switzerland’s take a more bracing approach. “Our consumers should have the freedom to invest in exotic instruments, even gamble,” says one official. Jörg Gasser, the state secretary for international finance, has little doubt that, if and when the bitcoin bubble bursts, investors will ask for regulation. But, he says, the sector must not be regulated to death.

That does not mean anything goes. His priority, says Mr Gasser, is to protect the integrity of Switzerland as a financial centre. The national regulator, FINMA, is investigating several ICOs for possible breaches of regulations, including anti-money laundering rules. On February 16th it issued guidance on how it would apply existing market legislation, and warned that some tokens would be treated as securities and have to follow stricter rules. A working group has been assembled to look at which rules, if any, ought to apply to ICOs. The aim is to increase legal certainty and ensure that, in the words of a press release from the State Secretariat for International Finance, a government department, “Switzerland remains an attractive location in this area.”

Crypto-entrepreneurs took the measured tone as indicating that Switzerland is still keen on their business. Indeed, as the sector matures, places that offer some regulatory protection or licensing should benefit, says Joey Garcia, a lawyer at Isolas LLP, who has just helped develop a licensing system in Gibraltar, a rival crypto-centre.

While crypto-companies are growing, physical hubs with well-crafted rules and a critical mass will continue to seem attractive. But crypto-currencies’ intrinsically decentralised nature means that eventually the benefits of being part of a cluster may weaken. Unless Zug continues to court them, only the vaults carved into the Swiss granite will stand the test of time.