Up and Down Wall Street

The Greatest Investment Bubble

By Randall W. Forsyth

    Photo: Getty Images 

If 2017 was the year of the bubble, 2018 stands a good chance of being the year when one or more bursts.

“That we are having a major speculative splurge as this is written is obvious to anyone not captured by vacuous optimism,” wrote John Kenneth Galbraith, who was a far better historian and writer than economist. He penned this for the introduction to the 1997 edition of The Great Crash 1929, early on in the irrational exuberance that would build into the dot-com bubble. But his description is equally apt for manias past and present:

“There is here a basic and recurrent process. It comes with rising prices, whether of stocks, real estate, works of art, or anything else. This increase attracts attention and buyers, which produces the further effect of even higher prices. Expectations are thus justified by the very action that sends prices up. The process continues; optimism with its market effect is the order of the day. Prices go up even more.”

The description written two decades ago by Galbraith seems as fresh as ever, with the incomparable and incomprehensible price action of Bitcoin—which soared 40% in a matter of 40 hours last week, according to The Wall Street Journal. While Coinbase, which allows individuals to participate in the frenzy, has become the most downloaded app on Apple’s iTunes, according to Recode, Bitcoin also was giving erstwhile Wall Street types the kind of volatility squeezed out of the modern stock, bond, commodity, and currency markets, as Barron’s cover story last week reported (“Bitcoin Storms Wall Street,” Dec. 2). The real fun should begin when Bitcoin futures trading begins Sunday evening.

That it ends is inevitable, and inevitably violent. “The descent is always more sudden than the increase; a balloon that has been punctured does not deflate in an orderly way,” Galbraith further wrote. “The phenomenon has manifested itself many times since 1637, when Dutch speculators saw tulip bulbs as their magic road to wealth,” he noted, adding that he wasn’t making a prediction. Neither is one offered here.

Galbraith posited 20 years ago that a bad stock market slump would take its toll on Americans’ spending, especially on big-ticket durable items, and “put pressure on their very large credit-card debt.” There was a relatively mild recession after the bursting of the dot-com bubble, but nothing like what he feared. He did not, however, live to see the housing bubble and the devastating effects of its bust, which actually did bring down the net worth of U.S. households, given many more of them had their wealth in their homes than in the stock market.

The $255 billion market capitalization of Bitcoin (as of Friday—it surely will be different by the time you read this) tops that of all but the biggest stocks of the Standard & Poor’s 500 index. The comparison of the cryptocurrency with equities was taken to a new extreme by one true believer who wrote that the value of JPMorgan Chase (ticker: JPM) had declined 89% this year, in Bitcoin terms. It is all a scheme of wealth redistribution, he asserted, to the enlightened believers of the new order from the old wealth, exemplified by JPMorgan Chief Executive Jamie Dimon, who famously declared Bitcoin a “fraud.”

But the size of Bitcoin pales against what really is the biggest bubble in the world. That would be the trillions of dollars worth of bonds with negative yields, contends David Rolley, co-team leader of the global fixed-income and emerging-debt group at Loomis Sayles.

According to JPMorgan’s latest tally, there is some $10.1 trillion in global government bonds with yields below zero—or 40 times as much as Bitcoin. That is down from the peak of $12.7 trillion reached in July 2016 in the wake of the market panic following the Brexit vote.

Of course, this isn’t the product of wild-eyed speculators’ relentless chase of a market’s accelerating ascent, but the result of sober central bankers’ monetary policies. The European Central Bank has been buying 60 billion euros’ ($70.6 billion) of bonds per month. The Bank of Japan, meanwhile, is acquiring Japanese government bonds in sufficient quantity to keep its 10-year yield pegged near zero percent.

In addition, JPMorgan also notes, euro-denominated corporate bonds total €847 billion, equal to 40% of the sector, a reflection of ECB buying. Among the bonds the ECB has snapped up are securities of Steinhoff International Holdings (SNH.Germany), which last week delayed its financial results and was investigating “accounting irregularities,” resulting in a 60% one-day drop in its shares.

The real effect of the negative bond yields has been to exert a downward gravitational pull on interest rates everywhere, even in places where they never fell below zero, as in the U.S. dollar market. Clearly, however, a security that guarantees a loss (if held to maturity) can’t be rationally priced. Only if its yield falls further, and its price rises, does it make sense. That’s what makes it a bubble.

So far, the bubble remains inflated. But things are due to change in the new year. The Federal Reserve has just begun to reduce its balance sheet, which more than quadrupled to more than $4 trillion from its multiple rounds of quantitative easing following the financial crisis. And the ECB has announced that it will trim its bond purchases, starting next year.

Peter Boockvar, chief market analyst at the Lindsey Group, estimates the Fed’s shrinkage of its balance sheet and the ECB’s tapered buying will mean $1 trillion less flowing into capital markets next year.

“I am completely amazed at the nonchalance with monetary policy, and some do not even mention it as a risk factor,” he writes in a client note, after listening to sell-side prognosticators’ 2018 market predictions. “Let me know if you’ve seen one forecast that includes a lower P/E multiple due to $1 trillion of liquidity that is being removed by the Fed and the ECB alone in 2018 on top of more Fed rate hikes. I haven’t seen many.”

That also should include the impact of subzero bond yields climbing into positive territory, which would result in price declines. Maybe the impact will be gentle and confined to central banks’ portfolios. Or maybe the biggest bubble won’t deflate gently.

THE SPECTER OF REDUCED LIQUIDITY has failed to keep U.S. stocks from scaling ever-higher peaks. Part of the reason is that there has been an actual easing in financial conditions, despite two Fed rate hikes this year and the near certainty of a third being announced Wednesday at the conclusion of Janet Yellen’s final Federal Open Market Committee meeting.

The easier financial conditions—which reflect a softer dollar, tighter credit spreads, and higher securities prices—recall the period of 2004-06, writes Albert Edwards, head of the global strategy team at Société Générale. The “measured” pace of predictable, quarter-point rate increases at each FOMC meeting allowed the inflating of the mortgage and housing bubble, with its disastrous consequences. Now, in contrast, Edwards argues, “the Fed’s desire to soothe the nerves of the financial markets has made a mockery of their tightening cycle.”

Fed officials have stuck to their go-slow policy owing to inflation consistently falling short of their 2% target. And despite a relatively robust labor market, wage gains continue to be meager. The November numbers released Friday continued that trend. Nonfarm payrolls increased by 228,000, a bit better than the consensus forecast of 195,000, as the effects of the hurricanes in the September numbers continue to be reversed. Average hourly earnings were up only 2.5% from the level a year earlier, barely ahead of a 2% rise in the consumer price index in the 12 months to October.

In 2018, the Federal Reserve may have to face two less-benign aspects of its dual mandate for price stability and full employment. According to the New York Fed’s Underlying Inflation Gauge, which seeks to flag trends in the CPI, prices are rising at closer to a 3% annual rate. If those pressures start to show up in the Fed’s favored gauge—the personal-consumption deflator, which has climbed just 1.6%, year-on-year—the pace of rate hikes could speed up, something the financial markets don’t expect.

Meanwhile, the seeming paradox of meager wage gains with full employment may be explained, at least in part, by demographics. The San Francisco Fed notes that workers who re-enter the workforce typically do so at lower pay than existing employees, especially compared with retiring baby boomers. How much this “silver tsunami” is tilting wages is a question mark for the Fed, which will be led by Jerome Powell, a lawyer, rather than an economist, by training.

To be sure, any number of so-called black swans could rock markets out of their low-volatility serenity. BCA Research lists five such serious but unlikely events. No. 1, in their view, is that President Donald Trump’s low poll numbers could cause him to seek “relevance” abroad, perhaps with a trade war with China or a confrontation with Iran. North Korea is too visible to be a black swan, but a coup in Pyongyang would qualify.

Another outlier would be a regime change in the U.K., with Labour, led by Jeremy Corbyn, producing a lurch to the left. Italy, however, is a “black swan hiding in plain sight,” with elections next year potentially unsettling complacency in the markets, as evidenced by its low bond yields. Finally, BCA sees a chance for sharp setbacks in Latin American markets, owing to both politics and the potential for a credit contraction induced by China. SocGen’s Edwards points out that China’s monetary policy already is tightening.

In all, lots to worry about in 2018, which doesn’t get mentioned much in the upbeat forecasts that predominate at this time of year.

The Coming Conflict Between China and Japan

By Jacob L. Shapiro

It is easy to forget that as recently as the 19th century, China and Japan were provincial backwaters.

So self-absorbed and technologically primitive were East Asia’s great powers that German philosopher Georg Wilhelm Friedrich Hegel said, “The extensive tract of eastern Asia is severed from the process of general historical development.” His description seems laughable today. China and Japan are now the second- and third-largest economies in the world. Japan’s failed quest for regional domination during World War II and its subsequent economic reconstruction profoundly affected the world. China’s unification under communism and its pursuit of regional power in the past decade have been no less significant.

And yet, for all the strength and wealth Beijing and Tokyo accumulated, since 1800 neither has been powerful enough to claim dominance of the region. Since European and American steamships discovered their technological superiority relative to the local ships in the first half of the 19th century, Chinese and Japanese development has proceeded at the mercy of outside powers. Japan tried to break out, and came close to breaking out during World War II, but was ultimately thwarted by the United States. China, already anointed by many as the world’s great superpower, remains a country divided. The lavish wealth found in its coastal regions is noticeably, if not entirely, absent from the interior.

Japanese Prime Minister Shinzo Abe (L) shakes hands with Chinese President Xi Jinping before the G-20 leaders’ family photo in Hangzhou on Sept. 4, 2016. GREG BAKER/AFP/Getty Images

This state of affairs is beginning to change – and the U.S.-North Korea stand-off over Pyongyang’s pursuit of deliverable nuclear weapons shows just how much. The United States does not want North Korea – a poor, totalitarian state of roughly 25 million malnourished and isolated people – to acquire nuclear weapons capable of striking the U.S. mainland. The U.S. has threatened North Korea with all manner of retribution if Pyongyang continues its pursuit of these weapons, and yet North Korea remains undaunted. It is doing this not because Kim Jong Un is crazy. It is doing this because it figures it will be left standing, come what may.

It may not be such a bad wager. From Kim’s point of view, there are only two ways to get North Korea to halt its development of nuclear missiles: The U.S. either destroys the regime or convinces it that continued tests would call into question its very survival. (For that to work, the regime would have to believe it could be destroyed.)

The U.S. can rail all it wants in the U.N.; it will fall on deaf ears. The U.S. can try to assassinate Kim Jong Un; someone else will take his place. The U.S. can forbid China from fueling North Korea; the North Koreans don’t use that much fuel anyway, and they have already demonstrated they will sacrifice much to defend their country.

One Step Closer

But can the U.S. take out the Kim regime, or at least make Pyongyang think it can? It’s hard to say.

There are only two ways to take out the regime. The first – using the United States’ own vast nuclear arsenal – would set a precedent on the use of weapons of mass destruction that Washington would rather not. The second – a full-scale invasion and occupation of North Korea – would strain even U.S. capabilities and wouldn’t have the desired outcome. The U.S. might be able to defeat the North Koreans in the field, but as Vietnam and the Iraq War showed, defeating the enemy in battle is not the same thing as achieving victory. And there is, of course, the question of China, which came to Pyongyang’s aid in 1950, the last time the U.S. fought on the Korean Peninsula, and might well again if the U.S. struck North Korea pre-emptively with massive force.

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Limited military strikes are another possibility. Politically attractive though they may be, they can only delay, not destroy, North Korea’s nuclear program. And they would surely enhance Pyongyang’s credibility. Every U.S. attack that doesn’t succeed in knocking out the political leadership would be used as propaganda, spun in the North Korean countryside as a victory against the “gangster-like U.S. imperialists.”

Thus is the extent, and limit, of American power. Around the world, the U.S. has been struggling to execute a foreign policy that does not rely on direct U.S. intervention. This is easier said than done, especially when the issue at stake is nuclear war. Analysts like me can scream until we are blue in the face that North Korea would never use its nuclear weapons because doing so would invite its own demise. But we are not the ones making the decision. We don’t bear the burden of being wrong.

That is the brilliance behind North Korea’s strategy. The goal is to prod the U.S. to react to its behavior – and then to use its reactions to shore up support. And the strategy is working. The U.S. has said time and again that it will not allow North Korea to have a nuclear weapon. If North Korea gets a nuclear weapon, then what good is a U.S. security guarantee? If the U.S. attacks North Korea without destroying the Kim regime – and I believe it can’t – then North Korea can say it defeated the imperialists as it continues to pursue its current strategy. If the U.S. agrees to remove its forces from South Korea in exchange for North Korea’s halting its testing, then North Korea is one step closer to its ultimate goal: unifying the Korean Peninsula under Pyongyang’s rule.

Doing, Not Saying

In every scenario, the conclusion is the same: The United States alone cannot dictate terms in East Asia. It cannot bring North Korea to heel. It cannot make China do what China does not want to do. It cannot even persuade its ally, South Korea, to pretend that a pre-emptive military option is on the table. Japan looks at all the things the U.S. cannot do, and for the first time since 1945 it must ask itself a question that leads to a dark place: What does Japanese policy look like if Tokyo cannot rely on U.S. security guarantees?

The North Korea crisis may not have created Washington’s predicament, but it exposed it in ways previously unseen, to China’s benefit. The U.S. has shed blood and spent untold sums of money forging an alliance network in East Asia to prevent any country there from challenging its power. And so it is the region’s great power, China, not North Korea, that is putting U.S. strategy to the test. Already an economic behemoth, China is rapidly developing its military capabilities. Its newly declared dictator-president, Xi Jinping, intends to preside over a massive transformation of the Chinese economy that, if successful, would make China more self-reliant and politically stable than at any point in the past four centuries. China still has a long way to go – too long before it first loses its political stability, in our estimation – but in the short term, China’s power is growing. Chinese adventurism in the South and East China seas, its strategic investments around Asia, and the continued development of its navy all validate its growing power.

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Its ascendance will inevitably bring China into conflict with Japan. Such conflict is nothing new – these civilizations have fought their fair share of wars. The brutality of the Japanese invasion of China in the 20th century – an invasion for which Korea was a staging ground – still lingers fresh in the memories of the Chinese and Korean people. But the conditions for conflict are different this time. For one thing, China and Japan are both powerful. In the early 20th century, Japan discovered the difficulties that many of China’s would-be conquerors did when it attempted to take over the Middle Kingdom, but Japan was still by far the superior power.

It’s hard to say which is stronger today. China has a greater population, but Japan is more stable and boasts better military and technical capabilities. This has the makings of a balanced rivalry.

China and Japan, moreover, are no longer worried about being subjugated. This may seem an obvious observation, but in fact it is the first time since the Industrial Revolution that both countries have been able to call their own shots. They came close a few times, of course. Japan nearly came to dominate the Pacific but was eventually subdued by the United States. China wanted to conquer Taiwan in a bid for complete unification, but the arrival of the U.S. 7th Fleet to the Taiwan Strait dashed the government’s hopes.

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Now, the first signs of the coming Sino-Japanese competition for Asia are reaching the surface.

Ignore the things Japanese Prime Minister Shinzo Abe and Xi Jinping have said to each other recently – their statements seek to obscure reality, not uncover it. Look instead at what they are doing. China is investing significant financial and political capital in the Philippines in an attempt to lure Manila away from the U.S. Japan is there with military aid and support, as well as economic incentives of its own. China sees strategic potential in cultivating a relationship with Myanmar, and Japan is there too, with promises of aid and investment without the kinds of strings China often attaches. Much has been made in the mainstream media about China’s One Belt, One Road initiative, a testament to Beijing’s excellent PR skills. Less time has been spent examining Japan’s counters – resuscitating the Trans-Pacific Partnership, pledging to invest more than $200 billion in African and Asian countries, and announcing various initiatives involving the Asian Development Bank, the Japan International Cooperation Agency and the Japan Infrastructure Initiative. China has bullied other powers out of the South China Sea, but Japan won’t be bullied out of the East China Sea.

Meanwhile, Japan advocates the Quadrilateral Security Dialogue – a grouping of the U.S., Japan, India and Australia – to keep China’s power confined to its traditional terrestrial domain.

The conflict will develop slowly. Its contours are just now taking shape. The United States won’t simply disappear from Asia entirely – Washington still has an important role to play, and how it manages the North Korea crisis will go a long way in defining the long-term regional balance of power. But over the next few years, the U.S. will begin to reach the limits of its powers, and as it does, it will pursue a new strategy that employs skillful manipulation of relationships instead of brute force. It will find that China and Japan are no longer severed from world history but shaping history on their own terms.

Fears over debt load take shine off tax reform

Problems of wealth inequality could put a brake on growth

Sam Fleming in Washington

The Republicans are proposing a system under which the US would generally not tax profits of US companies earned in any foreign country © Bloomberg

Even as US stocks roared higher on Monday in response to the passage of the Senate tax bill many analysts were expressing deep scepticism about the notion that the overhaul will transform an economy that is already running close to full employment.

Kent Smetters, a former Bush administration official who oversees the Penn Wharton Budget Model, said he expects at most a 0.1 percentage point uplift to annual growth rates over the course of 10 years as a result of the legislation. The long-run impact on trend growth will be negligible, he added, as the extra debt amassed as a result of lost revenue weighs on the economy. “It is not a significant boost,” he said.

Politically there is no doubt that the passage of the package comes at a highly opportune moment. The US has seen two successive readings of annual GDP growth running at 3 per cent or more, and the Atlanta Fed’s model points to 3.5 per cent growth for the final quarter of the year.

Assuming the legislation goes through, it will effectively put Republicans in a position to adopt the recovery as their own, pointing to their tax changes as fuel for the continued growth and potentially boosting their prospects in 2018’s midterm elections. Kevin Hassett, the chairman of the Council of Economic Advisers, told the FT before the Senate deal went through that significant tax reform would mean “at the very least the odds of sustaining growth at the 3 per cent level go up enormously”.

But the GOP will also have to take responsibility for widening deficits, with the Committee for a Responsible Federal Budget projecting that tax and spending legislation currently on the agenda could propel the US back to trillion-dollar deficits as soon as 2019. And the package arguably leaves unaddressed longer-term economic challenges alongside rising public debt, including higher inequality, poor educational outcomes, and slowing labour force growth.

The House and Senate now face the difficult task of reconciling their two versions of the legislation, as they dash to get a bill on the president’s desk by the end of the year. But the increasing likelihood of the tax bill’s becoming law is prompting analysts to boost their growth forecasts for the very short term.

Alec Phillips, a Goldman Sachs analyst, said the tax revenue reduction is worth around 0.6pc of gross domestic product in 2018 and 1.1pc of GDP in 2019. Looking at how much of this is actually going to be spent, and therefore turns up in extra GDP, it translates into a 0.3 percentage point boost to 2018 GDP and a 0.3 percentage point uplift to 2019 GDP, he said. “After that the size of the tax cut flattens off and starts to decline somewhat, so we don’t estimate any additional uplift to GDP in 2020.”

The main benefits being touted by the White House stem from reduced individual tax rates and the slashing of the headline corporate tax rate from 35 per cent to 20 per cent, which its economists expect to translate into higher investment and therefore increased wages. President Donald Trump on Monday took full credit for the soaring stock market as he brandished the tax cuts, declaring on Twitter that “jobs are roaring back”.

The Senate’s decision to delay the cut in the corporate rate to 2019, while allowing companies to immediately deduct capital investments from 2018, could further induce firms to rush through investments next year, according to Scott Greenberg of the Tax Foundation. This is because firms would be able to deduct the full cost against a 35 per cent rate but the profits from the investment would later be taxed at 20 per cent. He describes the effect as a “huge deal” in the short term, although not all analysts expect the big uplift to GDP from the measure that he does.

Over the longer term, the tax bill’s effects are far more ambiguous. Jason Furman, who chaired Barack Obama’s Council of Economic Advisers and is now at the Harvard Kennedy School, said that higher debt would gradually impose a mounting counterweight on the economy’s performance beyond next year. He said he too would advocate business tax reform, but “I would make sure it is paid for and make sure it does not open up new loopholes”.

What’s more, analysis of previous iterations of the tax overhaul has suggested that the benefits would be skewed to the richest in America, in part because holdings of corporate equities are concentrated in wealthier groups. In 2027, when the individual tax cuts will have expired, more than 60 per cent of the benefits would accrue to the top 1 per cent of earners, according to the Tax Policy Center. By that year, taxes would rise modestly for the lowest-income group, change little for middle-income groups, and decrease for higher-income groups.

Janet Yellen, the Federal Reserve chair, has described rising inequality as “disturbing” and suggested that if income is being shifted towards wealthier groups it could lower overall spending growth.

“I don’t think it is going to be a big benefit and it seriously intensifies the wealth inequality problem,” said Bill Cline, an economist at the Peterson Institute for International Economics. He said the principal beneficiaries of the package are likely to be holders of corporate shares and the top 1 per cent. The $1tn budget shortfall expected over the coming 10 years as a result of the plan could prompt some lawmakers to argue for cuts to social spending, which could further hurt those who are poorly off, he predicted.


What Will Happen if the FCC Abandons Net Neutrality?

Few issues in the technology world elicit such passionate — and at times angry — reactions as network neutrality, or the idea that internet traffic must be treated reasonably equally. Death threats, racist slurs, protests and millions of emails have descended on the Federal Communications Commission (FCC) as consumer groups, activists and tech companies mobilized the public to stop the agency from purportedly “destroying the internet as we know it.”

In the middle of this maelstrom is the new chairman of the FCC, Ajit Pai, who is an Indian-American and a Republican. On December 14, the commission will vote on an FCC proposal to revoke net neutrality and stop regulating internet service providers (ISPs) like landline phone companies — its two most critical and controversial changes. Passage of the proposed order is considered a done deal since the FCC has a Republican majority among its five members, although whether it can survive any future legal challenges is another matter.

“There is a lot of hysteria,” says Kevin Werbach, Wharton professor of legal studies and business ethics who has advised the FCC on broadband issues. He adds that the debate often is characterized by exaggerated claims, especially since the stakes are so high. “Net neutrality touches some very sensitive nerves on both sides of the debate. … It goes fundamentally to the heart of what the internet is and what its role is in our society.”

A similarly passionate outpouring occurred three years ago, when the FCC under President Obama proposed enacting net neutrality rules. They were voted into place in 2015 and later upheld in court — but after a fight from ISPs. Back then, Obama’s FCC Chairman, Tom Wheeler, faced enormous public pressure, too, says Gerald Faulhaber, Wharton professor emeritus of business economics and public policy and a former FCC chief economist. In addition to the FCC being flooded with comments about net neutrality, “he had people outside his house demonstrating and not letting him drive out of the driveway unless he agreed to do this. Apparently, this is happening to Ajit Pai, but much worse.”

Supporters often link net neutrality to free speech and unfettered, equal access to the internet.

They also want stricter rules to curb the conduct of ISPs. “Removal of the net neutrality rules could entirely take down the internet as a free and open source of information,” said Jennifer Golbeck, a professor at the University of Maryland, on the Knowledge@Wharton show on SiriusXM channel 111. “It’s going to be more corporate control over the content we see … potentially not just favoring things that benefit [ISPs] financially but favoring them politically.”

But critics say that too much regulation dampens innovation and investments in the internet, which has thrived for decades without formal net neutrality rules. For example, net neutrality would tamp down on innovations such as T-Mobile’s “Binge On” service, which lets customers stream video from Netflix, YouTube, Hulu and other sites without counting it against their data buckets, said Christopher Yoo, professor of law, communication and computer and information science at the University of Pennsylvania, on the radio show. Moreover, the order brings back the FTC as the antitrust enforcer of ISP behavior, protecting consumer interests and banning deceptive business practices. (Listen to a podcast of the radio show featuring Yoo and Golbeck using the player above.)

What Really Is Net Neutrality?

Complicating the net neutrality debate is the fact that most people do not fully understand the issue.

One big misconception by the public is that “the 2015 [Obama-era] rules were some kind of government regulation of the internet … that the internet wasn’t regulated and suddenly in 2015, the government imposed these regulations,” Werbach says. “The nuance gets lost. It is not [about whether] the internet is neutral or not. Companies manage networks all the time, but there’s a cleaner difference between managing networks for legitimate purposes and deliberately discriminating in an excessive way.”

Tim Wu, a professor at Columbia University, first proposed the concept of and coined the phrase “network neutrality.” In his 2002 paper, he said net neutrality “would forbid broadband operators, absent a showing of harm, from restricting what users do with their internet connection, while giving the operator general freedom to manage bandwidth consumption and other matters of local concern.” Wu also calls it a non-discrimination rule, but it is not a total ban on network discrimination of traffic.

That means broadband providers like Comcast, AT&T and Verizon can treat internet traffic differently if it is necessary to maintain and protect their networks. Wu called this permissible ground for discrimination. What’s forbidden is discrimination that could distort entire markets and harm the consumer. Technically, this could mean discrimination based on IP addresses, domain names, cookie information, and other factors, according to his paper. Net neutrality aims to protect the legitimate needs of ISPs to manage their networks while preventing the abuse of this power.

For example, if an online game takes up a lot of bandwidth or capacity, the ISP could handle it two ways. It could block traffic from the site through its IP address. But this act would violate net neutrality because by blocking access to this online game, it benefits other gaming sites and distorts the market. The right way to do it is to focus on bandwidth usage instead, Wu wrote.

Gamers who want a better experience would have to buy more bandwidth, or curtail their gaming. Here, the consumer has the choice of paying up or limiting playtime. This, he said, is “market choice” not one “dictated by the filtering policy” of the ISP.
Swing to the Left, Then Right

For decades, under both Democratic and Republican presidents, internet service was classified as an information service in the Communications Act of 1934 as amended in 1996. Such services offer a capability for “generating, acquiring, storing, transforming, processing, retrieving, utilizing, or making available information via telecommunications.” Put simply, it encompasses enhanced services such as computer processing and applications.

In contrast, landline phone service is classified under Title II of the Act as a telecommunications service — the transmission “between or among points specified by the user, of information of the user’s choosing, without change in the form or content of the information as sent and received.” It is a basic service that enables pure transmission capability.

As providers of information services, ISPs were much more lightly regulated than telecommunications services — such as the old Ma Bell. However, the FCC did adopt policies to preserve free internet access and usage and curb abuses. In 2004, FCC Chairman Michael Powell under President George W. Bush set out four principles of internet freedom: the freedom to access lawful content, use applications, attach personal devices to the network and obtain service plan information.

In 2010, under Obama’s first FCC chairman, Julius Genachowski, the agency’s Open Internet Order adopted anti-blocking and anti-discrimination rules after finding out that Comcast throttled BitTorrent, a bandwidth-intensive, peer-to-peer site where users shared files of TV shows, movies or other content. Faulhaber says Comcast made the mistake of “targeting a particular upstream company. That you can’t do. If you want to control traffic, you have to do it in a much less discriminatory way.”

But the 2010 order, which also required ISPs to disclose their network management practices, performance and commercial terms, was vacated by a federal court in 2014 after Verizon sued the FCC. The court said the FCC did not have the authority to act because ISPs are not regulated like common telephone carriers.

This ruling led to the 2015 order by Wheeler that reclassified ISPs like landline phone companies, giving the agency the power to regulate many things, including prices set by broadband providers, although this was set aside. The order also specified the no-blocking and no-discrimination of traffic, and banned paid prioritization, which would give faster internet lanes to companies that pay for it. And it crafted internet conduct standards that ISPs must follow. Last year, an appellate court upheld this order.

The current proposal by Pai rolls back Wheeler’s order, and more. It classifies ISPs back under information services. It allows paid prioritization. It also punts the policing of any ISP blocking and discriminatory behavior to the FTC to be investigated on a case-by-case basis. It dismantles Wheeler’s internet conduct standards because they are “vague and expansive.” But the proposed order does adopt transparency rules, requiring ISPs to disclose information about their practices to the FCC and the public.

Some Wharton experts think that both Wheeler and Pai swung a little too far — toward more regulation and less regulation, respectively. “I don’t think the FCC [under Wheeler] had to reclassify broadband [like plain old telephone service] in order to adopt effective net neutrality,” Werbach says. “But once they made that decision, I don’t think it’s a problematic decision by itself. It’s definitely not anything like a government takeover or pricing regulation of broadband as people argue.”

Faulhaber says that while he approves of what Pai did, “it goes a little further than I might have gone.” He would be fine with the FCC retaining the no-blocking and no-discrimination rules instead of shifting the policing responsibility to the FTC “in one fell swoop.” But Faulhaber argues that Pai was right to allow internet fast lanes. “Everybody in business offers multiple quality levels,” he says.

“If you go to the post office, you can send mail by express mail. Why do we insist it has to be one plain vanilla thing?”

Faulhaber adds that the Wheeler order is an example of a policy directed more by populism than economics. In justifying the decision to put ISPs under Title II, a majority of FCC commissioners under Wheeler routinely cited the receipt of four million comments on net neutrality — a record back then — to support their stance instead of applying a cost-benefit analysis to gauge its economic impact, according to a paper Faulhaber co-authored called, “The Curious Absence of Economic Analysis at the Federal Communications Commission: An Agency in Search of a Mission,” published this year in the International Journal of Communication. Pai referenced the paper in an April 2017 speech at The Hudson Institute, where he also announced the creation of an Office of Economics and Data at the FCC.

For ISPs, the issue is not so much net neutrality as it is about Title II. “All of the major ISPs like Comcast and AT&T are on the record saying that they support the idea of net neutrality, but they just oppose the legal classification of broadband as a regulated telecommunications service,” Werbach says. “I wouldn’t expect to see any dramatic changes in the companies’ practices near term. They’re going to wait and see how this all plays out, and they’re also not going to do something that will provoke significant backlash and pressure for more regulation.”

Extreme or Just Right?

Taken as a whole, Pai’s proposed order is “extreme” and removes “pretty much any limitations on the conduct of broadband providers,” Werbach says. While he believes that ISPs will pay attention to market signals and avoid activities that cause a customer backlash without the benefit of a big financial boost, this attitude could eventually change. “Over time, if all the rules are eliminated and the FCC no longer has the authority to police bad behavior, we’ve seen time and time again that eventually there’s no limit to what companies will do that turns out to be ultimately harmful to consumers and harmful to innovation.”

While Pai’s proposal requiring that ISPs disclose their network practices is a “good sign,” Werbach continues, “there’s a big difference between just putting something on your website saying here are the practices we use, and providing actual [real time] data on network traffic.” This was also an issue under Wheeler. “Frankly, even the Wheeler FCC rules don’t go far enough in terms of encouraging real transparency on what ISPs are doing.” For example, Netflix went to the FCC to complain that Comcast was slowing down its video streams, but engineers had a hard time pinning down the cause because much of the data is private.

During her radio show appearance, Golbeck noted that the danger of fast lanes is that smaller websites that cannot afford to pay the ISP could be left behind. Research shows that “even delays of less than a second in serving up content [will make people] bail from your site and go someplace else.” Conversely, she said, if ISPs speed up access to popular sites like Amazon and Netflix because they pay, “it inhibits the ability for other new startup sites to compete.”

Yoo countered that Netflix takes up a lot of bandwidth — its streams comprise more than a third of all internet traffic during primetime, when the network is congested, and it is growing.

“The growth of Netflix is requiring us to build bigger networks. If you add YouTube,” both take up 55% to 60% of online traffic, he said. “We have to expand capacity — who’s going to pay for that? Have Netflix pay for it? The network provider? Or both?” Yoo said it seems logical for both to share the cost. If the FCC bans paid prioritization, then consumers will eventually shoulder the cost of expanding network capacity, not Netflix. ISPs will pass down the cost to users since Netflix cannot pay for fast lanes.

However, Netflix is already paying for fast lanes. Years ago, when ISPs were slowing down video traffic because of bandwidth issues, Netflix struck deals with them that are tantamount to “pay for play, or paid prioritization,” Yoo pointed out. “They get faster service and they get charged a fee…. It increased performance for Netflix customers and it gave them better guarantees. All the way around, it was a better experience for consumers.” By banning all paid prioritization, he said, the FCC would create a “baby and the bathwater problem” — because it would throw out what’s good along with the bad.

Faulhaber is in favor of Pai’s proposed order overall. He points out that many of the fears voiced by net neutrality supporters are not applicable to the debate. For example, some people believe that without net neutrality, ISPs can charge consumers anything they want. “They can charge anybody anything they want now,” he says. Another fear is that ISPs would slow down certain traffic if paid prioritization is allowed. Again, these cases happen even setting aside the issue of paid prioritization. Here, Faulhaber favors looking at transgressions on a case-by-case basis.

Pai also was right to classify ISPs as information services again, not as common carriers, Faulhaber says. “The problem was Title II. It gives them the ability to regulate everything about ISPs. … That’s the scary thing about it,” he says. “The other scary thing is we’re just regulating ISPs now.

[Minnesota Sen.] Al Franken wants to extend net neutrality to content providers” such as Google and Facebook, which together control 75% of the public’s access to online news and hold much of Americans’ personal data. “This is the entrée to regulate the entire internet,” he says.

In the end, the issue of net neutrality and Title II will have to be resolved by Congress. Absent such action, FCC orders could ping-pong depending on who is in the White House — which goes against the agency’s history as a largely non-political, bipartisan body. “Everyone agrees that Congress has the authority to step in here, and virtually everyone on both sides agrees that this would be better addressed with legislation,” Werbach says. Thus far, lawmakers have not prioritized doing so, and “it’s pretty unlikely we’re going to see Congress do anything.”

The Brexit Tragicomedy


Puppets of UK politicians

PRINCETON – As the rest of the world looks on with a mixture of amusement and pity, British politics in the age of Brexit has come to resemble a soap opera. Can the chaos that is descending on the United Kingdom be good for Europe, or even for Britain? Perhaps, but only in the sense that train wrecks yield lessons about what to avoid.

British political actors know they are putting on a performance, and they speak candidly about life imitating art. Their model is the backstabbing drama of Game of Thrones or the dark comedy of House of Cards (the British version, not the long-winded American imitation that has been canceled in the wake of sexual-assault allegations against its star, Kevin Spacey).

Unlike in Hamlet, where everyone ends up dead, and an outsider (Fortinbras) shows up to reestablish normality, modern fictionalized political dramas never have a satisfying resolution.

The Brexit drama, then, is faithfully imitating art: it cannot have anything but a messy conclusion.

Brexit is not just a political upheaval; it is a revolution. Historically, radical political realignments have been rather rare in British politics. One example is the Glorious Revolution of 1688, which produced a two-party system comprising Whigs, who supported the new settlement, and Tories, who resisted it.

That system lasted for more than a century, until the 1840s, when Whig became synonymous with Liberal, and Tory with Conservative. But then, in 1846, the Conservative Party split over curtailing protective tariffs for grain, which was bad for the party’s rural farming base, but good for manufacturing, and for society generally. The resulting political balance lasted for almost a century, until the 1920s, when the Labour Party replaced the Liberals as the alternative to Conservatism.

Arguably, another political realignment may be past due. In the 2000s, British Prime Minister Theresa May played a crucial role in cleaning up the Conservative Party’s image as the “nasty party.”

But her Brexit strategy, in which she has avoided taking any clear positions, has transformed the party into something even worse: a dishonest, divided, weak political cabal whose decisions could prove lethal.

Brexit transcends the old two-party divide in British politics. The Conservative Party’s bloc in Parliament includes a small minority who regard Brexit as a disaster, others who want a well-negotiated compromise, and a substantial group who oppose any compromise and have embraced the idea of a clean break with the European Union.

Labour is similarly divided. The party’s leader, Jeremy Corbyn, is hostile to the EU, because it could prevent him from implementing his utopian socialist program. At the same time, many Labour MPs recognize that the EU plays a central role in providing economic opportunities and social mobility for British citizens.

Because no fundamental issues separate pro-EU Conservatives from pro-EU Labourites, practical cross-party cooperation has started to occur. But for any such parliamentary alliance to have democratic legitimacy, it will have to present itself not just as a coalition of likeminded MPs, but as a new political party, with a program to confront realistically the challenges of technological change and globalization.

Similar shifts have occurred in other European countries when established parties and traditions fell apart. In the 1990s, Italy’s largely bipartisan system disintegrated when Christian Democracy was engulfed by corruption scandals and the Communist Party was pulled apart by the collapse of the Soviet Union. Italian politics has been plagued by instability ever since.

In France, President Emmanuel Macron’s new political party, La République en Marche !, has effectively supplanted the old center-right Gaullist party, Les Républicains, as well the center-left Socialists. Still, Macron rightly recognizes that his overhaul of French politics will not succeed unless it is matched at the European level. If a Europe-wide shift does happen, it will owe much to the cautionary tale playing out in Britain.

In Germany, the breakdown of coalition negotiations between the Christian Democratic Union, the Christian Social Union, the Free Democrats, and the Greens suggests that a political realignment may be necessary there, too.

In fact, realignments may have a better chance of succeeding elsewhere in Europe than in the UK.

After all, Britain’s malaise runs much deeper than party politics. Brexit has ushered in a revolution in a country without a revolutionary tradition. Withdrawing from the EU will require uprooting a thicket of complex legal and institutional frameworks, around which most political norms and conventions revolve.

So far, every alternative arrangement that has been proposed has been problematic. For example, if Britain liberalizes its trade and regulatory policies, British workers could end up worse off than they were under the EU regime. Inevitably, every concrete step out of the EU is bound to lead to deeper factionalism.

Looking ahead, there are two possible scenarios for British politics. The first is the Hamlet scenario, in which the chaos continues until the UK crashes out of the European single market and customs union. The stage will be littered with political corpses, and an economic disaster will ensue.

In the second scenario, common sense prevails: Macron-style pragmatism takes root in Britain, supplanting the Poujade-style populism that fueled the anti-EU “Leave” campaign. This assumes that Macronism succeeds at the European level, so that it can serve as a foil to the dysfunctional, distorted politics of the United States, Russia, and Turkey, and to the new instability in Germany.

That outcome would also be Shakespearian, recalling nothing so much as All’s Well that Ends Well – one of the bleakest “comedies” in Shakespeare’s oeuvre.

Harold James is Professor of History and International Affairs at Princeton University and a senior fellow at the Center for International Governance Innovation. A specialist on German economic history and on globalization, he is a co-author of the new book The Euro and The Battle of Ideas, and the author of The Creation and Destruction of Value: The Globalization Cycle, Krupp: A History of the Legendary German Firm, and Making the European Monetary Union.