Permanent Market Support Operations

Doug Nolan
U.S. stocks posted the strongest week of gains since 2013 (would have been 2011 if not for late-day selling). The S&P500 surged 4.3%, and the Nasdaq Composite jumped 5.3%. The small cap Russell 2000 rallied 4.4%. After closing last Friday at 29.06, the VIX settled back down to a still elevated 19.46. Foreign markets recovered as well. Germany’s DAX rose 2.8%, and France’s CAC 40 gained 4.0%. The Shanghai Composite was closed for the lunar new year. The dollar index was back under pressure this week, sinking 1.5%, giving a boost to commodities prices. Price instability abounds.

While stocks rather quickly recovered a chunk of recent losses, the same cannot be said for corporate bonds. Notably, investment-grade bonds (LQD) rallied little after recent declines.
February 16 – Bloomberg (Cecile Gutscher and Cormac Mullen): “Corporate bond funds succumbed to rate fears that have gripped stocks to Treasuries. Investors pulled $14.1 billion from debt funds, the fifth-largest stretch of redemptions in the week through Feb. 14, according to a Bank of America Merrill Lynch report, citing EPFR data. High-yield bonds lost $10.9 billion alone, the second highest outflow on record. As benchmark Treasury yields traded at a four-year high, it shook the foundations of a key support for risk assets -- low rates. ‘Investors don’t sell their cash bonds in a big way until they are forced to, which happens when the outflows start picking up more sustainably,’ Morgan Stanley strategists led by Adam Richmond wrote…”

U.S. junk bond funds suffered outflows of $6.3 billion (from Lipper), the second highest ever. IShares’ high-yield ETF saw outflows of $760 million. U.S. investment-grade bond funds had outflows of $790 million (Lipper), the first outflows since September. This was a big reversal from last week’s $4.73 billion inflow. The iShares investment-grade ETF had outflows of $921 million, the “largest outflow in its 15-year history.” Even muni funds posted outflows ($443 million), along with mortgage and loan funds.

A strong equities rally into option expiration – after a bout of market selling and hedging - is not out of the ordinary. Hedges put on over recent weeks were unwound, creating potent buying power for the rally. Scores of systematic trading strategies that were aggressively selling into market weakness turned aggressive buyers into this week’s advance.

I’m not much interested in sharing my guess as to where markets might head next week. It certainly wouldn’t be surprising if this week’s buyers panic subsides abruptly and selling reemerges. At the same time, I’ve seen enough of short squeeze and derivative melt-up dynamics to take them seriously. They have had a tendency of taking on a life of their own. I’m not, however, shying away from my view that recent developments mark a critical juncture in the markets – and for the world of finance more generally. Markets could find themselves in trouble in a hurry.

My objective for the CBB is to offer (hopefully valuable) perspective. I believe the blowup of the “short vol” and the revelation of how quickly the great bull market can succumb to illiquidity and losses have fundamentally altered the risk-taking and leveraging backdrop. The cost of hedging market risk, while down this week, has risen significantly. Treasuries have revealed themselves as an inadequate hedge against risk assets. Moreover, exceptionally high asset correlations experienced during the recent sharp selloff have illuminated the shortcomings of many so-called “diversified” strategies. There will be ebbs and flows, often wild and intimidating. Yet I believe de-risking/de-leveraging dynamics will gain momentum.  
Fragilities will be exposed.

I have serious issues with contemporary finance. Unique in history, the world operates with a financial “system” devoid of limits on either the quantity or quality of “money” and Credit. 
Unlike a gold standard (or other disciplined monetary regimes), there is no mechanism to contain the creation of new finance. As such, traditional supply/demand dynamics have little relevance in the pricing of finance. Today’s contemporary financial apparatus – where central bankers largely dictate the price of Credit – lacks effective regulation of supply and demand. Importantly, the contemporary system fails to self-correct or adjust. Left unchecked, it feeds serial Bubbles and busts.

Early CBBs focused on the instability of this new world of “Wall Street finance.” Unfettered finance, much of it directly targeted to asset markets, had created powerful asset inflation and Bubble Dynamics. Indeed, by the late-nineties the perilous instability of contemporary finance had become abundantly clear. One could point to “portfolio insurance” contributing to the ’87 crash; the role of non-bank finance in late-eighties excess; the 92/93 bond/derivatives Bubble that burst in 1994; the 1995 Mexican collapse; the ’97 Asian Tiger collapses and the spectacular simultaneous 1998 Russia and Long-Term Capital Management debacles.

Somehow, there’s never been a serious and sustained effort to analyze contemporary finance’s shortcomings. Rather than contemplating evident deficiencies, each burst Bubble led immediately to whatever reflationary measures deemed necessary. Structural issued be damned. All along the way, few have been willing to admit the fundamental flaws inherent in various modern forms of risk intermediation. Rather than mitigate risk, structured finance and derivatives tend to distort, disguise and transfer myriad risks. Various risk intermediation mechanisms work to lower the cost of finance, in the process exacerbating Credit excess, risk-taking, speculation and leveraging.

Perhaps most momentous, the experiment in unconstrained finance spurred an experiment in economic structure. The U.S. economy was free to deindustrialize. With newfound access to unlimited finance and inflating asset prices, Americans were to indefinitely trade financial claims for endless cheap imports. The bane of “twin deficits” had been eradicated. Even more miraculously, the flood of finance the U.S. unleashed upon the world would, largely through foreign central banks, be recycled right back into booming American securities markets.

After the burst of the “tech” Bubble – and, importantly, the 2002 dislocation in the corporate debt market – the Fed panicked. Even more than 1987, 1990 and 1998, the Fed feared “the scourge of deflation.” Somehow, the Fed, Wall Street and others found solace in Bernanke’s radical monetary ideas of “helicopter money” and the “government printing press.” The Federal Reserve was willing to slash rates to one percent – and peg them there in the face of several years of double-digit annual mortgage Credit growth.

Let’s call it what it was: reckless. The Fed looked the other way from conspicuous financial and housing-related excess (as they have more recently in the securities markets). Why? Because they had specifically targeted mortgage Credit as their inflationary mechanism of choice. The Bubble was untouchable.

The 2008 crisis marked the failure of a great financial experiment. Fannie, Freddie and GSE risk intermediation failed. Wall Street structured finance failed. Derivatives markets and Wall Street firms failed. Counterparties failed. Across the financial landscape, catastrophic flaws were exposed. In short, contemporary finance failed spectacularly.

The ‘08/’09 crisis should have provided an historic inflection point. The greatest upheaval in decades should have marked the beginning of an era of more stable finance – of sounder money and Credit and firmer economic underpinnings. It would have been an arduous process, no doubt. Central bankers had other ideas.

I’ve never been tempted to give up on the analysis. For going on ten years, I’ve chronicled the greatest experiment in the history of central banking. Central bankers have adopted the most extreme rate, “money printing,” and market manipulation measures ever. They have guaranteed abundant cheap (virtually free) finance for going on a decade now. What was meant to be a temporary rescue of fragile private-sector, market-based finance morphed into history’s greatest global Bubble.

The greatest flaw in central banker doctrine/strategy was to believe that after intervening temporarily with reflationary measures the system would stabilize and gravitate right back to normal operations. Central bankers reflated a deeply unsound financial structure, only exacerbating flaws and compounding contemporary finance’s vulnerabilities. In particular, a decade of reflationary measures profoundly inflated risk intermediation distortions and fragilities.

The “Moneyness of Risk Assets” has seen Trillions flow into an untested ETF complex on the assumption that central bankers would ensure ETF holdings remained a safe and liquid store of value. Reflationary measures also incentivized Trillions to flow into sovereign debt, corporate Credit, structured finance and the emerging markets on the belief that central bankers would not tolerate another market crisis. Trillions have flowed into various derivative trading strategies on the view that central bankers would ensure liquid and continuous markets – no matter the degree of market excess.

The upshot has been market distortions and the accumulation of risks on an unprecedented scale. Fragilities have surfaced on occasion (i.e. “flash crash”), spooking the central banker community sufficiently to ensure that “temporary” reflationary measures evolved into Permanent Market Support Operations. Central bankers had slipped fully into the markets’ trap. Cautious measures expected to normalize policy over time only ensured that financial conditions loosened further - and global Bubble inflation accelerated.

Along the way, Permanent Market Support Operations changed the game – in global finance as well as throughout economies. Everyone was free to assume more market risk – savers, investors, pension funds and institutions, and the leveraged speculators. Corporate management could issue more debt and buy back more stock. Easy “money” ensured an easy M&A boom. It took time, but animal spirits in the Financial Sphere eventually manifested in the Real Economy Sphere.

The most aggressive companies, managers, entrepreneurs and swindlers all enjoyed the greatest success. Seemingly any clever idea could attract funding. With finance virtually unlimited and free, almost any investment could be viewed as having merit irrespective of prospects for economic returns. There was abundant “money” to be thrown at everything – the cloud, the Internet of things, AI, robotics, autonomous vehicles and all things tech, pharmaceuticals, alternative energy, all things media and so on. It became New Paradigm 2.0, with the earlier nineties version now such a triviality.

Things just got too crazy. Central bankers were much too complacent as Bubble Dynamics gathered powerful momentum. Booming asset inflation and 4% unemployment weren’t enough to convince the Fed it was time to tighten up the reins. Meanwhile, the ECB and BOJ clung stubbornly to negative rates and massive QE programs. Chinese Credit went nuts. Through it all, wealth disparities only worsened, fueling in the U.S. a populist movement and anti-establishment revolt that placed the Trump administration in power. Despite a massive accumulation of debt and ongoing large deficits – not to mention increasingly overheated late-cycle economic dynamics - the Republicans pushed through historic tax cuts. Next on the President’s agenda: tariffs and trade battles.

Everyone became so transfixed by daily stock market records, historically low volatility and the easiest conditions imaginable throughout corporate Credit. It was easy to ignore pressures percolating on the inflation front. And it became just as easy to disregard the possibility that central bankers might actually raise rates to the point of tightening financial conditions. 
Heightened uncertainty began to manifest in currency market volatility. Meanwhile, excesses were mounting in the securities markets on a daily basis – including incredible flows into perceived safe and liquid ETFs, rank speculation, “short vol,” derivatives and leverage.

For the most part during this extraordinary cycle, Monetary Disorder has remained conveniently contained within the securities and asset markets, seemingly staying within the purview of global central bank policymaking. Rather suddenly, however, markets are beginning to realize there are unfolding risks not easily resolved by monetary stimulus. Deficit spending has become completely unhinged, while inflation is gaining sufficient momentum to garner concern. As such, central bankers may feel compelled to actually tighten financial conditions. Bond markets are on edge, commencing a long-overdue price adjustment. At the minimum, the Fed and others will likely be less hurried when coming to the defense of unstable equities markets.

The bulls see this week’s quick stock market recovery as confirmation of sound underlying fundamentals. The selloff was a technical market glitch completely detached from the reality of booming corporate earnings, robust economic growth and extraordinary prospects.

I see this week’s big market rally as confirmation of the Bubble thesis. Markets have lost the capacity to self-adjust and correct. Derivatives and speculation rule the markets. Option expiration week certainly provides fertile ground for short squeezes and the crushing of put holders. But it does raise the important question of whether markets at this point can correct without dislocating to the downside. I have serious doubts. The quick recovery has markets again dismissing mounting risks. Perhaps it will also keep the Fed thinking economic risks are tilted to the upside – that they need to ignore market volatility and stay focused on normalization.

My view is that normalization is impossible. Extended global market Bubbles are too fragile to endure a tightening of financial conditions. At the same time, sustaining Bubbles has become perilous. Especially in the U.S., with deficits and a weak currency as far as the eye can see, the risks of allowing inflation to gain a foothold are significant. For the first time in a while, there is pressure on the Fed to tighten financial conditions. This places the great central bank experiment at risk. Bubbles don’t work in reverse.

The world is changing. These flows out of corporate debt ETFs are a significant development – another step toward “Risk Off.” Similar speculative and hedging dynamics that hit equities hold potential to spark major dislocation and illiquidity in corporate Credit. For further evidence of change, look no further than a Tuesday headline from the Wall Street Journal: “White House Considering Cleveland Fed President Mester for Fed’s No. 2 Job.” A central banker I admire considered for a top Fed post? Is this part of a changing of the guard at our central bank, or perhaps administration officials recognize that with years of huge deficits looming on the horizon, along with dollar vulnerability, the Fed will soon be in need of some inflation-fighting credentials.

Modi’s India is on course to top China for growth

Further business and legal reforms are needed to maintain progress

Martin Wolf

India matters now and will matter still more in future. It is a democracy; its economy is fast growing; and it will soon be the most populous country in the world. Westerners should passionately desire India to be a successful model of democratic and market-led development.

An important question then is whether the government of Narendra Modi, in office since May 2014, has made a decisive difference to India’s economic trajectory. The evidence is: not yet.

But the reforms it has introduced might make a more noticeable difference in the years ahead.

A decisive shift in India’s economic policies and performance occurred after the foreign currency crisis of 1991. India’s version of China’s “reform and opening up” raised average growth of gross domestic product per head to close to 5 per cent a year between 1992 and 2017.

The five-year moving average of growth of GDP per head reached 7.2 per cent in the years up to and including 2007, before slowing to 5.8 per cent in the years to 2017. That slowdown is disappointing. Yet, if this rate were maintained, GDP per head would double every 12 years.

That would be transformative — and not just for India, since its population is forecast by the United Nations to reach 1.6bn (17 per cent of the world’s total) by 2040. (See charts.)An important question is whether India’s rate of growth will continue to decline, stabilise or rise yet again. A crucial issue here is the marked fall in the country’s rate of investment, from a peak of 40 per cent of GDP in 2011 to 30 per cent in 2017. If the investment rate were to remain at the latter level, GDP growth is unlikely to rise to over 8 per cent a year, let alone to still higher rates, though it should not fall below today’s rates. In retrospect, the soaring investment rates of the early 2000s were themselves unsustainable. They bequeathed a “twin balance sheet” problem that resulted from the bad debt in banks and many businesses.

Analysis in the country’s recently published Economic Survey concludes that reversing an investment slowdown associated with such stressed balance sheets is a difficult task. The agenda, it suggests, includes cleansing the unhealthy balance sheets, which is now under way. Also important is further progress with easing the costs of doing business, by “creating a clear, transparent, and stable tax and regulatory environment”. Whether a government that recently de-monetised a large portion of the outstanding monetary stock overnight can create such a stable regime has to be questioned. The teething difficulties of the new goods and services tax, itself a valuable reform, did further damage.

Mr Modi indicated his determination to implement vital structural reforms in last month’s speech to the annual meeting of the World Economic Forum in Davos. His agenda is impressive and wide-ranging. The Economic Survey argues that the slowdown of the Indian economy in 2016 and early 2017 has already been reversed: it is now full(ish) speed ahead. Yet, on the basis of what has happened so far, a reasonable bet could be that growth will stabilise somewhere between 7 and 8 per cent a year, provided, significantly, the global environment remains supportive. In all, India should regain the title of “fastest-growing large economy in the world” from China, this year.

What about the longer-term challenges? Removing obstacles to higher investment and encouraging higher savings are both important. The Economic Survey also notes, triumphantly, that India jumped 30 places to break into the top 100 for the first time in the World Bank’s Doing Business, 2018. This is indeed the product of reforms. Yet India still lags 22 places behind China. It also came 164th in effectiveness in enforcing contracts. This reflects the inefficiency of the legal system, which has Dickensian characteristics. India could and should do far better still.

On balance, however, the potential for policy and institutional improvement in what remains a poor country (whose real GDP per head is about an eighth of US levels) should create confidence that rapid growth will continue. Yet the Economic Survey asks, boldly, whether there might now be a tendency for economies that lag as far behind the world’s richest as India still does to fail to catch up. In particular, it notes obstacles that did not exist in the past. These include the current backlash against globalisation, which might slow export growth; the tendency for the growth of industry to peak ever earlier in the development process, or “premature de-industrialisation”; the challenge of upgrading human resources; and the negative impact of climate change on agricultural productivity. The crucial challenge here is education. India continues to fail to provide adequate education to a vast portion of its children — a failure that will affect the quality of the labour force for many, many decades. The survey also makes a strong case for increasing India’s scientific effort and spending more on research and development, especially in the private sector.

A striking structural feature of India, whose significance goes far beyond economics, is social preference for sons. This shows up in the strong tendency to continue to have children until a son is born. India’s stock of “missing women” — women who would be there with a normal sex ratio — is now estimated at 63m. The number of unwanted girls — girls who only exist because parents actually wanted a boy — is also estimated at 21m. Worse, these prejudices are not disappearing with prosperity. While the treatment of Indian women has improved in many ways, benighted son preference persists. Both the outcome and the social attitudes that cause it have to change. They are hugely damaging. Economic development matters. On its own, it is never enough.

ETF growth is ‘in danger of devouring capitalism’

The rise of passive investment vehicles is reshaping the finance industry

Robin Wigglesworth

 © Cat O’Neil

Last spring something odd happened to a host of small US gold miners. Their stocks declined unexpectedly, despite the price of the lustrous metal hitting a five-month high at the time.

The dips were not caused by any of the usual reasons such as poor earnings statements, or signs of a waning appetite for gold among New York socialites, Indian brides or Chinese hoarders. Rather, they fell because of the swelling importance of exchange traded funds.

These odd ructions in the stock price of a few gold miners is an under-appreciated but potent example of how ETFs are having a mounting and sometimes unintended impact on markets, even as they save investors around the world billions of dollars worth of fees that would otherwise go to traditional fund managers.

ETFs are passive investment vehicles that combine the cheapness of index trackers, which merely attempt to mimic the returns of an underlying benchmark, with the trading ease and convenience of a normal stock.

Last year ETFs saw record growth and took in over $460bn globally. That amounts to nearly $1.8bn of new money every working day of the year. In 2018, the global ETF industry will almost certainly cross the $5tn mark for the total value of funds invested.

This shift out of traditional, “active” money management is one of the most profound changes to the global financial system in history and is now powerful enough to rewire how markets function. Many big investors are worried about the implications.

“Passive investing is in danger of devouring capitalism,” Paul Singer, the founder of Elliott Management, one of the world's biggest hedge funds, said in a letter to investors last year. “What may have been a clever idea in its infancy has grown into a blob which is destructive to the growth-creating and consensus-building prospects of free-market capitalism.”

In the case of the gold miners, a single fund, the VanEck Vectors Junior Gold Miners ETF, was causing the mysterious movements.

Its popularity meant that it had grown too big for the index it tracked, butting up against regulatory ceilings on how much of a company it can own. So in April last year, MVIS, Van Eck’s index business, decided to change the benchmark — nearly doubling the market value of gold miners it was allowed to invest in. That led other traders to anticipate that some companies would subsequently drop out of the index, pushing their shares lower.

Although it only affected a small corner of financial markets, and went largely unnoticed at the time, the event is a potent example of how the rise of ETFs is not just challenging traditional asset managers but starting to reshape markets in small but profound ways. The US equity market is the furthest ahead in this march towards passive investing, but nearly every market is now undergoing a quiet revolution.

“We can no longer be the fundamental investors we want to be,” complains Federico Kaune, head of emerging markets fixed income at UBS Global Asset Management. In addition to the usual array of macroeconomic data, he now makes daily checks on the inflows and outflows of ETFs — an absolute necessity in the age of passive investing. “It has dramatically changed the fabric of markets, no question,” he argues.

These concerns have been growing for a while. But over the past year the debate has expanded in tandem with the record-breaking ETF inflows.

Regulators are also exploring some of the challenges raised by this growth more closely. In September the US Securities and Exchange Commission hosted a one-day conference on ETFs, where various academics, analysts, regulators, lawyers and investors pored over their effects on financial markets.

For example, Itzhak Ben-David, a finance professor at Ohio State University, presented a paper that showed that when a company joins a major index both its ETF ownership and volatility goes up, and when it leaves its ETF ownership and volatility goes down. “No one doubts this [the ETF] is a great innovation, but at the same time it could have some unintended consequences,” Prof Ben-David said at the conference.

In perhaps the most high-profile attack on passive investing, Inigo Fraser-Jenkins, a senior analyst at research house Bernstein, sent out an note to clients in 2016 arguing that it was “worse than Marxism”, given that communists at least tried to allocate capital efficiently. The reactions in the passive investment industry were predictably scornful.

“I'd say consumers choosing better products at a cheaper price is the very essence of capitalism,” says Jim Rowley, senior investment strategist at Vanguard.

Mr Rowley says he and his colleagues have exhaustively examined whether ETFs are affecting the structure of markets, influencing correlations and volatility, and have concluded that there is nothing untoward going on. “Any changes have more to do with business trends rather than capital markets trends,” he argues.

There have been times when ETFs have been at the centre of some turbulence. On August 24 2015, markets were thrown in a tailspin by fears over China’s economy, with the turmoil exacerbated by chaotic trading in many ETFs. “That was a pretty bad day, no question about it,” admits Jim Ross, chairman of State Street’s SPDR exchange traded funds business.

The industry has banded together with market-makers and exchanges to resolve most of the technical issues thrown up by the tumult but Mr Ross remains concerned that some kind of rerun is likely. “We’ve got a lot of stuff done since then, but we’ll eventually have another event like that,” he says.

However, while the ETF industry is resigned to being blamed for future market mishaps, there is little evidence of it being the core cause of turbulence and there are few examples of ETFs significantly worsening a sell-off.

Indeed, the experience of correlation within share indices is a good example of how one major criticism of passive investing has recently proved to be misguided.

In the era following the financial crisis, individual stocks started moving increasingly in tandem, frustrating fund managers that depend on idiosyncratic movements to beat their benchmarks. Blame was apportioned to central banks’ aggressive monetary easing and the rise of ETFs. However, correlations have reversed over the past year — despite the money still rolling in to these funds.

That traditional hedge fund or mutual fund managers — and analysts that depend on their business — find faults with ETFs and passive investing is understandable and natural. Much of the money pouring into the industry has seeped out of active funds, leading to tightening pressure on their fees.

The average net expense ratio of US equity mutual funds fell to 1.13 per cent last year, compared with 1.44 per cent in 2000, according to Morningstar, a data provider. Competition from ETFs has been less intense in fixed income field, but is now on the increase, pushing down the average cost of administering US bond funds to 0.91 per cent in 2017, from 1.14 per cent over the same period.

ETFs have, therefore, saved investors many billions of dollars both directly and indirectly, through the price pressures they have put on traditional asset managers.

That is not to say that the ETF industry itself is in a universally comfortable position. A mounting price war is biting margins and, with most of the money flowing into the “big three” — BlackRock, Vanguard and State Street — many providers are having to shut funds that fail to gather enough assets.

Active managers have also enjoyed an upswing in performance, and lower fees make many mutual funds more attractive to investors keen on trying to do better than their benchmarks.

Nonetheless, few would be foolhardy enough to bet against the ETF industry enjoying another banner year.

A New US Defense Strategy for the Future

By Phillip Orchard


The Pentagon’s new National Defense Strategy articulated a profound shift in U.S. strategy, but one that has long been underway: Great power competition, not terrorism, is now the primary focus of U.S. national security.

According to the NDS: “The central challenge to U.S. prosperity and security is the re-emergence of long-term, strategic competition by what the National Security Strategy classifies as revisionist powers. It is increasingly clear that China and Russia want to shape a world consistent with their authoritarian model – gaining veto authority over other nations’ economic, diplomatic, and security decisions. Long-term strategic competitions with China and Russia are the principal priorities for the Department, and require both increased and sustained investment, because of the magnitude of the threats they pose to U.S. security and prosperity today, and the potential for those threats to increase in the future.”

The relegation of so-called rogue states and terrorist groups may seem premature, given the immediacy of these purportedly lesser concerns. It’s North Korea that is the focus of a reportedly contentious debate in the White House about whether to conduct a limited, “punitive” strike following the North’s next nuclear or ballistic missile test, and whatever the U.S. decides to do next could lay the groundwork for an extraordinary regional realignment. It’s Iran whose regional ambitions are dominating the attention of core U.S. allies in the Middle East and putting the nuclear deal back in the U.S. media spotlight. And it’s the threat of a major terrorist attack that still paralyzes the U.S. public like no other.

Meanwhile, in response to the NDS, the Chinese accused the U.S. of being stuck in a Cold War, zero-sum mindset – and it’s not hard to see the issue from their perspective. The U.S. is the world’s sole superpower. For all their ability to frustrate U.S. initiatives from time to time, neither China nor Russia has the intention or the capability to fully replace the U.S. on a global scale. And recent surges in Chinese and Russian assertiveness are, in large part, a function of fundamental vulnerabilities that are left exposed in the U.S.-led order.

But the U.S. isn’t gearing up to fight a new Cold War, nor dismissing the importance of threats posed by lesser powers. Rather, it’s trying to preserve something akin to the established order without getting overstretched and bogged down in conflicts that are somewhat peripheral to core U.S. interests. The overriding U.S. goal is to be able to manage and contain potential challenges across the globe through more subtle, remote manipulation, using a range of historical advantages, from economic power to its unparalleled naval might to its vast network of security allies and partners. Its approach to combating the Islamic State with a much smaller footprint than during the counterterrorism operations of the early 2000s illustrates how this shift has long been underway. But the U.S. is also grappling with some increasingly evident limitations in its ability to manage critical issues from afar – and larger powers like China and Russia are uniquely positioned to exploit these limitations to complicate the U.S. strategy.

This is evident in two core areas of focus in the NDS. The first is the heavy emphasis on maintaining the U.S. military’s decisive technological edge, which the NDS says is eroding. According to Secretary of Defense James Mattis, this should take priority over expanding the size of the military.

China and Russia are aiming to raise the cost of U.S. interference in their respective spheres of influence beyond what Washington may be willing to bear. And with the future of warfare increasingly influenced by the space and cyber realms, Russian or Chinese breakthroughs in these areas would make the United States’ sizable conventional and geographical advantages matter less. The Irans, North Koreas and even Islamic States of the world can dabble in these realms (cyber in particular), but not to the same extent. Nor can they leverage these tools to try to gain some degree of conventional forces parity in the way that China and Russia could to alter the balance of power in their immediate periphery.

The second, and perhaps most striking, part of the National Defense Strategy is just how much the Pentagon calls attention to threats – particularly economic – that it is ill-suited to do anything about, except in narrow settings. China is the main focus here.

The NDS states, “As China continues its economic and military ascendance, asserting power through an all-of-nation long-term strategy, it will continue to pursue a military modernization program that seeks Indo-Pacific regional hegemony in the near-term and displacement of the United States to achieve global preeminence in the future.” China’s use of “predatory economics to intimidate its neighbors,” as the Pentagon put it, threatens the U.S. primarily by weakening the alliance structure it would like to lean on to manage distant challenges. Indeed, at last year’s epochal Communist Party Congress, President Xi Jinping admitted that China is still several decades from becoming a world-class military power. Thus, it has little choice but to attempt to use its growing economic heft to forge political arrangements with its neighbors (such as the Philippines) that weaken U.S. standing in the region.

It’s debatable how effective Chinese economic statecraft can actually be, given the number of other deep-pocketed players in the region (particularly Japan), the fact that China is facing a prolonged economic slowdown, and the high risk of political blowback for leaders seen as selling out national sovereignty to Beijing. Nonetheless, the potential for Chinese economic coercion is why trade was a central component of the strategic rationale underpinning former President Barack Obama’s administration’s so-called Pivot to Asia, which the NDS echoes heavily. And it’s why, despite jettisoning the Trans-Pacific Partnership trade pact early last year, President Donald Trump’s administration has joined Japan, India and Australia in openly mulling ways to counter China’s One Belt, One Road Initiative. (Whatever the economic or political logic for the U.S. to withdraw from TPP, the pact was designed with broader strategic considerations in mind and would have deepened U.S. influence in key states like Vietnam, likely at the expense of Beijing.)

The Pentagon doesn’t offer much in the way of specific solutions to this problem. This is, in part, because countering Chinese economic coercion isn’t the Pentagon’s job, and the main point of the NDS is merely to focus attention on what the Pentagon has identified as emerging priorities. But by calling for the U.S. to “enlarge the competitive space” – i.e., challenging adversaries and exploiting their vulnerabilities from multiple and unexpected directions – the Pentagon is making the case for a comprehensively geopolitical strategy. And, after two decades of putting out brush fires across the globe, the U.S. is attempting to refocus on the strategic realities that will dominate its future.

Donald Trump Is Playing to Lose

J. Bradford DeLong

BERKELY – America certainly has a different kind of president than what it is used to. What distinguishes Donald Trump from his predecessors is not just his temperament and generalized ignorance, but also his approach to policymaking.

First, consider Bill Clinton, who in 1992 was, like Trump, elected without a majority of voters.

Once in office, Clinton appealed to the left with fiscal-stimulus and health-care bills (both unsuccessful), but also tacked center with a pro-growth deficit-reduction bill. He appealed to the center right by concluding the North American Free Trade Agreement (NAFTA), which had been conceived under his Republican predecessors; and by signing a major crime bill. And he reappointed the conservative stalwart Alan Greenspan to chair the US Federal Reserve.

Clinton hoped to achieve three things with this “triangulation” strategy: to enact policies that would effectively address the country’s problems; to convince voters who hadn’t supported him that he was looking out for their interests, too; and to keep his own base intact.

In 2008, former President Barack Obama was elected with a popular majority. But, like Clinton, he moderated many of his positions once in office. He tacked to the center with technocratic financial-rescue and fiscal-stimulus plans. And he pushed through a market-oriented health-care bill modeled after legislation that Mitt Romney had enacted while serving as the Republican governor of Massachusetts.

Obama also appealed directly to the right with an (unsuccessful) attempt at a “grand bargain” to cut deficits and social spending. His market-oriented cap-and-trade plan to regulate greenhouse-gas emissions was almost indistinguishable from that of his Republican opponent in the 2008 presidential election, Arizona Senator John McCain. And he reappointed Ben Bernanke, originally nominated by Republican President George W. Bush, to chair the Fed.

Obama strove to represent not “red” or “blue” America, but “purple” America. He pursued cautious and technocratic policies that he hoped would attract Republican support. And when his own supporters objected, he reminded them that national unity and mutual respect, not narrow partisanship, would eventually bend the moral arc of the universe toward justice.

Trump, by contrast, won the presidency while losing the popular vote by a wide margin. Yet, once in office, he promptly appealed to right-wing white nativists by issuing his promised travel ban against Muslims. He tried to destroy the 2010 Affordable Care Act (Obamacare) without having a plan for what would replace it. He again appealed to the nativist right by dismissing police brutality against African-Americans, and by describing white supremacists as “very fine people.” And he finished his first year by signing legislation that cuts taxes for the rich, but does little to win over anyone else.

This is not normal politics. Trump clearly has no interest in unifying the country or enacting policies that will actually work. He has not given the majority of Americans who oppose him any reason to change their minds, nor has he counseled his base on the need for durable policies rather than evanescent legislative victories. Most importantly, he has done nothing to help himself get re-elected.

Of course, the same now applies to many Republicans. Here in California last year, we were treated to a remarkable spectacle in which the state’s Republican delegation in the US House of Representatives did not even bother to argue for a tax package that would benefit their constituents. It was as if they had already given up on winning re-election, and were all looking forward to leaving Congress to take high-paying jobs as lobbyists.

According to the Trump administration, its next legislative priority is infrastructure. That sounds like an issue where Trump could tack left, by devising a plan with egalitarian distributional effects and evidenced-based provisions to boost economic growth.

But we shouldn’t count on that outcome. The Trump administration doesn’t seem to have any coherent policy-design process. There have been no hearings or white papers to assess the costs and benefits of various infrastructure proposals. Nor have there been any discussions with lawmakers to establish a rough consensus upon which to base legislation. As with the travel ban and the attempt to repeal Obamacare, there has been no public deliberation whatsoever. All we have are the president’s tweets.

Back in 1776, Adam Smith argued that, in a system founded on “natural liberty,” the government’s three tasks are to provide national defense, ensure public safety and the enforcement of property rights and contracts, and supply infrastructure. According to Smith, the government has the duty to “[erect and maintain] certain public works and certain public institutions, which it can never be for the interest of any individual, or small number of individuals, to erect and maintain.”

To Smith, the reason why governments must take up the task of building infrastructure was clear: “the profit could never repay the expense to any individual or small number of individuals, though it may frequently do much more than repay it to a great society.” Today, we know that public goods actually can be made profitable, but only by granting monopolies, which comes at a high cost to society.

Unfortunately, Trump’s staff does not seem to have gotten Smith’s memo about good government. The administration will most likely propose an infrastructure program based on public subsidies for private investors, who will then select projects from which they can profit by charging monopoly prices. The plan will be well-received at Fox News, and possibly even by pundits at The New York Times, who might stroke their chins and lament that the Democrats are rejecting Trump’s open hand on infrastructure.

But, unlike Clinton and Obama, Trump will have shown yet again that he does not intend to be the president of most, let alone all, Americans. Rather than use the opportunity provided by a debate over infrastructure to advance the cause of national unity, he will instead push the US further toward kleptocracy.

J. Bradford DeLong is Professor of Economics at the University of California at Berkeley and a research associate at the National Bureau of Economic Research. He was Deputy Assistant US Treasury Secretary during the Clinton Administration, where he was heavily involved in budget and trade negotiations. His role in designing the bailout of Mexico during the 1994 peso crisis placed him at the forefront of Latin America’s transformation into a region of open economies, and cemented his stature as a leading voice in economic-policy debates.