Squares, FAANGs, and Stock Valuations  

Valuing a stock isn’t hard. Each share is worth exactly as much as a buyer offers you when you try to sell. Quite simple. But of course, there’s more to it.

We heard a lot about valuations at my Strategic Investment Conference, and particularly about the “FAANG” stocks that drove much of the recent bull run. Now, only two weeks later, the “F” in that acronym (Facebook) is tumbling, with the others maybe not far behind. That’s a problem for every stock investor, FAANG or otherwise. So today we’ll look at valuations more broadly and then zero in on the social networking issues that are turning more problematic.

Photo: Getty Images

Several SIC speakers addressed these topics. I’ll review some today, but for the full story you really need to get our SIC Virtual Pass. I promise to stop hawking it after this week, but I want to give you one last chance. I’ve convinced my partners to extend the special $395 price until midnight this Monday. Click here to get it while you can

Euphoria Everywhere

The FAANG stocks, if you aren’t hip to the lingo, consist of Facebook (FB), Apple (AAPL), Amazon (AMZN), Netflix (NFLX), and Google (GOOGL). Google’s official name is “Alphabet” now, but it takes a G to make the acronym work. 

Whatever you call them, those five companies have ruled the technology sector the last few years and have wielded a heavy influence on the entire stock market. Apple is the world’s most valuable company by market capitalization, with Amazon and Google not far behind. So anyone indexing US large-cap equities – which means almost anyone with investment capital – simply must own them.

Owning the FAANGS was a big help in 2017. Here’s a chart my good friend Dave Rosenberg of Gluskin Sheff shared in his SIC presentation. It shows 2017 price returns for some selected asset classes. Last year pretty much everything went up, but not equally.

As you can see, the FAANG stocks outperformed other stock benchmarks as well as gold, oil, and bonds. And not just by a little. If you are an equity portfolio manager who didn’t own the FAANGs last year, you probably had some explaining to do. But Dave went on to demonstrate why 2018 or 2019 could be quite different, using four different S&P 500 valuation metrics:

• Forward Price to Earnings Ratio
• Price to Sales Ratio
• Price to Book Value Ratio
• Enterprise Value to EBITDA Ratio

Dave then calculated the percentage of time that each of these had been at its present level or below. Here’s the result for P/E ratio.

The S&P 500 forward P/E ratio has been below its present level 83% of the time since 1990. Repeating that exercise for the other three metrics and then averaging them, Dave found the index is presently at a 92nd percentile valuation event. Here’s Dave, from the transcript, with my bold added:

In other words, only 8% of the time in the past has the stock market in the United States been as richly priced as it is today. And if you want to come up with reasons why that’s the case, that’s fine. But just understand that we are extremely pricey. We’re more than just a one standard deviation event versus the historical average.

Dave then showed this surprising table, comparing historic bull markets with GDP change during the same period.

The 2009–2018 bull market from trough to peak averaged 17.3% annually. Nominal GDP rose 3.6% annually during that time, and real GDP rose 2.1%. Go up the table to the 1982–1990 bull run. It reached a similar magnitude at 17.5%, but nominal GDP rose 7.6% and real GDP 4.2%.

Yes, GDP has its flaws. Today’s economy isn’t like the 1980s. Nonetheless, how is it that stocks rose the same amount on half as much economic growth? Dave said that if the stock-GDP ratio today had remained what it was back then, the S&P 500 would be around 1,550 today. That’s how excessive valuations are now. The S&P slid again this week, as you probably noticed.

Here’s another way Dave looked at it: household net worth as a percentage of disposable income. The higher that ratio, the more wealthy and confident you probably feel if you are anywhere near average (and many aren’t, of course).

In 1999–2000 and again in 2006–2007, the ratio was near a peak, and people felt good. The good feelings didn’t last. Both times the ratio corrected back below its long-term average.

And now? The net worth/income ratio is above where it was at those last two cyclical peaks. It could go even higher, too – but not by much, I suspect – and the move down probably won’t be fun.

Whenever it happens, the next downturn will be something new: the first socially networked recession and bear market. It’s hard to believe now, but Facebook and Twitter were both just infants in 2007. Smartphones were still a high-end luxury item, too. We are now tied together in ways we were not back then. Those connections will make the experience quite different, so it’s worth talking about networks.

Square & Tower

In organizing the SIC agenda each year, I try hard to blend experts in other fields with economists and portfolio managers. I want attendees to leave with a richer, more nuanced, multidisciplinary view. That’s one reason Niall Ferguson is a perennial favorite. He looks at the economy with historical perspective and delivers insight we would otherwise miss.

This year Niall gave us some inside thoughts from his latest book, The Square and the Tower. I’m halfway through reading and highly recommend it. As all writers know, some of the best material doesn’t get into the final product, so Niall’s SIC presentation greatly enhanced the experience.

Niall’s book is about hierarchy and networks. Squares are where people meet and mingle. They are the source of creativity, invention, innovation. Towers, on the other hand, are where power resides – “hierarchical structured power,” as Niall calls it. The great tension in human history is between those two, the squares and the towers – and technology has increased that tension.

Rising tensions have all kinds of implications, but the most obvious was the 2016 political changes: populist uprisings in many countries, Brexit in the UK, and Trump’s election in the US. Would those have happened without the new networks Facebook and Twitter? Probably, but not as quickly. The process is continuing, too.

Niall pointed out something critical about networks: They are profoundly unequal. Networks may connect us all, but not in the same ways. Here’s Niall from the SIC transcript:

Networks are inegalitarian in two ways. The structure of the network is inegalitarian because of preferential attachment. When new people join a network, they want to be connected to the most connected nodes. Secondly, once networks become economic propositions run for profit, it’s winner takes all. And that is why five of the eight richest men in the world today are rich because of network economics.

He then showed a slide of those five men: Bill Gates, Jeff Bezos, Mark Zuckerberg, Larry Ellison, and Michael Bloomberg. In different ways, they all saw and exploited the value of connecting people via technology.

This network revolution had a dark side though, and we saw that dark side manifest in 2008.
Here’s Niall again.

The financial crisis, I think, needs to be understood as a colossal network outage. Very few central bankers understood the extent to which the international financial system had become a giant network. I think regulators and legislators underestimated the fragility of the system in 2008. They failed to see that a single node, a single investment bank that nobody regarded as pivotal to the system was in fact very important. And when Lehman failed, the system, the entire global credit system... you remember? I remember... threatened to collapse completely. Andrew Haldane, chief economist at the Bank of England now, is one of the few central bankers who think about this, and indeed this slide was taken from a deck that he did in 2011.

The way I see it is that since 2008 the rest of us have basically caught on with where the financial world was 10 years ago. Initially it was only the financial world that was networked to the max because it was still quite expensive to be networked 10 years ago. But with the advance of giant platforms like Facebook offering zero-cost networking, all of us are now as connected as only investment bankers were a decade ago.

Really pay attention to that chart. This is happening in literally hundreds of industries.

These ubiquitous connections were supposed to empower everyone. Instead, they empowered those who owned and controlled the networks. A handful of “platform” companies essentially gained the ability to micromanage the village square, defining what information each person could see and hear.

In fairly short order, the FAANG companies leveraged that ability to dominate the global economy. Amazon is in a sense eating retail sales by making price discovery much easier. You can compare prices simply by running your phone over a barcode while you shop in a store.

Similarly, Google and Facebook are eating advertising. Apple, Netflix, and their kin are eating leisure time. Our already weak form of capitalism has turned as monopolistic as it was in the Gilded Age more than a century ago. It wasn’t supposed to happen that way, but it did.

So now those companies face a worsening backlash. Evidence increasingly suggests that Facebook’s data trove affected election results more than previously understood. Whether that was spontaneous or planned isn’t yet clear. But many Facebook users and, more importantly, advertisers aren’t happy about it.

(To be clear, I am not talking about Russian use of Facebook or Twitter. Whatever they spent pales in comparison with what the candidates themselves spent, plus their surrogates and other groups.)

Cracks Forming

This discussion brings us back now to market valuation. As we saw above, the stock market is overvalued by many different measures. I shared Dave Rosenberg’s thoughts, but at SIC we heard a lot more from Steve Blumenthal, Mark Yusko, and several others. The evidence is adding up – and it’s not bullish, to say the least.

What drove valuations higher? Many reasons, but the FAANG companies are primary. Here’s another chart Niall Ferguson shared:

Tech stocks – including all the FAANG names except Netflix – were 8 of the world’s 12 most valuable companies when FT made this chart last year.

If several of these stocks start rolling over, the global bull market will be hard to sustain – and it’s already under assault for entirely different reasons, like rising interest rates, a potential trade war, and the overdue US recession.

It’s startling how fast the picture has changed. As of December, many bulls thought tax cuts would spark enough activity to keep the economy growing into 2019 and beyond. That opinion is considerably less common today, including at the Federal Reserve. Here’s the FOMC’s latest GDP projection, released just this week.

I include this chart not because the FOMC members are great forecasters; they are clearly not. But this is what they think, and their thinking guides their rate decisions, which do have consequences. They see real GDP growth rising to the 3% area this year before drifting back down to around 2% in the long run. And believing that, they still turned slightly more hawkish.

The Atlanta Fed’s GDPNow forecast is even more telling:

Less than two months ago, GDPNow was predicting almost 5.5% real GDP growth this quarter. From there, GDP growth has collapsed all the way to 1.8% as of March 23.

If the economy and markets are a mirror, we’re starting to see a bunch of cracks. The Bitcoin breakdown looks ominous in hindsight as possibly the first domino. Then we had the February VIX-driven correction, followed by trade worries and now FAANG fears.
Rifle Shots

My good friend Steve Blumenthal used this chart from Ned Davis Research. Essentially, NDR looks at 10 recession indicators, each of which have varying levels of reliability; but by combining them in one overall index, you get a much better picture. As of now, it says recession danger is relatively low for the next nine months.

That said, the clear consensus from SIC was that the economy is likely to slow down, and the potential for a recession by mid-2019 is very real. A looming slowdown will hit corporate earnings and eventually stock prices. Judging from February and then this week, we may already be entering that stage.

Of course, the conference wasn’t all bad news. We heard about major progress on the antiaging front. Speakers presented numerous investing ideas, and attendees exchanged more with each other. But I didn’t hear anyone suggest buying indexes and then going away. This is a time for well-aimed rifle shots.

All in all, it was the best Strategic Investment Conference of the last 15 years. If you are in the industry or are interested in investing and economics, you really should take the time to work through the transcripts and slide presentations of this conference. As I promised, this letter will be my last “pitch” for the Virtual Pass. I am so enthusiastic about this conference that I just wish everybody could experience it. Buy now, because the price goes up after this weekend.

And if you couldn’t make it to San Diego this year, then mark your calendar to join me in Dallas for the 16th annual Strategic Investment Conference. The dates are May 13–16, 2019. Start planning your schedules now.

Charlotte, Fort Lauderdale, Chicago, and Raleigh

I am home next week, but in April and May I travel to Charlotte, Fort Lauderdale, Chicago, and Raleigh for speaking engagements. I’ll share information on these as they draw closer.  

One last SIC thought. I think my favorite session of the conference, if the most troubling, was the panel with Democratic pollster Pat Caddell, Heritage Foundation economist Steve Moore, and demographics expert Neil Howe. This week I had long telephone conversations with both Pat and Neil, trying to get a handle on the future of US and global politics. That issue is becoming a significant portion of the book I’m working on. I think understanding the fragmentation of societies worldwide is as important as grasping the import of technological changes is. Throw in the increasingly worrisome macroeconomic developments and rising global debt, and a “Perfect Storm” may be brewing.

These periods of great societal regime change are rare. Of course, one such period saw the founding of this country; then came1824, 1860, and 1932. Now it feels as if another turning point is at hand. It is almost as if we are searching all over again for the definition of “American,” or “French,” “Italian,” “Brit,” or “German.”

Two weeks ago in “The Great Jobs Collision” I talked about the massive number of jobs that could disappear in the US over the next 12 years. This transition will mean even more angst. Yes, new jobs will be created, but they won’t be where the old jobs were lost, or require the same skills, or deliver the same pay.

Twenty years ago, the number of people who believed in universal basic income in the United States was relatively small. Today it is almost 50% and rising. Pat Caddell sent me an 80-slide deck of his latest polling results, which depict the country more divided than ever. Neil Howe’s data shows the same generational conflicts as well, just playing out on a different level.

We had some out-of-town guests last night, all from the financial industry, and the after-dinner conversation just kept reminding me that we must be willing to think the unthinkable. That is true both with regard to the incredibly fast-paced technological changes that are coming and with regard to the societal tremors and upheavals that lie ahead.

I believe this last conference and the follow-up conversations have had more impact on my thinking than any previous conference has. I am glad to be home next week because I really need more time to think. In the meantime, you have a great week.

Your still somewhat overwhelmed analyst,

John Mauldin


by Egon von Greyerz


Thus, you make a bet and if you are lucky you win a prize but you can also lose it all. Gambling has been around for thousands of years and maybe longer. The first 6-sided dice dates back 3000 years.

Eventually gambling became more organised as casinos were established. The first well known casino was set up in Venice in the early 1600s.

Casino means a small house and the house was the banker. The odds were naturally always in favour of the house and that has not changed for centuries. In the last 100 years, the bankers or the House have made fortunes and especially in the last 25 years as market manipulation has taken massive proportions.

Over the last 100 years, governments and central bankers have made the investment markets into a casino with only winners which primarily have been the bankers themselves.


Central and commercial bankers have created the most perfect Casino model, a model where the banker is the winner every time. Firstly, the banker issues the money with the help of infinite leverage. Then he sets the conditions – interest rates, fees, terms etc. To further improve his odds, the banker also manipulates markets so that they are always in his favor.

The most perfect market from the bankers’ point of view is the derivative market. This is the biggest financial market in the world. It consists primarily of unregulated Over the Counter (OTC) instruments. A derivative is an instrument which derives its value from underlying assets such as stocks, stock indices, bonds, foreign exchange, gold, silver etc.

Derivatives is the biggest money spinner of the financial system and has made many bankers very wealthy. The system is totally skewed against the buyers of the derivatives. Prices are set so that the issuer of the derivative cashes in virtually every time. Prices are always set for the bank to collect 100% of the premium and never pay out. As maturity of a derivative in the money approaches, the bank will do its utmost to manipulate the price to make the derivative worthless.

It is important to understand that the value of a derivative is derived from underlying assets but there is absolutely noting backing a derivative except for the credit standing of the issuer.


Total derivatives outstanding is around $1.5 trillion. The Bank for International Settlements (BIS) reports a figure of $500 trillion. But that figure is not credible since it was adjusted some years ago after netting off a major part of the gross exposure. The gross derivative exposure is 1070x central bank gold. So if central banks needed to cover an implosion of the derivative market with gold, the gold price would increase over 1,000 fold from here to $1.4 million. This might not seem a plausible price but we must remember that gold reached 100 trillion Marks during the Weimar Republic and is now in Venezuela 53 million Bolivars. (The black market price is 370 million bolivars). As global credit markets implode and money printing starts in earnest, a $1.4 million gold price might be much too low.


If we look at the derivative exposure of some of the major banks, it also shows a very dire picture:

With equity of 0.15% to 0.5% of total exposure, these banks are unlikely to survive the next crisis.

The exposure shown is most probably well below the real exposure since it is based on the BIS calculation. The real figure is probably twice as high. Still, it shows the massive risk that these banks are exposed to. They will of course argue that this is the gross exposure and that the net position is a fraction of the gross. That argument is valid in an orderly market when counterparty pays. In 2007-9 we saw what can happen when counterparty fails like with Lehman. The global financial system was then saved in the last minute. But with global debt having doubled since then and risk up manifold, next time we have a global crisis, counterparty is very likely to fail.


The risk in the derivative market is not recognised by the banks, central banks or the market.

In the 2007-9 financial crisis, it was mortgage linked derivatives that brought the world to the brink. Next time around it will also be the derivative market that will bring the financial system down. But that time, the system is unlikely to be saved. Interest rates are already low and money printing will have no real effect.

As the cube shows above, there is too little gold in the world to save the system when fiat money becomes worthless. Or to look at gold in a different way, gold and silver will need to appreciate at least 1,000 fold and probably a lot more, to reflect the losses in the system and the debasement of money.


Gold at $1,320 and silver at $16.50 represents incredible value in a financial system that is unlikely to survive in its present form. Precious metals is the only asset class which will maintain its purchasing power in the coming financial crisis. But more likely is that gold and silver will do a lot better than just maintaining value. Commodities are now finishing a major bear cycle and will outperform all asset classes in coming years. Gold and Silver will be the winners amongst all the commodities and will reach levels which are hard to imagine today.

What is guaranteed is that paper money will become worthless in the coming crisis and that most bubble asset classes will decline 75-95% in real terms. Gold is nature’s money and as such will be the only money that will survive the coming crisis just as it has for over 5,000 years.

America v China

The battle for digital supremacy

America’s technological hegemony is under threat from China

“DESIGNED by Apple in California. Assembled in China”. For the past decade the words embossed on the back of iPhones have served as shorthand for the technological bargain between the world’s two biggest economies: America supplies the brains and China the brawn.

Not any more. China’s world-class tech giants, Alibaba and Tencent, have market values of around $500bn, rivalling Facebook’s. China has the largest online-payments market. Its equipment is being exported across the world. It has the fastest supercomputer. It is building the world’s most lavish quantum-computing research centre. Its forthcoming satellite-navigation system will compete with America’s GPS by 2020.

America is rattled. An investigation is under way that is expected to conclude that China’s theft of intellectual property has cost American companies around $1trn; stinging tariffs may follow. Earlier this year Congress introduced a bill to stop the government doing business with two Chinese telecoms firms, Huawei and ZTE. Eric Schmidt, the former chairman of Alphabet, Google’s parent, has warned that China will overtake America in artificial intelligence (AI) by 2025.

This week President Donald Trump abruptly blocked a $142bn hostile takeover of Qualcomm, an American chipmaker, by Broadcom, a Singapore-domiciled rival, citing national-security fears over Chinese leadership in 5G, a new wireless technology. As so often, Mr Trump has identified a genuine challenge, but is bungling the response. China’s technological rise requires a strategic answer, not a knee-jerk one.

The motherboard of all wars

To understand what America’s strategy should be, first define the problem. It is entirely natural for a continent-sized, rapidly growing economy with a culture of scientific inquiry to enjoy a technological renaissance. Already, China has one of the biggest clusters of AI scientists. It has over 800m internet users, more than any other country, which means more data on which to hone its new AI. The technological advances this brings will benefit countless people, Americans among them. For the United States to seek to keep China down merely to preserve its place in the pecking order by, say, further balkanising the internet, is a recipe for a poorer, discordant—and possibly warlike—world.

Yet it is one thing for a country to dominate televisions and toys, another the core information technologies. They are the basis for the manufacture, networking and destructive power of advanced weapons systems. More generally, they are often subject to extreme network effects, in which one winner establishes an unassailable position in each market. This means that a country may be squeezed out of vital technologies by foreign rivals pumped up by state support. In the case of China, those rivals answer to an oppressive authoritarian regime that increasingly holds itself up as an alternative to liberal democracy—particularly in its part of Asia. China insists that it wants a win-win world. America has no choice but to see Chinese technology as a means to an unwelcome end.

The question is how to respond. The most important part of the answer is to remember the reasons for America’s success in the 1950s and 1960s. Government programmes, intended to surpass the Soviet Union in space and weapons systems, galvanised investment in education, research and engineering across a broad range of technologies. This ultimately gave rise to Silicon Valley, where it was infused by a spirit of free inquiry, vigorous competition and a healthy capitalist incentive to make money. It was supercharged by an immigration system that welcomed promising minds from every corner of the planet. Sixty years after the Sputnik moment, America needs the same combination of public investment and private enterprise in pursuit of a national Project.

Why use a scalpel when a hammer will do?

The other part of the answer is to update national-security safeguards for the realities of China’s potential digital threats. The remit of the Committee on Foreign Investment in the US (CFIUS), a multi-agency body charged with screening deals that affect national security, should be expanded so that minority investments in AI, say, can be scrutinised as well as outright acquisitions. Worries about a supplier of critical components do not have to result in outright bans. Britain found a creative way to mitigate some of its China-related security concerns, by using an evaluation centre with the power to dig right down into every detail of the hardware and software of the systems that Huawei supplies for the telephone network.

Set against these standards, Mr Trump falls short on every count. The Broadcom decision suggests that valid suspicion of Chinese technology is blurring into out-and-out protectionism. Broadcom is not even Chinese; the justification for blocking the deal was that it was likely to invest less in R&D than Qualcomm, letting China seize a lead in setting standards.

Mr Trump has reportedly already rejected one plan for tariffs on China to compensate for forced technology transfer but only because the amounts were too small. Were America to impose duties on Chinese consumer electronics, for example, it would harm its own prosperity without doing anything for national security. An aggressively anti-China tack has the obvious risk of a trade tit-for-tat that would leave the world’s two largest economies both worse off and also more insecure.

Mr Trump’s approach is defined only by what he can do to stifle China, not by what he can do to improve America’s prospects. His record on that score is abysmal. America’s federal-government spending on R&D was 0.6% of GDP in 2015, a third of what it was in 1964. Yet the president’s budget proposal for 2019 includes a 42.3% cut in non-defence discretionary spending by 2028, which is where funding for scientific research sits. He has made it harder for skilled immigrants to get visas to enter America. He and some of his party treat scientific evidence with contempt—specifically the science which warns of the looming threat of climate change. America is right to worry about Chinese tech. But for America to turn its back on the things that made it great is no answer.

Mexico: A History of Power Vacuums

Mexico’s northern borderlands have become notorious for their lawlessness. At times it can seem that organized crime groups have as much control as the federal government. Last year was actually Mexico’s most murderous year on record. The drug trade is the easy and obvious explanation for this phenomenon, and it isn’t wrong – but it is incomplete.
Mexican governments have always had a difficult time ruling over the outer reaches of their domain. The Spanish Empire, which also had the capital of its Viceroyalty of New Spain in Mexico City, had similar issues. The Aztec Empire (also based in Mexico City, though it called it Tenochtitlan) would have encountered the same problem if it had gotten much larger. The common thread here isn’t narcotics; it’s geography. The region around Mexico City is the heartland of Mexico, but it’s also disconnected from the farthest reaches of the country by distance, mountain ranges and plateaus.
This Deep Dive will take a closer look at the features of Mexico’s geography that make its borderlands and peninsulas so difficult to control from the center. We’ll also look at Mexico’s history, which is rife with periods that promoted the localization of security and independent-minded regional security forces. And we’ll discuss the northern border region and its relationship to the U.S., specifically what it would take for the U.S. to intervene militarily to secure the border and quell the violence.
Geography Then and Now
Mexico City, the seat of Mexico’s government, has a very basic problem: It has a lot of territory to govern and many physical obstacles between itself and much of that territory. Mexico is one of only two places in the world (the other is off the coast of Peru and Ecuador) that resides on or near the junctions of four tectonic plates – the Pacific, Cocos, Caribbean and North American plates. This makes the country a hub for seismic activity, the cause of Mexico’s many mountain ranges and plateaus. The mountainous topography separates the country into regions with unique physical environments. In some areas this hindered the development of population centers, and it has defined the culture as well as which economic activities are viable.
Narrow coastal plains and basins run along either side of the country. To the extreme northwest and southeast are the Baja California and Yucatan peninsulas, respectively. Just a short distance inland, three mountain ranges flank the mainland – the Sierra Madre Occidental in the west, the Sierra Madre Oriental in the east, and the Sierra Madre del Sur in the south. Between the western and eastern mountain ranges is the massive Mexican plateau.

Geographically, the Mexican plateau is a single feature; geopolitically, there’s a clear division between the northern and southern plateau regions. The Chihuahaun Desert dominates the northern plateau. It does not easily support large-scale vegetation, wildlife or human populations. The southern plateau, on the other hand, sits at an altitude 3,000 feet (900 meters), which gives it a much more habitable climate, and its valleys to the south are among the most habitable in the country. Temperatures in the southern plateau and valley average 40-80 degrees Fahrenheit (about 4-27 degrees Celsius) year-round and rarely reach extreme levels. Annual rainfall is typically about 28 inches (71 centimeters), well above the roughly 15 inches needed to maintain agricultural practices, and arable land makes food production possible.

Put these factors together and it makes sense why the valley south of the southern plateau region is the heart of Mexican civilization – the center of the Aztec empire and still the geopolitical heartland of the country today. The coast could support a large population, but any capital there would have found itself even more disconnected than Mexico City is from the rest of the country. The southern plateau isn’t perfect, but it is the best chance a civilization has to expand and project power to all corners of modern-day Mexico.
In fact, a glance at the pre-Columbian empires – mostly the Aztec but also the Mayan – provides a blueprint for understanding how Mexico’s mountain systems still impede power projection today. Both civilizations reached their limits in large part because of the difficulties that came with regularly traversing mountain ranges. For the Aztec, administrative systems were put in place to reflect this. The Aztecs’ capital was Tenochtitlan, modern-day Mexico City. As their empire expanded, direct control over their new holdings did not. In some areas they allowed local officials to govern and demanded tribute in return.

Nearly 500 years have elapsed since the Aztec Empire fell, but the situation isn’t all that different for Mexico today. Technology has reduced geography’s impact, but rarely does innovation overcome geography entirely. The mountains and long distances that afflicted the ancient empires of the land are still making it hard for the government in the valleys off the southern plateau to have a strong presence in Mexico’s peninsulas, coastal regions and northernmost states.
The Monumental Task of Unification
Mexico’s topography poses the same challenges to internal security that it does to central governance. Historically, Mexico City could not easily move large numbers of troops over vast distances and treacherous terrain, so it has had no choice but to rely on local forces to augment the national security forces. The Mexican states, in turn, have been conditioned to be self-reliant on security. From time to time, the isolation of some areas and subsequent feeling of alienation has engendered the creation of armed rebel groups hoping to secede from or even overthrow the national government. Combined, these trends have led to a strong belief in homegrown security and skepticism of the national government. This strongly influences the way the state and non-state actors respond to lapses in security in modern Mexico. Where geography and estrangement once fostered rebellion and independence movements, today those factors help explain the rapid growth of organized crime groups and the vigilante groups that have popped up to stop them.
The reliance on local forces to augment central government forces dates back to Mexico’s colonial period, though initially it had less to do with the region’s terrain or vastness. Throughout the 17th and 18th centuries, Spain was engaged in multiple wars across Europe. The Spanish crown needed its troops for battles in the near abroad, and so once Mexico was considered conquered, Spain redirected military resources to its European endeavors. Much of the day-to-day security responsibilities were put in the hands of the colonists and local authorities. Mayors and business elites often funded irregular militias  to help enforce security in the countryside and city centers.
Over time, Spain sent more regular troops over to Mexico, but mostly it tried arming and training locals to enforce security. By the early 19th century, near the start of Mexico’s war for independence, there were approximately 40,000 security forces in Mexico, only 6,000 of which were professional soldiers. The rest were from local militias. When Mexico’s independence movement took shape, it drew most of its fighting force from those local militias.
Once Spain was driven out, however, Mexico still faced the monumental task of unification. Many states were reluctant to answer to a central authority immediately after ridding themselves of Spanish rule. As a colony, economic activities had been poorly integrated – the states’ focus had been on shipping goods to Spain, not to each other. And the states had their own longstanding militias, whose members often had a strong affinity for their local authorities.
As a result, the newly formed Mexican government spent much of the 1830s and 1840s confronting secessionist movements. The central government was ill-equipped to deal with so many threats at once. Many state and local governments refused to pay more taxes and support a national army, preferring instead to maintain their own forces for defense. Large-scale rebellions erupted in Zacatecas and Tabasco, while republics temporarily formed in the territories of Texas, Yucatan and Rio Grande. (Texas eventually joined the United States, Yucatan returned to Mexico, and Rio Grande split the difference – part went to Texas, the rest became the Mexican states of Coahuila, Nuevo Leon and Tamaulipas.) Not coincidentally, all the areas where republics formed are far from the southern plateau region, and mountain ranges or deserts separate them from Mexico’s core.
Later in the 19th century and into the 20th century, other political shifts reinforced the idea that local security forces must have a prominent role. When the French tried to re-establish a monarch in Mexico in 1861, some Mexican elites endorsed the effort. Much of the country didn’t. France sent its military to impose its will. Local forces had to be commandeered to fight the French national troops. During the French intervention, the ousted Mexican government still strove to function in parallel to the French and was never fully quashed.
Then in 1910 came the Mexican Revolution, when the idea of local force development was even more vital to the revolution’s success. The longstanding government of President Porfirio Diaz used patronage to build close ties with local leadership and used the military to crush dissent. Though this approach succeeded in bringing economic growth and the most stable government structure the country had seen up to that point, it was unsustainable. Many segments of society lacked input or representation in government, and eventually they fought back.
The revolution gave a voice to the miners and farmers and factory workers who had been voiceless under the elitist government. When it came time to write a new constitution in 1917, more power was given to the local authorities. The new constitution provided a framework for security and conflict resolution under the guidance of local community leaders.
Modern Mexico
A century later, the most vexing areas for the Mexican central government are those in the northern part of the country because of their proximity to the United States.
The U.S.-Mexico border stretches almost 2,000 miles (3,100 kilometers), long enough for distinct sections to develop. A 2011 Foreign Policy Research Institute report provides a geopolitical breakdown of the border and surrounding region into three parts. First, there is Baja California, which consists of Mexico’s Baja California and Baja California Sur states (bordering California). Then there is the central band of the border referred to as the Sierra Madre, which includes Sonora and Chihuahua states (bordering Arizona, New Mexico and west Texas). The northern sections of Durango and Sinaloa are essentially part of this border section, though they don’t actually border the United States. Finally, there’s the Rio Grande Basin, which sits just south of Texas and includes Coahuila, Nuevo Leon and Tamaulipas as well as the northern parts of Durango, Zacatecas and San Luis Potosi (which, again, aren’t on the border but are so connected to the border states that they may as well be).

Economically, some of these states are as connected, if not more connected, to their neighbors to the north than they are to the people in the southern plateau who govern their lives. These are realities that Mexico can live with, but the violence and insecurity of the northern states are a different story. Mexico City cannot let the situation deteriorate to the point that it loses the ability to exert authority, or even worse, that the U.S. feels compelled to intervene.
Baja California is strategically valuable for Mexico as a natural land buffer along the Pacific coast. Much of the peninsula, and its population, is closer to California than it is to Mexico City. As a result, the peninsula boasts strong cross-border ties with the U.S., and American companies have been influential in the region’s development. On the Atlantic coast, the Rio Grande Basin provides its own strategic value given its proximity to the Gulf of Mexico. Its local businesses are closely tied to the Texas economy, which is as important, if not more so, to the local livelihood as Mexico City.
The Sierra Madre region in the center is one of the most difficult regions for Mexico to control. It includes mountainous terrain on either side, with the vast Chihuahuan Desert in between. This was one of the least populated areas during the colonial and early independence times. Because of the terrain, ties with Mexico City are meager, and it is difficult to sustain population centers. These conditions bred a strong feeling of distance from Mexico’s central government. Once upon a time, clashes with indigenous groups like the Comanche were frequent, and a distinct rancher and cowboy culture took root, which contrasted sharply with the cosmopolitan, aristocratic society of the capital. Mexico’s wars have also had a large impact on the people of this area. During the war for independence, Spain severed Mexico City’s supply lines to the north, and Sonora state suffered as a result. Inhabitants of the area were also the most affected among Mexicans by the exchange of territory at the end of the Mexican-American War.
Mexico’s government today faces the same challenges in projecting power as those that came before it. Its ability to influence the outer reaches of the country dwindle with each mile and mountaintop, same as ever. The difference today is that the actors filling the power void aren’t concerned with self-governance; they’re organized crime groups fighting for turf, and vigilante groups fighting for peace. After so many instances in which local populations benefited from taking matters into their own hands, there is a sense of local entitlement to self-governance. The result has been widespread violence, the deterioration of local institutions and a central government looking more and more to the military to re-establish law and order.
As the violence creeps toward and exceeds historic levels and uncertainty grows about the government’s ability to control it, the U.S. is paying close attention to the potential for spillover. It’s not unheard of that the U.S. would react to security threats emanating from across the border: Instability during Mexico’s revolution provoked a U.S. military intervention in 1916, when the U.S. Army sent a “Punitive Expedition” force to capture Pancho Villa.
But if that’s what it takes for the United States to intervene, we are a long way from intervention. At the time of its revolution, Mexico’s central government was extremely weak, and multiple border incursions had resulted in the killing of U.S. citizens on U.S. soil. Before Washington got involved, it pursued other measures such as putting more troops on the border, declaring martial law along the Texas border and setting up blockades to prevent arms shipments from reaching Mexico. Today, its focus is on building a Wall.

The Real Reason for Trump’s Steel and Aluminum Tariffs

Martin Feldstein

Worker stand in a steel workshop in Zouping

CAMBRIDGE – Like almost all economists and most policy analysts, I prefer low trade tariffs or no tariffs at all. How, then, can US President Donald Trump’s decision to impose substantial tariffs on imports of steel and aluminum be justified?

Trump no doubt sees potential political gains in steel- and aluminum-producing districts and in increasing the pressure on Canada and Mexico as his administration renegotiates the North American Free Trade Agreement. The European Union has announced plans to retaliate against US exports, but in the end the EU may negotiate – and agree to reduce current tariffs on US products that exceed US tariffs on European products.

But the real target of the steel and aluminum tariffs is China. The Chinese government has promised for years to reduce excess steel capacity, thereby cutting the surplus output that is sold to the United States at subsidized prices. Chinese policymakers have postponed doing so as a result of domestic pressure to protect China’s own steel and aluminum jobs. The US tariffs will balance those domestic pressures and increase the likelihood that China will accelerate the reduction in subsidized excess capacity.

Because the tariffs are being levied under a provision of US trade law that applies to national security, rather than dumping or import surges, it will be possible to exempt imports from military allies in NATO, as well as Japan and South Korea, focusing the tariffs on China and avoiding the risk of a broader trade war. The administration has not yet said that it will focus the tariffs in this way; but, given that they are being introduced with a phase-in period, during which trade partners may seek exemptions, such targeting seems to be the likeliest scenario.

For the US, the most important trade issue with China concerns technology transfers, not Chinese exports of subsidized steel and aluminum. Although such subsidies hurt US producers of steel and aluminum, the resulting low prices also help US firms that use steel and aluminum, as well as US consumers that buy those products. But China unambiguously hurts US interests when it steals technology developed by US firms.

Until a few years ago, the Chinese government was using the Peoples Liberation Army’s (PLA) sophisticated cyber skills to infiltrate American companies and steal technology. Chinese officials denied all wrongdoing until President Barack Obama and President Xi Jinping met in California in June 2013. Obama showed Xi detailed proof that the US had obtained through its own cyber espionage. Xi then agreed that the Chinese government would no longer use the PLA or other government agencies to steal US technology. Although it is difficult to know with certainty, it appears that such cyber theft has been reduced dramatically.

The current technology theft takes a different form. American firms that want to do business in China are often required to transfer their technology to Chinese firms as a condition of market entry. These firms “voluntarily” transfer production knowhow because they want access to a market of 1.3 billion people and an economy as large as that of the US.

These firms complain that the requirement of technology transfer is a form of extortion. Moreover, they worry that the Chinese government often delays their market access long enough for domestic firms to use their newly acquired technology to gain market share.

The US cannot use traditional remedies for trade disputes or World Trade Organization procedures to stop China’s behavior. Nor can the US threaten to take Chinese technology or require Chinese firms to transfer it to American firms, because the Chinese do not have the kind of leading-edge technology that US firms have.

So, what can US policymakers do to help level the playing field?

This brings us back to the proposed tariffs on steel and aluminum. In my view, US negotiators will use the threat of imposing the tariffs on Chinese producers as a way to persuade China’s government to abandon the policy of “voluntary” technology transfers. If that happens, and US firms can do business in China without being compelled to pay such a steep competitive price, the threat of tariffs will have been a very successful tool of trade policy.

Martin Feldstein, Professor of Economics at Harvard University and President Emeritus of the National Bureau of Economic Research, chaired President Ronald Reagan’s Council of Economic Advisers from 1982 to 1984. In 2006, he was appointed to President Bush's Foreign Intelligence Advisory Board, and, in 2009, was appointed to President Obama's Economic Recovery Advisory Board. Currently, he is on the board of directors of the Council on Foreign Relations, the Trilateral Commission, and the Group of 30, a non-profit, international body that seeks greater understanding of global economic issues.