Market Realities

Doug Nolan


Markets have grown well-versed at disregarding structural issues. I'm still amazed at what the marketplace was willing to ignore throughout the mortgage finance Bubble period: A doubling of mortgage Credit in just about six years; the California housing market out of control by 2005; $1.0 TN of subprime CDS in 2006; the unprecedented growth in leveraged securities holdings and so on. Unrelenting Trade and Current Account Deficits. Didn't the excesses of the cycle ensure a crash?

For those of us who have studied financial history, 2002-2008 financial follies pale in comparison to "Roaring Twenties" excess that unfolded without ramifications in the eyes of the securities markets - well, that is, until the Great Crash. What today's markets have chosen to overlook - and what people have come to believe - are even more astounding.

Excesses over the past (almost) decade have been in the "Roaring Twenties" caliber: Prolonged, deeply structural and accompanied by epic misperceptions. There's no mystery why markets regress into a dysfunctional mechanism that hears no evil, sees no evil and speaks no evil. Given time (and ample "money" and Credit), asset inflation trumps worry; greed concurs fear.

Prolonged Bubble Dynamics ensure everyone eventually gets aboard the great bull market. Once on the ride, the myopic optimistic view takes on a life of its own, crushing dissent in the process. And the deeper the structural deficiencies - the more resolute central bankers will be with ongoing central bank accommodation. Especially during periods of central bank activism (the current cycle and the "Roaring Twenties" topping the list), structural deficiencies over time turn bullish for asset prices and financial speculation.

Structural U.S. Trade and Current Account Deficits are a root cause of much that afflicts the world economy these days. At $57.6 billion, February's U.S. trade deficit was the largest since 2008. At $154bn, Q4 '17's Current Account Deficit was the biggest going back to Q3 2008. Even in the depth of economic recession, the U.S. in 2009 ran a Current Account Deficit of $384 billion. Indicative of historic structural maladjustment, the U.S. has not posted a quarterly Current Account surplus since 1991. This was only possible because of Fed activism.

Incessant U.S. monetary inflation overwhelmed the world with dollar balances, with the process of inflating the world's reserve currency unleashing synchronized monetary inflation and Bubbles around the globe. The U.S. has deindustrialized, shifting to a financial, consumption and services based economic structure. These and related powerful forces have fomented intractable financial and economic fragility, wealth inequality, social discontent and geopolitical instability.

Inflating securities markets have distorted perceptions. Just ignore President Trump's blustering tariff rhetoric - it's all an "art of the deal" negotiating tactic. They'll get to the negotiating table and come to terms. Economic fundamentals are robust; a glorious earnings seasons starts soon. Trump will turn pragmatic and back down. China will make some concessions, enough for both sides to save face. The President surely won't push this to the point of causing a problem for the great bull market.

In reality, the China issue goes far beyond trade. The Chinese have been working diligently for years now to attain superpower status - to supplant U.S. global hegemony and achieve their rightful destiny. With the extravagant assistance of U.S. trade and loose finance more generally, China has enjoyed essentially limitless resources to invest in world class manufacturing capabilities, global trade dominance, technological prowess and a formidable military complex. Is the U.S. to simply cede global power and influence to Beijing without even mustering a stab at countermeasures? The President and others believe strongly that something must be done after years of Washington neglect.

It's no coincidence that the past decade has seen the parallel ascent of the strongman central banker (i.e. Bernanke, Draghi, Kuroda…) and the strongman autocrat (i.e. Putin, Xi, Trump, Erdogan, Sisi, Duterte - to name just a few). Putin and Xi, in particular, have gone to extraordinary measures to secure domestic power and global influence. Xi has taken firm control of Beijing, while Beijing has placed even tighter reins on domestic "markets," finance and the overall Chinese economy.

China and Russia have solidified close economic and military bonds. They have also worked intensively to develop strategic trade, financial and economic institutions and relationships outside the purview of U.S. dominance. The U.S. has spent the past decade printing "money," inflating asset prices, stoking consumption and reveling in quite a financial mania. Others - our principal competitors - have been in intense preparation. For what is not at this point clear.

I'll assume China would today prefer the status quo. They're in no hurry for a confrontation - economic or otherwise. It would suit their objectives to pursue the steady, disciplined execution of their long-term strategy. They'll be willing to make limited concessions - but there will be no backing down. Zero sign of weakness; no inclination to give in to Trump. Willing to fight "at any cost." The strongman Xi, having recently accomplished an incredible power grab domestically, will not shy away from the opportunity to demonstrate his power on the global stage. And he'll enjoy overwhelming domestic support when confronting the U.S. "bully."

For the Chinese, the impetus of "Trump tariffs" goes way beyond trade. The Trump administration seeks to rein in China's global superpower ambitions. China always claims it will "never succumb to external pressure." At last, they have attained the power to back up the bravado. Better to move decisively to bloody Trump's nose wrestling over trade. After all, there are bigger battles brewing on the horizon: Taiwan, the South China Sea, global resources, new technologies, military superiority, etc.

One could make the argument that the Chinese Bubble creates the type of acute financial and economic fragility that dictates a cautious approach from Beijing. The counterargument is that there are advantages domestically - and ample historical precedent - for villainizing foreigners. The great Chinese "meritocracy" has badly mismanaged key aspects of financial and economic development - the steep costs of which will surface when the Bubble finally succumbs. Why not pin blame on foreigners (the U.S. and Japan, in particular) determined to unjustly undermine China's phenomenal progress?

President Trump, as well, has justification not backing down. For years, China has abused its trading relationship with the U.S. (and others). The Chinese have in recent decades fragrantly stolen industrial and military secrets, technologies, and intellectual property. Comprehensive and sophisticated efforts to misappropriate have paid fantastic dividends - with meager cost and consequence. Akin to the North Korean situation, past administrations (of both parties) have talked tough, negotiated diffidently, acquiesced and, in the end, empowered serious threats to United States security. Stock prices notwithstanding, the President would not be a crazy lunatic for believing our country has been left with no other choice: something must be done.

Both sides likely believe their adversary has more to lose. President Trump can bluster "my trade deficit is bigger than yours." With his Thursday evening statement of "an additional $100 billion of tariffs," the Chinese will rather quickly run out of U.S. imports to list for potential reciprocal treatment. The Trump administration likely sees the robust U.S. economy on stronger footing than China's, and the U.S. banking sector relatively well positioned to deal with some adversity.

After taking extraordinary control measures over its financial system and economy, Beijing surely believes the U.S. has more to lose from the standpoint of securities markets tumult. Beijing also believes much of the world will have sympathetic ears to their protests against Trump's overhanded threats of tariffs and trade wars. China can try to claim the moral high ground, which will not sit well in the Oval Office.

After opening Wednesday's session down 500 points, the DJIA rallied almost 1,100 points in about eight hours of trading. Administration officials (notably Wilbur Ross and Larry Kudlow) adeptly walked back market fears of an unfolding trade war. It's all a negotiating tactic. These efforts - along with the market rally - were crushed by the President's Thursday evening "additional $100 billion…" pronouncement. Larry Kudlow said he learned of the new tariff list Thursday night. Friday afternoon from "The Hill": "President Trump's new top economic adviser Larry Kudlow joked Friday that he's 'gotta beat' former communications director Anthony Scaramucci's 11-day tenure in the White House."

The markets have been willing to overlook structural issues along with White House chaos. Market participants have remained composed: Tax cuts coupled with conviction that the threat of sinking stock prices will keep the President from doing anything too destabilizing. Such remarkable composure appeared at risk during Friday trading. There was no attempt at walking back the President's statement. The "additional $100 billion" may have been a negotiating tactic, but no longer can it be taken for granted that the President is fixated on stock prices. Was Trump incensed by the Chinese response, his team's approach to damage control - or both?

This is a President increasingly willing to "go off script," "call his own shots" and relish being "unhinged." And rather suddenly the unpredictability and unconventionality of the President on matters of momentous importance do matter to the stock market.

Does President Trump believe the long-overdue confrontation against abusive Chinese trade and business tactics take precedence over short-term stock market performance? For good reason, the markets are increasingly fearful he might.

The conventional view holds that the economy drives the securities markets. In reality, and after several decades of financial innovation and policy activism, the securities markets lead economic performance like never before. This is where structural issues can suddenly and unexpectedly play a decisive role.

Milton Friedman and others referred to the 1920s as the "golden age of capitalism." Were financial and economic structural underpinnings robust in the late-twenties, only to be undercut by the failure of the Federal Reserve to respond (with money printing) forcefully to the 1929 stock market crash and associated bank capital shortfalls? Or, instead, had underlying structures become progressively impaired by a prolonged period of Terminal Phase (financial and economic) Bubble excess? Was the Great Crash inevitable - an historic inflection point marking the commencement of an unavoidable adjustment process: the fusing of what had become an epic divide between inflated market perceptions and deflating financial, economic, social and geopolitical prospects.

April 5 - MarketWatch (Mark DeCambre): "Vanguard founder Jack Bogle has been around the block. The 88-year-old investing titan, who is basically the father of passive investing, says this renewed regime of volatility in stocks is uncanny… 'I have never seen a market this volatile to this extent in my career. Now that's only 66 years, so I shouldn't make too much about it, but you're right: I've seen two 50% declines, I've seen a 25% decline in one day and I've never seen anything like this before.'"

Is Risk-Free Really Risk-Free?

The Mind Blowing Concept of “Risk-Free’ier”

By Michael Lebowitz, 720 Global

• The Earth is flat
• Cigarettes are healthy
• Leeches are the cure for everything
• The universe revolves around the Earth
• California is an island
• Red wine is healthy, unhealthy, healthy…
  

 

Facts are essential as they offer humans a sense of stability in a chaotic world. For instance, we find comfort in the “fact” that the life-sustaining sun will continue to shine for billions of years. If there were serious doubts about this fact, our lives would be very different today.

In this article, we debunk a “fact” that serves as the foundation for the pricing of all financial assets. It was not that long ago that people who thought the earth round were labeled delirious madmen. Today, questioning the “risk-free” status of U.S. Treasury securities (UST), as we do, will lead many financial professionals to decry our prudence as foolish irrationality. That said, we would rather assess the situation objectively than get caught “swimming naked when the tide goes out”.

Mesofacts

In a must-read article entitled, My Leitner-esque Moment, Kevin Muir of The Macro Tourist blog broaches the topic of sovereign debt risk and, in what must be a moment of temporary insanity, questions the so-called “risk-free” status of UST.

Sovereign debt risk exists and said bonds default from time to time. Despite history and facts, associating the word “risk” with UST is for some reason blasphemous amongst financial professionals. The yields of UST are treated by all investors, even those nay-sayers like Muir and ourselves, to be the risk-free rate. This argument does not refer to the risk of changing yields but more importantly to that of credit risk.

All financial and investment models and theories assume that UST have no credit risk which, by definition, implies zero chance of default. What in this world has no risk? If you can name something, congratulations, we cannot.

For background, consider that sovereign debt defaults have been commonplace among big and small countries. The graph below shows the frequency by country since 1800.

Graph Courtesy Carmen Reinhart and Kenneth Rogoff

Go back further in time, and almost all nations can be added to that list. The United States stands alone as an economic and military powerhouse that has never defaulted. (It is important to note that many people, ourselves included, believe the U.S. defaulted when it went off the gold standard.)

Despite America’s perfect credit record thus far, it would be false to assume that UST are “risk-free”. This type of fact, assumed by the masses, is what Samuel Arbesman, the author of The Half-Life of Facts, calls a mesofact. A mesofact, unlike the known effect of gravity, is not a fact of the natural order destined to last for eons. Nor will it have a very short existence, like the fact that the sun is currently shining on my garden.  Essentially, a mesofact is one that has temporary permanence.

We refuse to debate whether UST are risk-free as we patently know that cannot be true. Instead, we consider the mindset of a bond trader and describe the ways we might measure U.S. credit risk.

The Mindset of a Bond Trader

“This next part of my post might be difficult to accept. Many will simply write off the theory as the ravings of a lunatic.”

Kevin Muir’s quote precedes a discussion about whether or not a U.S. corporate bond can trade at a yield below that of a similar maturity UST.

Can a corporate bond be even less risky than “risk-

 

free”? The concept of “risk-free’ier” is mind-bending.

Fresh out of college, on day one on a trading desk, a bond market trainee is taught the practical (non-academic) concept of spreads. Unlike stocks, which trade at a dollar price and are not easily comparable to the price of other stocks or indices, all bonds trade at a yield spread to some benchmark, usually UST. Frequently, in fact, the dollar price of a bond is not even computed until after a trade is consummated.

To better describe this pricing methodology let’s relate it to the solar system. Bonds closest to the sun (UST) are the highest rated. As one travels away from our starting point, and the distance between planets and the sun increases, the perceived credit risk and therefore the yield spread over “risk free” Treasuries increases. In the fixed income universe, AAA-rated corporate and municipal bonds tend to trade with the tightest (or smallest) spread to comparable maturity UST as they have lowest default probability. Traveling further out the credit curve toward lower-rated bonds, the spread increases as default risk increases and the certainty of repayment decreases. The graph below shows the gyrations of various corporate bond indexes aggregated by credit ratings and their spread to UST over time.

Data Courtesy: St. Louis Federal Reserve (FRED)

 

In bond trader parlance, one would say the up and down movements of the lines above represent tightening (spread is declining) or widening (spread is increasing) relative to Treasuries. The graph below takes the orbit, or the percentage spread between BBB-rated corporate bonds and UST from 1997 to today, and plots it in a circular format to help further highlight this concept. (The orbit-like axis markers (0-8) are the percentage spread between BBB bonds and UST).

Data Courtesy: St. Louis Federal Reserve (FRED)

 

Back to the solar system. If we told you that, over the last few years, Mercury was tracking progressively closer to the sun, you would likely assume the orbit of Mercury is changing. Although inconceivable based on current scientific knowledge, what if it was determined that Mercury’s orbit was unchanged and the altered distance was due to the re-positioning of the sun? Similarly, what if the spreads of non-Treasury bonds were not 100% reflective of the factors that determine the yield for each security but also a change in the perceived risk in the benchmark itself?

Altered State

The U.S. Treasury Department is expected to issue over $1 trillion of debt in each of the next four years. This is additive to the $21 trillion debt load that is currently outstanding and must be refunded when bonds mature. Even more troubling, the growth rate of forecasted debt issuance is almost twice the size of the Congressional Budget Office’s (CBO) most optimistic economic growth forecast. As we have argued on many occasions, such a divergence between the debt burden and the means to service and payoff the debt cannot continue indefinitely. Deficits and debt do matter, and given this unsustainable situation, there is inherent credit risk in UST despite what finance professionals may tell you.

Ironically, there are currently two popular ways to measure the credit risk of the risk-free security, and neither of them currently reflect the absence of risk. The two commonly followed gauges are the credit ratings assigned to UST via the credit rating agencies and Credit Default Swaps (CDS) traded in public markets. Currently two of the three major credit rating agencies (Moody’s and Fitch) assign the highest credit rating of AAA to the debt of the United States. S&P rates them at a less than perfect AA+. Credit default swaps (CDS) are derivative contracts that enable an investor to buy insurance on the default risk of a debt issuer. If the issuer defaults, the insurance holder is made financially whole. The CDS of the United States currently trades at 27.5 basis points, which implies the odds of default are about 1.50-2.00%

A Third Way to Measure Default Risk

As Kevin Muir implies in his article, there is a third way to evaluate credit risk. Kevin wonders about the implications of a corporate bond trading at a lower yield than a U.S. Treasury of comparable maturity. We take that thought a step further. Could the spread between corporate bonds and UST, even though they are currently positive, be expressing heightened credit concerns for Treasury securities as opposed to less default risk for corporations?

What if the spread of AAA rated corporate bonds to UST were to tighten by ten basis points over the next month? Bond traders will robotically claim the spread tightening is a function of increased demand, reduced supply and/or a better economic outlook for the bond issuer. Given current circumstances, is it unreasonable to suggest that the yield on the corporate bond was unaffected and the yield on the U.S. Treasury increased due to credit concerns? Might it be possible the Sun has, against all conceivable logic, moved?

This concept is extremely hard to grasp, especially for those of us with decades of experience trading bonds. There are many instances in finance where a large majority of participants are gripped by muscle memory and habit. They are wed to the idea that the future credit history of the U.S. will be what it has been in the past. If we are to be successful investors over the long run, especially at crucial turning points, we must fight false assumptions, bad habits and challenge the durability of even the most basic “facts”.

Summary

Debunked facts are not only common but reflect a healthy progression of human knowledge. Such advancement, otherwise known as innovation and productivity, has led the human race to longer life spans, improved technologies, and greater economic well-being.

The fields of finance and economics, unlike most sciences, do not always seem to ascribe to the notion of incremental learning. Those in the financial community tend to repeat the same errors of the past. Just the past 100 years provides ample evidence of this through multiple boom-bust periods in which those Ph.D.’s from the best universities made the same critical mistakes. As such, the “growth” of logic and critical thinking in economics tends to be more cyclical than incremental. Mesofacts are presumed permanent, effectively stifling progress.

“I find it funny that the most vocal critics about the spiraling upward out-of-control government debt are often those investors’ most likely advocating positions in long-dated sovereign bonds as a place to hide. The surprise of this cycle will be that risk-free sovereign bonds provide no safety against the next crisis, but will instead themselves be the source of the instability. Think about hedging against the unthinkable happening.” – Kevin Muir

We concur with Kevin. No one has a crystal ball with the mystical ability to know when the imbalance of debt will overwhelm the nation’s ability to pay for it.  We would argue that the United States is well beyond that point of no return and the missing piece of the puzzle is the point at which investors realize that fact. One glance at recent patterns of buyers of UST argues that some of our largest foreign sponsors may be asking these very same questions. That said, all investors should recognize that U.S. Treasury debt does indeed have credit risk and that risk is growing.

We intend to persuade you to think about things in ways that few do. In doing so, you will be able to rise above the large majority of investors that get caught in the sinkhole of cyclical thinking. Compounding your wealth depends on it.

Michael Lebowitz, CFA

Trump, Xi and how to play poker with Pyongyang

Only Sino-American understanding can ensure lasting agreement on the Korean peninsula

Philip Stephens



A summit in prospect with America’s Donald Trump. An audience in the Great Hall of the People with China’s Xi Jinping. We can only guess, but the odds are that North Korea’s Kim Jong Un is feeling rather pleased with himself. A backward, brutally repressive regime ruling a nation of 25m now commands the undivided attention of the leaders of the world’s foremost powers.

The international community should welcome Mr Kim’s visit to Beijing. The alternative might well have been war. Only months ago Mr Trump was promising to rain fire and fury on Pyongyang to destroy its nuclear weapons programme. The US president refused to contemplate a North Korean nuclear missile capable of hitting America’s west coast. The potential costs of a military conflict are incalculable. Yet Beijing has been unwilling or unable to restrain its recalcitrant ally and neighbour.

Now, on the face of it, we have the prospect of real diplomacy. By sending a North Korean delegation to the Winter Olympics in Pyeongchang, Mr Kim broke the freeze in relations with South Korea. His offer to meet Mr Trump upended calculations in Washington and put US military preparations on hold. The Beijing trip has signalled that China now feels obliged to lift the exclusion order it had imposed on Mr Kim in response to his repeated defiance of demands to rein back the nuclear programme.

The official Chinese Xinhua news agency reported that Mr Xi had lauded his guest: “This year there have been promising changes in the situation on the Korean peninsula, and we express our appreciation for the major efforts that North Korea has made in this direction.” These words come after years during which Mr Kim has excoriated Beijing for supporting UN sanctions against Pyongyang. Mr Xi, a new Chinese emperor in all but name, is not accustomed to such climbdowns. But if Mr Kim was ready to meet Mr Trump, China could not afford to stay on the sidelines.

A cynic — even a more open-minded sceptic — would say that the North Korean leader has played the diplomatic game brilliantly. He has bought himself time to develop his ballistic missile programme. And he has muddied the water as regards responsibility for the crisis. When Mr Kim says he wants to discuss de-nuclearisation of the Korean peninsula, what he means is that North Korea retains a right to nuclear weapons for as long as the US has a military presence in South Korea. That is not a trade any US president would be ready to make. But if talks now break down, as old Asia hands are inclined to expect they will, the blame could be shifted to the US.

There is nothing to suggest that Mr Kim’s nuclear ambitions have dimmed. Doctrine in Pyongyang has it that a bomb, and the means to deliver it, are the only sure guarantee against an attempt by Washington to overturn the regime. North Korean diplomats forever remind western counterparts about what happened to Iraq’s Saddam Hussein and Libya’s Muammer Gaddafi. Mr Trump’s threats to overturn the international nuclear deal with Iran only hand further ammunition to Pyongyang.

What Mr Kim wants from talks with the US is recognition as a fully fledged nuclear power. Only when it feels secure will Pyongyang consider arrangements to reduce military tension on the peninsula. American experts differ as to how close the regime is to building a missile that can carry a warhead across the Pacific. But after a long spell when they talked in terms of years, they have begun thinking in months.

So it may well be that the best these various summit meetings (Mr Kim confirmed on Thursday that he will also meet South Korean president Moon Jae-in) offer is the prospect of war deferred. Pyongyang, and perhaps Beijing, may hope that by the time Washington discovers it has been duped, it will have lost its enthusiasm for a conflagration in east Asia. Talk will have turned to containment. Much of the world nowadays shapes its foreign policy for an era beyond Mr Trump. Why should North Korea be any different?

True optimists will see another possibility. They picture negotiations as a poker game. Between them Mr Trump and Mr Xi hold almost all of the high cards. But as long as they are playing against each other, Mr Kim emerges the winner. Change the dynamic of the game and the North Korean leader would be forced to show his hand.

It should have been obvious all along that a settlement would depend first and foremost on a Sino-American understanding. Both nations want Mr Kim to give up the bomb. Mr Trump wields the military might. And Pyongyang is almost totally reliant on Beijing for supplies of energy and food. China, though, is more fearful of regime collapse — with a reunified Korea extending US influence up to the Chinese border — than it is unnerved by the nukes. For his part, Mr Kim wants above all to remain in power.

If there is a way through the tangle, and I am not sure there is, it resides in an Sino-American agreement that jointly underwrites the territorial integrity of North Korea and, awful though it is to contemplate, the security of Mr Kim’s regime. This would be in effect the treaty that was never signed at the end of the Korean war. And, with the joint backing of Beijing and Washington, the offer could be made to Mr Kim in a manner such as he could not refuse.

AI-spy

The workplace of the future

As artificial intelligence pushes beyond the tech industry, work could become fairer—or more oppressive

The Dark Matter of Trade

Ricardo Hausmann



CAMBRIDGE – If you are flying a plane, it is useful to know how to keep it level. To do so, you must be able to read the instruments. If the plane is flying level, but you think it is heading down, you may pull back on the yoke and put the plane into a stall. This is what may be happening today with US trade policy.

At the core of the problem are two questions: whether the United States has a trade deficit, and, if so, what to do about it. The Trump administration says the US does have a deficit, and that the solution is an easy-to-win trade war.

Economists tend to dispute Trump’s answer to the second question. They argue that external imbalances are the reflection of domestic imbalances. In every transaction, what one party calls spending, the other calls earning. So, the sum of all market participants’ earnings must equal their total spending. But if you divide the world into two types of people – residents and non-residents – then the only way that non-residents can earn more than they spend in your country is if the residents are spending more than they earn. So external deficits reflect residents’ spending in excess of income – in which case the problem will not go away through a trade war, unless it forces residents to spend less, by, say, taxing them with tariffs. But the government is doing everything it can to achieve the opposite: it is lowering taxes and increasing spending by record amounts, thus aggravating the imbalance. Trade policy is not the answer to trade deficits.

But the first question remains: Is there a trade deficit to begin with? Is the plane heading down, requiring action? This ends up being a tricky question. Once upon a time, most international transactions involved trade in goods, which are bulky, so it was easy for customs agents at ports, airports, and land borders to report them to the statistical office. In the year to September 2017, the US balance of goods exported and imported recorded a deficit of $789 billion, or about 4% of GDP.

But the problem is that international trade today does not comprise only goods. It also includes services, such as travel, tourism, telecommunications, transportation, insurance, and others. In the same period, the US ran a services surplus of $242 billion, implying that, when added to the deficit in goods, the US is in the red by $547 billion, or 2.8% of GDP. In the case of the bilateral relationship with Canada, including services turns the deficit into a surplus.

There are other corrections as well, like interest and dividends paid and earned, as well as labor remittances. When all of these are included in what is known as the current-account balance, the US had an external deficit in 2017 of $450 billion, or 2.3% of GDP.

The accounting implication of this deficit is that it must be paid either by running down financial assets or by increasing liabilities – that is, by increasing net debt (net of assets). And as the debt increases, interest on it must be paid, leaving less money to spend. If unchecked, the accumulation of debt will sooner or later force an end to the deficit.

From 1999 to 2017, the sum of all the official current-account deficits has amounted to $9.4 trillion. In 1999, the net interest and dividend income of the US amounted to $11 billion. That would be the income generated by a net asset position of $275 billion if we assume a rate of return of 4%. But since then, given the estimated current-account deficit, the US should have borrowed, in net terms, $9.4 trillion. Added to the initial positive net asset position of $275 billion, the US should be in the red for $9.1 trillion. And if we assume that the US borrowed the money at 4%, then it should be paying out $364 billion a year, in net terms, to its foreign creditors.

But the amount the US pays for its supposed $9.1 trillion in net debt is nothing. Instead, it made $208 billion in the year to September 2017, a difference of $572 billion. If that were the consequence of owning some kind of asset that yields 4% a year, it means that instead of owing $9.1 trillion, the US accumulated an asset worth $5.2 trillion. The difference is a whopping $14.3 trillion.

What is going on? Why can the US run a deficit, borrow from the rest of the world, not pay for it, and make out like bandits instead? And what is this weird asset that is worth 73% of GDP?

In a 2005 joint paper with Federico Sturzenegger, the current Governor of the Central Bank of Argentina, we called this weird asset “dark matter.” Like its cosmic equivalent, it cannot be directly observed, but its effects can be felt, not through its gravitational force, but through its financial return. Our work showed that it is mostly coming from the international value of each country’s technology, in ways that are poorly captured by the way the statistics are put together, but it is real. We can see it in the extraordinary value coming from the international activities of Amazon, Apple, Facebook, Google, Hollywood, and Uber, which are poorly captured as exports of either goods or services. It is a financial return to the deployment of technology abroad, a return that other countries actually pay.

Once dark matter is taken into account, there is no US external deficit. If the current position is maintained, there will be no real accumulation of debt that would require an increase in net future payments to the rest of the world. Ignoring the reality of dark matter implies acting as if the plane was nose-diving when it is actually flying high.

Donald Trump has argued that trade wars are easily won by the country with the deficit, because the other party has more to lose. Think again. There is no deficit. Just as trade has moved from goods to services and on to knowledge, so may trade wars. A tariff on steel may be answered by a tax on Amazon or Google. In fact, the European Union, for other reasons, is already moving in that direction. Being in the dark about the dark matter of trade may lead the world to a truly dark place.


Ricardo Hausmann, a former minister of planning of Venezuela and former Chief Economist of the Inter-American Development Bank, is Director of the Center for International Development at Harvard University and a professor of economics at the Harvard Kennedy School.

China, oil, and the dollar

By Ed Crooks


The US dollar’s position as the dominant global reserve currency has been resented by other countries for decades. The perception that the US wields outsized influence was encapsulated back in 1971 when John Connally, Richard Nixon’s Treasury secretary, told European finance ministers: “The dollar is our currency, but it’s your problem." Whenever a financial innovation looks like it might have a chance of dethroning the mighty dollar, there is always a flurry of excitement.

All eyes this week have been on the threat of a possible trade war between the US and China.

But commentators have suggested China’s new renminbi-denominated oil futures contract, launched last week, could also be seen as a sign of international tensions over shifting economic relationships. Intelligence group Stratfor’s assessment was that through crude oil futures, and gradual financial liberalisation, “China is hoping to break the dollar's stranglehold on the global financial system”. However, it noted, for as long as China is the world’s largest oil importer, and exporting countries prefer to be paid in US dollars, then the dollar is likely to remain dominant. Analysts warned that China’s capital controls would limit the international appeal of the contract. The South China Morning Post observed that the contract resulted from “China’s ambitions to secure bargaining power” over oil pricing, but it was described as just a “baby step” in that direction. Huang Lei, an independent commodity futures analyst, told the paper the contract was far from becoming a regional benchmark, adding: “Globalisation is a long, long process”. John Kemp of Reuters struck a more positive note, however, arguing that the contract had “a good chance of confounding the doubters” to become a success.

One point to watch will be whether China starts paying for its oil in renminbi instead of dollars. Reuters reported that China planned a “pilot programme” of renminbi payments, possibly starting in the second half of this year. The first buyers could be Russia, which has long been interested in breaking the dollar’s dominance, and Angola, which was recently forced to scrap its currency’s dollar peg. Nick Cunningham for OilPrice.com pointed to one development that could give the new contract a boost: the reimposition of US sanctions on Iran. Marc Chandler explained some of the reasons why the dollar is expected to remain the dominant reserve currency for the foreseeable future, regardless of how the renminbi oil contract fares. China's holdings of US Treasury bonds are often described as giving it a "nuclear option" in a trade dispute, and Kate Duguid and Trevor Hunnicutt for Reuters explained why the metaphor is highly appropriate: dumping US debt would be likely to prove a self-destructive tactic for China.

Royal Dutch Shell is one of the international oil companies being pushed by investors to adopt more ambitious goals for addressing the threat of global warming, and last week it set out a vision of what that might mean. It published what it called its “Sky scenario”, described as “a technically possible, but challenging pathway for society to achieve the goals of the Paris Agreement”. The agreement committed the signatories to holding the increase in the global average temperature since pre-industrial times to "well below" 2C, and to "pursuing efforts" to limit it to 1.5C. There is a lot of detail in the report, which is worth reading in full, but this is one chart that particularly struck me, comparing the “Sky” scenario with two others — "Mountains” and Oceans” — that are not consistent with the Paris target. The Sky scenario is the right-hand bar in each group of three. Up to 2025 there is little difference, but by 2050 the scenarios diverge significantly. Sky has a lot more solar power — the orange bar — less coal, and less gas. The scenario is neither a forecast nor a policy prescription, Shell says, but it does give an idea of the expected tradeoffs and the consequences of different choices.

Russia and the west’s moral bankruptcy

Vladimir Putin’s wealth extraction machine could not operate without our connivance

Edward Luce


The Russian foreign ministry in Moscow. Tit-for-tat expulsions of diplomats will, on its own, count for little © AFP


It is often said that Russia is a competitor to western democracy. But that is misleading. The country is run for the benefit of Vladimir Putin and his oligarchic circle. Its regime is a model only to other budding kleptocrats.

Most of the world aspires neither to Russia’s politics nor its living standards. Alas, the west’s chief ideological threat comes from within. Mr Putin’s wealth extraction machine reveals the west’s moral failings. His abettors could not do it without our connivance.

This is especially true of the US and Britain. In contrast to most western democracies, the US and UK permit anonymous ownership. Most democracies legally require the beneficial owner of an asset, such a company or property, to be made known. Not so in the largest English-speaking democracies. Roughly $300bn is laundered in the US every year, according to the US Treasury. Britain and its offshore financial centres take in about $125bn. Most of it goes undetected. The largest foreign share of it is Russian, according to Anders Aslund, a leading specialist on Russia’s economy. Estimates of Mr Putin’s personal wealth range from $50bn to $200bn. Even the lower figure would exceed the gross domestic product of most UN member states. Yet we have taken few steps to disrupt it.

Western expulsion of 130 Russian diplomats certainly looks like action — and is far better than doing nothing. Alone, however, it will do little to disrupt the merry-go-round. Indeed, traditional tit-for-tat expulsions offer an illusion of crisis that suits Mr Putin. It is kabuki theatre Russian-style. Why else would Donald Trump or Theresa May agree to it?

The motivations of the US president and British prime minister deserve scrutiny. The brazenness of the nerve agent poisonings in the UK this month made them impossible to ignore. It was as though Mr Putin left his signature.

Perhaps that was because the UK had done so little to investigate at least 14 suspicious Russian deaths on its soil in the previous decade. Many, such as that of the exiled oligarch Boris Berezovsky in 2013, were written off as suicide. Others were ruled to be from natural causes, such as the 2012 death of whistleblower Alexander Perepilichny.

In many cases, the UK’s Home Office, which was run by Mrs May for six years, dragged its feet. Mrs May refused on national security grounds to release government files to the Perepilichny inquest. This was in spite of the fact that traces of Gelsemium, a toxic plant that induces cardiac arrest, had been found in his body. Those seeking insight into the UK police’s insouciance should read Buzzfeed’s exemplary investigations.

Britain has now been jolted into a display of resolve. Having corralled a show of western unity, Mrs May is looking good. Compared with Jeremy Corbyn, the Labour leader and an habitual Russophile, she looks positively Thatcherite. Yet the expulsions will alter little. A large chunk of the value of London property transactions is estimated to be Russian. Too many London banks, real estate agents and luxury service providers thrive on Russian money.

The US, like Britain, is hospitable to ill-gotten money. But in one key respect America is more deeply compromised.

It is often forgotten that Mr Putin blamed Hillary Clinton for the 2015 leak of the Panama Papers, which exposed the network of shell companies, associates and methods by which he and his friends salted away their money. To give one example, the leaks showed the net worth of Mr Putin’s closest friend, Sergei Roldugin, to be about $130m. Mr Roldugin plays the cello for a living.

Another associate was Mikhail Lesin, Mr Putin’s former senior adviser, and a founder of the television network RT (formerly Russia Today). Mr Lesin fell out with Mr Putin. He was found dead in a Washington DC hotel in 2015. Though his body was severely battered, the US authorities took months to rule the death accidental. Mr Lesin was meant to give evidence to federal investigators the next day.

Is it any surprise Mr Putin has grown so bold? Russia’s attempts to sway the 2016 US election were partly payback for the Panama Papers.

Most of the west has the Russia threat back to front. Russia’s economy is no larger than Italy’s and its military is in disrepair. It is run by an autocrat who dares not release his grip for fear of losing everything. The weapon Mr Putin fears most is transparent accountancy. Tellingly, he stores his wealth in jurisdictions where property rights are secure and the rule of law still holds.

On top of that the west offers a dictator’s bargain: the greed of a system that has lost its moral compass. All that was true before the gift of Mr Trump’s election. How much juicier is it now?