The Debt Train Will Crash

By John Mauldin

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We are approaching the end of the debt Train Wreck series. I’ve spent several weeks explaining why I think excessive debt is dragging the world economy toward an epic crash. The tracks ahead are clear for now but will not remain so. The end probably won’t be pretty. But there’s good news, too: we have time to get our portfolios, our businesses, and our families prepared.

Today, we’ll look at some new numbers on just how big the problem is, then I’ll recap the various angles we’ve discussed. This problem is so big that we easily overlook key points. I hope that listing them all in one place will help you grasp their enormity. Next week, and possibly a few after that, I’ll describe some possible strategies to protect your assets and family.

Now on with the end of the train.

Off the Tracks

Talking about global debt requires that we consider almost incomprehensibly large numbers. Our minds can’t process their enormity. How much is a trillion dollars, really? But understanding this peril forces us to try.

Earlier in this series, I shared a 2015 McKinsey chart that summed up global debt totals. They pegged it at $199 trillion as of Q2 2014. Note that the debt grew faster than global GDP. Everything I see suggests it will go higher at an ever-increasing rate.

Source: McKinsey Global Institute

Last month, McKinsey published a very useful online tool for visualizing global debt, based on Q2 2017 data. It shows a total of $169T, which is less than McKinsey said in 2014. Is debt shrinking? No. The new tool excludes the Financial debt category, which was $45T three years earlier. A separate Institute for International Finance report said financial debt was $59T at the end of 2017. These aren’t quite comparable numbers, but in the (very big) ballpark range we can estimate total debt was somewhere between $225T (per McKinsey) and $238T (per IIF) in mid-2017. (IIF’s latest update last week says it is now $247T).

Source: McKinsey Global Institute

That would mean world debt grew something like 13% in the three years ended 2017. If so, it would be a slowdown comparable to the 2007-2014 pace McKinsey showed in the chart above—but still faster than world GDP grew in those three years. McKinsey says global debt (ex-financial) grew from $97T in 2007 to $169T in mid-2017.

Importantly, households aren’t driving this. Governments accounted for 43% of the increase McKinsey cites and nonfinancial corporate debt was 41%. That is where I think the coming train crash will originate. Governments have more debt than corporations, but also more tools (like taxing authority) to manage it.

On the other hand, governments also have massive “unfunded liabilities” that don’t show in the numbers above. So, they aren’t in a great position, either.

Bottom line: There’s going to be a train wreck here. Which train will go off which track is unclear, but something will. And we’re all going to feel it.

Woes to Come

We launched this journey in my May 11 Credit-Driven Train Crash letter. I described my friend Peter Boockvar’s perceptive statement: “We no longer have business cycles, we have credit cycles.”

His point is subtle yet critical. Post-crisis growth, mild as it’s been, has been largely a function of debt, which central banks encouraged and enabled. The result was inflated asset prices without the kind of “recovery” seen in previous business cycles. Interest rates, i.e. the cost of debt, thus became critical.

With rates now moving up again, premium asset prices are losing their raison d’etre and will stabilize and eventually fall. Peter Boockvar says this, not the conventional business cycle, is what will set off recession. That’s key. Lower asset prices won’t be the result of the next recession; they will cause that recession.

I showed in that letter how companies will need to refinance about $4T of bonds in the next year, almost all of it at higher rates. This will hit debt-burdened companies that are already struggling and make it almost impossible for some to keep operating. Lenders, i.e. high-yield bond holders, will try to exit their positions all at once only to find a severe shortage of willing buyers.

The following week in Train Crash Preview, I listed the steps in which I think the crisis will unfold. They fall in four stages.

  • The Beginning of Woes: Something, possibly high-yield bonds, will set off a liquidity scramble. It will spread through the already-unstable financial system and trigger a broader credit crisis.

  • Lending Drought: Rising defaults will force banks to reduce lending, depriving previously stable businesses of working capital. This will reduce earnings and economic growth. The lower growth will turn into negative growth and we will enter recession.

  • Political Backlash: Concurrent with the above, employers will be automating jobs as they grow desperate to cut costs. Suffering workers—who are also voters—will force higher “safety net” spending and government debt will skyrocket. A populist backlash could lead to tax increases that prolong the recession.

  • The Great Reset: As this recession unfolds, the Fed and other central banks will abandon plans to reverse QE programs. I seriously think the Federal Reserve’s balance sheet assets could approach $20 trillion later in the next decade. But it won’t work because the world simply has too much debt. They will need to find some way to rationalize or “reset” the debt. Exactly how is hard to predict but it probably won’t be good for lenders, or for the holders of government promises like pensions and healthcare.

Next in High Yield Train Wreck, we dove deeper into the dream-driven high-yield bond market exemplified by this year’s nutty $702-million WeWork issue. I quoted Grant Williams, who wrote a masterful takedown of this craziness.

Ten years into the ongoing laboratory experiment being conducted by the world’s central banks, everywhere you look there are multiple examples of the kind of lunacy those policies have fomented by reducing the cost of capital to virtually zero and forcing investors to take risks they would ordinarily avoid in order to find some kind of return.

WeWork is one example of a company for whom, in the face of rapid growth, massive negative cashflows aren’t a problem, but there are plenty of others. Uber, AirBnB, SnapChat and, of course, Tesla have all captured the imagination of investors thanks to lofty dreams, articulated by charismatic CEOs—but the day things turn around and the economy begins to weaken or, God forbid, investors seek a return on their investment as opposed to settling for rolling promises of gigantic, game-changing revenues to come, it is over.

We went on to talk about the insanity of yield-hungry investors practically throwing cash at borrowers while demanding little in return. I also showed how this is not simply a junk-rated company problem, since almost half of investment-grade companies are rated BBB and could easily slip to junk status in a downturn.

Source: On My Radar

Growing Leverage

The week after we turned to Europe in The Italian Trigger. Unfortunately, Italy isn’t Europe’s only problem. The big Kahuna is Germany, which spent years offering generous vendor financing to the rest of the continent to entice the purchase of German goods. The result: a giant trade surplus for Germany and giant, unpayable debts for those who bought German goods.

The Euro currency union is fatally flawed because it leaves each member state to set its own fiscal policy. There are good reasons for that, but it is not sustainable indefinitely. The Eurozone must get either much more centralized or fall apart. All the Rube Goldberg contraptions the ECB and others invent are temporary fixes. They’ve worked so far. They won’t work forever.

I still think the most probable scenario is that Germany and the Netherlands (and the rest of the northern European cabal) reluctantly agree to let the European Central Bank mutualize all the sovereign debt, taking onto their balance sheet and issuing new ECB-backed debt for the entire zone. There would have to be serious constraints on running deficits after that point, but it would prevent a breakup, or at least delay it for another decade or so.

Of course, within a few years those new deficit constraints would be ignored. I said in a previous letter Germany will need to collect almost 80% of GDP in 30 years in order to be able to deliver its promised healthcare and pensions. Their inability to do that will be evident much sooner. Germany will end up becoming one of the biggest problems.

The next installment, Debt Clock Ticking, was a bit philosophical. I talked about debt letting you bring the future into the present, buying things you couldn’t afford if you had to pay for them now. But the entire world went into debt for the equivalent of tropical vacations and, having now enjoyed them, realizes it must pay the bill. The resources to do so do not yet exist. So, in the time-honored tradition of lenders everywhere, we extend and pretend. But with our ability to pretend almost gone, we’re heading to the Great Reset.

Source: Moody’s Investor’s Service

Then I reviewed some of the McKinsey and IIF numbers and described the amount of leverage that’s built up in the system. Just a decade after the Great Recession, the average non-financial business went from 3.4x leverage to 4.1x. They are now roughly 20% more leveraged than they were the last time all hell broke loose. CEOs and boards seem to have learned little from the experience—or maybe learned too much. If you believe the Fed has your back, then leveraging to the moon makes sense.

Pension Problems

The last three letters in the series got personal for many readers as I talked about pension debt. In The Pension Train Has No Seat Belts, we looked at the demographic challenge facing US pension funds, mainly state and local government plans but also some private ones. We are asking a shrinking group of working-age people to support a growing number of retirees and that’s just not going to work.

Source: Peter G. Peterson Foundation

The promises employers made to workers are a kind of debt. They’re the borrowers, workers are the lenders… and unlike in 2008, this time it will be lenders who get hurt the most. A new report by the American Legislative Exchange Council (ALEC) shows the unfunded liabilities of state and local pension plans jumped $433 billion in the last year to more than $6 trillion. That is nearly $50,000 for every household in America.

Nor is this only a US problem, as we saw in Europe Has Train Wrecks, Too. According to the World Economic Forum, the United Kingdom alone has a $4-trillion retirement savings shortfall that will rise to $33 trillion by 2050. This in a country whose entire GDP is only about $2.6 trillion and doesn’t account for the increasingly likely disaster Brexit will be. Switzerland, Spain, and others have similarly dire outlooks, often driven by even worse demographics than we have in the US. Germany, as noted above, is simply off the rails.

Finally, in Unfunded Promises, we reached the ultimate debt problem: US government unfunded liabilities. On paper, Washington’s debt is about $21.2 trillion… but that doesn’t include the $13.2-trillion unfunded, off-the-books Social Security liability, or the $37-trillion Medicare unfunded liability. Those aren’t my numbers, by the way; they come from the Social Security and Medicare trustees and are probably understated. My friend, Boston University professor Larry Kotlikoff, thinks it should be more like $210 trillion. He has a considerable amount of published works and a book he co-authored with fellow Texan Scott Burns.

That’s not all. The federal government also has liabilities for civil service and military pensions, veteran benefits, some defaulted private pensions via PBGC, and open-ended guarantees to entities like FDIC, Fannie Mae, and more.

The budget outlook is horrible even without all that, too. The Congressional Budget Office thinks federal debt will be 200% of GDP by 2048, and that by 2041 it will take all federal tax revenue just to support Social Security, the various health care programs and pay interest. That’s before defense or anything else the government does. And that’s assuming relatively high growth and NO recessions and a rising stock market forever as we ride off into the sunset.

I wrapped up quoting my friend Dr. Woody Brock, who thinks the most likely outcome will be wealth taxes at federal, state, and local levels. I truly hope he’s wrong about that, but I fear he is not. My preferred new tax for the US would be a VAT that eliminates the Social Security tax (thus giving lower-income workers and businesses a raise) but still funds Social Security and healthcare. Other government expenditures would be funded from income taxes which could be reduced significantly, and even eliminated on incomes below $50,000. Now that’s a tax cut that would boost the economy and balance the budget.

There really are only two ways to solve this problem: massive taxes on someone, or a debt liquidation of some kind. And remember, if you are getting a retirement pension fund and/or healthcare, your benefits are part of that “debt liquidation.” Both will be painful. We have pulled forward our spending and must eventually pay for it. The time is coming. Please don’t shoot the messenger.

Let’s summarize. Global debt is over $225 trillion. By the beginning of the next decade it could be over $300 trillion. Global government unfunded liabilities are easily in the $100-trillion range today and could easily double by the end of the next decade. Debt service, pensions, and healthcare will take 20-25% of GDP in many countries (more in some of Europe).

Your mileage may and will vary by country. In some, there will be inflation and in others, deflation. We will be thinking the unthinkable and choosing policies that seem insane to even mention today. But then, think about what Japan is doing. And the ECB. Add in automation and the loss of hundreds of millions of jobs in the OECD countries. Then think about what will happen in the emerging economies.

But at the same time, imagine all the new companies being built and fortunes made. The opportunities. The situation, as Doug Casey once quipped, “Is hopeless, but not serious.” Not yet. Not for you and me.

Next week we’ll discuss what you can do, but not just in Thoughts from the Frontline. I mentioned recently we were working on a new project. I announced part of it on Monday, but if you missed my email, you can watch my message by following this link.

 Quite simply, it is the biggest free event we have ever put together for you, and we developed every single part of it with your most pressing investing concerns in mind. Watch out for an email from me on Monday, when I launch Week 1 of Bull or Bust: Navigating the High-Speed Train Wreck. I promise you won’t want to miss it.

Los Angeles, Puerto Rico, Maine, and Beaver Creek

I have several visitors coming over the next nine days, then I fly to meet a special new acquaintance in Los Angeles for a day. I’ll come back, write my letter, and then Shane and I go to visit some friends in Puerto Rico. Then, of course, the annual Maine economic/fishing conference and a few weeks later, a board meeting for Ashford, Inc. at the Beaver Creek Park Hyatt which the company owns. If you are in Puerto Rico or Beaver Creek, drop me a line and maybe we can get together.

It is time to hit the send button. Thanks for all the stories about YOUR immigrant families that came my way this week in response to last week’s letter. And here’s hoping we can make a little progress on the art of the trade deal. Might make us all a little less nervous, at least in the markets and many businesses. Have a great week!

Your hopeful-about-the-future analyst,

John Mauldin
Chairman, Mauldin Economics

Donald Trump is doing Europe a favor

As pressure on the EU mounts, White House hostility could even strengthen the unión

Gideon Rachman

The EU is infected by a “populist leprosy”; its fate hangs in the balance; the cracks in the organisation are widening. These are not the ravings of a deluded Brexiter. On the contrary, they are the views of, respectively, the president of France, the chancellor of Germany and the president of the European Commission.

Emmanuel Macron, Angela Merkel and Jean-Claude Juncker were speaking before last week’s EU summit. The agreement reached there on migration allowed the three leaders to claim modest progress. But there is no doubt that internal pressures on the EU are mounting. With populist and nationalist politicians in power in Italy, Poland, Hungary, Austria and Slovenia, it is becoming harder to form an EU consensus. Further rows on migration, reform of the eurozone and the EU budget are all but guaranteed.

External pressures are also mounting. Donald Trump’s hostility to the bloc becomes plainer by the day. Last week the US president tweeted that the EU was “set up to take advantage of the US”, a dramatic departure from America’s traditionally supportive attitude. In a couple of weeks’ time, Mr Trump will hold his first summit with another leader with a considerable animus against the EU: Russia’s Vladimir Putin. The EU’s political leaders have reason to watch that meeting with real apprehension.

If Mr Trump follows through on his threat to levy huge tariffs on European cars, the pressures on EU leaders will only increase. Yet, oddly enough, the Trump administration may be doing the bloc a favour. Just at the time that internal tensions are building among the 28 member states, the US is reminding them of the importance of a collective defence of European interests.

European leaders are intensely aware that America’s EU strategy (as well as China’s and Russia’s) is likely to be an effort to “divide and rule”. With its 28 national governments (soon to be 27) and ponderous governance structure, the EU is a tempting target for such tactics. But, for all their differences, the bloc’s leaders understand the strategic importance of their unity on trade, particularly if a global trade war is indeed in the offing.

Small countries are at the mercy of American pressure on trade. But the EU’s economy is collectively larger than that of the US. The size of the European internal market offers its nations some form of protection against bullying from Washington, as well as the possibility of meaningful retaliation. Indeed, further retaliatory measures are being prepared in Brussels should the US carry through on its threats to the European car industry.

The EU’s awareness of the strategic and economic value of its internal market is reflected in the strong and unified position it has taken on the Brexit negotiations. British attempts to “cherry pick” some of the internal market’s benefits have been firmly rebuffed. At a time of division on so many other issues, the EU27 seem to be relishing their unity and power in the Brexit negotiations.

Evidence of EU strength is badly needed because the cracks that were papered over at the Brussels summit last week are bound to open again, soon. The plan to create processing centres for asylum seekers inside and outside the EU has big practical, political and legal hurdles to overcome. It fails to answer the question of who will host the centres, and where migrants (successful and unsuccessful) will be resettled. The package of eurozone reforms also looks thin. And an even larger battle is looming, as the bloc begins consideration of its next budget.

The populist tide could have further to rise, with nationalist parties such as the Sweden Democrats and the Alternative for Germany still gaining in the polls. The European Parliament elections in 2019 — ideal territory for protest voters — could dramatically change the tone in Brussels. At that point, the traditional federalist strategy of calling for a strengthening of the powers of the parliament could backfire spectacularly. The barbarians will be inside the gates.

As both Ms Merkel and Mr Macron have hinted, it is entirely possible that these mounting pressures — internal and external — could cause the EU to disintegrate. If the EU cannot make its migrant deal work, then countries will increasingly resort to unilateral actions, in particular, by restoring border checks to stop internal flows of migrants. That would imperil the bloc’s cherished Schengen zone of passport-free travel. The failure to agree deep reforms to the eurozone also puts the threat of the break-up of the euro back on the table.

But the risks involved in the break-up of the single currency are likely to remain a powerful constraint on the radicalism of the populists. The EU retains a remarkable ability to turn outsiders into members of the club. Witness the transformation of Alexis Tsipras, the prime minister of Greece, who in three years has changed from socialist firebrand to smooth-talking, tax-cutting, European federalist.

It is distinctly possible that the current generation of populists will undergo similar transformations as they realise the value of EU membership and the risks of breaking up the club. If so, the EU could yet shake off its troubling bout of leprosy, and confound the critics once again.

A real story

The rich world needs higher real wage growth

Pay is rising, but so are prices. Blame more expensive oil

CENTRAL bankers and economists have spilled much ink in recent years on the question of why wages have not grown more. The average unemployment rate in advanced economies is 5.3%, lower than before the financial crisis. Yet even in America, the hottest rich-world economy, pay is growing by less than 3% annually. This month the European Central Bank devoted much of its annual shindig in Sintra, Portugal to discussing the wage puzzle.

Recent data show, however, that the problem rich countries face is not that nominal wage growth has failed to respond to economic conditions. It is that inflation is eating up pay increases and that real—that is, inflation-adjusted—wages are therefore stagnant. Real wages in America and the euro zone, for example, are growing more slowly even as the world economy, and headline pay, have both picked up (see chart).

The proximate cause is the oil price. As the price of Brent crude oil, a benchmark, fell from over $110 a barrel in mid-2014 to under $30 a barrel by January 2016, inflation tumbled, even turning negative in Europe. That sparked justified worries about a global deflationary slump. But it was an immediate boon for workers, who saw nominal pay increases of around 2% translate into real wage gains of about the same size. (An exception was Japan, where a rise in the sales tax from 5% to 8% in 2014 squeezed wallets.)

Since then, nominal wage growth has gradually picked up as labour markets have tightened, roughly in line with the predictions of economists who use broader measures of slack than just the unemployment rate. But inflation has risen in tandem with wages, as the oil price has recovered to close to $75 a barrel. That means many workers are yet to feel the benefit of the global economic upswing that began during 2017. In America and Europe, real wages are growing barely faster than they were five years ago, when unemployment was much higher.

In the long run, changes in real wages are linked to changes in workers’ productivity, which has grown slowly everywhere since the financial crisis. In the year to the first quarter of 2018, for example, American productivity grew by only 0.4%. But some spy a rebound. For current forecasts of blazing economic growth in America to bear out, productivity must grow faster. In the second half of 2017, productivity in Britain grew at the fastest rate since 2005. The Bank of Japan thinks that firms there are investing heavily to boost productivity so that they do not have to pay for higher wages by raising prices.

Yet even a recovery in productivity would not guarantee good times for workers. In recent decades the share of GDP going to labour, rather than to capital, has fallen because real pay has increased more slowly than productivity. In advanced economies labour’s share fell from almost 55% to about 51% between 1970 and 2015, according to researchers at the IMF. A widely heard explanation is that a fall in union membership, combined with rising offshoring and outsourcing, has eroded workers’ bargaining power. More recently, economists have suggested that labour’s falling share could be linked to the rise of “superstar” firms such as Google that dominate their markets and have low labour costs relative to their enormous profits.

Reversing the fall in labour’s share of GDP would require real wages to grow faster than productivity, weighing on firms’ profit margins. Continued tightening in labour markets might yet boost workers’ bargaining power enough for that to happen, as was the case during the late 1990s and late 2000s, two unusual periods in which labour’s share of GDP rose across the rich world. There is still room for improvement. For instance, even where unemployment rates are low, the number of part-time workers who want full-time jobs remains unusually high. This continues to weigh on wage growth, according to an analysis by the IMF late last year.

Some countries, such as Italy, still suffer from unemployment rates that are far higher than they were before the financial crisis. Such pockets of slack might constrain wages everywhere now that goods are produced in international supply chains and sold on global markets. In a recent working paper, Kristin Forbes of the Massachusetts Institute of Technology concluded that the influence on inflation of global slack and commodity prices has grown in the past decade, while local economic conditions have become less important. Philip Lowe, the governor of Australia’s central bank, told the audience in Sintra that when he asks firms that are struggling to find workers why they do not pay more, they “look at me as if I’m completely mad” and deliver a lecture on how competitive the world has become.

If slack were eliminated everywhere, pay might rise faster. The question is whether inflation continues to rise in tandem as companies find that, when push comes to shove, they can pass higher costs onto their customers. If they can, there is little hope for much improving workers’ lot in real terms. The Federal Reserve has been raising interest rates in response to a perceived inflationary threat. The European Central Bank, too, is tightening, saying that it will probably stop asset purchases at the end of the year. Mario Draghi, its president, points to growth in hourly pay of 1.8% as a justification for the move.

That seems a little hasty, given workers’ lamentable fortunes in recent decades. But hawks think there is little room to boost real wages by running labour markets hotter. If they are proved right, it will be hard to refute the argument that structural changes in the economy, rather than weak demand alone, have stacked the deck against workers. Governments will then have to find novel ways to respond—or hope for another crash in the oil price.

Global Aging and Fiscal Solvency

Martin Feldstein

CAMBRIDGE – Government programs to support retirees are in trouble in every country, owing to increasing life expectancy and the rising ratio of retirees to taxpayers. The problem will worsen in the years ahead as the adverse demographic trend increases the fiscal burden of funding pensions and health care.

The problem is uniquely different in the United States, because America’s “trust fund” system of financing Social Security will create a crisis when the fund is exhausted. Though the options at that time will be different from the choices facing other governments, policies to avoid the US crisis are relevant to other countries that confront population aging.

Here’s how the US system works: by law, a payroll tax is dedicated exclusively to financing retiree benefits. Employers and employees each pay 6.2% of cash earnings up to an individual maximum of $128,000, an amount that increases annually with average wages. These tax funds are deposited into the Social Security Trust Fund and invested in government bonds.1

Individuals are entitled to benefits at age 67 based on their lifetime payroll tax payments, with the option to take actuarially reduced benefits as early as age 62 or to wait until age 72 with an actuarial increase. The annual benefits rise with an individual’s average lifetime earnings, according to a schedule that causes the ratio of benefits to past earnings to decline as those earnings rise.

Because of the aging of the population, the total level of benefits is increasing more rapidly than tax collections. In 2010, total Social Security tax revenue was $545 billion and benefit payments totaled $577 billion. Because the interest on the previously accumulated bonds was $108 billion, the total size of the trust fund increased by $76 billion. Six years later, in 2016, the tax revenue was up to $679 billion and the benefits were up to $769 billion. The resulting cash deficit was $90 billion, almost exactly equal to the interest that year, leaving the size of the trust fund relatively unchanged.

Since 2016, the benefit payments have exceeded the combination of the tax funds and the interest, causing the trust fund balance to decline. Looking ahead, the Social Security Administration’s actuaries estimate that the annual decline in the trust fund will continue, until the balance is zero in 2034. At that point, the trust fund will no longer have any interest income. Because benefits can be paid only from the trust fund, the benefits will have to be decreased to the amount of the taxes being received that year.

If Congress does not change the law, the actuaries predict that benefits would have to be reduced immediately in 2034 by 21%. Alternatively, to avoid that 21% reduction, the tax would have to rise by 26.5%, from a combined 12.4% to nearly 16%.

While it is hard to predict what a future Congress will do, I find it hard to believe that a majority would vote to reduce the level of benefits by 21% or to increase the level of the payroll tax paid by all employers and all employees by 26%.

The most likely alternative would be to use general income tax revenue to maintain the level of benefits. That would require an increase in personal tax rates of about 10%. That strategy would shift the burden of the Social Security program to higher-income households, which pay the bulk of personal income taxes. That may explain why left-of-center politicians are not trying to avoid the future Social Security crisis.

The crisis in 2034 could be prevented by increasing the standard Social Security retirement age, as the US did in 1983. Back then, with Social Security’s finances in trouble, Congress agreed on a bipartisan basis to raise gradually the standard retirement age from 65 to 67. Since then, life expectancy for someone at that age has increased by three years. Congress could now vote to increase gradually the standard Social Security retirement age by another three years, from 67 to 70. Because life expectancy at 67 is about 17 years, a three-year increase in the age for full benefits would be a 17% reduction in lifetime benefits, almost enough to offset the shortfall that results from the reduced revenue. It would be even better to adjust the annual retirement age each year for the actuarial increase in life expectancy.

An alternative strategy for dealing with the increasing cost of retiree benefits would be to move away from a pure pay-as-you-go (PAYG) system by adding an investment-based component. Instead of investing the revenue from the 12.4% payroll tax in government bonds, a significant portion could be invested in a portfolio of equities, as corporate pension systems do. The trust fund would then grow more rapidly, and the crisis would be avoided.

Although the trust fund system in the US creates the prospect of a crisis when the fund is exhausted, the remedies to avoid that outcome would help other countries that now have a PAYG system – increasing the age for full benefits or combining the existing system with equity funding. The sooner these changes are made, the more viable the fiscal situation – and the more reliable future benefits – will be.

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.

China GDP growth slips to 6.7% in second quarter

Deleveraging campaign hits infrastructure spending as impact of trade war looms

Gabriel Wildau in Hong Kong

Not so fast: China's economic growth is slowing as domestic demand moderates © Bloomberg

China’s economy expanded by 6.7 per cent in the second quarter, its slowest pace since 2016, as the impact of an aggressive deleveraging campaign curtailed investment in infrastructure.

The pace of annual expansion announced on Monday is still above the government’s target of “about 6.5 per cent” growth for the year, but the slowdown comes as Beijing’s trade war with the US adds to headwinds from slowing domestic demand. Gross domestic product had grown at 6.8 per cent in the previous three quarters.

A campaign to tackle excessive debt and financial risk that began early last year, following almost a decade of heavy credit stimulus, has weighed on fixed-asset investment, a pillar of overall growth. Such spending grew only 6 per cent in the first half of the year, a record low.

“A main reason for the slowdown is that infrastructure investment began to slow down in the first quarter as the government was trying to control local government debt,” said Haibin Zhu, chief China economist at JPMorgan Chase in Hong Kong.

“The good news is that there is space to provide more fiscal support through tax cuts and higher infrastructure investment. We expect they will move along these lines.” 

Tighter monetary policy has also dragged on growth. Data released on Friday showed that M2 money supply and overall credit growth — including bank lending and off-balance-sheet lending — both grew at their slowest pace ever in June. The impact of new rules aimed at curbing risks from shadow banking has led to a sharp contraction in lending by non-bank institutions.

In response to signs of a slowdown, the central bank has loosened policy in recent weeks, cutting the amount of reserves the country’s banks are required to keep on deposit. Analysts believe that credit probably bottomed out in June and will accelerate in the next few months.

Mao Shengyong, a spokesman for the National Bureau of Statistics, said the impact of US-China trade conflict on China’s economy would be “relatively limited”.

But on the eve of a top-level summit with the EU on Monday, where China’s president Xi Jinping is expected to try to project a united front against US-led trade protectionism, Mr Mao also emphasised that any negative impact would extend beyond China.

“This trade friction that the US has unilaterally kicked up will influence both countries. But now the world economy has deeply integrated supply chains. It’s a global distribution, so many countries will be affected,” he said.

The impact of the trade war is not yet evident in China’s published economic data. Chinese customs data released on Friday showed that China’s monthly bilateral trade surplus with the US was the highest on record in June at $29bn. Overall exports rose 11.3 per cent last month, beating expectations.

But trade conflict may begin to appear in macro data in the next few months, after the US and China each imposed $34bn in tariffs beginning on July 6. That will sharpen the trade-offs facing policymakers between growth and deleveraging.

“We expect growth in [the second half] to be challenged by the slow credit growth and softer real estate activity. Also, the intensifying trade conflict with the US will start to weigh on growth,” Louis Kuijs, head of Asia economics at Oxford Economics in Hong Kong, wrote on Monday.

“But China’s most recent export data suggests that overall global demand momentum remains solid for now.”

The US Weighs Its Options in the South China Sea


Over the past year, there’s been a growing chorus of warnings from the United States that it’s preparing to adopt a more confrontational stance in the South China Sea. With China’s installation of radar jamming equipment and long-range anti-ship and anti-aircraft missiles this spring on Fiery Cross Reef – one of China’s seven artificial islands in the disputed Spratly archipelago – the pretense that Chinese President Xi Jinping intended to uphold his vague pledge in 2015 to refrain from militarizing the islands has evaporated. Now, the quiet standoff appears primed to enter a new phase.

Last month, for example, a top U.S. general talked openly about the U.S. ability to destroy Chinese military installations in the South China Sea, and Defense Secretary James Mattis said the U.S. is planning a “steady drumbeat” of naval exercises near Chinese holdings in the disputed waters. In May, the U.S., Japan and Australia agreed to formulate an “action plan” on cooperation in the South China Sea. Even France and the United Kingdom are talking openly about becoming more active in the region. But it’s far from clear what the U.S. and its allies really have in mind. The U.S. has few options that would alter the facts on the ground, and those that would push the Chinese back carry substantial risks. Ultimately, the South China Sea just may not be important enough to the U.S. to take such risks.    

This Deep Dive examines U.S. strategic interests in the South China Sea (or lack thereof) and gauges what may compel the U.S. to push back against Chinese assertiveness there. It then looks at the oft-misunderstood freedom of navigation operations, known as FONOPs – to date, Washington’s favorite tool for dealing with the territorial dispute – and explains why such ops will do little to deter Beijing. Finally, it assesses the United States’ options in the South China Sea should it want to go further in limiting China’s expansion in the hotly contested waters.
U.S. Interests in the South China Sea
The United States is relatively uninterested in who controls a few man-made molehills in the Spratly Islands. But the U.S. would be vitally concerned should any country attempt to use its position to restrict freedom of navigation either for U.S. naval ships or global trade. Some 30 percent of global maritime trade and about half of all global oil tanker shipments pass through the waters each year. Someday, the thinking goes, China could use the reefs that it has turned into remote military outposts, combined with its increasing sea denial, naval, coast guard and maritime militia capabilities, to restrict movement there – or at least threaten to do so – and coerce other countries that rely on the waters. Already, it has begun using them to deny other littoral states the ability to fish, drill for oil and so forth in the disputed waters.

But, at least at present, the U.S. doesn’t need to roll back China’s island-building to keep Beijing from restricting maritime traffic. So long as the U.S. can cut off Chinese commerce flowing through chokepoints along what’s known as the first island chain and through the Malacca and Sunda straits, China likely couldn’t disrupt maritime traffic in the South China Sea, even if it had a good reason to. The Chinese economy would be crippled, and the world would be united against it. Attempting to shut down sea lanes would be an act of desperation. It’s not the kind of thing China could threaten in order to gain leverage against the U.S. in scenarios short of war.

Moreover, for the foreseeable future, the military assets stationed on the artificial islands would likely prove only of marginal value in an all-out conflict between China and the United States. Located more than 700 miles (1,100 kilometers) south of Chinese bases on Hainan, the Spratly bases do effectively expand the range of China’s missiles and bombers. The supersonic YJ-12B anti-ship cruise missiles and HQ-9B anti-air missiles placed on Fiery Cross Reef in May give China missile coverage over a vast area of the South China Sea, including a base in Palawan expected to host U.S. forces. Three of the artificial islands have runways capable of handling bombers and fighter jets. If China struck first in a conflict, these capabilities would certainly come in handy. But the island bases likely wouldn’t last long. Their locations are fixed and cannot be camouflaged, making them easy pickings for U.S. missiles.
Still, the U.S. has reasons to want to put an end to China’s militarization of the islands. And since dislodging the Chinese will get only harder as China’s maritime and anti-ship missile capabilities and ranges improve, the U.S. has an interest in acting sooner rather than later. Perhaps the most important reason is to maintain its credibility with its allies and potential partners in the region – those that are already suffering materially from China’s expanding presence. If the U.S. appears to be washing its hands of the territorial disputes in the South China Sea, it will heighten the sense among claimant states like the Philippines and Vietnam that the distant U.S. wouldn’t intervene on their behalf.

Philippine President Rodrigo Duterte has a point when he says U.S. disinterest in a war over China-occupied reefs off the Philippine coast has given Manila – a U.S. treaty ally – little choice but to comply when Beijing dictates terms on fishing and resource extraction. To date, the U.S. has declined to confirm that its mutual defense treaty with Manila, which the U.S. has kept vague to avoid getting drawn into a war not of its choosing, even covers the South China Sea. (Further alienating Manila, the U.S. has confirmed that its treaty with Japan covers the disputed Senkaku Islands.) Vietnam’s recent cancellations of two much-needed drilling projects, reportedly under threat from Beijing, spoke louder than words. All this plays into China’s narrative that Southeast Asian states would be wise to accept its ascension as regional hegemon as a fait accompli.

This becomes a problem for U.S. strategy if it leads regional states – the Philippines, in particular – to abandon cooperation with the U.S. at Beijing’s behest and allow China to take up positions that give it access through critical chokepoints. In such a scenario, the U.S. would lose its trump card and its status as traditional guarantor of regional maritime trade. Already, the Duterte administration has been delaying implementation of a landmark pact giving the U.S. rotational access to Philippine bases, including one on Palawan, near the Spratlys.

Thus, the U.S. has been gradually bolstering its presence in the South China Sea to reassure other littoral states and signal to Beijing that the U.S. is not abandoning the region. But the question remains just how much Washington thinks China’s expansion in the disputed waters matters to U.S. interests – and just how far the U.S. is willing to go to protect those interests.
A Primer on Freedom of Navigation Ops
At minimum, the U.S. appears primed to accelerate the pace of freedom of navigation operations. The goals and mechanics of these operations, and how they fit into U.S. strategy in the Western Pacific and beyond, are often mischaracterized. Since we’re likely to be hearing a lot about them in the coming years, it’s worth understanding how they work and what they can and cannot achieve.

The basic goal of FONOPs is to reinforce norms (such as free navigation and maritime law), particularly those outlined under the U.N. Convention on the Law of the Sea, which came into force in 1994. (The U.S. is not an UNCLOS signatory, providing much rhetorical and propaganda fodder to China, which is. Nonetheless, the U.S. treats UNCLOS as customary international law and is effectively its staunchest enforcer.) Since the late 1970s, the U.S. has quietly conducted scores of FONOPs around the world each year, only publicizing them, with minimal detail, in an annual report. China is not the only target; in 2017, the U.S. targeted excessive maritime claims of 22 countries, including allies and partners like the Philippines, Vietnam, Malaysia, Taiwan, India and Indonesia.
China’s Claims
In the South China Sea, U.S. FONOPs have taken on a much higher profile, in part because China’s territorial claims are so vast and its violations of UNCLOS have been so flagrant. China has reclaimed more than 3,000 acres of land atop seven reefs that previously were at least partially submerged.

Under UNCLOS, if China’s holdings met the definition of an island – a feature always above water and capable of sustaining human life or economic activity – then they would grant China three things: a territorial sea within the surrounding 12 nautical miles, a contiguous zone between 12 and 24 nautical miles, and an exclusive economic zone extending out 200 nautical miles. A state can exercise sovereign control over a territorial sea, making and enforcing its own laws in the waters (as well as the airspace above) free from outside interference. In an exclusive economic zone, the state has exclusive resource rights. However, if the China-occupied feature were considered merely rock – always above water but incapable of sustaining human life or economic activity – then it would give Beijing a territorial sea and a contiguous zone but no exclusive economic zone. And if determined to be at a low-tide elevation – i.e., a maritime feature that is submerged at high tide – it would generate none of the three. (Transforming a rock or low-tide elevation into an artificial island does not alter its legal character.)
In 2016, the Permanent Court of Arbitration at The Hague ruled that all seven of China’s artificial islands in disputed parts of the South China Sea are either rocks or low-tide elevations, not islands, meaning none grant China exclusive resource extraction rights. It also ruled that China’s historical rights to waters within its sweeping “nine-dash line” do not supersede UNCLOS. Importantly, the court did not rule on rightful ownership of any of the reclaimed islands – just that whoever controls them is not entitled to the benefits that would be granted by an island, and thus many of China’s claims and activities are not in accordance with international law. Officially, the U.S. has also stopped short of taking a position on which feature belongs to which country.
What FONOPs Actually Achieve – And What They Don’t
FONOPs are one way for the U.S. to uphold the 2016 international tribunal ruling. The operations can take many forms, depending on what legal point the U.S. is trying to make or the type of excessive maritime claim the U.S. is intending to challenge. Most are focused on reinforcing what’s known as “innocent passage.” Under UNCLOS, a warship from any country is allowed to transit through the territorial waters of another so long as it refrains from activities such as military exercises or surveillance operations, research and survey activities – and so long as it moves “continuously and expeditiously” through the waters. It’s also considered out of step with UNCLOS for a state to demand that ships passing through its territorial waters provide prior notice or obtain permission before doing so, though some countries disagree with this interpretation. Where a country like China is making such demands, the U.S. will often have a warship sail through territorial waters without notice or permission. Narrow point made.

Sometimes, the U.S. will use FONOPs to more pointedly discredit China’s sweeping claims. In May 2017, for example, the USS Dewey sailed near Mischief Reef, a low-tide elevation built up by China in the Spratlys some 150 miles from Philippine shores. To assert that the man-made island does not grant China, say, the right to block Philippine fishermen from the area, the U.S. did two things prohibited under the principle of innocent passage: First, it sailed in a zigzag pattern, rather than passing through expeditiously. Second, while within 12 nautical miles of the reef, the crew conducted a man overboard exercise. Both activities implicitly made the point that the U.S. does not consider the waters around Mischief Reef to be Chinese territory. Beijing’s standard response to U.S. FONOPs – tailing the warships with their own and demanding that they promptly leave – is intended to make the opposite point and show the folks back home that they’re “standing up” to the imperialist Americans.
If all this seems like little more than shadowboxing over legal minutiae, that’s not far from the truth. FONOPs make for good headlines, but they are not an actual deterrent and never were intended to be. Technically, they don’t even assert that the U.S. thinks that China shouldn’t be allowed to occupy the reefs. They don’t generate leverage for the U.S. or punish China for its aggressiveness. Since the U.S. quietly conducts dozens of them each year around the world, and since they work best when conducted at a regular clip, they don’t signal displeasure about an unrelated point of tension with Beijing or serve as warnings of, say, a growing willingness to confront China. They may help reassure allies about U.S. engagement in the region, but they achieve less in this regard than joint exercises would and nothing more than routine operations in international waters would. Mostly, they assert a uniform legal principle and underscore the U.S. role of protector of the high seas. If it could trust China to comply with UNCLOS, the U.S. would likely be satisfied. But recent history shows that making international law the focal point of U.S. strategy would be fruitless. The U.S. has conducted FONOPs around Chinese features at a steady clip since 2016, including at least seven since President Donald Trump took office. They have not altered Beijing’s strategy or behavior in any discernible way.
Going Beyond FONOPs
If the U.S. wants to stop China’s expansion in the South China Sea, it won’t have many clear-cut options for doing so. The problem for the U.S. is its superior firepower can’t be put to much use so long as it’s not willing to pick a fight over other countries’ islands, meaning the U.S. likely wouldn’t be playing to its strengths.

It can attach some costs to Chinese actions, however. For starters, it can ramp up security assistance to Southeast Asian littoral states and better equip them to defend themselves – supporting the U.S. goal of relieving itself of duties as the global policeman and allowing it to better manage regional affairs from afar. It’s already been doing this, to a degree, and growing Japanese security assistance to the Philippines, Vietnam and Malaysia has amplified U.S. efforts. (Notably, though, the current version of the legislation setting the Pentagon’s budget in 2019 would cut funding for security assistance to Southeast Asia by half.) The U.S. could make it clear that certain Chinese moves will be met with a commiserate increase in military aid to the region, creating at least some room for negotiation. The main limit of this approach is that most South China Sea states have no hope of ever achieving parity with the Chinese, making them unlikely to force the issue. Some, like Vietnam, have substantial sea denial capabilities that could be used to at least temporarily restrict Chinese freedom of action. But using them would risk drawing them into a larger conflict they’d have little hope of winning, while also leading to Chinese economic retaliation.

One step the U.S. has not yet even threatened is pressuring Beijing with targeted sanctions. Multinational Chinese construction firms doing the island-building, telecommunications firms installing equipment on the atolls, and commercial airliners ferrying civilians there would be obvious targets. It’s doubtful this would deter Beijing, which sees its South China Sea islands as an integral part of its anti-access/area denial strategy and will happily tolerate sanctions if it means avoiding the humiliation of backing down. It has ways to continue on without the help of commercial partners, anyway. But for the purposes of raising the cost of expansion and doing something tangible in support of allies like the Philippines, this, too, would go further than mere FONOPs. The U.S. certainly has not been meek about targeting Chinese firms and banks with secondary sanctions to further its goals on North Korea, Iran and trade.

Ultimately, however, to restore the status quo, the U.S. would need to bring power to bear directly. This could take one of two forms. The first is to do what China has done to the Philippines, Vietnam and Malaysia and blockade its access to the islands. There is a strong case that this would be legal under UNCLOS. The U.S. doesn’t have the sort of coast guard or paramilitary assets in the region that China uses to harass and block outside vessels. To avoid having to police the situation by itself with warships ill-suited for the task, the U.S. would want to lean on a multinational coalition involving coast guards and civilian vessels from littoral states, plus allies like Japan, Australia and European powers – though it’s uncertain to what degree these states would be willing to provoke China in this manner. This option would have the highest risk of accident or incident that leads to unwanted escalation, and the mechanics would be exceedingly tricky. Washington would have to decide ahead of time if it’s really willing to risk war with rules of engagement that allow U.S. forces to come to the defense of a partner vessel that comes under attack.

The second option, on the extreme end of the spectrum, would be a military operation to expel the Chinese from their man-made islands and restore the status quo – or at least threaten to if China launches a new island-building project on a contested reef. This, too, would risk sparking a broader conflagration with China, but a wider war would not be automatic. For one, U.S. operations would be targeting remote outposts that were uninhabited three years ago and wouldn’t put many Chinese citizens at risk, making it conceivable that Beijing could use its media controls to contain a nationalist backlash and avoid getting drawn into an all-out war it’s not ready for. For another, China wouldn’t be able to do much to fight back even if it wanted to. China’s installation of military assets like radars and anti-air and anti-ship missiles on the islands notwithstanding, the Chinese navy would still be poorly equipped to defend them – especially those several hundred miles from the naval and air bases and missile installations on the mainland.

Most important, since the U.S. would not have much need to take and hold the islands, it could attack from a distance using standoff cruise missiles and potentially avoid direct confrontations between U.S. and Chinese warships and warplanes in China’s backyard. This means Chinese counterattacks would largely be punitive, not tactical, even if the growing range and sophistication of China’s “carrier killer” anti-ship missiles and longer-range ballistic missiles are making it harder for the U.S. to act with impunity. The U.S. wouldn’t need to open broader operations to neutralize Chinese air power or disrupt Chinese logistics networks, and Chinese counterattacks would risk escalation against the world’s most powerful military for little tactical benefit. In other words, there would be no World War II-style fights to the death over critical islands, and the operations could stay relatively contained.

Doing this wouldn’t decisively eject the Chinese from the islands or deny them future access. Nor would it prevent China from harassing Philippine fishermen or Vietnamese oil drillers. But it would attach a major cost to Chinese aggression, while demonstrating U.S. willingness and ability to play the role of arbiter in the South China Sea. Even milder U.S. threats have compelled China to back off in the past. In 2014, for example, the Chinese coast guard stopped blocking resupply boats from reaching Philippine marines marooned on Second Thomas Shoal when a U.S. surveillance plane showed up overhead. And in 2016, the Obama administration reportedly drew a red line around Scarborough Shoal, a flashpoint reef seized from the Philippines in 2012, compelling Beijing to abandon reclamation plans there.

Still, war has a way of taking on a life of its own, and it’d be naive to dismiss the risk of escalation. Regional support cannot be guaranteed. It would also give cause for Beijing to retaliate indirectly on other issues important to the United States. At minimum, it would amount to a complete breakdown of U.S.-Chinese relations at a time when there are still many issues where the U.S. wants Chinese cooperation. The U.S. would effectively be prioritizing ally reassurance in the South China Sea over trade, North Korea and so forth. Geopolitical issues of this magnitude are not settled in a vacuum. Unlike Philippine anglers blocked from Scarborough Shoal, the U.S. could reasonably decide it has bigger fish to fry.