Latent Fragilities

Doug Nolan

I have a rather simple Bubble definition: "A self-reinforcing but inevitably unsustainable inflation." Most Bubble discussions centers on the deflating rather than the inflating phase. A focus of my analysis is the progressively powerful dynamics that fuel Bubble excess, along with attendant distortions and maladjustment - and how they sow the seeds of their own destruction.

The ongoing "global government finance Bubble" is unique in history. Rarely has market intervention and manipulation been so widely championed. Never have governments and central banks on a concerted basis inflated government debt and central bank Credit. And almost a full decade since the crisis, the massive inflation of "money"-like government obligations runs unabated - across the continents.

The IMF calculated first quarter real global GDP growth at 3.64%, near the strongest expansion since 2011. U.S. Q2 GDP of 4.1% was the strongest since Q3 2014. There have been only eight stronger quarters of U.S. growth over the past 18 years.

Extreme and protracted policy (fiscal and monetary) stimulus has indeed stimulated real economy expansion. Given sufficient scope and duration, stimulus will invariably fuel spending and investment. Unfortunately, however, the artificial boom is not without myriad negative consequences. Is the boom sustainable? Have we today reached the point where economic growth is self-supporting? Or, instead, is the global boom vulnerable to the curtailment of aggressive stimulus? Has global government stimulus promoted a return to stability? Or has almost a decade of unprecedented measures only exacerbated Latent Fragilities?

It was yet another week that seemed to support the Acute Latent Fragility Thesis.

July 22 - Financial Times (Gabriel Wildau and James Kynge): "China's central bank injected Rmb502bn ($74bn) into its banking system on Monday to help fortify a weakening domestic economy against the impact of an escalating trade war with the US and growing friction with Washington over its falling currency. The injection was the most emphatic move in a series of recent indications that Beijing is moving to ease monetary policy… Raising the risk that the US-China trade war could turn into a currency war, Mr Trump has accused Beijing of manipulating the renminbi, which last Friday reached its lowest point for a year against the US dollar. It has fallen 5% since the start of last month."

Despite GDP growth in the neighborhood of 6.0%, booming household borrowings, an unrelenting apartment Bubble and an ongoing Credit boom, China has once again been compelled to resort to aggressive stimulus in an attempt to hold its tottering Bubble upright. The Chinese economy's vulnerability to a U.S. trade war is generally offered as the impetus behind recently announced measures. Perhaps exposure to the faltering EM Bubble is also a pressing concern in Beijing.

July 22 - Wall Street Journal (Jeremy Page and Saeed Shah): "Pakistan's first metro, the Orange Line, was meant to be an early triumph in China's quest to supplant U.S. influence here and redraw the world's geopolitical map. Financed and built by Chinese state-run companies, the soon-to-be-finished overhead railway through Lahore is among the first projects in China's $62 billion plan for Pakistan. Beijing hoped the $2 billion air-conditioned metro, sweeping past crumbling relics of Mughal and British imperial rule, would help make Pakistan a showcase for its global infrastructure-building spree. Instead, it has become emblematic of the troubles that are throwing China's modern-day Silk Road initiative off course. Three years into China's program here, Pakistan is heading for a debt crisis, caused in part by a surge in Chinese loans and imports for projects like the Orange Line, which Pakistani officials say will require public subsidies to operate."

A few decades ago it was Japanese Bubble Finance spreading its tentacles around the world. This week saw Japanese 10-year yields almost reach 11 bps, near the high going back to January 2016. It took two Bank of Japan (BOJ) interventions - offers to buy unlimited JGBs - to push yields back below 10 bps by Friday. There is considerable market focus on next week's BOJ policy meeting, along with heightened concerns in Japan for the sustainability of the BOJ's policy course. Holding "market" yields indefinitely at zero promotes distortions and imbalances. Various reports have the BOJ contemplating adjusting this policy. The BOJ may also adjust its ETF purchase program viewed as distorting the Japanese equities market.

Sharing a similar experience to central bankers around the globe, the BOJ has seen the impact of its inflationary policies much more in booming securities markets rather than from (stagnant) aggregate price levels in the real economy. Despite a massive expansion of central bank Credit, Japanese core consumer price inflation is expected this year to be about half the bank's 2.0% policy target. Increasingly, the 1% difference in CPI must seem secondary to risks mounting in the financial markets.

July 26 - Bloomberg (Masaki Kondo and Chikafumi Hodo): "For all the speculation over possible Bank of Japan policy tweaks next week, the most important change for global bond markets may already be underway. While market watchers disagree about whether the BOJ will adjust its target of keeping 10-year yields around zero percent, its steady reduction in purchases of longer-maturity debt and more expensive overseas hedging costs mean Japanese funds are already contemplating bringing more money back home. The BOJ's steps to buy fewer bonds has seen the annual increase in its debt holdings slow to 44.1 trillion yen ($398bn) versus its guidance of 80 trillion yen. Last quarter the reductions were entirely focused on so-called super-long bonds, which are the most attractive to insurers. What happens next in the world's second-largest bond market has the potential to cascade globally given Japanese investors hold $2.4 trillion of overseas debt."

It's a big number: $2.4 TN. BOJ policy has nurtured great Latent Fragilities. For one, policy measures have incentivized Japanese institutions and investors to comb the world for positive yields (fueling Bubbles, in the process). Moreover, there is surely a large yen "carry trade" component, as financial speculators essentially borrow free in yen to leverage in higher-yield global instruments. The dollar/yen bottomed in late March, not coincidently about the same time U.S. and global (developed) equities put in trading bottoms. After trading as low as 104.74, a weaker yen saw the dollar/yen rally to trade last week at 112.88. Having reversed course, the dollar/yen closed Friday at 111.05.

I would argue that the ECB has also nurtured great Latent Fragilities. The ECB Thursday confirmed that policy rates would remain near zero at least through the summer of 2019. "What are they afraid of?" German two-year yields ended the week at negative 0.61%, the French two-year at negative 0.44%, and Spanish yields at negative 0.33%. Even Portugal enjoys negative borrowing costs out to two-year maturities (-0.23%). The German government is paid to borrow out to five years (-0.17%). To be sure, European debt instruments have inflated into one of history's most distorted Bubble markets - and I'll assume Mario Draghi is not oblivious.

Italian 10-year yields jumped 15 bps this week to a four-week high 2.74%. Draghi was again questioned about Target2 balances during the ECB's post-meeting press conference. It's a critical issue that garners surprisingly little attention, perhaps because it is deftly deflected by the head of the ECB. Besides, it was a 2012 worry that proved short-lived.

Journalist: "How do you rate the risk in this [Target2] system, especially for the Bundesbank and compared to the Italy National Bank, for example?"

ECB President Mario Draghi: "First of all, let me make a general point. Target2 is a payment system, as such it doesn't generate instability. It's the way a monetary union settles its payments, and it's devised to make sure the money flows unencumbered across countries, individual sectors, companies - all economic agents. So that's the first thing we should always keep in mind.

The second thing is how to interpret recent numbers which show an increased number of Target liabilities in certain countries. Well, this is again a question that was asked several times in the past. Most of the movement in Target2 liabilities depends on our own asset purchase program - and depends on how and where - especially where - the balances of the purchases of bonds are settled. About 50% of the institutions… that sell bonds to the national central banks are not in the euro area and settle their account with one or two core countries where the financial centers reside. So, in this sense, you see that the accounting settlement of the balances do depend on where the settlement is made. It has nothing to do with capital flows from one country or another. Keep in mind that 80% of the institutions - banks namely - that sell bonds to the national central banks do not reside in the country where the purchaser's national central bank resides. A lot of inter-country payments and flows do not say anything very specific about the overall situation.

But going back to the recent movements in the liabilities in certain countries, you see that first of all they are not unprecedented - this is not the first time. We've seen movements as large and even larger in the past. Second…, they are of second order with respect to the massive movements produced by our own purchase program. So, the bottom line is the system works very well. The people who want to cap it, collateralize, limit - I mean, the truth is that they don't like the euro. They don't like the monetary union. Because the only way a monetary union can work is if they have an efficient payment system - which is what Target2 is. And I think it is just too early to understand exactly what part of the liabilities do reflect political uncertainty."

Italy's Target2 liabilities rose $16.3 billion during June to a record $481 billion, with a two-month gain of almost $55 billion. It's worth noting that Italy's liabilities surged from about zero in mid-2011 to $289 billion at the height of the European crisis back in August 2012. The ECB's "whatever it takes" stabilization program saw these liabilities shrink to $130 billion by July 2014. They've been basically heading south ever since.

Clearly, there is a lack of confidence in Italy's future position in the monetary union. And, at this point, it is not clear what might reverse the steady outflows from Italian financial institutions and assets. I don't completely disagree with Mr. Draghi's assertion that ECB policy is having a significant influence on Target2 balances. When Eurozone central banks buy Italian debt securities in the marketplace, the sellers are choosing to hold (or dispose of) these balances in other countries - thus creating a Bank of Italy liability to another euro central bank (largely the Bundesbank). Why is this not a major festering problem? Germany's Target2 assets rose $20 billion in June to a record $976 billion - having now more than doubled since December 2014.

That Germany will soon have accumulated an astounding $1.0 TN of Target2 assets implies acute Latent Fragility in the euro region. This was never supposed to happen. These balances reflect mounting imbalances plugged by freely-flowing central bank "money." ECB sovereign debt purchases have so compressed interest-rate differentials that there is today insufficient incentive to hold Italian and other "periphery" debt. But a market adjustment toward more realistic Credit spreads risks bursting Bubbles and blowing up debt markets. The entire European monetary integration experiment hangs in the balance.

So, the ECB is forced to stick with negative interest rates and "money" printing operations, and countries such as Italy accumulate liabilities that they will never service, leaving the German people to fret receivables that will never settle. Draghi's assertion that the payment system "works very well" is at best misleading. With imbalances growing bigger by the month, the semblance of a well-functioning payment system depends on monetary policy remaining extraordinarily loose. Stated differently, Acute Financial Fragilities are held at bay only so long as "money" remains free and created in abundance.

I believe we've reached the stage where a meaningful tightening of finance in Europe risks acute bond market instability and perhaps even the entire euro experiment. For those believing this is hyperbole, allow me to phrase this differently: Italy and other "periphery" nations are one financial crisis away from demanding an alternative monetary regime.

A reasonable question: Why then is the euro not under more pressure? Well, Japan is only a meaningful tightening of financial conditions away from major bond market and financial system issues. The yen is a big wildcard. China is only a meaningful tightening away from major financial and economic issues. The renminbi is a big wildcard. The emerging markets are already suffering the effects of a tightening of financial conditions. Many EM currencies are in trouble.

Why is the euro not weaker against king dollar? Because the dollar is fundamentally an unsound currency - in a world of unsound currencies.

July 24 - Wall Street Journal (Josh Zumbrun): "The U.S. remained by far the largest driver of global current-account imbalances in 2017, running the world's largest deficit and adopting policies-mainly a shift toward much larger fiscal deficits-that are likely to increase its imbalances in coming years. The U.S. ran a $466 billion current-account deficit, meaning the nation imported far more than it exported. The U.S. has become an increasingly large driver of global deficits, accounting for 43% of all global deficits last year, up from 39% in 2016, according to the International Monetary Fund's annual assessment of the state of global imbalances. Washington's shift toward major deficit spending will move the U.S. trade deficit 'further from the level justified by medium term fundamentals and desirable policies,' the IMF said."

I would argue that the U.S., as well, is only a meaningful tightening of financial conditions away from serious issues. Inflated U.S. securities markets have been on the receiving end of huge international flows, much a direct consequence of QE (i.e. ECB and BOJ) and rampant Credit growth (China and EM). It would appear that U.S. residential and commercial real estate markets are already feeling the effects of waning international flows.

In the eyes of complacent markets, vulnerabilities - China, Japan, EM, Eurozone, UK, etc. - ensure the coterie of global central bankers remain trapped in aggressive stimulus. Yet there appears increasing recognition within the central bank community that further delays in the start of "normalization" come with mounting risks. That they have all in concert far too long delayed getting the process started ensures great Latent Fragilities.

The Dow jumped 1.6% this week, the Banks 2.4% and the Transports 2.0%. The S&P500 added 0.6%, its fourth straight weekly gain. But the week saw (Crowded Long) declines of 16.7% in Facebook, 21.4% in Twitter, 9.5% in Electronic Arts and 8.2% for Intel. The broader market underperformed. Interestingly, the Goldman Sachs Most Short index dropped 3.1%. Rather abruptly, there are indications of nervousness and vulnerability below the market's surface.

The historic mistake was to believe that aggressive monetary policy would reduce systemic Fragilities. Stimulation of economies and animal spirits, no doubt, but at the cost of mounting latent instability. It's the six-year anniversary of "whatever it takes;" approaching the 10-year anniversary of the financial crisis; going on ten years since the massive Chinese stimulus. This week provided further evidence of trapped central banks.

EM rallied again this week, reducing the safe haven Treasury bid. Two-year Treasury yields jumped eight bps this week to 2.67%. The ten-year is again knocking on the door of 3.0% yields. I have no doubt that a surprising spike in Treasury yields would expose Latent Fragilities. The same question applies to Treasuries as it does to fixed-income markets around the globe: How much speculative leverage has accumulated over the past decade? Keep in mind it's the speculation and leverage that typically dooms a Bubble. Indeed, the interaction of leverage and depreciating asset values becomes a critical factor in why Bubbles are unsustainable.

First, it was the February blow-up of the "short vol" trade. Then instability engulfed the emerging currencies, debt and equities markets, followed by a destabilizing spike in Italian yields. The Chinese renminbi sinks a quick 5%. This week saw further weakness in the Chinese currency, along with hints of instability in Japanese and Italian bonds. Importantly, Beijing stimulus measures come with atypical currency vulnerability.

All in all, the Latent Fragility case is coming together. Financial conditions are tightening, and myriad Bubbles are showing the strain. And while the VIX traded below 12 this week (ending the week at 13.03), my hunch would be that liquidity in the volatility markets has quietly receded. The next VIX spike could get interesting.

Trump lays bare Britain’s ‘special relationship’ delusion

Tensions between London and Washington are nothing new

Lawrence Freedman

That Britain is a country “in turmoil” is one of US president Donald Trump’s more accurate observations. It is a turmoil to which he contributes. Instead of offering a beleaguered UK prime minister a helping hand, he has added to Theresa May’s woes by blatantly encouraging her most hardline Brexit critics. Mrs May finds herself having to cope with enormous strains in the two relationships at the heart of Britain’s foreign policy: with the US and with Europe.

This is not a wholly unique situation. In early December 1962, as Britain’s first attempt to join what was then the “common market” was about to fail, former US secretary of state Dean Acheson noted that Britain “had lost an empire but failed to find a role”. This unhelpfully set in motion a quest for that special role. Finding it became the holy grail of British foreign policy.

The search focused on Britain’s relationship with the US. The Suez crisis of 1956 had demonstrated in a humiliating manner that Britain could no longer pursue ambitious policies against American wishes. Just before Acheson’s speech, the Pentagon had decided to abandon the Skybolt missile upon which the future of Britain’s nuclear strike force depended. It took an emergency summit between prime minister Harold Macmillan and president John Kennedy for the US to substitute the much more appropriate Polaris missile. The episode underscored the extent to which Britain’s strategic independence had been compromised.

Macmillan had already decided, post-Suez, that the only way to sustain any position in the world was to stay as close as possible to the US. In this way, shared history and culture, along with the security connections forged during the second world war, could keep Britain centre stage. The country may not have found a special role, but it did have a special relationship.

Britain was clearly the junior partner, although at times London flattered itself that it could make up for a lack of raw power by using its mature wisdom to guide the brash newcomer. But there was also a solid foundation. The intense co-operation between diplomats, military staffs, intelligence agencies and nuclear establishments worked to the benefit of both. The two also had similar world views and were fully embedded in the network of multilateral institutions set up after the war to keep the international system as orderly as possible.

Most importantly, the relationship stayed so close because a series of great causes held it together. Following the joint fight against the Nazis — the greatest cause of all — this sense of shared endeavour was sustained through the cold war. Then with the collapse of the Soviet Union came more positive opportunities to spread western values and practices in eastern Europe and beyond. This was followed by the darker period of the “war on terror”.

These great causes did not prevent disagreement. Even during the 1980s, when Margaret Thatcher and Ronald Reagan were on a shared ideological campaign, they had their differences, for example over the Falkland Islands in 1982. Yet the Falklands episode also indicated the underlying strength of the relationship. While Thatcher was furious that Reagan sought a deal between the Argentine aggressor and his aggrieved ally, the Pentagon and American intelligence agencies were actively working to make sure that British forces had the support they needed.

Tony Blair declared after the al-Qaeda attacks of September 11, 2001 that the UK would stand “shoulder-to-shoulder” with the US. He set himself up as a committed strategic adviser to president George W Bush, even when this led to the invasion of Iraq. The episode illustrated the limits of the alliance. Mr Blair could exercise some influence when the White House was undecided about what to do, but he could not get it to budge once it had made up its mind up. The result was that Britain found itself part of an ill-prepared and much-criticised occupation.

This left a legacy. There was little appetite for new operations of a similar kind, other than the occasional use of air power. David Cameron’s failure to get parliament to back a military response to Syria’s use of chemical weapons in September 2013, and Barack Obama’s own reluctance to get involved in another ground war in the Middle East, marked the end of this activist stage in the special relationship.

Weariness replaced the confidence with which the 21st century had begun. The international order that had served the interests of the two countries so well was under challenge from critics at home as well as abroad. The UK’s vote to leave the EU was one symptom of this challenge; Mr Trump’s election another. There was even a theoretical possibility of a new stage in the special relationship marked by the two working together outside the multilateral institutions that they had both worked so hard to develop and sustain.

But Mrs May has never been able to bring herself to support the radical break with the past that Mr Trump represents. On every issue in which he has challenged mainstream thinking (climate change, Iran, trade), the UK has found itself on the same side as its EU partners.

Before the Brexit vote it might have been possible to compensate for Mr Trump’s unpredictability with a more active role in the EU, but that is no longer available. A country whose role in the world always depended on the quality of its partnerships with others now faces an unusually lonely future. To lose one special relationship is a misfortune; to lose two together looks like carelessness.

The writer is emeritus professor of war studies at King’s College London and author of ‘The Future of War: A History’

 Is The Interest Rate Death Spiral Finally Starting?

The yield on Italy’s 10-year bond is up by about 100 basis points from its 2018 low. Meanwhile, its government continues to borrow money and roll over its existing debt. But now it has to do so at ever-higher interest rates, which means it has to pay more interest, which means its deficits are rising, forcing it to borrow even more money, and so on until this “interest rate death spiral” becomes fatal.

It would already be fatal, if not for the European Central Bank’s willingness to buy Italy’s bonds at extremely favorable prices (i.e., very low interest rates). But now the ECB is promising to stop doing that, which leaves Italy in the early stages of a very negative feedback loop.

Italian 10-year bond yield intrest rate death spiral

Not our problem, you say? Italy is irrelevant to everyone including most Italians, so its imminent financial crisis is no more important than Venezuela’s.

Fair enough. Let’s move closer to home and start the story over:

The yield on US 2-year Treasury paper is up almost 100 basis points since last September.

Meanwhile, the government continues to borrow money and roll over its existing debt. But now it has to do so at ever-higher interest rates, which means it has to pay more interest, which means its deficits are rising, which means it has to borrow even more money at higher interest rates, and so on until this “interest rate death spiral” becomes fatal.

It would already be fatal if not for the Federal Reserve’s willingness to buy Treasury bonds at extremely favorable prices (i.e., very low interest rates). But now the Fed is promising to stop doing that, which leaves the US in the early stages of a very negative feedback loop.

US 2-year note yield interest rate death spiral

Here’s what the US government’s interest payments would be under different average interest rates:

US government interest cost interest rate death spiral

Note that the highest rate used in this table – 6% – is about average for the two decades prior to 2000.

So it only seems extreme in today’s era of monetary experimentation. We’ll get back there, one of these days.

Except that we won’t. An annual interest bill of 1+ trillion dollars would send the deficit – which is projected exceed a trillion without a meaningful rise in interest rates – above $2 trillion. And – since new interest will accrue on each year’s new borrowing – the current 21 trillion of US government debt would grow by around 10% a year in this scenario, kicking the process of higher rates producing higher deficits into overdrive. This impossible-to-hide acceleration will in turn produce extreme responses from governments and/or markets, including but not limited to spiking inflation, plunging bond prices, capital controls, martial law and a global monetary reset.

Italy will probably get there first, which allows Americans to view our future by looking across the Atlantic. So you see it does matter.

And remember, this scenario involves only central government debt, which is cumulatively dwarfed by private sector debts, state and local unfunded pension liabilities, emerging market external dollar debts, and bank derivatives. And all of these things are vulnerable, one way or another, to rising interest rates, which means the interest rate death spiral, when it kicks into high gear, will be something for the history books.

In the US Trade War, Vietnam Waits With Open Arms

The manufacturing exodus from China will likely benefit others in Southeast Asia.

By Phillip Orchard

It’s been a tough few years for Vietnam. Hanoi has felt increasingly abandoned by its Southeast Asian counterparts and outside powers alike in its dispute with Beijing over the South China Sea.

Meanwhile, a rare bout of political instability in the senior ranks of the ruling Communist Party, along with a proliferation of protest movements over a range of issues, have unnerved the government and speak to rising social and economic pressures at home. But in the Trump administration’s trade war, Vietnam might get a timely gift – one that will offer the country a more prominent, if awkward, role in the growing U.S.-Sino competition.

For more than a decade, China has been gradually losing foreign manufacturers to its neighbors due to rising wages. Southeast Asian states have been natural beneficiaries, having invested heavily in manufacturing and export infrastructure since putting the regionwide chaos wrought by the Cold War largely behind them. In northern Vietnam, wages are little more than half those in the manufacturing heartland of southeastern China. As a result, foreign investment has surged in Vietnam, rising nearly 8.5 percent in the first half of this year over the same period in 2017 – itself a record year.

Meanwhile, Vietnam has signed onto the revived Trans-Pacific Partnership trade pact, which is expected to be ratified by all 11 remaining members this year, and it’s moving toward a major free trade agreement with the EU. This means the country will become only more attractive to firms seeking unchecked access to lucrative consumer markets in Europe and the Pacific Rim. (For similar reasons, Thailand and Indonesia are now moving toward joining the TPP.)

But the trade war’s effects on this trend depend on just how far the U.S. is willing to escalate matters, particularly whether it follows through with the tariffs on $200 billion in Chinese exports the White House announced this week. The spat may end up strengthening the U.S. dollar and weakening the yuan to the point that exporting from China remains competitive. But on the whole, the added costs from tariffs, along with Beijing’s proven willingness to retaliate against firms from geopolitical foes like the U.S., South Korea, Taiwan and Japan, are likely to accelerate the manufacturing exodus from the Middle Kingdom. According to the Peterson Institute, foreign-owned firms are responsible for more than 60 percent of U.S.-bound exports from China. Vietnam is waiting with open arms.

Vietnam’s Trump Card

Unlike their multinational counterparts, Chinese firms can’t head abroad to dodge tariffs nearly as easily, considering the government’s utmost priority is to keep people at home employed. This gives Vietnam another card to play. Since last year, Beijing and Hanoi have been toying with plans to set up a series of bonded zones on the two countries’ shared border, where labor, capital and materials could cross freely. The border zones are close to major Chinese manufacturing centers in Guangdong province and the Yangtze River Delta, and China has invested heavily in cross-border infrastructure links and customs clearance facilities in recent years. With minimal assembly done in the bonded zones, Chinese wares could ostensibly be labeled as made in Vietnam and exported to the U.S. without concern for the new tariffs.

The border zones alone can’t facilitate trade on a scale China would need to fully offset the effects of the trade war. And moving goods across borders, however seamlessly, still increases the cost of doing business, making Chinese exports less competitive. Moreover, Chinese transshipments through Vietnam have run afoul of Western powers in the past. In 2016, both Washington and Brussels launched probes into Chinese steel falsely being labeled as made in Vietnam to circumvent EU and U.S. quotas. A country can add a “made in” label to a product so long as it is “substantially transformed” there. But if the U.S. determines that Chinese goods are merely passing through Vietnam en route to the U.S., the goods are likely to end up saddled with tariffs anyway – and Hanoi may end up in Washington’s crosshairs even more than it already has. (Vietnam was included in a recent Commerce Department investigation into unfair trade practices, and President Donald Trump criticized the trade deficit during his visit to the country in November.)

Nonetheless, tracking and cracking down on such activities is difficult and requires substantial cooperation from the host country. Ultimately, it’s Vietnam’s choice whether to go along with China here. And this gives Hanoi some much-needed leverage over both the U.S. and China that it could try to cash in on other issues – say, military assistance from the U.S., or the two foreign-backed drilling projects in the South China Sea that Hanoi canceled reportedly under threat from Beijing.

Vietnam doesn’t have a completely free hand in the matter. Last month, mass protests erupted in several Vietnamese cities over plans to grant foreign investors (Chinese firms, in particular) 99-year leases over land in several other special economic zones. Chinese businesses were also targeted by widespread nationalist protests in 2014. The Vietnamese leadership shares the public’s wariness of China’s expanding footprint in the country and its track record of economic coercion. Hanoi has long been deeply divided over how much to risk retaliation by taking a harder line against Beijing, leading to bouts of paralysis during crises. Fears of China’s capacity to exploit these divides and undermine the Vietnamese Communist Party’s continued rule was one factor behind its recent launch of a sweeping anti-corruption campaign and a drive to unwind the military’s extensive business interests. (Ironically, both initiatives are modeled on ones successfully implemented by Beijing.) To date, Vietnam has reportedly been dragging its feet on implementing the border zones agreement signed last year, reportedly due to these concerns.

The desire to keep nudging economic and security ties with the U.S. forward is presumably playing a role in Hanoi’s hesitation as well. Even without the TPP, Vietnam exported more than $46 billion in goods to the U.S. last year. Still, Hanoi would be more concerned about pleasing the U.S. if Washington had stayed in the TPP and if it felt that the U.S. was willing to go beyond largely symbolic measures in pushing back against Chinese assertiveness in the South China Sea more forcefully on Hanoi’s behalf. Furthermore, since the Obama administration lifted the longtime U.S. embargo on arms sales to Vietnam in 2016, Hanoi has yet to make a major purchase. American arms are uniquely expensive, meaning Vietnam would need the U.S. to shoulder some of the cost to buy more, yet Washington is reportedly considering cutting the budget for security assistance to Southeast Asia instead. Meanwhile, the U.S. has been pressuring countries to reduce arms trade with Russia – the foremost backer of Vietnam’s rapid military modernization.

In short, the U.S. hasn’t given Vietnam much reason to shed its historical wariness of close alliances with Western powers. Ultimately, if there’s ample money to be made on the margins of the U.S.-China trade war – or an opportunity to exact concessions from Beijing over the South China Sea – Vietnam won’t say no purely for Washington’s Benefit.

The Bigger Picture

For the U.S., all this speaks to the broader challenge it’s facing in achieving the various goals of the trade war, many of which are working at cross purposes with each other and with broader U.S. strategic aims. If the goal is to lower the overall U.S. trade deficit and restore the competitiveness of U.S. industries that have lost out to globalization, compelling firms to move from one low-cost country to another won’t help. Complicated supply chains flow through too many countries, labor costs in the U.S. are too high, and U.S. firms have invested too much in robotics and automation for labor-intensive manufacturing in the U.S. to be competitive. And as countries target U.S. industries with countermeasures, there will be new incentives for U.S. exporters to head abroad to avoid them. The Harley-Davidson case is instructive here.

If the goal is to isolate China and force it to abandon mercantilist trade practices and theft of U.S. technology, while weakening its capacity for economic coercion against its neighbors, it’ll be hard to achieve without a broad coalition acting in tandem. To an extent, despite their own ongoing trade spats with the White House, allies in Europe and the Western Pacific are still working toward a common goal with the United States. The EU, Japan, Australia, South Korea and Taiwan certainly share the U.S. concern about Chinese moves on the high-end technology front – and are enacting measures such as stricter screening of Chinese FDI as a result.

But tightly coordinated action and enforcement is critical. The more cracks China can exploit, by finding alternate export markets and import substitutes, accessing foreign technology in different countries and intimidating countries like Vietnam, the less effective the U.S. offensive will be.

The U.S. originally spearheaded the TPP, in large part, to give multinational manufacturers every reason to leave China for countries like Vietnam, while also creating strong incentives for such countries to enforce a common set of rules governing the modern, globalized economy – ones that the U.S. would have the dominant hand in writing. The stalled Transatlantic Trade and Investment Partnership likewise would have helped the EU and the U.S. form a united front in this regard.

Strengthening the World Trade Organization, rather than weakening it as the U.S. has done by vetoing all appointments of new appellate judges and threatening to undercut it altogether by simply ignoring its rulings, would too. Over the long term, a U.S.-led rules-based trade regime in the Pacific would boost U.S. leverage over Beijing on a range of issues, help regional states like Vietnam better resist Chinese assertiveness on their own and allow the U.S. to better manage a balance of power in the region from afar.

Of course, free trade has had social consequences in the U.S. and Europe that can’t be dismissed as irrelevant to geopolitical considerations, and multilateral trade pacts are imperfect tools. But the lack of a coherent and consistent strategy with which to manage the global effects of a trade war may actually create more problems than Washington had to begin with. It may even lead strategically important countries like Vietnam to scramble for shelter in places the U.S. would rather they not.

Humans Plus Robots: Why the Two Are Better Than Either One Alone


Knowledge@Wharton: What inspired the book, and specifically the title?

Paul Daugherty: It started two years ago when Jim and I were working a lot of research around artificial intelligence. We believe that artificial intelligence has immense potential for us to improve the way that people both work and live. The issue that Jim and I saw is that, in contrast to the opportunity that we see today, a lot of the dialogue is negative. It’s about human versus machine. It’s the 50th anniversary of the movie 2001: A Space Odyssey, where we had the HAL 9000 famously say, “I can’t do that, Dave.” There’s a narrative about the machine against the human, and it creates this dynamic that the machines are against us.

We really believe that artificial intelligence is a new technology that can dramatically improve the way that we live and work, and give us better tools to be more productive and more effective. We wrote “Human + Machine” to emphasize that it’s about us being equipped with better tools to do things more effectively. We think that has tremendous potential for business.

James Wilson: We find in our research that companies that focus on human and machine collaboration create outcomes that are two to more than six times better than those that focus on machine or human alone. For instance, BMW has found that robot/human teams were about 85% more productive than the old assembly line process, where you had industrial robots over on one side of the factory and people working on an old automated assembly line. When they got rid of that set up and started bringing people and collaborative robots to work together, they really started to see those big productivity improvements that just weren’t possible through the old way of thinking about automation. 
Knowledge@Wharton: How does Accenture view AI and its applications?

Daugherty: We see tremendous potential for AI within our business and are investing greatly in developing our business very quickly. We help companies deploy technology and new solutions to run their business more effectively, and we have never seen a part of our business grow as fast as what we’re seeing with artificial intelligence in terms of potential in the real work we’re doing to help clients with AI. Even in our own business, it is transforming the way we do a lot of our work. We use AI in the way that we build systems and solutions for our clients, and we are deploying AI capability to recruit people more effectively and manage our people more effectively.

One of the things that we talk about in the book is this idea of responsible AI, the ethics and new questions we need to answer with AI. We have developed COBE, which stands for Code of Business Ethics, and it is an internal AI-enabled chat bot to help our people better understand some of the ethical issues and questions that come up in business generally but also with artificial intelligence.

Knowledge@Wharton: Even with the growth of AI within your company, the communication element with employees is vital?
Daugherty: A lot of people are daunted by the term artificial intelligence. What does it really mean? The term sometimes scares us because it sounds like we are changing the way that people think. In contrast, we believe this is about humans plus machine and technology and giving us better capability. We use the term superpower because it gives us superpowers with better tools to do things more effectively.

The real important thing is training people to use this technology more effectively. We think it is imperative for business leaders to figure out and put in place new learning platforms and training capabilities so that people are ready for this. Because if the people aren’t ready for AI, I think we will have some issues in business and in some communities. The imperative that we all face is not the lack of jobs, which is sometimes the focus, or the machines taking the jobs, which we don’t really think is the reality, but it’s preparing people for the new jobs that are coming.

Knowledge@Wharton: But every company is looking for efficiency, correct? Artificial intelligence can take us to that next level of efficiency, whether it be within the office or outside on sales or in HR.

Wilson: You can keep pushing for more and more efficiency with artificial intelligence, but what we’re finding really is that we’re moving from an age of efficiency focus and automation to an age of imagination. As we began to look at leading companies, we started to see that about 9% of companies that were really getting the most potential out of artificial intelligence were reimagining old processes rather than just making them more efficient. 
For instance, General Electric is using intelligent agents to empower its maintenance workers to make multimillion-dollar operational decisions as they are working on industrial equipment. The workers can interact with the AI agents to get recommendations of machine performance, get the confidence levels coming from the machine based on data or get predicted costs based on data from the machines.

But the workers are making these judgment calls out on the line. So, the story that we see at GE and a number of other companies is not about efficiency at all, it’s really about reimagining processes in ways that weren’t possible before. GE says that they have moved from routine maintenance to unique maintenance, where workers are empowered to make these powerful decisions out on the line. That story, and the story that we have been hearing again and again, isn’t simply one of efficiency, it’s one of innovation and imagination.

Knowledge@Wharton: You examine how this reimagining will impact various elements of the business structure, including the supply chain. Can you talk about that?

Daugherty: We think the supply chain is a massive area of impact for artificial intelligence along with other technologies. We see warehouses, distribution centers and logistic centers being transformed through the use of AI — better receiving goods and understanding what is received into the warehouse, storing them more effectively so that they can understand the stock and pick goods to be shipped more efficiently.

There are many implications like that in warehouses and in logistics and that part of the supply chain. Then you think about the transportation part, getting things where they need to go faster. You have tremendous potential there as well to dramatically rethink and reimagine the way your supply chain can work so you can get those goods to consumers more effectively.

One of the things that we see with AI is a personalization in whatever part of the business you apply it to. In the supply chain, it’s being able to personalize the way you get the product to the customer faster. A great example of this is Stitch Fix, a very innovative retailer that uses AI to understand what you might want to buy, then has personalized fashion advisers who look at those recommendations and create a specialized clothing package just for you that they then ship it to you.

That requires a very different design process, a very different assembly of the products, a very different supply chain and distribution process to get something that personalized to the consumer. It’s a great example of human plus machine, where the human is using AI to better understand what the customer wants.

Knowledge@Wharton: Traditional retailers have been hurt by this digital shift. What do they need to do to keep up with the changes in the marketplace?

Wilson: Companies really need to start rethinking jobs around what we call the missing middle. One thing that we see in our research is that about two-thirds of executives these days are scratching their heads. It might be in retail, it might be in some of these industries that are being affected by automation. They’re scratching their heads and asking, “what new types of jobs are we going to need in the age of artificial intelligence? How do we change and retrain our current work force for the age of AI?”

Almost 30% of executives and senior HR leaders already have a bit of experience rewriting job descriptions for the age of AI, as we see in our research. So, we’re really beginning to see fundamentally new types of jobs that are being augmented by AI.

For instance, Walmart recently started rolling out robots that work in the aisles alongside associates. In a lot of ways, they are augmenting the associates. The robots go up and down aisles and scan for inventory and look for missing items, which are things that the associates used to spend a lot of time doing. Now, associates can spend more time interacting with customers, answering customer questions, running into the back room and getting things for customers that they couldn’t find in the aisles.

Knowledge@Wharton: How has AI changed marketing?

Daugherty: That’s where we see a lot of activity right now with clients across a number of industries — financial services, retail, consumer goods, etc. — as they look at reimagining their front office in terms of how they interact with customers. As companies use more chat bots and virtual agents to help offload and answer some customer questions, and to help human advisers better serve customer needs, the way that the chat bot or virtual agent responds really represents the company.

It gets into what Jim said earlier about the new categories of jobs. We’re hiring people at Accenture right now, and we see need for more of what we call personality trainers for the AI we’re developing. How do you make sure that that chat bot or agent that you are using in your company embodies the brand, the values, the way you want to interact with your customers, and that you get the business result that you want? I think the big question for companies to think about as they deploy technology is, if AI is positioned to become the brand of your company, how are you developing it?

Wilson: The marketer today is empowered like never before. We have been doing research on this trend toward the democratization of AI, where it is getting easier and easier to use AI tools. A marketer now can upload a data set to a cloud platform and start doing some powerful analyses using AI that wasn’t possible before. Cluster analysis, classification, anomaly detection, doing customer segments in ways that really weren’t possible before.

We’re seeing that marketers and sales are becoming empowered thanks to AI, and we think this trend is going to accelerate over the next two to five years.

What Europe can teach America

By Edward Luce

With the exception of soccer, many Americans believe they have little to learn from Europe. Donald Trump’s continuous sniping taps into a deep-seated stereotype about Europeans. They talk a big moral game. But they cannot walk the geopolitical walk. Much of this is true. No European carrier group patrols the Pacific — nor is ever likely to again. In terms of defence, no country matches the 3.6 per cent of GDP that America spends. But some of it is plain wrong.

On foreign aid, the picture is the opposite. Members of the OECD club of rich countries have long pledged to give 0.7 per cent of their GDP in aid — in much the same way that Nato members commit to spending 2 per cent on defence. The US spends just 0.18 per cent of its GDP on aid — and Trump is looking to slash that by a third. The UK spends exactly 0.7 per cent and Germany is just shy at 0.66 per cent. Between them, Germany and the UK’s aid budgets dwarf America’s. Spending on diplomacy is also going in the other direction. Again, Trump wants to eviscerate the state department’s presence in the world.

Who cares, Trump supporters ask. The answer starts in the Pentagon. Jim Mattis, Trump’s increasingly sidelined defence secretary, speaks for most of America’s generals when he argues that aid is a far cheaper alternative to weaponry. “If you don’t fund the state department fully, then I need to buy more ammunition,” he told Congress. The 1947 Marshall Plan may have been the biggest aid programme in history. But it cost a fraction of what it would have taken to reverse Joseph Stalin’s inroads into western Europe. Today’s challenge is more complex. It comes in two forms. First, migrants are heading north into Europe and the US and fuelling the fires of populism. Second, China is winning the soft power great game in much of the developing world — from Africa to Latin America — with its infrastructural largesse. At the turn of the century less than a fifth of development financing came from China. That has risen to three quarters. The rest of us, including the World Bank, are now minnows by comparison.

This is where Europe’s plans are relevant to the US. The European Commission has pledged to increase its aid spending by 30 per cent between 2021 and 2027 — mostly to stem the flow of migrants through north Africa. Some of this may be questionable — not least the idea of setting up “processing centers” in countries such as Libya. Anything that is enthusiastically endorsed by Italy’s Matteo Salvini should give us deep pause. But it is going up. Making it work is essential to Europe’s regional security. By contrast, Trump wants to cut US aid by the exact same amount. US programmes in countries such as El Salvador and Honduras, which are blighted by kleptocracy and gang warfare, would be hard hit. More humans would travel north. More humanitarian catastrophes would pile up on America’s borders. Trump also wants to link foreign aid to countries’ voting records at the UN, such as whether they endorse the US embassy’s move to Jerusalem. Of course, China does much the same (which is why the number of countries that recognise Taiwan is dwindling fast). But it is doing so on a larger and rising budget. When he was trying to sell his plan to a sceptical public, George C Marshall said: “Our policy is directed not against any country or doctrine but against hunger, poverty, desperation and chaos.” He might also add that it was cheaper than war. As Ronald Reagan said when he directed aid to Marxist-run Ethiopia: “A hungry child knows no politics.” Trump is breeding a global generation of anti-Americans.