The Makings of a 2020 Recession and Financial Crisis

Nouriel Roubini , Brunello Rosa


NEW YORK – As we mark the decennial of the collapse of Lehman Brothers, there are still ongoing debates about the causes and consequences of the financial crisis, and whether the lessons needed to prepare for the next one have been absorbed. But looking ahead, the more relevant question is what actually will trigger the next global recession and crisis, and when.

The current global expansion will likely continue into next year, given that the US is running large fiscal deficits, China is pursuing loose fiscal and credit policies, and Europe remains on a recovery path. But by 2020, the conditions will be ripe for a financial crisis, followed by a global recession.

There are 10 reasons for this. First, the fiscal-stimulus policies that are currently pushing the annual US growth rate above its 2% potential are unsustainable. By 2020, the stimulus will run out, and a modest fiscal drag will pull growth from 3% to slightly below 2%.1

Second, because the stimulus was poorly timed, the US economy is now overheating, and inflation is rising above target. The US Federal Reserve will thus continue to raise the federal funds rate from its current 2% to at least 3.5% by 2020, and that will likely push up short- and long-term interest rates as well as the US dollar.1

Meanwhile, inflation is also increasing in other key economies, and rising oil prices are contributing additional inflationary pressures. That means the other major central banks will follow the Fed toward monetary-policy normalization, which will reduce global liquidity and put upward pressure on interest rates.

Third, the Trump administration’s trade disputes with China, Europe, Mexico, Canada, and others will almost certainly escalate, leading to slower growth and higher inflation.

Fourth, other US policies will continue to add stagflationary pressure, prompting the Fed to raise interest rates higher still. The administration is restricting inward/outward investment and technology transfers, which will disrupt supply chains. It is restricting the immigrants who are needed to maintain growth as the US population ages. It is discouraging investments in the green economy. And it has no infrastructure policy to address supply-side bottlenecks.

Fifth, growth in the rest of the world will likely slow down – more so as other countries will see fit to retaliate against US protectionism. China must slow its growth to deal with overcapacity and excessive leverage; otherwise a hard landing will be triggered. And already-fragile emerging markets will continue to feel the pinch from protectionism and tightening monetary conditions in the US.

Sixth, Europe, too, will experience slower growth, owing to monetary-policy tightening and trade frictions. Moreover, populist policies in countries such as Italy may lead to an unsustainable debt dynamic within the eurozone. The still-unresolved “doom loop” between governments and banks holding public debt will amplify the existential problems of an incomplete monetary union with inadequate risk-sharing. Under these conditions, another global downturn could prompt Italy and other countries to exit the eurozone altogether.

Seventh, US and global equity markets are frothy. Price-to-earnings ratios in the US are 50% above the historic average, private-equity valuations have become excessive, and government bonds are too expensive, given their low yields and negative term premia. And high-yield credit is also becoming increasingly expensive now that the US corporate-leverage rate has reached historic highs.

Moreover, the leverage in many emerging markets and some advanced economies is clearly excessive. Commercial and residential real estate is far too expensive in many parts of the world. The emerging-market correction in equities, commodities, and fixed-income holdings will continue as global storm clouds gather. And as forward-looking investors start anticipating a growth slowdown in 2020, markets will reprice risky assets by 2019.1

Eighth, once a correction occurs, the risk of illiquidity and fire sales/undershooting will become more severe. There are reduced market-making and warehousing activities by broker-dealers. Excessive high-frequency/algorithmic trading will raise the likelihood of “flash crashes.” And fixed-income instruments have become more concentrated in open-ended exchange-traded and dedicated credit funds.

In the case of a risk-off, emerging markets and advanced-economy financial sectors with massive dollar-denominated liabilities will no longer have access to the Fed as a lender of last resort. With inflation rising and policy normalization underway, the backstop that central banks provided during the post-crisis years can no longer be counted on.1

Ninth, Trump was already attacking the Fed when the growth rate was recently 4%. Just think about how he will behave in the 2020 election year, when growth likely will have fallen below 1% and job losses emerge. The temptation for Trump to “wag the dog” by manufacturing a foreign-policy crisis will be high, especially if the Democrats retake the House of Representatives this year.

Since Trump has already started a trade war with China and wouldn’t dare attack nuclear-armed North Korea, his last best target would be Iran. By provoking a military confrontation with that country, he would trigger a stagflationary geopolitical shock not unlike the oil-price spikes of 1973, 1979, and 1990. Needless to say, that would make the oncoming global recession even more severe.

Finally, once the perfect storm outlined above occurs, the policy tools for addressing it will be sorely lacking. The space for fiscal stimulus is already limited by massive public debt. The possibility for more unconventional monetary policies will be limited by bloated balance sheets and the lack of headroom to cut policy rates. And financial-sector bailouts will be intolerable in countries with resurgent populist movements and near-insolvent governments. 1

In the US specifically, lawmakers have constrained the ability of the Fed to provide liquidity to non-bank and foreign financial institutions with dollar-denominated liabilities. And in Europe, the rise of populist parties is making it harder to pursue EU-level reforms and create the institutions necessary to combat the next financial crisis and downturn.

Unlike in 2008, when governments had the policy tools needed to prevent a free fall, the policymakers who must confront the next downturn will have their hands tied while overall debt levels are higher than during the previous crisis. When it comes, the next crisis and recession could be even more severe and prolonged than the last.

Nouriel Roubini, a professor at NYU’s Stern School of Business and CEO of Roubini Macro Associates, was Senior Economist for International Affairs in the White House's Council of Economic Advisers during the Clinton Administration. He has worked for the International Monetary Fund, the US Federal Reserve, and the World Bank.

Brunello Rosa is co-founder and CEO at Rosa & Roubini Associates, and a research associate at the Systemic Risk Centre at the London School of Economics.

Inviting the Next Financial Crisis

It is infuriating that officials have put the welfare of most Americans at risk to enrich the wealthiest few.

By The Editorial Board

The economy has come a long way from the dark days of 2008, when the collapse of Lehman Brothers and the bailout of big banks led to worldwide economic disaster. For much of the last decade, the economy has been growing and the stock market has been rising. But this steady climb is lulling bankers, lawmakers and regulators into repeating mistakes that contributed to that crisis and cost millions of people their jobs, homes and savings.

The financial system and economy are clearly on much firmer ground than they were a decade ago. Wages are barely keeping up with inflation, but the unemployment rate, which climbed as high as 10 percent, has fallen to 3.9 percent. The housing market, once crippled by foreclosures, has sprung back to life, with home prices scaling new heights in many parts of the country. Banks, once dependent on taxpayer dollars to keep their doors open, are raking in profits.

Much of the credit for the recovery belongs to the swift response from the Obama administration, the Federal Reserve and Congress. Lawmakers and President Barack Obama worked to stimulate the economy by nearly $1 trillion. The Fed pumped life into the financial system by lowering interest rates, buying bonds and rescuing institutions like the American International Group, which had insured financially compromised banks. Congress enacted the Dodd-Frank law, imposing tighter regulations on financial institutions and limiting their ability to take bet-the-farm risks with borrowed money. The law helped instill confidence in banks that had squandered their credibility by blowing billions on dubiously engineered investments that few understood and fewer could explain in plain English. It also created the Consumer Financial Protection Bureau, which defended consumers from predatory businesses. And Congress and Mr. Obama extended health insurance to 20 million people with the Affordable Care Act, protecting vulnerable families from crushing medical bills.
Yet the economy has still not fully recovered. The per capita gross domestic product of the United States is about $70,000 smaller over the average person’s lifetime than it would have been had the economy stayed on the trajectory it had been on before the crisis, according to a recent analysis published by the Federal Reserve Bank of San Francisco. The authors of that report — Regis Barnichon, Christian Matthes and Alexander Ziegenbein — conclude that the economy is “unlikely to regain” that lost ground, a stunning acknowledgment of the permanent and significant costs of avoidable financial crises.

•By The New York Times 

Of course, averages obscure a lot. Americans have not shared equally in the losses from the crisis. Families of modest means have far fewer, or in many cases zero, assets; they may have lost their homes and their savings. The average family of three earning less than $42,500 a year saw its net worth chopped nearly in half, to $10,800 in 2016, from $18,500 in 2007, the Pew Research Center found. Wealth of families earning $42,500 to $127,600 fell by nearly a third, to $110,100. Yet, the wealth of affluent families who earn more than $127,600 jumped nearly 10 percent, to $810,800.

The crisis and the government response to it worsened longer-term trends that have caused wages to stagnate for most families while rewarding the top 1 percent with an ever-bigger slice of the economic pie. Obama officials and Congress clearly made a big mistake early in the recession by focusing more intently on saving banks — and, thus, bankers and investors — and much less on directly helping families facing foreclosures and layoffs. Later in the recovery, the decision by Republican leaders in Congress to oppose every Obama proposal prevented the government from doing much to help people regain what they had lost or to heat up the tepid recovery with infrastructure spending and other stimulus measures.

Before the crisis, the share of economic output that went to workers had been falling steadily since early 2001, when it stood at 64 percent. After the crisis it plunged to about 56 percent, according to the Bureau of Labor Statistics, rising only slightly in the last few years.

This is because as workers’ incomes have stalled, corporate profits have shot up, especially for a small number of what some experts call “superstar firms,” including technology giants like Apple; Alphabet, which owns Google; and Facebook.  
As a few big companies with relatively few employees amass greater market power and profits, less is left over for workers, according to a 2017 working paper by economists from M.I.T., Harvard and the University of Zurich.  As a candidate, Donald Trump spoke about getting tough on Wall Street, fighting corporate consolidation and looking out for “forgotten men and women” — rhetoric that won him the support of some working-class voters who had backed Mr. Obama. But he and his fellow Republicans in Congress have governed like conventional far-right conservatives — going easy on Wall Street, doing little about corporate consolidation, bolstering corporate profits and gutting a range of protections for those “forgotten men and women.”
Last year, Republicans claimed their biggest legislative victory of the Trump era, reducing federal revenue by $1.5 trillion over 10 years by slashing taxes on corporations and wealthy families. The legislation provides generous and permanent tax cuts to rich people in the investor class, including foreigners who own stock in American businesses. Working-class families, by contrast, received minor savings that are set to automatically vanish after 2025. The tax law will widen income inequality and encourage financial excesses by overstimulating an economy that is already nine years into a recovery.

Consider the stock market, which has shot up after the tax cut was enacted; the S.&P. 500 stock index closed at a new high on Friday. Many analysts argue that the market is not overvalued and has room to run — comments eerily similar to what Wall Street’s salesmen were saying in 2007 and 2008. Yet, the market appears to be more overvalued now than it was before the crisis, according to an indicator created by Robert Shiller, the Yale economist who won a Nobel Prize for his work on bubbles in the stock and real estate markets. His data show that the S.&.P 500 stock index has an adjusted price-to-earnings ratio of 32.29, which indicates that investors are willing to pay $32.29 for $1 of corporate profits. In 2007 and 2008, that ratio never reached 28.

Lawmakers and the administration, and even the Federal Reserve, which should know better, are also sowing the seeds for another crisis by unraveling the financial regulations put in place in the last 10 years. In May, Congress voted to roll back parts of the Dodd-Frank law by exempting banks with assets of up to $250 billion, up from $50 billion, from stricter federal oversight. This was supposedly done to help smaller, community banks, but the change was so sweeping that it would leave fewer than 10 big banks under the kind of supervision many independent experts concluded was necessary after the crisis.

In addition, officials at the Fed and other government agencies have proposed relaxing the Volcker Rule, named for the former Fed chairman Paul Volcker, which restricts big banks from gambling with their depositors’ money on high-risk investments. The regulators also want to ease capital requirements for banks, which will increase profits for the likes of Citigroup and JPMorgan Chase by letting them operate with more borrowed money rather than capital raised from shareholders. Last year, federal regulators decided that A.I.G. is no longer a systematically important financial institution, freeing it from the tighter government scrutiny applied to businesses whose collapse could set off a chain reaction of failures. While A.I.G. is smaller than it was in 2008, when it nearly toppled many big banks, it is still a very big domino in the financial system.

Wait, there’s more. Mr. Trump has effectively neutered the Consumer Financial Protection Bureau by handing control of it temporarily to his budget chief, Mick Mulvaney, who has done the bidding of big banks as a bureaucrat and when he was a House member. He has stopped new investigations by the bureau and watered down penalties against lenders accused of preying on borrowers, to the point that the penalties are meaningless. Recently Mr. Trump appointed Kathy Kraninger, who has little experience in consumer finance, as the permanent head of the bureau.
The speed with which officials are moving to undo financial regulations is stunning to economists who remember their history. “The last time we regulated in the 1930s, it took us 30 or 40 years to take off those regulations,” said Raghuram Rajan, an economist at the University of Chicago and former governor of the Reserve Bank of India. “This time we are doing it in 10 years.”
And the regulations that were dismantled and eliminated could have helped prevent or reduce the severity of the last crash. Mr. Rajan, who was prescient in warning about the last crisis, said it’s unwise to deregulate now because businesses and individuals have borrowed a lot of money in recent years in the United States and other countries, raising the risks of economic problems down the road.

With investors bidding up stock prices and pouring billions of dollars into money-losing start-ups as if nothing could go wrong, it is all the more frightening and infuriating that officials have so quickly tossed aside the lessons from the last crisis. In making life grander for the most comfortable Americans, the government is putting everyone’s economic prospects at greater risk.

The Global Economy’s Fundamental Weakness

Richard Kozul-Wright  


GENEVA – When Lehman Brothers declared bankruptcy ten years ago, it suddenly became unclear who owed what to whom, who couldn’t pay their debts, and who would go down next.

The result was that interbank credit markets froze, Wall Street panicked, and businesses went under, not just in the United States but around the world. With politicians struggling to respond to the crisis, economic pundits were left wondering whether the “Great Moderation” of low business-cycle volatility since the 1980s was turning into another Great Depression.

In hindsight, the complacency in the run-up to the crisis was clearly unconscionable. And yet little has changed in its aftermath. To be sure, we are told that the financial system is simpler, safer, and fairer. But the banks that benefited from public money are now bigger than ever; opaque financial instruments are once again de rigueur; and bankers’ bonus pools are overflowing. At the same time, un- or under-regulated “shadow banking” has grown into a $160 trillion business. That is twice the size of the global economy.

Thanks to the trillions of dollars of liquidity that major central banks have pumped in to the global economy over the past decade, asset markets have rebounded, company mergers have gone into overdrive, and stock buybacks have become a benchmark of managerial acumen. By contrast, the real economy has spluttered along through ephemeral bouts of optimism and intermittent talk of downside risks. And while policymakers tell themselves that high stock prices and exports will boost average incomes, the fact is that most of the gains have already been captured by those at the very top of the pyramid.

These trends point to an even larger danger: a loss of trust in the system. Adam Smith recognized long ago that perceptions of rigging will eventually undermine the legitimacy of any rules-based system. The sense that those who caused the crisis not only got away with it, but also profited from it has been a growing source of discontent since 2008, weakening public trust in the political institutions that bind citizens, communities, and countries together.

During the synchronized global upswing last year, many in the economic establishment spoke too soon when they began to forecast sunnier times. With the exception of the US, recent growth estimates have fallen short of previous projections, and some economies have even slowed. While China and India remain on track, the number of emerging economies under financial stress has increased. As the major central banks talk up monetary-policy normalization, the threats of capital flight and currency depreciation are keeping these countries’ policymakers up at night.

The main problem is not just that growth is tepid, but that it is driven largely by debt. By early 2018, the volume of global debt had risen to nearly $250 trillion – three times higher than annual global output – from $142 trillion a decade earlier. Emerging markets’ share of the global debt stock rose from 7% in 2007 to 26% in 2017, and credit to non-financial corporations in these countries increased from 56% of GDP in 2008 to 105% in 2017.

Moreover, the negative consequences of tightening monetary conditions in developed countries will likely become more severe, given the disconnect between asset bubbles and recoveries in the real economy. While stock markets are booming, wages have remained stuck. And despite the post-crisis debt expansion, the ratio of investment-to-GDP has been falling in the advanced economies and plateauing in most developing countries.

There is a very big “known unknown” hanging over this fragile state of affairs. US President Donald Trump’s trade war will neither reduce America’s trade deficit nor turn back the technological clock on China. What it will do is fuel global uncertainty if tit-for-tat responses escalate. Even worse, this is occurring just when confidence in the global economy is beginning to falter. For those countries that are already threatened by heightened financial instability, the collateral damage from a disruption to the global trading system would be significant and unavoidable.

Yet, contrary to conventional wisdom, this is not the beginning of the end of the postwar liberal order. After all, the unraveling of that order started long ago, with the rise of footloose capital, the abandonment of full employment as a policy goal, the delinking of wages from productivity, and the intertwining of corporate and political power. In this context, trade wars are best understood as a symptom of unhealthy hyper-globalization.

By the same token, emerging economies are not the problem. China’s determination to assert its right to economic development has been greeted with a sense of disquiet, if not outright hostility, in many Western capitals. But China has drawn from the same standard playbook that developed countries used when they climbed the economic ladder.

In fact, China’s success is exactly what was envisioned at the 1947 United Nations Conference on Trade and Employment in Havana, where the international community laid the groundwork for what would become the global trading system. The difference in discourse between then and now attests to how far the current multilateral order has moved from its original aims.

At first, the Lehman crisis did trigger a revival of the post-war multilateral spirit; but it proved fleeting. The tragedy of our times is that just when bolder cooperation is needed to address the inequities of hyper-globalization, the drums of “free trade” have drowned out the voices of those calling for a restoration of trust, fairness, and justice in the system. Without trust, there can be no cooperation.

Richard Kozul-Wright, Director of the Division on Globalization and Development Strategies at the United Nations Conference on Trade and Development, is the author of Transforming Economies: Making Industrial Policy Work for Growth, Jobs and Development.

Trump's Appeal in Asia

Standing Up to China

Larry Diamond

Those who value democracy in Asia—and even many who don’t—are desperate for a counterweight to the rise of a new authoritarian superpower.

Anyone who thinks Donald Trump must be reviled around the world for his bigotry, ignorance, and simplistic hyper-nationalism might be surprised to visit Asia. Here, in eight days of intensive conversations in India, Hong Kong, and now Taiwan, from where I’m writing, I find—as I expect I would encounter in other conversations, from Japan to Singapore—surprisingly frequent gratitude for one simple thing: Finally, there is an American President who is standing up to China.

Briefly set aside the damage that Trump’s self-declared trade war may do to many American farmers and to some American manufacturers, if not to the American economy as a whole. Suspend for a moment the natural liberal instinct to assume that people elsewhere around the world who value equality, civility, and the rule of law must be just as appalled by Trump’s antics and impulses as so many Americans are. And just view the world through worried Asian eyes.

Look at Southeast Asia, which is living under the growing shadow of Chinese military expansion, economic domination, and political penetration. Look at the Philippines, Indonesia, Vietnam, and Malaysia, which have seen their logical (just look at the map) and legal claims to sovereignty over portions of the South China Sea flicked away by a People’s Republic of China that is bound and determined to dominate the whole maritime zone, is overfishing it with abandon, and is brazenly creating new militarized islands to create “facts on the sea.” Look at India, whose 2,100-mile land border with China remains in dispute, and which sees China projecting its naval power and economic hegemony deep into the Indian Ocean—most spectacularly, by using the classic neo-colonial method of debt diplomacy to pressure Sri Lanka into granting it a 99-year lease over the strategic port of Hambantota.

Or look at Australia, which has recently woken up to the alarming scope of China’s covert intrusions into its politics, media, and civil society in order to mute Australian criticism of (not to mention resistance to) Beijing’s geopolitical ambitions. In late June, the Australian parliament passed a bill—hailed as “the most significant counter-espionage reforms in Australia since the 1970s”—that strengthens the state’s ability to prosecute covert foreign influence operations in politics and civil society and another that creates an American-style registry of foreign lobbyists.

Australia has been on the front lines of China’s projection of “sharp power,” which uses covert, coercive, and corrupt methods to burrow into the political, civic, and economic life of democracies. But many democrats view Hong Kong as the real canary in the coal mine. Pointing to China’s relentless, multifaceted efforts to penetrate and subvert the politics, media, and organizational life of an open society, a veteran Hong Kong democratic politician warned me, “Our past is your present, and our present is your future.”

The warning was obviously melodramatic; since 1997, Hong Kong has been part of the People’s Republic of China, giving Beijing degrees of access and control well beyond what it can achieve in any sovereign country. But under the terms of the 1984 Sino-British Joint Declaration, Beijing committed to a system of “one country, two systems,” in which Hongkongers’ basic “rights and freedoms, including those of the person, of speech, of the press, of assembly, of association, . . . [and] of academic research,” would be respected and ensured for at least 50 years after the 1997 handover. It is those basic rights that are under growing pressure as the Beijing authorities threaten and punish freedom of expression.

A critical juncture in Hong Kong’s downward spiral came with Beijing’s 2014 pronouncement—what came to be known as the “31 August Decision”—closing the door on democratic aspirations in Hong Kong. The people of Hong Kong had been waiting since 1997 for the right to choose their chief executive in a reasonably free, fair and open election, and for the right to directly elect all of the seats in their parliament, the Legislative Council or “LegCo”. Since 1997, they had been stuck with a system in which half of the seats in parliament are filled through more or less narrow “functional constituencies”, and in which the chief executive is chosen not through universal suffrage but by a narrow “selection committee,” dominated by Beijing loyalists.

Article 45 of Hong Kong’s Basic Law—the constitutional document which sets forth the rules of authority in Hong Kong and its relationship to the central government in Beijing—states that “the ultimate aim” of Hong Kong’s political development is “the selection of the Chief Executive by universal suffrage upon nomination by a broadly representative nominating committee in accordance with democratic procedures.” Hong Kong’s pan-democrats—who have consistently won a majority of the democratically elected LegCo—believe that article promised a democratic election for executive authority, even if its corollary embrace of “the principle of gradual and orderly progress” required a waiting period.

After Beijing rebuffed their aspirations for democratic change in 2007, claiming Hong Kong was not yet “ready” for democracy, Hongkongers looked to 2017. After all, how could anyone reasonably claim that twenty years after the handover of power, Hong Kong—one of the richest and most highly educated societies in Asia—would not be “ready” for democracy?

When Beijing cavalierly rejected democracy then as well—making, in its 31 August 2014 Decision, a take-it-or-leave-it offer of a chief executive election in which only two or three Beijing-friendly candidates would be allowed to contest—the society erupted. In what came to be known as the Umbrella Movement, tens of thousands of young people and other Hong Kong citizens took to the streets to demand a free election with universal suffrage. For 79 days they occupied key streets and public places, pressing their political demands. But as so often happens in prolonged street demonstrations, the movement split between radical and moderate forces, and the public grew weary of the disruption. Several movement leaders, including youth activists Joshua Wong and Nathan Law and Hong Kong University Law Professor, Benny Tai, were prosecuted. The prison authorities tried to break and humiliate the slender 20-year-old Wong, along with other detainees, but they utterly failed.

Wong and Law, along with Agnes Chow and other student activists, then turned to electoral politics, forming a political party, Demosistō, that advocated for a referendum on Hong Kong’s sovereignty after 2047, and electing the 23-year-old Law to the LegCo in 2016. Soon thereafter, however, Law and five other newly elected LegCo members were disqualified for allegedly not taking the oath of office properly and respectfully. In this way, and through numerous other means, Hong Kong’s government and the Communist Party authorities in Beijing are trying to whittle down the ranks of opposition in the LegCo, grind down the resolve of Hong Kong’s democrats, and bury aspirations for freedom in Hong Kong.

Gradually, Hong Kong’s democrats feel the noose of Chinese Communist repression slowly tightening. In late 2015, five staff members of a dissident Hong Kong bookstore went missing, only to surface in China and elsewhere, the apparent victims of abduction and coercion by agents of Chinese authority. The abductions, which, according to the South China Morning Post, “raised fears for the city’s autonomy and concerns over the potential loss of freedoms,” continue to cast a chilling pall over civic life in Hong Kong. Increasingly, academics associated with the democratic cause find their careers threatened and journalists watch with alarm as their media enterprises are acquired by pro-Beijing tycoons.

On Tuesday, Beijing’s office in Hong Kong lambasted the Foreign Correspondents Club for hosting a speech that day by Andy Chan, leader of the pro-independence Hong Kong National Party, which the authorities are moving to ban. By continuing its relentless bullying of views it does not like, Xi Jinping’s government is only confirming a central theme of Chan’s speech: that China’s increasingly authoritarian communist party-state now constitutes “a threat to all free peoples in the world.”

Democratic forces in Hong Kong are in the eye of the storm, but Taiwan, which is one of Asia’s most liberal democracies, has the most to lose. As China’s military modernization speeds forward, along with its continuing efforts to deprive Taiwan of the ability to participate in international affairs, there is keen awareness here of the gathering danger. Hence, President Tsai Ing-wen is carefully avoiding provoking the PRC government, at the same time that she increases defense spending and pushes a “Go South” policy to expand trade and investment with Southeast Asian nations and thereby reduce economic dependence on Beijing. Increasingly, though often discreetly, she is getting a sympathetic reception in the region and beyond. For it is not only Asia’s democracies that are alarmed. From Singapore to Vietnam, authoritarian regimes as well feel their sovereignty under pressure and their national security at risk.

All of this serves to explain Donald Trump’s strange appeal in Asia today—even to progressives, gay rights activists, and leftwing intellectuals who would be appalled by his politics in any other context. Those who value democracy in this region—and even many who don’t—are desperate for a counterweight to the rise of a new authoritarian superpower, and they know that can only come from the world’s other superpower.

Larry Diamond is senior fellow at the Hoover Institution, Stanford University. He coordinates the democracy program of the Center on Democracy, Development, and the Rule of Law (CDDRL) within the Freeman Spogli Institute for International Studies (FSI).

A Reality Check for Retail

Slowing sales growth should make investors question the conventional wisdom that stores have figured out how to fend off Amazon

By Justin Lahart

Department store sales fell 1% in August after gaining 1.4% in July.
Department store sales fell 1% in August after gaining 1.4% in July. Photo: Gabby Jones/Bloomberg News

About that retail revival. It might be less powerful than investors think.

Strong second-quarter results from many retailers bolstered the optimistic view that industry bulls have been spinning this year. Stores have finally started to figure out , AMZN -0.99%▲ developing clicks and mortar strategies that are helping them defend their turf against the online giant. It is part of why stocks of retailers have been among the year’s best performers. 
But Friday’s retail sales report suggests that the third quarter might not be as rosy as the second. The Commerce Department reported that overall sales rose just 0.1% in August from a month earlier, after rising 0.7% in July. That was the slimmest gain since January, when sales declined.

The sales report hardly counts as a death knell for the American consumer, but it does suggest that the very strong retail sales figures from the three months ended in July, which coincides with the fiscal second quarter for most retailers, weren’t sustainable.
The details of the report reinforce this sense. Department store sales fell 1% in August after gaining 1.4% in July. Furniture and home-furnishing store sales fell 0.3% after a flat reading a month earlier. And apparel and accessory store sales slipped 1.7% after gaining 2.2%.

Online sales appear to have moderated as well. Nonstore retail sales—a category dominated by Amazon—increased by 0.7% in August, versus a July gain of 1.5%. Even so, nonstore retailers share of sales excluding auto dealers, gasoline stations and restaurants and bars climbed slightly to a record 19.1% from 19%. So Amazon is still making inroads.

And the competition among other retailers remains intense. Price surveys conducted by Wolfe Research analyst Scott Mushkin show that Walmarthas been aggressive on prices, holding them steady and in some cases reducing them. Thursday’s inflation report from the Labor Department showed that apparel prices slipped by 1.6% in August from a month earlier.

Anybody who thinks retailing suddenly became easy could be in for a big disappointment.

My naive part in Lehman’s downfall

John Gapper: I was wrong to call for the bank to be allowed to fail

Ten years ago, Jim Wilkinson, then US Treasury chief of staff, sent a distressed email to a fellow official. “I just can’t stomach us bailing out Lehman . . . will be horrible in the press.” Two days later, his boss Hank Paulson warned others on a conference call: “I can’t be Mr Bailout.”

A few hours before Mr Paulson spoke, the Financial Times published a rather jaunty column by me, advising the Treasury secretary to take the weekend off to pursue his hobby of birdwatching. The government should resist the pressure to save Lehman Brothers, as it had Bear Stearns and Fannie Mae and Freddie Mac, the mortgage institutions, I wrote. It had “talked tough about moral hazard . . . but been a soft touch.”

Within days, Mr Paulson took my advice (and that of others) and allowed Lehman to collapse, triggering the worst postwar financial crisis and unleashing economic and social damage that still endures. It is rarely that an article backfires so rapidly and spectacularly, and I have had a decade to reflect on my part in Lehman’s downfall.

Despite the passage of time, those involved still argue about whether the investment bank could legally have been saved by the government and the Federal Reserve, and how much difference ignoring critics such as me would have made. My conclusion is that I was wrong, but I wish I had been right.

Of course you were wrong, readers may feel: it should not take 10 years to work that out. But moral hazard is not just a construct to be avoided in economics textbooks. Consider the bitterness bequeathed by bailouts, the outrage at how bankers were saved from folly, and the price that others paid. Intervention turned out to be a necessity, but a very painful one.

We cannot be sure whether rescuing Lehman itself would have lessened the pain. Scott Freidheim, a former Lehman executive, insists that it “would have prevented the carnage the world experienced”. Conversely, Jamie Dimon, chief executive of JPMorgan Chase, told the US Financial Crisis Inquiry Commission in 2010 that “you would still have had terrible things happen”.

I tend to the latter view. AIG, the insurance company that backed toxic mortgage derivatives, rapidly had to be saved and the system was too fragile to have been stabilised by one bailout. Paul Volcker, former Fed chairman, compared the rescue of Bear Stearns in March 2008 to the fictional Dutch boy who put his finger in a flood dyke to save Haarlem. But Wall Street was springing leaks everywhere.

It does not matter to me that Lehman was treated more harshly than either Bear or, subsequently, Goldman Sachs and Morgan Stanley. The FCIC concluded that inconsistency “increased panic and uncertainty in the market”, but instituting a bailout formula would have encouraged further abuses. No bank should have had the right to expect, or to demand, salvation.

But none of this, nor my self-justification in 2010 that letting Lehman fold had been “a gamble worth taking”, gets me off the hook. My argument was about more than the fate of one foolish bank. It covered all of Wall Street’s investment banks and trading institutions apart from retail banks.

What strikes me now is less my wrongness than my naivety. I hoped and believed — implausibly, given that barriers between commercial and investment banks had been weakened by changes in US law and mergers — that investment banks were still small and separate enough to collapse without precipitating a crisis.

Drexel Burnham Lambert had gone bankrupt in 1990 with a salutary lack of official intervention. The Fed was even criticised for corralling Wall Street banks into a room and cajoling them into a private bailout of Long-Term Capital Management, the hedge fund, in 1998. It strived vainly to limit public involvement in the same way on the fateful Lehman weekend.

Things had changed in ways that I utterly underestimated. The Fed’s guarantee of short-term funding “should prevent a run on the bank,” I wrote about Lehman. Ouch. By Monday, not only was it bankrupt but the entire US commercial paper market was locking up. As to AIG’s hidden place at the heart of the financial system, I had no idea and few others did either.

It was soon evident that the Fed and the US government had little choice but to salvage the system by propping up other banks, no matter how unpalatable it was. Letting them all go the way of Lehman would have punished the financial elite for its recklessness and avoided moral hazard, but the economic cost was too high.

The dyke was breached and has been terribly hard to rebuild. Rather than trying to restore the old divide between systemic and risk-taking institutions, US regulators gave the biggest ones equal status. Banks are less leveraged but the system is just as amorphous — one study found that non-banks such as hedge funds make 30 per cent of loans to mid-sized US companies.

We live with the consequences of that week in September, not only in asset inflation and economic distortions but in the sense of unfairness that many people justifiably feel. I wish we were still in the state I imagined.

China Suddenly Has Trouble Building Things

Infrastructure is the key to turning around flagging investment—but that may be trickier than it looks

By Nathaniel Taplin

Beijing wants to shore up growth without inundating the economy with cheap credit. To see how hard that will be, take a look at China’s roads and railways. 
China is the 800-pound gorilla of global infrastructure. Its building prowess has permeated popular culture, as in the disaster movie “2012” where China constructs giant ships to help humankind escape rising seas. Recently, however, China’s infrastructure build has all but ground to a halt.

Chinese local governments, which account for the bulk of such investment, have to date funded it in two main ways. The most popular method has been to set up so-called local-government financing vehicles, or LGFVs. These off-balance sheet entities mushroomed after the financial crisis, when local governments—which back then were still not allowed to issue their own debt—were called upon to invest billions to stimulate the economy.
A worker checks his phone at a construction site wall depicting Beijing’s central business district, Sept. 19, 2017.

A worker checks his phone at a construction site wall depicting Beijing’s central business district, Sept. 19, 2017. Photo: Andy Wong/Associated Press 

The central government last year started to crack down on such opaque borrowing, alarmed at its vast scale—and potential for corruption. In the past four months, a net $19 billion has flowed out of LGFV bonds.

These days Beijing prefers that local governments borrow on-the-books, through the now legal municipal bond market. The problem is that lower-rated and smaller cities are mostly shut out, even though they do most actual capital spending. As a result, investment has kept slowing even though China’s net muni bond issuance in July was three times higher than it was in March.

Infrastructure investment excluding power and heat was up just 5.7% in the first seven months of 2018 compared with a year earlier, down from 19% growth in 2017. A state-owned investment company in China’s far west has just punted on its debt, raising the prospect of more LGFV defaults and a much worse selloff in the corporate bond market, further damaging investment.

Eventually, all the cash big cities and provinces are raising through muni bonds will start filtering down. Meanwhile, the investment drought will likely worsen, raising pressure on Beijing to ease credit conditions further—making the incipient rally in the yuan hard to sustain. That also means China’s debt-to-GDP ratio, which fell marginally in 2017, could start rising again next year. 
Odds still remain good that this round of stimulus will be smallish, particularly since the crucial real-estate market is still doing well. But China’s leaders haven’t figured out how to crack down on local governments’ dubious infrastructure spending during good times without severely damaging growth—or how to loosen the reins during bad times without creating lots more bad debt. Unless they can square that circle, it bodes ill for the nation’s long-term prospects.

Stops and starts

Talks to update NAFTA are chugging along

The outlines of a revamped deal appear close to being settled

AUGUST is normally a sleepy month in Washington, DC. Not this year, especially for politicians and lawyers (and politicians’ lawyers). For trade negotiators, too, life is busier than ever. Talks to revamp the North American Free-Trade Agreement (NAFTA) are in full swing. As The Economist went to press, Mexican and American delegations were still haggling furiously, chiefly over new rules covering trade in cars. But a breakthrough looked possible.

Under NAFTA, cars from Mexico and Canada can be imported into America tariff-free as long as they meet criteria set out in the pact, known as rules of origin. By tweaking these rules, negotiators can shape supply chains.

The current agreement requires, for example, at least 62.5% of a car to come from within the region, which nudges carmakers towards North American parts. This stage of the NAFTA talks has centred on just how much more onerous the revised deal’s conditions should be. If the negotiators press too hard, they risk losing influence altogether as carmakers opt to ignore the new deal in favour of paying non-NAFTA tariffs.

As of August 22nd, the outline of the new rules had largely been settled. NAFTA-compliant cars will have to contain more North American content, made with a minimum amount of North American steel and aluminium. Some part of each car will also have to be built by workers earning a minimum wage. If a company meets two of the three criteria, the third will be relaxed. Finer details, and the speed of implementation, were still to be hashed out.

Convergence on cars would represent serious progress. It may even pave the way for a trilateral agreement in principle over the coming weeks. (A detailed final deal will take longer.) Robert Lighthizer, the United States Trade Representative, has floated a date of September 3rd, “if everybody wants to get it done”.

That they do. Mexico’s president, Enrique Peña Neto, leaves office on November 30th. Both he and his successor want Mr Peña to be the one to sign. The Canadians just want to end the uncertainty. Mr Trump’s Republican party could use a win ahead of November’s mid-term elections. But thorny issues remain unresolved, notably the American proposal for the deal to expire every five years. There is still work to be done.