China for the Trade Win?

By John Mauldin

 TFTF Image

With all the trade war talk, we all ask the obvious question: Who will win? President Trump says the US will win. Chinese business leaders say no, we will win. Free-traders on both sides say no one will win. Few stop to ask, “What does a ‘win’ look like?”

This makes discussion difficult. People are chasing after a condition they can’t even define. Victory will remain elusive until they know what they want. Regardless, you can score me on the “no one wins” side. I believe, and I think a lot of evidence proves, that free trade between nations is the best way to maximize long-run prosperity for everyone.


As Keynes famously said, we’re all dead in the long run. Trade war may end with no winners, but the parties will be better and worse off at various times as it progresses. So we have to distinguish between “winning” and “holding a temporary lead.”

On that basis, I think the US will have the upper hand initially, and could hold it for a year or two. This is because, for now, our economy is relatively strong and we can better withstand any Chinese retaliation. Beyond that point I think our current policies will begin to backfire, maybe spectacularly.

Remember, too, China has growing trade surpluses with much of the world. One Chinese insider told me that within four years China can replace lost US exports via increased trading with the rest of the world. I can’t verify that but looking at general statistics it certainly seems plausible. That doesn’t mean lost US trade won’t be felt, but China is not entirely helpless.

When watching a fight, we ask metaphorically, “Who will blink first?” In this case, that’s the wrong question. Neither side will blink but one may eventually fall to the floor, unconscious. So the better question might be, “Who will faint first?”

Next week we will deal with the tariff situation, as I get that question a lot. But let me state right here: I hope President Trump is engaged in a trade bluff and not a trade war. The market seems to think so. My Asian sources believe that it will be resolved by the end of this year. But make no mistake, an actual trade war along the lines being threatened will impact both economies negatively. Enough to throw the US into recession? Enough to cut Chinese growth in half? No one actually knows, which is a big part of the problem.

 Now, let’s dig into China.
Empire of Debt

I described in my last two letters the many good things happening in China. Businesses are prospering while living standards rise as well. The country’s vast interior is still quite poor but life is improving (with the notable exception of the Uighurs, a Muslim minority in Western China).

We didn’t talk about how they are financing this progress. The answer is, “with a lot of debt.” You often hear about China’s government and corporate debt, but less about households. So let’s start there.

Back in 2015, I wrote about China’s insanely leveraged farmers and others who bought stocks with borrowed money. Most regretted it, some sooner and more intensely than others. But that period seemed to convince the government to keep tighter control over consumer credit.

But note, controlling credit isn’t the same as eliminating credit, or even reducing it. Beijing wants consumers to borrow in sustainable, productive ways, as Beijing defines them. So overall household debt growth has not slowed.

Source: Gavekal

Chinese consumer debt is growing quite a bit faster than Chinese GDP. This means that consumer debt is a growing percentage of the economy. It’s not a big problem now but at this rate will become one soon.

This chart shows how Chinese household debt is growing compared to other economies.

Source: Gavekal

Household debt relative to GDP is near-flat or declining in the US, Japan, Germany, and France. In China, it’s grown from 40% to 50% of GDP in just two years. Yes, those developed countries have higher absolute debt levels, but they also have higher household incomes. So this trend, if it continues, will get more worrisome.

Now, what happens when these indebted Chinese consumers find living costs rising due to a trade war with the US?

One possibility is “not much” because they don’t really need our goods. They have plenty of domestic alternatives in most categories. Nevertheless, removing or limiting US competition could raise prices in some categories.

But the bigger problem is that a trade war will mean lower exports, probably affecting the jobs of some indebted consumers. How many is unclear. China has both domestic demand and other countries it can trade with, should the US decide to raise barriers. Domestic demand might weaken if exporters have to reduce employment and the government doesn’t step in with some kind of stimulus.

The problem here is that any stimulus would probably increase government debt, a problem we haven’t even discussed yet. Not to mention corporate debt rising as companies try to keep operating with lower revenue.

Debt in Pictures

Like everything else about China, its debt is hard to visualize. There’s a lot of it.
Here is a chart from Bloomberg that projects three scenarios out to 2022.

Source: Bloomberg

Bloomberg’s base case shows Chinese debt-to-GDP reaching 330% by 2022, which would place it behind only Japan among major economies. It might be “only” 290% if GDP growth stays high.

Here’s another look from Citi Research (via my friend Steve Blumenthal). This is private sector credit creation. The US series is only bank credit, by the way, so this isn’t an apples-to-apples comparison. But then much of Chinese debt is bank credit. The “shadow banks” are relatively new. Xi seems to be trying to reduce their influence. However you look at it, China has huge private debt.

Finally, here’s a “Total Credit to Private Non-Financial Sector” graph we made on FRED using Bank for International Settlements data. That means it excludes bank debt. The US has the most such debt at $29.5T as of year-end 2017, but China is not that far behind with $26.5T. China’s debt of this type was quite a bit more than Japan, the UK, and Canada combined.

Even so, Chinese growth has been largely funded by debt. Make no mistake, loans have fueled almost everything. You can argue those loans have funded a great deal of useful infrastructure and housing, with a stimulative effect. But that debt will eventually have to be repaid, and debt is future consumption brought forward. That means at some point Chinese growth is going to slow down. Maybe not for a decade or so, but they have to pay the piper.

Like the US, China also has off-the-books debt that may not show up in the totals. For instance, its social security plan is underfunded amid an aging population and shrinking prime-age workforce. The 29% payroll tax (yes, you read that right) that should be funding it often goes uncollected and the debt goes higher still. One analyst estimated strict enforcement would cut corporate profits by 2.5% and shave 0.6 percentage points off nominal GDP growth. With the Chinese government now making aggressive efforts to collect the tax, which it clearly needs, growth could falter.

Any way you look at it, China has a staggering amount of debt. Maintaining it will grow more difficult if the economy turns down. The same is true for the US, of course. Which country is better equipped to survive a trade and currency conflicto?

Wargaming the Trade War
This week President Trump ordered more tariffs on an expanded list of Chinese imports. The rate will be 10% starting next week and rise to 25% at the beginning of 2019, unless China agrees to new trade policies before then. (Notably, he excluded consumer electronics products like smartphones, which shows the administration is not entirely tone deaf to the impact tariffs have on US consumers.)
Let me be very clear on one thing: I totally agree with the president that China has taken unfair advantage of global trade rules. Its requirements for foreign companies to disclose intellectual property (that then finds its way to Chinese state-owned enterprises) is outrageous. That must stop and we need to resolve assorted other differences. The question is how to accomplish it.
I had hopes Trump’s business negotiation skills would enable more productive trade negotiations. It doesn’t seem to be happening that way. To me, the best strategy would have been to assemble a united front of other top economies and demand China change its ways. We are not the only major country that has a trade problem with China. Then I would have pivoted to seeking better terms with Canada, Mexico, the EU, and others. Instead, he has aggravated allies and made working with them difficult, at best.
Part of negotiating is to have realistic demands. You will never succeed by demanding your adversary cut his own throat. Xi Jinping can be flexible on many things but he still presides over a Communist government and a command economy. That leopard is not going to change its spots. They are never going to abandon their technology goals embodied in their “Made in China 2025” program, nor would any other country.
I am not the only one who thinks this. Check out this unusually blunt tweet from former trade diplomat Harald Malmgren, who literally wrote the book on US trade policy, serving under presidents starting with JFK. He’s retired now but remains “plugged in” to global finance better than almost anyone I know.
Source: Twitter
Now, it may be that the White House team is less talented than they think. Peter Navarro’s continued presence, and the president’s apparent confidence in him, is not reassuring. I said when his name was first mentioned that Navarro understands neither economics nor trade. He has done nothing to change my opinion.
But another possibility is they have an entirely different strategy than we think. Some of my contacts believe the real goal is to make US businesses pull back from operating in China at all. If that’s the goal, they are off to a good start. But that is not good for US businesses or for the US.
For the moment, the US side is negotiating from a marginally stronger position. Our economy is growing nicely and can withstand some tariff pain—though it will hurt certain sectors. This is already happening, in fact. But in the long run we are playing a very dangerous game.
International trade is like plumbing. Goods and money flow around through pipes and you can only squeeze so much through them. When the US imports goods from China, we simultaneously export dollars to China. We can do that because our currency is what everything else is settled in. Reducing imports would mean we also reduce dollar exports, leaving the rest of the world with less water in its pipes. That’s not good at all, if we want to maintain our position on top of the food chain.
In researching this letter, I ran across a nice, short explanation of the threat by currency expert Taggart Murphy. I can’t say it better myself so I’ll just quote him (emphasis mine).
Trump is doing everything he can to bring on the end of the days when the US can borrow whatever it wants in whatever amounts it wants. To be sure, there is no recipe book. The dollar is now so entrenched as the world’s money that if your assignment were to bring the curtain down on that—and thus the ability of the US to borrow whatever it wants whenever it wants—it’s not at all clear what you would do.
But you’d start by doing everything that Trump is doing—pick fights with all your allies, blow the government deficit wide open at the peak of an economic recovery, abandon any notion of fiscal responsibility, threaten sanctions on anyone and everyone who seeks to honor the deal Obama struck with Iran (thereby almost begging everyone to figure out some way to bypass the US banking system in order to do business), [Which they are openly doing –JFM] throw spanners into the works of global trade without any clear indication of what it is precisely you want for a country that structurally consumes more than it produces and thus by the laws of accounting MUST run trade and current account deficits.
That’s strong language but exactly right, especially the last part. Trade deficits are President Trump’s bugaboo, yet he might as well complain about the weather. It is what it is. The US will run a trade deficit unless we accept some combination of higher savings and lower consumption. That’s not my opinion; it’s math. Threatening China will not change it.
Trying to wean the US public off of consumption and force higher savings is just not going to work, either, which means we are going to run trade deficits.
But that is just fine. As long as we have the world’s reserve currency, we can run trade deficits with essentially no consequences. We aren’t comparable to Argentina or other countries that get into trouble because of their trade deficits. Nobody, not even their citizens, wants to hold the Argentine dollar or the Venezuelan bolivar.
This brewing trade war, if it continues, will initially favor the US but we will gradually lose the advantage as the rest of the world builds new pipes to bypass us. Something similar happened to the United Kingdom, our predecessor hegemon. We don’t know what a new world financial order would look like but the US dollar would not be on top of it.
This might be an interesting parlor game if it weren’t happening against the backdrop of populist politics, enormous debt, mass refugee migrations, and rapid technological change that could put millions out of work. Talk about “who wins” is really misleading.
Think about a boxing match. Who’s “winning” in the early rounds? Whoever threw the last punch is ahead for a moment. But then they take a punch and the lead changes. It’s only later in the match that you see which fighter has staying power.
I think the US-China trade war will be something like that. It will take a long time to see how it shakes out, and meantime we’ll see both sides alternately throwing and absorbing punches. The lead will change often and the winner could even be a third party that may not exist yet.
It is my fervent hope that China makes a genuine effort to reduce their most abusive practices, and that President Trump takes that for a “W” and calls off the tariffs. I think that is the most likely outcome. One of my most inside sources in China, whom I spoke with this week while he was in Shanghai, believes that to be the case, and most Chinese do, too. Which is why the markets are being rather sanguine about the whole process. We should learn more in the coming months.
Great Debt Reset
Debt is certainly one of the main challenges facing China and many nations around the globe today. The decades-long growth of debt in many countries from small, manageable levels to excessive levels is coming to an end.

Bond markets will eventually rebel. We will have to restructure the debt and it will have a profound impact on how we meet future investment challenges.
As an investor, you will have to think differently to accumulate and maintain your wealth. If you’re an investment professional, you are entering one of the most disruptive periods the industry has ever seen. In either case, meeting these challenges will require thinking beyond a traditional stock-and-bond approach. Core holdings in the bull markets of our youth will no longer suffice in the future. Investors will need a better asset allocation approach. While I don’t talk about my own investment strategy in this letter very often, I think I owe it to you to tell you what I am doing for my clients. This is why I created the CMG Mauldin Smart Core Strategy.
Instead of using the traditional diversification approach, potentially resulting in a collection of across-the-board losers, the Mauldin Smart Core diversifies among trading strategies. The goal is to win by minimizing losses and having the flexibility to capitalize on market opportunities. The CMG Mauldin Smart Core Strategy is a tactical portfolio that follows a disciplined process, able to respond to the global economy on a daily basis. It utilizes four ETF strategists that trade a diversified basket of ETFs across asset classes, countries, sectors, fixed income, commodities, and cash.
The global debt super cycle is coming to an end and it will unfold in what I’m calling “The Great Reset.” I’ve just written a detailed report on how I think you should view your investments and why I believe Mauldin Smart Core can navigate the volatility coming to global financial markets. Download my free report, The Great Reset, here.
I’m making a quick trip to San Francisco tomorrow to meet with Jim Mellon, one of the smartest investors I know. Jim made his first billion in real estate and has now turned his attention to antiaging technologies. It looks like we will be working together on at least one venture, if not more.
After that meeting, I will turn around and be back in Dallas for two presentations in Dallas on October 4 at the Dallas Money Show, which happens to be on my 69th birthday. It’s at the Hyatt Regency Dallas so I hope to see you there. Then early in November I will be going to Frankfurt to do a presentation and either before or after that Shane and I will need to once again visit Puerto Rico.
I had such a great response to last week’s Art Cashin story, I’m going to close with another one. As he tells it:
In my very early days on Wall Street my income was rather small and I looked for other possible ways to seek fame and fortune. At the time, folk singers were very big—The Kingston Trio, Joan Baez, Bob Dylan, etc.
We formed a quartet and sang at bars and small clubs for a few months. Impatient, I talked our way into an audition with the Chairman of ABC-Paramount Records. We sang four songs for the Chairman and Chief A&R guy. When we finished, the Chairman said "you guys are really good! We just signed a guy from Atlantic Records. If he doesn’t work out, we'll do an album and send you on a national tour."
The guy from Atlantic Records was named Ray Charles—and that was the end of my singing career.
I also tried to sing but I was merely a good amateur. I was a high tenor and sang solos in Handel’s Messiah, high school musicals, chorales, quartets, folk rock groups. I even sang with the Fort Worth Opera chorus. I enjoyed being a tenor, then nasal surgery in my 40s turned me into a baritone and I couldn’t carry a tune.
I miss singing. Now, when I am alone, sometimes I go to YouTube, find some music and sing. Off-key or not, it just feels good. With that, I will hit the send button. You have a great week!
Your going-to-listen-to-folk-music-on-YouTube-this-weekend analyst,
John Mauldin
Chairman, Mauldin Economics


Populism is the true legacy of the global financial crisis

The ‘hard working classes’ so beloved of politicians were the victims of the crash

Philip Stephens

The legacy of the global financial crisis might have been a re-imagination of the market economy. Anything goes could have made way for something a little closer to everyone gains. The eloquent speeches and bold pledges that followed the crash — think Barack Obama, Gordon Brown, Angela Merkel and the rest — held out just such a prospect. Instead we have ended up with Donald Trump, Brexit and beggar-thy-neighbour nationalism.

The process set in train by the September 2008 collapse of Lehman Brothers has produced two big losers — liberal democracy and open international borders. The culprits, who include bankers, central bankers and regulators, politicians and economists, have shrugged off responsibility. The world has certainly changed, but not in the ordered, structured way that would have been the hallmark of intelligent reform.

After a decade of stagnant incomes and fiscal austerity, no one can be surprised that those most hurt by the crash’s economic consequences are supporting populist uprisings against elites. Across rich democracies, significant segments of the population have come to reject laissez-faire economics and the open frontiers of globalisation. Large-scale immigration can be disruptive during the best of times. Throw in austerity and immigrants are all too easily cast as scapegoats.

Most striking is how little has changed in the operation of international financial markets. A handful of bankers were sacked and some institutions faced hefty penalties and fines. But the burden has fallen on the state or on shareholders. The architects of unfettered financial capitalism are still counting the noughts on their bonuses. The worst that has happened is that they must wait a bit longer before cashing in.

Despite initial regulatory reforms — banks have to hold somewhat more capital and employ armies of compliance officers — life on Wall Street and in the City of London has gone on much as before. Bankers are paid the earth for socially useless activities, taxpayers fund large state subsidies in the shape of too-big-to-fail guarantees, and clever young mathematicians create new, dangerously obscure instruments to keep trading rooms busy. Now, as then, profit is privatised and risk nationalised. Missing is the competition that keeps capitalism honest.

To the extent there were postmortems, radical conclusions were put aside to gather dust as soon as they were published. Central bankers denied complicity. So did the agencies charged with market oversight. Alan Greenspan, who was Federal Reserve chairman until 2006, was the high priest of unfettered markets. He is still revered as a sage. As governor of the Bank of England, Mervyn King cut its systemic regulatory resources and heaped blame for the crisis on investment banks. Retired from public office, he now consults for Citigroup.

As for the politicians, they promised finance would be pulled from its gilded pedestal, that Main Street would be given primacy over Wall Street and markets would be servants rather than masters of the people. “We are all in this together,” George Osborne, then Britain’s chancellor of the exchequer, used to say. We were not. The cost of the crash fell largely on the shoulders of those least able to bear it. Fiscal retrenchment focused largely on cuts in public spending rather than higher taxes. In Britain’s case, Mr Osborne set the ratio at 80:20. The less you earn, the more you rely on state spending. The “hard working classes”, so beloved of politicians when they need votes, were the victims.

To make these, almost self-evident, observations is to explain the return of populism. Who can be surprised that white, blue-collar Americans turned out of once-secure employment now back Mr Trump? Nor is it strange that similar demographic groups supported Brexit — swayed by the toxic rhetoric that blames their misfortune on immigrants. Look across continental Europe and the rise of extreme nationalism mirrors the erosion of the social market economy — a brand of capitalism that offered a stake to ordinary voters.

The strains have been intensified, of course, by digital technology and by the anti-competitive rent-seeking of a handful of tech behemoths. The cost of Google’s aggressive tax avoidance falls on those least able to bear it. The emotion that has done most to swell the ranks of the populists has been a sense of unfairness — the belief that elites are indifferent to their plight.

Mr Trump et al do not have any answers. To the contrary, the US president’s fabled “base” will be losers from his trade wars. They have already been robbed by his tax cuts for the very rich. British workers will be worse off as a consequence of Brexit. The League in Italy and National Rally, formerly the National Front, in France are selling the same snake oil. But many of the grievances they identify are real.

Historians will look back on the crisis of 2008 as the moment the world’s most powerful nations surrendered international leadership, and globalisation went into reverse. The rest of the world has understandably concluded it has little to learn from the west. Many thought at the time that the collapse of communism would presage the permanent hegemony of open, liberal democracies. Instead, what really will puzzle the historians is why the ancien régime was so lazily complacent — complicit, rather — in its own demise.

‘We’re Using the Future for a Fiscal Dumping Ground.’ Beware Trillion-Dollar Deficits

By Jack Hough

‘We’re Using the Future for a Fiscal Dumping Ground.’ Beware Trillion-Dollar Deficits
Photo: New Studio

There’s no snooze button on the national debt clock, though you wouldn’t know it by the way public alarm has quieted as the situation grows worse.

October begins a new fiscal year for the U.S. government—and a faster ballooning of how much it owes. Barring a behavioral miracle in Congress, trillion dollar yearly budget shortfalls will return, perhaps as soon as the coming year. And unlike the ones brought by the financial crisis and Great Recession of 2007-09, these will start during a period of relative plenty, and won’t end.

Debt held by the public, a conservative tally of what America owes, will swell from $15.7 trillion at the end of September, or 78% of gross domestic product, to $28.7 trillion in a decade, or 96% of GDP.

Those estimates, provided by the Congressional Budget Office, are based on reasonable assumptions about economic growth, inflation, employment, and interest rates, but they leave out some important things. They assume that the nation’s need for increased infrastructure investment, estimated by the American Society of Civil Engineers at $1.4 trillion through 2025, goes unmet. They don’t account for the possibility of another financial crisis, or war, or a rise in the frequency or severity of natural disasters, and they assume that some Trump tax cuts will expire in 2025.

There is no clear milestone that marks the moment a country loses control of its finances, but consider how the bar has already been lowered for what seems possible in Congress. Even debt scolds no longer talk seriously about America paying down what it owes, or holding the dollar amount steady. The new path of fiscal prudence involves containing debt at some manageable percentage of GDP, and the opportunity for that is slipping.

“It’s a generational issue,” says Robert Bixby, executive director of the Concord Coalition, a nonpartisan group focused on the debt. “We’re using the future for a fiscal dumping ground.”

Just holding the line at 78% of GDP over the next three decades would require finding massive, immediate savings in the budget—$400 billion over the coming year, rising gradually to $690 billion by 2048, using 2019 dollars. In comparison, America spent $590 billion in fiscal 2017 on defense, and $610 billion on all other discretionary items. (The rest of the $4 trillion in spending went for mandatory programs, such as Social Security and Medicare, and for interest on the debt.)

This past week didn’t inspire confidence. House Republicans introduced Tax Cuts 2.0—bills touted as “permanent tax relief for families and small businesses.” But a fresh decline in federal revenue and the resulting increase in the deficit will hardly come as relief to the taxpayer whose share of the national debt, now $164,000 on average, is already set to top $250,000 in a decade. The 2.0 round has little chance in the Senate, and appears mostly designed to force Democrats into voting against “relief” ahead of midterm elections. Investment bank UBS forecasts a 60% likelihood that Democrats will take the House in November, with Republicans keeping the Senate, the most likely result of which will be gridlock. Here’s hoping a mixed Congress can get something done, because even now, there remain plausible paths to fiscal reform.

Both Sen. Mike Enzi (R., Wyo.), chairman of the Senate Committee on the Budget, and Rep. Steve Womack (R., Ark.), chairman of the House Budget Committee, declined to talk with Barron’s about the debt.

This is no panicked warning for stock and bond investors, because the chances of a debt-driven blowup appear low in the near term. In fact, the biggest risk related to markets is that placid conditions will add to complacency. With the 10-year Treasury yield near 3%—around half its average of the past half-century—it’s clear that there remain eager buyers for America’s debt.

The problem is that we could be wrong about the limited investment risk. “I don’t think bonds adequately reflect what at some point in the future, with high probability, will be trouble in bond markets and with interest rates, due to our fiscal situation,” says Robert Rubin. Treasury Secretary from 1995 until mid-1999 in the Clinton administration, he was one of the last in that position to oversee budget surpluses. Rubin points out that Greek government bond yields were modest for years before spiking past 25% in 2012, during a debt crisis.

If the party that has long branded itself as fiscally conservative—and showed off a debt clock during the 2012 Republican National Convention, in a call to action—now has little interest in containing deficits during good times, the result could be a costly backlash during the next bust. Bond guru Jeffrey Gundlach oversees more than $120 billion in investor assets as chief investment officer at DoubleLine Capital, and was early to predict Donald Trump’s election win and the shift to faster debt growth. He has called the act of expanding deficits while the Federal Reserve is raising interest rates a “suicide mission.”

Gundlach expects investors to buy Treasuries if the threat of deflation returns “as a Pavlovian reaction” and notes that a high short position in them could even set up a short squeeze. “After that, you might find yourself with a more radical reaction,” he says. “There could be elevated acceptance of a universal basic income—just send everyone money.” Already, there is a movement afoot among a some economists on the left who point out that governments that borrow in money they print can’t technically go bankrupt, and say that budget deficits are, if anything, too small.

When deficits are large, money tends to be spent on “stupid things,” says Maya MacGuineas, president of the nonpartisan Committee for a Responsible Federal Budget. “If you don’t have constraints, you don’t think about how to spend wisely.” MacGuineas calls the debt “the most predictable crisis we’ve ever faced,” but says spotting the tipping point will be difficult, because much depends on other countries, and their appetite for our debt. “We can borrow a lot more if we’re still the best-looking horse in the glue factory,” she says.

The gross national debt, a figure commonly used for debt clocks, topped $21 trillion in March. We focus here on debt held by the public, which subtracts amounts owed by one part of the government to another, such as Treasuries held in the Social Security trust fund. The debt is what we owe. The deficit is the amount by which we go further into the hole each year.

Not all deficits are bad. The $1 trillion-plus deficits America ran for four years ending in 2012 helped shore up its financial system and prevent a deep recession from turning into a prolonged depression. Keynesian economics calls for deficit spending and lower taxes during economic slumps to stimulate demand, with the money recouped through surpluses during good years. That last part isn’t happening, however. “Now Keynesian seems to mean you stimulate all the time,” says Gundlach.

If the debt were growing more slowly than the economy—or put differently, with the deficit projected to total 4.6% of gross domestic product over the next year, if GDP were climbing faster than 4.6% in nominal terms—the burden could be said to be slowly diminishing. As it turns out, the economy is estimated to have risen faster than that on an annualized basis last quarter, but it got a boost from temporary factors, including a rush by America’s trading partners to stock up on goods ahead of new tariffs.

Over the coming 10 fiscal years, the CBO estimates real annual GDP growth averaging about 1.7%, and nominal growth of 4.0%. Deficits, meanwhile, are expected to rise from here, averaging 4.9% of gross domestic product annually over the coming decade. The projected downshift in economic expansion owes in part to a widely accepted demographic challenge: the ongoing retirement of the baby boomers, which will hold back expansion of the labor force, a key determinant of GDP gains.

A few commonly prescribed fiscal remedies won’t, on their own, do the job: cutting foreign aid; cracking down on waste, fraud and abuse; and reining in welfare. Foreign aid, using a broad definition that includes things like military assistance to fight terrorism, is around $50 billion a year—a sliver of needed savings. Waste, fraud and abuse are surely all lurking in the budget, but the Government Accountability Office puts improper payments for all federal entities at $141 billion in fiscal 2017, and the challenge is driving that figure lower without spending mightily on new compliance efforts. Consider welfare a catchall term for means-tested programs that are part of mandatory spending, like Medicaid; the earned-income tax credit; and the Supplemental Nutrition Assistance Program, sometimes still referred to as food stamps. Then the combined dollar amount is significant—an estimated $742 billion this fiscal year. But it is dwarfed by the $2.1 trillion that will be spent on mandatory programs that aren’t means-tested, like Social Security, military retirement programs, and most of Medicare.

“There’s no low-hanging fruit, politically,” says Concord Coalition’s Bixby. “It’s the entitlement programs, and the baby boomers have already begun to collect.” The boomers are sometimes described as a metaphorical pig in a python, but Bixby points out that while Social Security’s deteriorating fiscal condition could stabilize after the boomers retire, it will not reverse, and that Medicare’s challenges will keep growing. “It’s more like a telephone pole in a python,” he says.

Like Bixby, former Treasury Secretary Rubin points to cutting Medicare cost growth and raising federal revenue as jobs 1 and 2 in fixing the deficit. “You need comprehensive health-care reform that is focused on costs,” says Rubin. “If you can reduce cost growth in Medicare and Medicaid, even without cutting entitlements, you’re halfway there,” he says. The other half is revenue. During the last, brief flirtation with budget surpluses, from 1998 through 2001, yearly federal receipts were 19% to 20% of GDP. Over the next several years, that figure is expected to bottom at 16.4% before beginning to rebound—if certain tax cuts expire.

There is little consensus around the theory that deficit-fueled tax cuts goose growth enough to pay for themselves over time. But there is every reason to believe that fiscal reform will be good for growth, as interest costs are contained and private investment takes the place of government borrowing. Even under the scenario of merely holding the debt to 78% of GDP for the next 30 years, the CBO estimates that gross national product per person would end up 4.5%—or about $4,100—higher, compared with baseline assumptions.

The last bold effort to deal with the debt was the Simpson-Bowles plan drafted by a bipartisan commission appointed by President Obama in 2010, when debt was 61% of GDP. It called for nearly $4 trillion in deficit reductions through 2020, with big cuts to discretionary spending, changes for Social Security and Medicare, and a lowering of personal and corporate tax rates, combined with purging the tax code of breaks. That would have put debt on a course toward an estimated 40% of gross domestic product by 2035. The final draft, titled “The Moment of Truth,” didn’t win enough support to come to a vote in Congress.

The last big fiscal success, the “Clinton surpluses” of 1998-2001, can be traced in part to the efforts of President George H.W. Bush. He was faced with a dangerous combination of a weakening economy and high interest rates. To convince the Federal Reserve to lower rates, he needed smaller budget deficits. A Democratic Congress wouldn’t agree to spending cuts without higher tax revenue. But Bush had famously promised, “Read my lips, no new taxes” during the 1988 Republican Convention. In the end, he reached a bipartisan deal that included about $2 in spending cuts for each $1 in added revenues, including from a tax hike on high earners. That deal helped cost Bush re-election in 1992. President Clinton followed up with a deficit-cutting budget in 1993.

The deficit fell from 4.5% of gross domestic product in 1992 to near-breakeven five years later, before swinging to surpluses. The lesson of what might rightly be called the Bush-Clinton surpluses is that budget reform isn’t a job for narcissists or glory seekers, because the public outrage forms immediately, and the benefits don’t become clear until much later, by which time others will have arrived to help collect the high-fives.

The good news is that, if the courage to tackle the deficit somehow visits Capitol Hill, financial markets appear likely to cooperate, at least for a while.

In a recent analysis, economists at J.P. Morgan studied historical debt defaults, bailouts and inflation spikes since World War II in countries that resemble the U.S. economically. They found that the probability of these things occurring within any five-year period was less than 6%. Statistically, the link between debt levels and crises is surprisingly weak. That is, crises have occurred in countries with lower debt/GDP than the U.S. has now, and some countries with higher debt/GDP have avoided crises. Many crises corresponded with specific currency problems that, for the U.S., seem less relevant.

The economists’ takeaway is that it’s “too early to worry about a U.S. sovereign debt crisis,” but also that “we should not ignore lessons from history on the fragility created by debt.”

Andy McCormick, head of the U.S. taxable bond team at T. Rowe Price, is similarly confident about the near term. “The next six months to two years—no problem,” he says. “When debt hits 100% of GDP, it could shake people up, but it’s a little too long-term for me to put into portfolios.

If he’s right, there’s an opportunity, while bond yields and interest costs remain low, to put aside partisan antics and take bold action to restore fiscal order. It won’t be easy, but it will never be this easy again.

The new geography of innovation

Why startups are leaving Silicon Valley

Its primacy as a technology hub is on the wane. That is cause for concern

“LIKE Florence in the Renaissance.” That is a common description of what it is like to live in Silicon Valley. America’s technology capital has an outsize influence on the world’s economy, stockmarkets and culture. This small portion of land running from San Jose to San Francisco is home to three of the world’s five most valuable companies. Giants such as Apple, Facebook, Google and Netflix all claim Silicon Valley as their birthplace and home, as do trailblazers such as Airbnb, Tesla and Uber. The Bay Area has the 19th-largest economy in the world, ranking above Switzerland and Saudi Arabia.

The Valley is not just a place. It is also an idea. Ever since Bill Hewlett and David Packard set up in a garage nearly 80 years ago, it has been a byword for innovation and ingenuity. It has been at the centre of several cycles of Schumpeterian destruction and regeneration, in silicon chips, personal computers, software and internet services. Some of its inventions have been ludicrous: internet-connected teapots, or an app that sold people coins to use at laundromats. But others are world-beaters: microprocessor chips, databases and smartphones all trace their lineage to the Valley.

Its combination of engineering expertise, thriving business networks, deep pools of capital, strong universities and a risk-taking culture have made the Valley impossible to clone, despite many attempts to do so. There is no credible rival for its position as the world’s pre-eminent innovation hub. But there are signs that the Valley’s influence is peaking. If that were simply a symptom of much greater innovation elsewhere, it would be cause for cheer. The truth is unhappier.

Silicon Plateau

First, the evidence that something is changing. Last year more Americans left the county of San Francisco than arrived. According to a recent survey, 46% of respondents say they plan to leave the Bay Area in the next few years, up from 34% in 2016. So many startups are branching out into new places that the trend has a name, “Off Silicon Valleying”. Peter Thiel, perhaps the Valley’s most high-profile venture capitalist, is among those upping sticks. Those who stay have broader horizons: in 2013 Silicon Valley investors put half their money into startups outside the Bay Area; now it is closer to two-thirds.

The reasons for this shift are manifold, but chief among them is the sheer expense of the Valley. The cost of living is among the highest in the world. One founder reckons young startups pay at least four times more to operate in the Bay Area than in most other American cities. New technologies, from quantum computing to synthetic biology, offer lower margins than internet services, making it more important for startups in these emerging fields to husband their cash. All this is before taking into account the nastier features of Bay Area life: clogged traffic, discarded syringes and shocking inequality.

Other cities are rising in relative importance as a result. The Kauffman Foundation, a non-profit group that tracks entrepreneurship, now ranks the Miami-Fort Lauderdale area first for startup activity in America, based on the density of startups and new entrepreneurs. Mr Thiel is moving to Los Angeles, which has a vibrant tech scene. Phoenix and Pittsburgh have become hubs for autonomous vehicles; New York for media startups; London for fintech; Shenzhen for hardware. None of these places can match the Valley on its own; between them, they point to a world in which innovation is more distributed.

If great ideas can bubble up in more places, that has to be welcome. There are some reasons to think the playing-field for innovation is indeed being levelled up. Capital is becoming more widely available to bright sparks everywhere: tech investors increasingly trawl the world, not just California, for hot ideas. There is less reason than ever for a single region to be the epicentre of technology. Thanks to the tools that the Valley’s own firms have produced, from smartphones to video calls to messaging apps, teams can work effectively from different offices and places. A more even distribution of wealth may be one result, greater diversity of thought another. The Valley does many things remarkably well, but it comes dangerously close to being a monoculture of white male nerds. Companies founded by women received just 2% of the funding doled out by venture capitalists last year.

Shadows of the colossi

The problem is that the wider playing-field for innovation is also being levelled down. One issue is the dominance of the tech giants. Startups, particularly those in the consumer-internet business, increasingly struggle to attract capital in the shadow of Alphabet, Apple, Facebook et al. In 2017 the number of first financing rounds in America was down by around 22% from 2012. Alphabet and Facebook pay their employees so generously that startups can struggle to attract talent (the median salary at Facebook is $240,000). When the chances of startup success are even less certain and the payoffs not so very different from a steady job at one of the giants, dynamism suffers—and not just in the Valley. It is a similar story in China, where Alibaba, Baidu and Tencent are responsible for close to half of all domestic venture-capital investment, giving the giants a big say in the future of potential rivals.

The second way in which innovation is being levelled down is by increasingly unfriendly policies in the West. Rising anti-immigrant sentiment and tighter visa regimes of the sort introduced by President Donald Trump have economy-wide effects: foreign entrepreneurs create around 25% of new companies in America. Silicon Valley first bloomed, in large part, because of government largesse. But state spending on public universities throughout America and Europe has fallen since the financial crisis of 2007-08. Funding for basic research is inadequate—America’s federal-government spending on R&D was 0.6% of GDP in 2015, a third of what it was in 1964—and heading in the wrong direction.

If Silicon Valley’s relative decline heralded the rise of a global web of thriving, rival tech hubs, that would be worth celebrating. Unfortunately, the Valley’s peak looks more like a warning that innovation everywhere is becoming harder.

E Pluribus Unum


It’s that time of year — the long weekend when we gather with friends and family to celebrate hot dogs, potato salad and, yes, the founding of our nation. And it’s also a time for some of us to wax a bit philosophical, to wonder what, exactly, we’re celebrating. Is America in 2013, in any meaningful sense, the same country that declared independence in 1776?

The answer, I’d suggest, is yes. Despite everything, there is a thread of continuity in our national identity — reflected in institutions, ideas and, especially, in attitude — that remains unbroken. Above all, we are still, at root, a nation that believes in democracy, even if we don’t always act on that belief.

And that’s a remarkable thing when you bear in mind just how much the country has changed.

America in 1776 was a rural land, mainly composed of small farmers and, in the South, somewhat bigger farmers with slaves. And the free population consisted of, well, WASPs: almost all came from northwestern Europe, 65 percent came from Britain, and 98 percent were Protestants.

America today is nothing like that, even though some politicians — think Sarah Palin — like to talk as if the “real America” is still white, Protestant, and rural or small-town.

But the real America is, in fact, a nation of metropolitan areas, not small towns. Tellingly, even when Ms. Palin made her infamous remarks in 2008 she did so in Greensboro, N.C., which may not be in the Northeast Corridor but — with a metropolitan population of more than 700,000 — is hardly Mayberry. In fact, two-thirds of Americans live in metro areas with half-a-million or more residents.

Nor, by the way, are most of us living in leafy suburbs. America as a whole has only 87 people per square mile, but the average American, according to the Census Bureau, lives in a census tract with more than 5,000 people per square mile. For all the bashing of the Northeast Corridor as being somehow un-American, this means that the typical American lives in an environment that resembles greater Boston or greater Philadelphia more than it resembles Greensboro, let alone true small towns.

What do we do in these dense metropolitan áreas? Almost none of us are farmers; few of us hunt; by and large, we sit in cubicles on weekdays and visit shopping malls on our days off.

And ethnically we are, of course, very different from the founders. Only a minority of today’s Americans are descended from the WASPs and slaves of 1776. The rest are the descendants of successive waves of immigration: first from Ireland and Germany, then from Southern and Eastern Europe, now from Latin America and Asia. We’re no longer an Anglo-Saxon nation; we’re only around half-Protestant; and we’re increasingly nonwhite.

Yet I would maintain that we are still the same country that declared independence all those years ago.

It’s not just that we have maintained continuity of legal government, although that’s not a small thing. The current government of France is, strictly speaking, the Fifth Republic; we had our anti-monarchical revolution first, yet we’re still on Republic No. 1, which actually makes our government one of the oldest in the world.

More important, however, is the enduring hold on our nation of the democratic ideal, the notion that “all men are created equal” — all men, not just men from certain ethnic groups or from aristocratic families. And to this day — or so it seems to me, and I’ve done a lot of traveling in my time — America remains uniquely democratic in its mannerisms, in the way people from different classes interact.

Of course, our democratic ideal has always been accompanied by enormous hypocrisy, starting with the many founding fathers who espoused the rights of man, then went back to enjoying the fruits of slave labor. Today’s America is a place where everyone claims to support equality of opportunity, yet we are, objectively, the most class-ridden nation in the Western world — the country where children of the wealthy are most likely to inherit their parents’ status. It’s also a place where everyone celebrates the right to vote, yet many politicians work hard to disenfranchise the poor and nonwhite.

But that very hypocrisy is, in a way, a good sign. The wealthy may defend their privileges, but given the temper of America, they have to pretend that they’re doing no such thing. The block-the-vote people know what they’re doing, but they also know that they mustn’t say it in so many words. In effect, both groups know that the nation will view them as un-American unless they pay at least lip service to democratic ideals — and in that fact lies the hope of redemption.

So, yes, we are still, in a deep sense, the nation that declared independence and, more important, declared that all men have rights. Let’s all raise our hot dogs in salute.

Published in July 4th, 2013

Shorting Loans: A Hedge Against Financial Trouble

It won’t take much for investors in booming loan funds to wake up to the growing risks

By Paul J. Davies

The growing risks in low-quality loans are starting to attract attention from market watchers.
The growing risks in low-quality loans are starting to attract attention from market watchers. Photo: bryan r. smith/Agence France-Presse/Getty Images

Riskier corporate debt may face a very bumpy ride this year.

One way to play this is to bet against an exchange-traded fund that buys U.S. leveraged loans, the risky debt behind takeovers and private-equity deals. The biggest of these is the Invesco Senior Loan ETF . BKLN -0.07%▲

The loan market has been flooded with inexpert money, which has worsened lending standards even compared with the debt bubble that ended in the 2008 banking crisis. There is plenty to spook investors and loans are still a relatively illiquid market, so a little selling pressure can cause a lot of trouble.

The growing risks in low-quality loans are already starting to attract attention. Excluding income from interest, Invesco’s loan ETF has slid about 1% since late January, its high point in 2018. The next largest loan ETF, run by Blackstone GSO, is off by a similar amount.

So far, the declines have been more than offset by the income generated by the loans, but the declines could now accelerate. Three risks in particular probably aren’t appreciated enough by nonspecialist investors.

First, rising interest rates are great for investors in floating-rate loans—until they aren’t, to paraphrase a UBS analyst. There comes a point when higher interest payments start eating up too much of a company’s cash Flow.

U.S. rate increases have already pushed up total interest costs for loans by a percentage point to about 5.7% since the final three months of last year, according to UBS. And higher funding costs haven’t been matched by earnings growth for more lowly rated borrowers.

Second, there are more lowly rated borrowers than ever: Today almost two-thirds of leveraged loan issuers are rated B2 or lower by Moody’s, or single-B in other agencies’ scales. That compares with less than half in 2006.

Third, a growing share of borrowers reports leverage multiples based on adjusted earnings numbers; in other words, they add back dollars for one-time costs or for savings the owners plan to achieve.

Together these problems suggest losses will be greater when borrowers default than in previous cycles. But investors won’t wait for widespread losses before reducing their exposure. When junk-rated energy companies hit trouble in late 2015, all high-yield credit sold off. At that time, Invesco’s loan ETF dropped more than 7% between September 2015 and February 2016.

Now, the profits of some U.S. sectors are likely to be hurt by the escalating trade war, which could hurt the whole high-yield market again. The end of ultraloose monetary policy and rising yields on safer assets will also make risky credit less attractive to investors.

Whatever the trigger, it won’t take much to spark trouble for leveraged loans.

The Slavery Incentive

Ricardo Hausmann  

immigrant workers farm

CAMBRIDGE – Have you ever wondered why business schools do not teach the proper way to whip a worker to obtain maximum effort without damaging the asset? Had business schools existed before the American Civil War, one can conceive of at least a lecture, if not a full course, on the subject. Instead, business schools teach about corporate culture and values, on the assumption that maximum effort can be obtained from workers if they identify with the firm’s mission and goals.

So why have slavery and other forms of bonded labor declined so dramatically in so many places around the world, and what can be done to abolish them completely? It might be tempting to assume that the decline of slavery is the consequence of human moral progress. But in his masterful book The Other Slavery, Andrés Reséndez shows how inadequate this assumption is. The book addresses the history of slavery and other forms of bondage of indigenous peoples in the Americas, a topic that has received much less attention than African-American enslavement.

As the book shows, Indian slavery in the Americas was outlawed by Charles I of Spain in 1542 and abolished in Peninsular Spain even earlier. The legislation against Indian slavery was further strengthened during the regency of Mariana of Austria (1665-1675), the mother of Charles II.

The laws were based on Catholic values and pushed by an activist group that included Bartolomé de las Casas, who championed the rights of indigenous peoples as children of God and subjects of the King. But, despite legal prohibitions, slavery proved remarkably resilient, with colonists using subterfuges such as debt peonage, “just wars” (which sanctioned enslavement of captured enemies as a more moral outcome than justified slaughter), and other tricks.1

The reason for this resilience is probably best understood not as the consequence of poor law enforcement but of the profitability of slavery, which generated incentives too strong for laws to contain. The implication is that the dwindling of slavery today and its potential further reduction may depend on market rather than legal incentives.

Slavery was widespread, including in Europe, when it developed in the Americas, where – from the perspective of the Spanish settlers – acute labor shortages prevailed. Mining and plantation agriculture were labor-intensive, but the population had collapsed precipitously upon contact with Europe, owing to some combination of war, disease, oppression, and the disruption of livelihoods. Moreover, those jobs were dirty, dangerous, and demeaning. Gold mining in particular was almost a death sentence: workers seldom survived more than three years before succumbing to mercury poisoning or accidents.

Slavery did not succeed in keeping labor costs down because the slaves themselves were expensive. In the sixteenth century, slavers invaded other Caribbean islands to abduct workers and sell them to gold miners on the island of Hispaniola (today’s Dominican Republic and Haiti). In the seventeenth century, slavery was used in Bolivia to operate the silver mines in Potosí.

In the eighteenth century, Comanches would hunt Apaches to sell to Mexican silver miners. Even after the US Civil War, the Fourteenth Amendment did not protect Native Americans: in the 1880s, the Supreme Court ruled that it did not cover them, and they gained citizenship rights only in 1924.

After the end of the international slave trade in the 1830s, what developed in the Caribbean was not free labor but indentured labor, with East Asians making the journey in exchange for what could be thought of as fixed-term slavery, similar to debt bondage. In the US, after the end of the post-Civil War period known as Reconstruction, southern states enacted vagrancy laws, which permitted the authorities to imprison displaced former slaves and condemn them to forced labor if it could be argued that they were idle.1

How is bondage different from free labor, and why did the latter displace the former? Part of the answer may be technological: technologies that require effort that is hard to observe, or that use expensive and fragile equipment, may be inappropriate for slavery. For example, entrusting valuable assets to disgruntled slaves may be unwise. But this logic should not be exaggerated. After all, Nazis enslaved millions of gentiles from occupied countries, transported them to labor camps, mostly in Germany, and forced them to produce, inter alia, war materiel.

One fundamental difference between free labor and slavery is that slaves must be bought, meaning that the gains from exploitation do not necessarily accrue to the current slave owner, but are anticipated in the purchase price of the slave. This also means that capital would have to be expended in owning the slave, an expense not required of free labor. In a world of less-than-perfect capital markets, this expense may have had a serious opportunity cost in terms of the forgone investments in equipment and other inputs.

The fundamental difference between the two institutions is the range of options given to the worker. Bondage means that the worker cannot leave if he finds the conditions disagreeable. If the alternative to slavery is starvation or death, people may well choose slavery.

Today, migrants often face limited options. If they are undocumented, as millions are in the US, they cannot turn to the authorities to protect their labor rights, making them vulnerable to exploitation and abuse. If they are legal, they often get a visa that allows them to work only for the sponsoring firm. If they find the conditions disagreeable, they cannot just change employers: they must leave the country.

By restricting the workers’ outside options, employers may get them to accept terms that freer individuals would reject. That may be a reason why there is so little urgency in solving the problem of undocumented immigrants in the US, and why many countries protect citizens differently than foreigners. It may also be the reason why countries have refused to empower refugees, whether Syrians or Venezuelans, with rights. So long as the incentives to enslave persist, the effort to end slavery – by whatever name – will have to continue.

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