Market reckoning is coming after a decade of QE

The divergence between asset prices and incomes has historically generated problems

Michael Mackenzie

The stellar ride asset prices have enjoyed since the demise of Lehman Brothers dominates the financial system. And the prospect of a reversal is rightfully worrying.

Years of ultra low, and in some cases negative, interest rates, alongside massive quantitative easing programmes, have been a grand experiment in monetary policy. Low rates have compelled investors to seek higher returns from riskier assets such as equities, junk bonds and, until early this year, local currency emerging market debt.

Another feature of bond yields stuck at low levels is that they enhance the value of companies’ future cash flows and, in doing so, help share prices. This explains in part the appeal of owning fast-growing tech companies that generate vast cash flows, such as Apple and Amazon, that in recent weeks have reached $1tn valuations.

When they embarked on QE the aim of central banks was to create a wealth effect in the form of rising equity and home prices that, in turn, would bolster the broad economy. In QE’s early days, fear of an inflationary surge was strongly felt among some investors. Gold bugs can only look back wistfully on 2011, when the spectre of QE unleashing inflation drove the precious metal to the dizzy heights of $1,900 an ounce.

The fact that an inflation scare didn’t materalise is why the 10-year Treasury note yield sits well shy of its April 2010 peak of 4 per cent, and its inability to sustain a rise above 3 per cent continues to support US stocks and junk bonds.

Rather than generate a surge in inflation, a data point helps illustrate that it has been the boom in asset prices that has defined the decade for financial markets since the crisis.

Russ Mould, investment director at AJ Bell, notes that US household net worth has risen beyond $100tn and is nearly 50 per cent higher than its prior cyclical peak a decade ago. In contrast, the Census Bureau shows that the median real US household income today has only just returned to the levels of 2007.

The divergence has been fuelled by the boom in asset prices and, as Mr Mould reminds us, in both 2000 and 2007 markets and the economy faced a dramatic reckoning after gains in household net worth outpaced net income for several years.

A crucial difference between today and prior periods of elevated asset prices is pointed out by Dhaval Joshi at BCA Research, who notes that 1990 was largely focused on Japan, in 2000 tech and telecoms led the way while 2007 reflected the US mortgage and credit boom.

This time the rise in asset prices has been far broader and with the Federal Reserve leading central banks’ retreat from QE, the cracks we are seeing across parts of emerging markets and the faltering performance of non-US equities raises concern that this is the start of a broader reckoning.

As US overnight interest rates have risen to 2 per cent and the Fed’s balance sheet is shrinking, the mood music for global markets has shifted since the most recent peak for FTSE All World equity index in January. Exclude the US from this measure of global developed and emerging large and mid-sized companies, and it has fallen some 13 per cent from its early year high. In sharp contrast the US equity market hit a new all-time high just weeks ago, reflecting the hefty bump corporate earnings have enjoyed from the Trump administration’s tax cuts.

With the latest US inflation data on Thursday arriving a touch below expectations, the prospect of the 10-year Treasury yield rising back over 3 per cent has dimmed for now. But how long a buoyant economy and signs of inflationary pressures can square with a 10-year yield below 3 per cent is a key question for markets. Should the US labour market remain buoyant, fuelling faster wage gains, the ingredients for an inflation scare are in place.

Indeed, Lael Brainard, a member of the Federal Reserve’s board of governors, this week indicated there was scope for the central bank to raise short-term rates above the current estimate of the longer-run rate, which is just shy of 3 per cent.

All of which presents a huge policy challenge to the Fed as tax cuts fuel concern in some quarters of an economy that will soon overheat. For highflying US asset prices, the principal danger is that a sharp rise in long-term bond yields, via an inflation scare, would very much leave Wall Street looking like Icarus.

The silver lining for investors is that in such a scenario the best thing to buy will be a 10-year bond that would then offer a far more attractive yield.

Remembering ‘Lehman Weekend’: Where Are the Risks Now?


September holds the dubious honor of being the month that marked two cataclysmic events with profound global impact: the Sept. 11, 2001, terrorist attacks that ignited the war on terror, and the Sept. 15, 2008, bankruptcy filing of Lehman Brothers that marked the beginning of the global financial crisis.

“This is an incredible week, I think in the U.S. and for the whole world,” said Wharton Dean Geoffrey Garrett, who moderated a panel of Wall Street veterans at the Tarnopol Dean’s Lecture Series on ‘The Future of Finance: 10 Years After the Financial Crisis.’ “If I look back on the first 18 years of this new millennium, the two most important dates are 9/11 and 9/15.

“Today, we’re looking back, and looking forward, on the 10th anniversary” of the financial crisis,” Garrett said. The crisis was followed by the Great Recession, and “amidst all of that, I think we had literally unprecedented, coordinated global economic policy action.” Post-crisis, he said, the recession was so deep that global trade declined 30% in one year after three decades of yearly gains. “We had a very long recovery, but most people think it’s been a much shallower recovery than others in American history. And we continue to have more financial innovation — it just looks different from the period before.”

Sharing their recollections of the crisis and prognostications for the future were Robert Wolf, former CEO of UBS Americas who now heads 32 Advisors; Marc Rowan, co-founder and senior managing director of Apollo Global Management, one of the world’s largest private equity firms; James Dinan, founder and chairman of York Capital Management; and Ruth Porat, former CFO of Morgan Stanley now CFO of Google and parent Alphabet. She joined the panel by video.

Fateful Weekend

Wolf remembers that fateful weekend before Lehman went under. He got a call on Friday right around the close of the market to come to the Federal Reserve Bank of New York building in Manhattan from his office in Stamford, Conn. He would later find out that he was one of a dozen executives who had been summoned — 10 were U.S. CEOs and two came from foreign firms — UBS and Deutsche Bank.

Wolf said he walked into a room and saw the who’s who of Wall Street, many of whom are no longer in their positions: Merrill Lynch CEO John Thain, Morgan Stanley CEO John Mack, Citigroup CEO Vikram Pandit, JPMorgan Chase CEO Jamie Dimon, and others. “We didn’t know what the situation was at that time,” Wolf recalled. “All of a sudden, [former Treasury Secretary Hank Paulson, former New York Fed President Timothy Geithner and former SEC Chairman Christopher Cox] walk in and say, ‘We have until Sunday night to determine the fate of Lehman, and there will not be a government bailout.… We all were jaws down.”
Garrett asked whether anyone in the room objected to the government’s decision. “There were definitely challenging questions of why” there would be no bail out, Wolf said. But “they had made up their mind because of the backlash they had with Bear [Stearns],” which JPMorgan agreed to acquire after the government backstopped the deal.

That weekend, the plan was to split Lehman, putting the bad assets into one bank and good assets in another, Wolf said. The good bank could perhaps be shopped to billionaire Warren Buffett, Barclays, Bank of America or other buyers. The bank with the troubled assets would be financed by the group in the room. This was the plan as of Saturday. But on Sunday, the plan fell apart after the U.K. regulator would not clear an acquisition by Barclays. In hindsight, it was probably a good call. “The truth is, what is the good bank of Lehman? You don’t really know what was under the hood,” Wolf said.

Wolf noted that the ‘Lehman weekend’ witnessed the most cooperation he has seen among Wall Street firms, which normally compete against each other ferociously. “We were collaborative because we all knew what would happen on Monday morning if Lehman failed,” he said. “We were not collaborative because we actually cared about Lehman.… We cared about the outcome and [what] we used to call ‘fixed bayonets.’ You protect your own castle.”

Google’s Porat said back in 2008 she was asked by Paulson, Geithner and former Fed Chair Ben Bernanke to help lead a team to analyze what to do with Fannie Mae and Freddie Mac as the subprime-fueled mortgage crisis threatened to engulf them. She was also asked to help them with AIG, where a non-insurance unit that loaded up on credit default swaps was sinking the firm.

“To me, the most frightening moment in the financial crisis was actually AIG,” Porat said. During that ‘Lehman weekend,’ she went home on Sunday only to be called back to the New York Fed. “I got a call from Treasury [saying], ‘We worked on the wrong thing. Can you come back down?” Porat recalled. “It didn’t seem real at the time. Their comment was — ‘It’s AIG. AIG will be out of money by Wednesday.’ This was late Sunday night.”

Garrett recalled that period as well. He was in Australia, which has a highly regulated financial system that is largely insulated from Wall Street. But the country felt the tremors. “With the fall of Lehman Brothers, there was a near instantaneous freezing of credit markets in Australia — so much so that crisis meetings happening in Washington and London were also happening in Australia literally at the same time in real time. That showed me that this was truly a global crisis, and it was moving at warp speed.”

The Post-crisis World

But with the post-crisis reforms, is the global financial system safer today? “Absolutely,” said Wolf, who supported the Dodd-Frank financial reforms and was an advisor to President Obama. “The banks are much stronger today. Leverage in the system is probably 70% less.” He said U.S. banks recovered faster than European banks because “they took their pain and went on the offense quickly.… They understand when you’re on defense, you’re losing and when you’re on offense, you’re winning.”

Apollo’s Rowan saw opportunity in the chaos of the crisis. As banks pulled back from the credit markets, his firm went in. “You have banks that are going through the fence and not lending. You have regulations coming in and pushing banks out of a whole lot of business. You have a regulatory environment where the best people no longer want to work in a banking environment. You have investors who need yield.” Indeed, Apollo went from managing $10 billion in credit before the crisis to $200 billion.

York Capital, a hedge fund, also did well. But Dinan initially didn’t expect it. Around late 2008 to early 2009, “we were looking at more existential issues that had not very pleasant endings,” he said. But remembering his experience in prior market meltdowns, Dinan said he learned that “when the dead start walking, that’s when you start paying attention.” York Capital went from “total risk neutral” to “total risk engage” and began investing. Before the crisis, York had a couple of years of losses. But in a few months, the firm had recouped it all.

Dinan shared another thing he learned in investing: “Credit investors smell the fear before equity investors do.” That’s because unlike shareholders, they don’t have a lot of upside but they assume the risk of debt defaults. He also gave his own spin on the popular Wall Street adage that the best time to buy is when there’s blood on the streets. “That’s sort of true, but not completely true,” Dinan said. “The best time to buy is when there’s blood on the streets, but not if it’s your blood.”

Porat said four lessons she learned in the crisis could apply to the world today. Every company and every industry needs to identify its source of vulnerability and protect against it when times are good. Also, build data analytics, strengthen risk measures and improve transparency so one is not running a business “with mud on the windshield.” Third, it’s important to have the will and the means to enact change. “Too often, by the time you have the will, you no longer have the means,” she said.

Finally, build a strong team. “How fortunate we were to have had Secretary Paulson … take that leadership role and to have President Bush have the judgement to really defer to the team that was assembled,” Porat said. “In my view, the country really benefited from that type of leadership, and we would have been dramatically worse off if we didn’t have a team that moved with that speed [to navigate through] a very tricky situation.”

New Risks?

Garrett asked the panelists what kept them up at night. What risks do they see emerging? Dinan said, “Right now, the situation in Europe is not very healthy. The third largest economy in the Eurozone, Italy, is undergoing a populist movement that could really lead to potentially the unraveling of the whole Eurozone. The ramifications would be too big.… I’ve hedged it out.”

Rowan is concerned about the surge in passive investing and ETFs. “A massive amount of the equity markets and the credit markets are now in the hands of liquidity-driven investors rather than credit or fundamental-driven investors,” he said. “Liquidity-driven investors buy something when they have cash and sell when they don’t have cash” instead of basing their investment decisions on fundamentals of a business.

Moreover, “if you’re a fundamental investor and you pick a stock that’s not part of the index, it’s generally not going to move,” Rowan added. “It’s unclear to me that fundamentals in the short and medium term will be reflected in the value of securities prices.… I think that destroys a lot of value. A lot of buy-side money focused on fundamental investors has moved out of their hands and into the hands of ETFs. If the buy-side was where regular folks went to get access to investment alpha [return], … I think it’s getting harder because the industry is getting indexed.”

Dinan added that the surge in investor money into ETFs is “basically making passivity and beta [volatility] a self-fulfilling prophecy, and it’s a great party while it’s going on, but all parties do end.” He observed that “as long as everybody feels good, the risk gene goes into remission and nobody wants to miss out.”

Rowan also is concerned about a Dodd-Frank change that “removed dealer capital from the industry. It used to be securities firms and banks made markets. They were the break between the buyer and seller.” But now, he said, “you have no break between buyer and seller because there is no capital in the securities trading system — and you have an indexed market.” For regular folks investing in the public markets, “you are almost at the mercy of liquidity.

Liquidity-driven events going up — it feels great. In the next downturn, it’s not going to feel so good. I think we’ve actually taken steps from a regulatory and structural point of view that are going to exacerbate movements down in price.”

Rowan also is concerned about the mark-to-market decline in assets as passive investing activity soars. “You [could] have a massive decline in assets that has nothing to do with the quality of assets but as a result of liquidity,” he said. “Companies [could be] rendered insolvent, which is fine if there are long-term structures in place. But if there are not long-term structures in place and people start removing capital from places that have these kinds of mark-to-market, that’s how you get a full blown financial crisis.”

As for Wolf, “what keeps me up at night is the chaos in this administration.” Longer term, what he is concerned about is the “lack of fiscal discipline. I think that someone is going to have to pay the piper. I think it’s going to be the generations that come [afterwards]. You cannot have trillions of dollars of deficit and think that no one’s going to be paying for it.… I think we’re going to have a real fiscal issue that is going to really hurt the system.”

The Limits of China’s Debt Trap

By Phillip Orchard


This month marks five years since Chinese President Xi Jinping laid out his vision for the Belt and Road Initiative, Beijing’s sprawling infrastructure push spanning dozens of countries, during a pair of visits to Kazakhstan and Indonesia. BRI is less a concrete, well-defined plan and more an umbrella term for a jumble of China-backed projects involving myriad goals, many of them purely commercial. China has an oversize industrial base to keep humming, plus a vast labor pool to keep busy, at a time when it’s entering a prolonged phase of slowing growth. And it has proved adept at combining diplomatic influence with the lending power of its state-owned banks to pry open new opportunities for its firms abroad.

However, a large number of prominent BRI projects appear commercially dubious, at best. Indeed, Chinese firms have been able to win so many contracts so easily in part because BRI is littered with projects that were unable to attract investment from other sources. China has outsize tolerance for risky “white elephants” with poor prospects for ever turning a profit not because it has money to burn. Rather, there are broader economic and strategic dimensions at play. For example, some projects are intended to open up trade routes that bypass maritime chokepoints, while also helping integrate less developed interior Chinese provinces into the global economy to reduce the steep wealth imbalances between the coast and the interior.

What has outside powers on edge, though, is the suspicion that Beijing is using BRI as a sort of Trojan horse to, at minimum, cultivate political influence with which it can tightly align weaker states to China’s strategic interests and weaken the established Western-led liberal order. Powers like India and Australia, which have reason to fear a Chinese encroachment into their traditional spheres of influence, think an overriding goal of BRI is to dramatically expand China’s military footprint as well.

Such concerns manifest most acutely in the series of deepwater ports China is building in strategically valuable locations throughout the Indo-Pacific along what it calls its “Maritime Silk Road,” also commonly referred to as China’s “String of Pearls.” Of course, merely building deepwater ports isn’t the same as building a naval base. Host countries have a vote over how a port is used, and they have their own strategic and political pressures to consider, not to mention the need to balance relations with neighboring powers that have no desire to see a People’s Liberation Army base on their doorstep. But rival governments claim that some BRI projects are set up to snare host countries in “debt traps” and essentially strip them of that vote.

With its international economic and strategic interests expanding, China has good reason to want to develop the military capabilities to protect them. And this requires a network of naval and air bases beyond mainland China. The question is: Can BRI really be the means toward this end? This Deep Dive examines the strategic potential of China’s String of Pearls and the viability of “debtbook diplomacy” as a way to pursue Beijing’s broader aims, with a particular focus on China’s effort to expand its military footprint abroad. It concludes that China’s success or failure will hinge less on economic leverage and more on its ability to convince regional states that their best bets – strategically, militarily and economically – are with Beijing.

The Strategy Behind the String of Pearls

All told, China now has ownership stakes in nearly two-thirds of the world’s major deepwater ports, including long-term leases over ports in strategically valuable locations from Greece to Tanzania to Argentina – and across the Indo-Pacific. Again, most of these are merely commercial ventures, no different from U.S. port terminals operated by firms from Singapore, South Korea and Denmark. The Chinese navy has minimal use for the China-backed Greek port of Piraeus, and minimal hope of ever gaining full-time access to it.

But it’s not hard to see why China’s rivals are wary of certain projects. India sees Chinese port projects in Pakistan, Sri Lanka, Bangladesh, Myanmar and the Maldives as encirclement. Australia sees Chinese projects from Vanuatu to Fiji as an attempt to project power in the same area where the Japanese tried to cut off Australian supply routes in World War II. Japan sees China-backed ports in Malaysia, Thailand and Cambodia as boosting China’s ability to threaten critical flows of natural resources to the home islands.

These ports would certainly have considerable value to the Chinese navy as it seeks to build out its bluewater capabilities. To prevent the U.S. and its allies from being able to close off maritime chokepoints in the Strait of Malacca and what’s known as the first island chain, it needs the ability to take the fight to the enemy deeper into the Pacific. To secure Chinese shipping traffic farther afield and protect its growing investments, it needs to be able to maintain a full-time presence in the Indian Ocean and around the Horn of Africa. To come to the aid of the ever-growing Chinese diaspora and prove to regional states that it can carry the common security burdens currently shouldered primarily by the U.S., it needs to be able to respond quickly and decisively far from Chinese shores. It can’t do any of this without a bluewater navy, and a bluewater navy requires, at minimum, a far-flung network of logistics and support facilities. In other words, BRI’s military dimensions are a logical outgrowth of China’s comprehensive pursuit of national power.

Indeed, Chinese military planners have been fairly open about the navy’s need for a network of bases – and fairly transparent about their support for the String of Pearls to take on dual-use functions – calling for a dozen or more available ports across the globe. Already, Chinese law requires Chinese transportation firms working in ports abroad to provide replenishment services for Chinese naval vessels. Such activities have been taking place since at least 2016, including in Thailand, according to a report by the Center for Advanced Defense Studies.

While China’s overriding interests are clear, though, the notion that Beijing is intentionally trying to snare weaker states in debt traps as a means to military ends is harder to prove. It’s not hard to understand why China’s rivals are concerned about this tactic. There’s a long history of countries mixing commercial and military power for strategic gain, after all. China should know: This is how the U.K. ended up with Hong Kong. And the logic behind such concerns is fairly straightforward. As the Pentagon put it in its latest report on Chinese military power: “Some countries participating in BRI could develop economic dependencies on China, often from over-relying on Chinese capital. Some BRI investments could create potential military advantages for China, should China require access to selected foreign ports to pre-position the necessary logistics support to sustain naval deployments in waters as distant as the Indian Ocean, Mediterranean Sea, and Atlantic Ocean to protect its growing interests.”

Yet, such a coercive strategy would carry myriad risks that may needlessly undermine China’s long-term strategic aims. China needs friends, and it’s not yet powerful enough to win allies simply by dictating terms – particularly in a crowded region where multiple other powers hold considerable sway. It’s not 19th-century Britain.

The Anatomy of a Debt Trap: Sri Lanka

The case of how Sri Lanka ended up ceding control – and an unclear degree of sovereignty – over 15,000 acres of land around a deepwater port to a Chinese state-owned firm for 99 years is held up as a cautionary tale about BRI’s harder edges and the attendant risks for Beijing.

No one else would touch the deepwater port Sri Lanka’s former president, Mahinda Rajapaksa, wanted to build in his hometown of Hambantota on the island nation’s southeastern coast. There was some logic to the project. Sri Lanka sits astride the world’s busiest shipping lane; a steady stream of traffic heading between East Asia, the Middle East and Europe is visible from on shore. And Sri Lanka has long been keen to emulate Singapore’s success as a shipping and logistics hub. But the country’s primary existing deepwater port just 150 miles (240 kilometers) away in the capital, Colombo, had slack capacity and was set to undergo its own China-funded expansion, so outside investors saw the Hambantota port as an unviable vanity project by a strongman who had turned the government into a family enterprise.

Beijing had grown cozy with Colombo throughout the first decade of the 2000s, thanks in large part to security assistance that had helped bring about the end of Sri Lanka’s 26-year civil war against the Tamil Tigers and other militant groups – a war that had isolated Rajapaksa’s government from the West over alleged human rights abuses against civilians caught in the crossfire. In 2007, Beijing offered to finance the port with some $307 million provided by its Export-Import Bank at around market rates, but with some conditions. According to leaked diplomatic cables, for example, Beijing demanded that the state-owned China Harbor Engineering Co. be the one to build the port and be allowed to import thousands of Chinese laborers to do it. According to The New York Times, Sri Lankan officials say China also demanded an intel-sharing arrangement regarding activities around the port. An international airport and a cricket stadium were to be built as well, for good measure. The port was completed by 2010 but quickly proved a commercial disaster, berthing just a few dozen ships in its first three years. (The airport lost its only daily commercial flight earlier this year.) In 2012, to make the port more attractive to business, Rajapaksa turned to the Chinese again to finance a $757 million expansion. China agreed, but at much steeper terms, with all outstanding loans to be repaid at a fixed rate of 6.3 percent.

In the 2015 elections, Sri Lanka’s growing dependence on China became a campaign issue. Despite China Harbor reportedly funneling millions of dollars into his campaign to protect its investments, Rajapaksa was swept from office. The new government promptly canceled an order to purchase Chinese fighter jets and launched a slew of investigations into China-fueled corruption. But it inherited the same debts – including, to China, an amount equivalent to more than 8 percent of the country’s gross domestic product – and couldn’t find enough support from other outside sources, forcing it to turn to China almost immediately for another $1 billion to make ends meet. In mid-2017, to wipe its share of the project’s debts from the books, Sri Lanka agreed to a debt-for-equity swap that gave another Chinese state-owned firm, China Merchants Port, 85 percent ownership over the port, plus another 15,000 acres of adjacent land for an industrial zone, for the next century. The Chinese flag was raised over the port amid mass protests in December.

The final agreement includes a stipulation barring foreign navies from accessing the port without Colombo’s permission, and the Sri Lankan government has repeatedly insisted this will be enforced. But it’s not hard to imagine Beijing dangling any number of sticks and carrots to push for naval access. Nor is it hard to imagine Beijing trying to exploit the murky state of sovereignty over the port to force the issue. In 2014, for example, during a state visit by Japanese Prime Minister Shinzo Abe, China put the Rajapaksa government in a diplomatic fix when it quietly docked a nuclear submarine at a part of the Colombo port considered a “Chinese enclave” – rather than a part controlled by the Sri Lankan military that normally hosts visiting warships – reportedly in violation of bilateral protocol. (The new Sri Lankan government managed to turn down a Chinese request for a submarine visit last year without incident.) Yet, there’s only so much military value China can extract from Hambantota without Colombo’s explicit consent. Moreover, in July, Colombo announced that it would move its southern naval headquarters to the Hambantota port, partially as a show of Sri Lankan sovereignty. Meanwhile, India is reportedly in advanced talks to buy a majority stake in the empty airport at Hambantota – a move that would greatly diminish the port’s naval value for China. If a clandestine naval base was ever Beijing’s goal in Hambantota, it appears to have been one that was rather easy to thwart.

There’s also nothing to suggest that China is on the road to securing a green light from Colombo to transform the port into a full-fledged base anytime soon. To push Sri Lanka too far on the point at present would risk making it politically infeasible for Colombo to concede. It would also sow further wariness in other regional capitals over taking on Chinese debt. Hambantota isn’t important enough to jeopardize the whole of BRI. China is playing a long game, though. Its bet on Rajapaksa may have backfired, but governments come and go, and its port holdings in Sri Lanka give it untold influence that will outlast many more. China will have ample opportunities to try to cement a military foothold the old-fashioned way: by coaxing Sri Lanka into more lasting strategic alignment.


Ultimately, the Sri Lanka case tells us several things. One, Chinese leverage from Chinese credit is real. It’s notable that Sri Lanka’s new government took the course that it did. In theory, Colombo could have just defaulted on what it owed to China and moved on. The downside of being a creditor nation is that, if you really need the money back – or if you really need the project you’re financing to be completed and (in China’s case) serve fundamental strategic imperatives – the debtor holds quite a bit of leverage in its own right. But Colombo’s fear of the reputational costs of default, its lack of alternative sources of outside lending, its hope that BRI will eventually pay off for the Sri Lankan economy, and its unwillingness to burn bridges with China suggest that Beijing may be able to reap at least some concessions of strategic value in similar situations elsewhere. But such tactics inevitably have a short shelf life. As China gains a reputation for predatory lending (irrespective of how much it deserves this reputation), and as countries balk increasingly at Chinese funding for dubious projects, Beijing will be left competing for economic influence via investments where it’s not the only one bidding.

Two, political opposition may always be an obstacle for China in BRI countries, particularly with military projects that inflame nationalist concerns about sovereignty. China is struggling to navigate similar political currents in Malaysia, Myanmar, Pakistan and Vietnam, among others. Of course, political pitfalls are inherent to any attempt to establish a military foothold overseas and not automatically insurmountable. Just ask the U.S., which has managed to hold onto bases across the Middle East despite withering and often violent opposition. The U.S. military has even been booted from treaty allies like the Philippines. On Sept. 9, a party in Okinawa opposed to the critical U.S. bases on the island swept local elections. Still, Chinese predatory lending, bribery, reliance on Chinese labor and so forth are probably making Beijing’s political problems particularly vexing. And anti-ethnic Chinese sentiments in a number of BRI states will further complicate things. The cases of Sri Lanka and Malaysia, in particular, cast doubt on China’s ability to win long-term allies in other deeply divided countries like the Maldives, where Beijing is likewise seen as putting its thumb on the scale for one particular party.

Three, to withstand the vagaries of local politics and make sense from one government to the next, a lasting partnership must be anchored in mutual strategic interest. Short-term political interest compelled Manila to expel the U.S. Navy from Subic Bay in 1991. But the two countries’ strategic alignment never really weakened, and within two decades, Manila and Washington were inking a new deal to provide U.S. forces rotational access to five bases. China’s success or failure in Sri Lanka and other BRI states was always going to hinge on its ability to persuade partner states that bringing in the Chinese navy would bring with it tangible and lasting security benefits that work directly in their strategic interest. Money can buy only short-term influence, and debt only short-term leverage.

Take China’s deepening military ties with Pakistan, for example. The future of China-Pakistan relations is by no means smooth sailing, and the debts from its massive BRI project, the China-Pakistan Economic Corridor, have put the new government in Islamabad in a bind. Accordingly, on Sept. 10, the Financial Times reported that Islamabad is seeking to renegotiate the terms of the project. But the bilateral security relationship is rooted in ample common interest – from containing upland militants to counterbalancing against India. As a result, China, which has already been sending warships to the deepwater port it’s building at Gwadar, appears primed to secure the right to build a dedicated naval and air base farther to the west in Jiwani.

In some ways, the prospects for strategic partnerships appear best in countries farthest from Chinese shores – away from the territorial disputes, historical animosities and modern sources of potential conflict that continue to bedevil China’s relations with its closest neighbors. In the same way, U.S. remoteness can at once be a strategic weakness (since countries doubt U.S. willingness to intervene on their behalf) and a strength (since countries have little to fear of a direct U.S. attack).

But the problem for China is that, in pushing out, it’s encroaching on other powers’ traditional spheres of influence, and it’s not yet powerful enough to do so without spurring rival states into action. India won’t let China use BRI to tie Sri Lanka, the Maldives, Bangladesh and so forth without a fight. The same goes for Australia and island nations across the South Pacific, and for Japan and the Philippines, Thailand and Malaysia. Indeed, Japan is deepening involvement as far as Sri Lanka as well; for example, a Japanese warship made a quick visit to Hambantota in April, and the country’s defense minister toured the port last month. In fact, Japan is reportedly coordinating with India and Singapore to develop the deepwater port at Trincomalee farther north. Where China makes a play, other emerging powers are making counters (while learning to coordinate with one another, and the U.S., in the process).

In other words, China is facing stormy seas ahead. To win over the strategically located allies whose ports it needs, China has to prove capable of delivering the security benefits everyone else won’t or can’t – it has to give them ample reason to take on the political risks at home, shrug off pressure from China’s rivals, stop hedging their bets and throw their lot in with Beijing. But China cannot easily prove this capability until it has access to their ports. The U.S. network of friends and friendly ports came about through epochal shifts in the geopolitical landscape that left it as the sole guarantor of security on the global seas. Debt traps alone will do little to help China skip to the front of the line.

Who Really Creates Value in an Economy?

Mariana Mazzucato  

LONDON – After the 2008 global financial crisis, a consensus emerged that the public sector had a responsibility to intervene to bail out systemically important banks and stimulate economic growth. But that consensus proved short-lived, and soon the public sector’s economic interventions came to be viewed as the main cause of the crisis, and thus needed to be reversed.

This turned out to be a grave mistake.

In Europe, in particular, governments were lambasted for their high debts, even though private debt, not public borrowing, caused the collapse. Many were instructed to introduce austerity, rather than to stimulate growth with counter-cyclical policies. Meanwhile, the state was expected to pursue financial-sector reforms, which, together with a revival of investment and industry, were supposed to restore competitiveness.

But too little financial reform actually took place, and in many countries, industry still has not gotten back on its feet. While profits have bounced back in many sectors, investment remains weak, owing to a combination of cash hoarding and increasing financialization, with share buybacks – to boost stock prices and hence stock options – also at record highs.

The reason is simple: the much-maligned state was permitted to pursue only timid policy responses. This failure reflects the extent to which policy continues to be informed by ideology – specifically, neoliberalism, which advocates a minimal role for the state in the economy, and its academic cousin, “public choice” theory, which emphasizes governments’ shortcomings – rather than historical experience.

Growth requires a well-functioning financial sector, in which long-term investments are rewarded over short-term plays. Yet, in Europe, a financial-transaction tax was introduced only in 2016, and so-called patient finance remains inadequate almost everywhere. As a result, the money that is injected into the economy through, say, monetary easing ends up back in the banks.

The predominance of short-term thinking reflects fundamental misunderstandings about the state’s proper economic role. Contrary to the post-crisis consensus, active strategic public-sector investment is critical to growth. That is why all the great technological revolutions – whether in medicine, computers, or energy – were made possible by the state acting as an investor of first resort.

Yet we continue to romanticize private actors in innovative industries, ignoring their dependence on the products of public investment. Elon Musk, for example, has not only received over $5 billion in subsidies from the US government; his companies, SpaceX and Tesla, have been built on the work of NASA and the Department of Energy, respectively.

The only way to revive our economies fully requires the public sector to reprise its pivotal role as a strategic, long-term, and mission-oriented investor. To that end, it is vital to debunk flawed narratives about how value and wealth are created.

The popular assumption is that the state facilitates wealth creation (and redistributes what is created), but does not actually create wealth. Business leaders, by contrast, are considered to be productive economic actors – a notion used by some to justify rising inequality. Because businesses’ (often risky) activities create wealth – and thus jobs – their leaders deserve higher incomes. Such assumptions also result in the wrong use of patents, which in recent decades have been blocking rather than incentivizing innovation, as patent-friendly courts have increasingly allowed them to be used too widely, privatizing research tools rather than just the downstream outcomes.

If these assumptions were true, tax incentives would spur an increase in business investment. Instead, such incentives – such as the US corporate-tax cuts enacted in December 2017 – reduce government revenues, on balance, and help to fuel record-high profits for companies, while producing little private investment.

This should not be shocking. In 2011, the businessman Warren Buffett pointed out that capital gains taxes do not stop investors from making investments, nor do they undermine job creation. “A net of nearly 40 million jobs were added between 1980 and 2000,” he noted. “You know what’s happened since then: lower tax rates and far lower job creation.”

These experiences clash with the beliefs forged by the so-called Marginal Revolution in economic thought, when the classical labor theory of value was replaced by the modern, subjective value theory of market prices. In short, we assume that, as long as an organization or activity fetches a price, it is generating value.

This reinforces the inequality-normalizing notion that those who earn a lot must be creating a lot of value. It is why Goldman Sachs CEO Lloyd Blankfein had the audacity to declare in 2009, just a year after the crisis to which his own bank contributed, that his employees were among “the most productive in the world.” And it is also why pharmaceutical companies get away with using “value-based pricing” to justify astronomical drug-price hikes, even when the US government spends more than $32 billion annually on the high-risk links of the innovation chain that results in those drugs.

When value is determined not by specific metrics, but rather by the market mechanism of supply and demand, value becomes simply “in the eye of the beholder” and rents (unearned income) become confused with profits (earned income); inequality rises; and investment in the real economy falls. And when flawed ideological stances about how value is created in an economy shape policymaking, the result is measures that inadvertently reward short-termism and undermine innovation.1

A decade after the crisis, the need to address enduring economic weaknesses remains. That means, first and foremost, admitting that value is determined collectively, by business, workers, strategic public institutions, and civil-society organizations. The way these various actors interact determines not just the rate of economic growth, but also whether growth is innovation-led, inclusive, and sustainable. It is only by recognizing that policy must be as much about actively shaping and co-creating markets as it is about fixing them when things go wrong that we may bring this crisis to an end.

Mariana Mazzucato, Professor in the Economics of Innovation and Public Value and Director of the Institute for Innovation and Public Purpose at University College London, is the author of The Value of Everything: Making and Taking in the Global Economy.