MBS and the Core

Doug Nolan

The Dow (DJIA) traded as low as 24,122 in late-Monday afternoon trading. By Friday's open, the Dow had rallied 1,457 points, or 6.0%, to 25,579. Relatively speaking, the Dow was a tame kitten. From Monday's intraday lows, the Nasdaq100 rallied as much at 7.8%. The Semiconductors won this week's Wild Animal competition, rallying 12.7% (week's lows to highs). At 11.9%, the Biotechs were a close second. The Homebuilders (XHB) rallied as much as 11.3% before ending the week with a gain of 7.3%.

A couple obvious questions come to mind: Bear market rally or just another "buy the dip, don't be one" opportunity for a market again ready to scale new heights? Is President Trump now ready to strike a trade deal with China - or was he just goosing the markets ahead of the midterms?

Let's start with the markets. They certainly had the likeness of a classic "rip your face off" bear market rally. The Goldman Sachs Most Short index surged 9.0% off Monday lows. For the week, this index rose 6.1%, showing off a 2.5 beta versus the S&P500's return (6.1%/2.4%). In the semiconductor space, heavily shorted On Semiconductor, NXP Semiconductor, AMD and Micron Technology gained 23.9%, 18.5%, 14.8% and 13.9%, respectively. A long list of heavily shorted retail stocks gained double-digits this week, as the XRT Retail Index surged 4.3% for the week.

There were a number of heavily shorted biotech stocks that posted 20% plus gains for the week. A bunch of regional banks rose between five and nine percent. And I'd be remiss for not mentioning (everyone's favorite short) Tesla. In just 10 sessions, Tesla rallied (38%) from a low of $253 to Friday's $346 close.

It's certainly worth noting that short squeeze dynamics were not limited to U.S. equities. Let's start at the epicenter of global crisis dynamics, the big banks. The Hang Seng (Chinese) Financial index rallied as much as 8.3% off the week's lows, to end the week up 6.3%. Japan's TOPIX Bank index rallied 5.4% for a weekly gain of 3.9%. Italian banks rose 6.1% this week. European banks (STOXX600) rallied 7.4% off Monday lows, to post a weekly rise of 5.4%. Deutsche Bank recovered almost 11% to finish the week up 8.8%.

The Wildness definitely included the emerging markets. The EEM ETF rallied as much as 10% off of Monday's lows to end the week up 5.6%. Major stock indices were up 7.0% in Argentina, 6.8% in South Africa, 5.0% in India, 4.4% in Taiwan and 4.0% in Turkey. Brazil's Ibovespa index gained 3.4% this week, increasing gains from June trading lows to 25%. Curiously, the Brazilian real declined 1.6% this week. Overall for the week, key EM currencies were caught up in the global short squeeze. The Argentine peso jumped 3.8%, the Turkish lira 3.0%, the South African rand 2.1%, the South Korean won 1.8%, the Indonesian rupiah 1.8%, and the Indian rupee 1.4%. Down 3.3%, the Mexican peso was the glaring exception.

Ten-year Treasury yields traded as low as 3.06% in nervous Monday trading. And while yields ended the week significantly higher, it's worth noting that the October 5th closing high of 3.23% was only 17 bps higher than Monday's "risk off" low yield. That's a meager pullback in yields considering the drubbing global equities were taking.

There's a number of possible explanations for the recent stickiness of Treasury yields, including: 1) Inflationary pressures have gained more momentum than in the recent past. 2) Global de-risking/deleveraging is impacting global market liquidity more generally, with effects even in safe-haven sovereign debt markets. 3) U.S. fixed-income markets have succumbed to deleveraging and resulting waning liquidity. 4) Markets now don't expect the Fed to respond to "risk off" dynamics as early or aggressively as in the past. 5) The U.S. economy maintains significant momentum, especially in terms of tight labor markets.

Ten-year Treasury yields jumped eight bps Friday on the back of stronger-than-expect payrolls data. At 3.21%, yields are only two bps below the seven-year highs posted a month ago. October's 250,000 job gains were a full 50,000 above expectations, as tight labor markets turn tighter by the day. After 10 months, y-t-d job gains of 2,125,000 are running 18% above comparable 2017. October's 32,000 added manufacturing jobs were double expectations, with 2018's 227,000 added manufacturing jobs 64% above comparable 2017. Last month's 3.7% unemployment rate compares to October 2017's 4.1%. October's 3.1% y-o-y gain in Average Hourly Earnings was the strongest since April 2009 - and compares to the year ago 2.3%. If I were a bond, I'd be on edge.

November 2 - Bloomberg (Christopher Maloney): "The bloodbath last month in the mortgage-bond market points to what the future may be like without Federal Reserve hand holding. Investors are now wondering if anyone will step in to stop the bleeding. Returns on mortgage-backed securities in October lagged Treasuries by 37 bps, the most since November 2016… Last month's weakness coincided with the Fed ending its mortgage purchases as it winds down the $1.7 trillion MBS portfolio it amassed since the financial crisis to support the market… In a situation rarely seen over the last four decades, there isn't going to be a government entity -- which before the financial crisis included Fannie Mae and Freddie Mac -- at hand to provide liquidity for mortgage-backed securities…"

Benchmark MBS yields jumped 10 bps Friday to 4.06%, the high going back to April 2011. Yields surged 16 bps this week and are now up 108 bps y-t-d.

My thesis holds that the global Bubble has been pierced at the "Periphery." After erupting at the "Periphery," de-risking, deleveraging and Contagion have been gravitating toward the "Core." Sinking MBS prices (spiking yields) confirm my view that "Periphery to Core Crisis Dynamics" have now attained important momentum at the "Core."

My assumption has been that a most-prolonged period of ultra-low rates and QE liquidity backstops has heavily incentivized leveraged speculation around the world. Globally, levered "carry trade" strategies (borrow cheap in one currency to purchase higher-yielding securities elsewhere) have proliferated. It's worth noting that the NY Fed's holdings on behalf of foreign (chiefly central bank) owners of Treasuries/Agencies dropped $19.8bn last week (to a 3-month low $3.414 TN), the biggest decline since April. I see this as likely evidence of speculative de-leveraging, capital flight, and foreign central bank purchases (dollar sales) to support their currencies. For years now, speculative international flows into EM were at least partially recycled into U.S. markets (including central bank purchases of Treasuries and Agencies). It would appear these flows have slowed significantly - and perhaps are at risk of reversing as global deleveraging gains further momentum.

I believe huge speculative leverage has accumulated here at home as well. I have posited that higher-yielding corporate Credit has been as bastion of speculative excess. And going all the way back to the early-nineties, the mortgage arena has been treasured by a flourishing leveraged speculating community. The MBS marketplace has generally been highly liquid, with securities easily financed in the booming "repurchase agreement" ("repo") market.

The above Bloomberg article noted a "situation rarely seen over the last four decades." The market is questioning the source of market liquidity going forward. This has become a pressing issue now that the Fed has begun liquidating its MBS portfolio. The predicament is compounded by the GSE's unsound financial position, one that limits their capacity to provide a powerful liquidity backstop as they did throughout the nineties and for much of the mortgage finance Bubble period (until their growth was impeded by revelations of accounting fraud).

If it is correct that de-risking/deleveraging dynamics have reached the "Core," the MBS marketplace faces challenges. In particular, as the hedge funds suffer mounting losses elsewhere (i.e. stocks, global markets, corporate Credit…), they will turn more averse to risk generally, including a vulnerable MBS marketplace. And as the speculator community moves to de-risk in MBS, it is not obvious who will step up to buy. Alternatively, as they hedge interest-rate risk by shorting Treasuries, this places additional selling pressure on a Treasuries marketplace already facing massive issuance and formidable Fed liquidations.

Mortgage-backed securities are a problematic instrument. When yields drop, borrowers refinance or are more likely to purchase new homes. MBS owners get their money back much sooner than they would prefer (with lower reinvestment yields) When yields rise, MBS duration increases as borrowers hold their attractive mortgages longer.

Over recent decades, this fundamental MBS weakness was more than offset by two critical factors. One, the GSE's eagerness to purchase securities, especially during deleveraging/crisis backdrops. Second, the Fed's willingness to aggressively cut interest-rates in the event of "risk off" marketplace liquidity issues (or, better yet, to buy $1.8 TN of MBS). With rates and yields currently rising, MBS vulnerability is obvious. Meanwhile, traditional offsetting liquidity advantages (GSEs and Fed) are anything but readily apparent going forward.

After the mortgage finance Bubble collapse, it was only natural to anticipate a significant widening of risk premiums throughout the mortgage complex. I expected a fundamental repricing of mortgage Credit, but it was not to be. The Fed slashed short-term borrowing costs to zero and expanded its balance sheet to $4.5 TN, including the purchase of $1.8 TN of mortgage-backed securities. Moreover, after a period of shrinkage, the GSEs again began expanding their mortgage holdings. Between expanding Fed and GSE holdings and the relatively weak household demand for mortgage borrowings, mortgage borrowing costs collapsed.

MBS yields averaged 7.75% during the nineties, and then sank to 6.00% during 2000 through 2007. Well, benchmark MBS yields averaged an extraordinary 3.25% between 2009 and 2017. This pricing anomaly might have finally run its course, with major ramifications for the mortgage marketplace, overall securities market liquidity and the general economy. For a very long time, the MBS marketplace acted as both a key source of marketplace liquidity and a centerpiece of government (Treasury and Federal Reserve) policy activism. The Fed's post-crash efforts to collapse borrowing costs both significantly reduced household mortgage payments, while enriching the holders of mortgage securities. But now losses for levered holders of MBS are mounting, including for the Fed and the barely capitalized GSEs. Payback Time.

I don't want to dismiss the importance of the unfolding U.S. and China trade war - or possible successful negotiations. A trade agreement would be market positive. The markets were buoyed this week by constructive comments from President Trump and Chinese officials. Commentators were understandably skeptical of the timing just days before the midterms. Yet it doesn't take highly speculative "oversold" markets much to be incited into a decent short squeeze.

At the same time, I don't believe the U.S./China trade spat has been the major force behind global de-risking/deleveraging. Stated differently, this dispute worsened the situation but was not the catalyst behind the bursting of the global Bubble. Indeed, from a de-risking/deleveraging perspective, Friday's yield jump was ominous. Fixed-income investors and speculators have no doubt been hoping that "risk off" would provide some relief on the market yield front. With an equities short squeeze and strong payrolls data, the pressure just became too intense.

MBS yields have broken out to the upside, with corporate and Treasury yields close behind. Equity market players are certainly hoping a trade deal is in the works. Fixed-income players not so much. And it is within fixed-income on a global basis that problematic leverage lurks. Leveraged "risk parity" strategies saw some relief from this week's equities rally, but they must look at rising market yields with increasing trepidation.

We're now only days from the midterms. It's an especially difficult event to handicap from a market standpoint. Red wave or blue wave. I don't recall midterm elections where the outcome had the potential to be so market moving. Blue wave - big. Red wave - big. Making things all the more interesting, there has been major market instability heading into the elections. This ensures there have been major shorting and hedging efforts - to hedge/speculate both on the markets and midterm outcomes.

I'll assume large quantities of put options and derivative protection have been purchased. In the event of a red wave, there is ample firepower for an unwind of hedges and short covering to spark a rally. In the event of a blue wave, a market downdraft would see aggressive hedge-related selling by players caught on the wrong side of derivative protection previously sold. The stock market response to the anticipated blue House and red Senate split decision is not clear at all. But maybe equities have become a diversion. In a week where the focus was on short squeezes and tantalizing equities rallies, perhaps the more decisive development was in surging MBS and corporate yields.

‘Winners Take All’: Can Elites Really Change the World for the Better?

Winner Take All Banner

Peter Vanham, U.S. media lead for the World Economic Forum, critiques the condemnation leveled at some prominent mainstream economic ideas on how to overcome income inequality — and their supporters — in this review of the new book, Winners Take All: The Elite Charade of Changing the World, by author and former New York Times columnist Anand Giridharadas.

Is the World Economic Forum, the organization I work for, part of an “elite charade”? Is its real impact to do well for itself and its members, rather than “to improve the state of the world” as it claims? It is, with a bit of a stretch, the premise of a new book by Anand Giridharadas, Winners Take All: The Elite Charade of Changing the World. He asserts that the global elite do more harm than good, even if they think otherwise.

He isn’t the only one to make the claim. Nobel Prize winning economist Joseph Stiglitz, in a New York Times review of his book agreed there is “an elite that, rather than pushing for systemic change, only reinforces our lopsided economic reality — all while hobnobbing on the conference circuit.” Are they making a fair assessment? Before jumping to conclusions, let’s review their analysis.

In his book, Giridharadas starts with a somber observation. The world our youth grows up in, he writes, is one where the appeal of working for McKinsey or Goldman Sachs is greater than that of working for an NGO or government – even when your goal in life is to change the world. Their parents would stand on the barricades against war or capitalism; the new generation is more compliant.

As an example, he points to Hilary Cohen, a recent graduate from Georgetown University, who in college did develop a sense of wanting to do good in her life and career. But if in the past, a socially involved person like her would most likely end up joining the ranks of government, a religious organization, or an NGO, she instead chose to work for McKinsey.


Disappointment for young people like Cohen is often quick to follow, the author thinks. As soon as people enter such companies, they realize that the majority of the projects there are not about doing good, but about optimizing the profits of the company they consult. But from early on in their career, they’re molded by companies who form the heart of the current capitalist system.

I can relate to this first part of the book. I, too, joined the ranks of a consulting firm, Bain & Company, lured in part by the idea that some of its consultants wound up working for Bridgespan, a pro bono consulting firm for NGOs. Of course, I ended up working for banks and private equity firms instead. So far for the idealism, that’s true. But is it really a bad thing, to work for a company rather than in government?

The real problem with this situation, Giridharadas writes, is not the over-promising by companies to a younger generation of do-gooders. It is the truly held belief by these companies that all of the world’s problems can be solved through “corporate social responsibility” and philanthropy, that taking on societal problems in an entrepreneurial way can be a “win-win” for the entrepreneurs and for the people they want to help.

But this ideology of the “harmony of human interests” doesn’t check out, he writes. “It radically overestimates who will benefit from change,” Greg Ferenstein, a former reporter of TechCrunch, tells him. In reality, suffering cannot be innovated away. In a market economy, some people will be left behind. “Win-lose” is a more probable outcome, if a benign government doesn’t correct. There is profit to be made from misery, but it won’t fundamentally end misery.

What compounds the problem, writes Giridharadas, is that the “optimism” ideology is strongest in the new epicenter of the global economy: Silicon Valley. Venture capitalists and entrepreneurs there are, at the same time, the most ambitious and the least cognizant of their adverse impact. They want to “own the universe” but act like they’re underdogs when it comes to their true economic impact.

Yet it is precisely the new platform economy they’ve been building which does most to upend the once dominant middle class. Why? Because “the Ubers and Airbnbs and Facebooks and Googles of the world are at once radically democratic and dangerously oligarchic,” according to Joshua Cooper Ramo, a journalist and authority on networks Giridharadas talked to.

Indeed, these platform monopolists allow everyone to be part of their platform but reap the majority of benefits for themselves, and make major decisions without input from those it will affect. In this world, Giridharadas writes, users are like medieval peasants and the tech giants like Leviathan princes. They turn back the clock centuries rather than to bring us to a brave new world.

Sadly, we are not hearing too much from people who make these sorts of analyses. According to Giridharadas, that is because intellectuals and critics lost out to more agreeable “thought leaders.” These TED-styled thinkers “zoom in,” focusing on individual opportunities in a way that is compatible with a win-win ideology. They talk about possibilities, about self-improvement.

The critics who do “zoom out” to look at systemic issues, on the other hand, fell out of favor with the business elites. They dare speak of inequality, its causes and painful solutions, but are told to tone it down. They speak of win-lose, a faux pas in the eyes of “philanthrocapitalists.” Several people Giridharadas spoke to, including a TED speaker and foundation president, were in that situation.

The result of all this, writes Giridharadas, is “the-Trying-to-Solve-the-Problem-with-the-Tools-That-Caused-It” issue. Consulting firms like McKinsey, philanthropists like Bill Gates, organizations like the World Economic Forum: they may solve individual problems. But the price to pay is that societal problems are “recast in the light of a winner’s gaze.” The macro-effect is that nothing really changes.

A similar problem exists in the business world at large, Giridharadas believes. Even Michael Porter, the guru of modern enterprise theory, now has second thoughts on the effects of the doctrine he helped spread. “Somehow in being efficient, clever and productive, people thought they had the license to stop thinking about the well-being of everybody else in the system,” he said.

But if some thinkers are starting to see the light, it is not a trend. It leads to one of the more powerful paragraphs of the book: You can inspire the rich to do more good, it reads, but never tell them to do less harm. You can inspire them to give back, but not to take less. You can inspire them to join the solution, but never accuse them of being part of the problem.

So where did that attitude come from? And how can we change it? The origins, Giridharadas believes, are to be found in America’s Gilded Age. Early monopolists and philanthropists like Andrew Carnegie initiated “the idea that after-the-fact benevolence justifies anything-goes capitalism.” The idea, however faulty, persists until today.

What that idea fails to capture, he writes, is that many people aren’t left behind because of their inability to adapt to technological changes – as we like to believe – but because of their ancestry, color or disability. And if that is true, if the playing field on which wealth is accumulated is not level and fair, should individuals be allowed to accumulate wealth on this scale in the first place?

No, the author says. Yet philanthropy, a “doing well by doing good” attitude, and the idea that the private sector can solve societal ills, are only gaining more traction. Initiatives like (the now defunct) Clinton Global Initiative, Bloomberg’s Global Business Forum — and indeed, the World Economic Forum — tell commercial enterprises it is good and right to do good and build their brands.

Doing so, these private initiatives for special public purposes “crowd out the public sector, further reducing both its legitimacy and its efficacy, and replace civic goals with narrower concerns about efficiency and markets,” Aaron Horvath and Walter Powell, two Stanford sociologists, tell Giridharadas. It is the core of the problem. It stands in the way of a more profound solution.

Certainly, it is good to “lure the private sector into the public problem-solving arena.” But the outcome should never be that the private sector takes over control, whether directly or indirectly. Their responsibility is to their shareholders alone, while that of government is to the entire public. Such private interests can never really do good for society at large, Giridharadas believes.

So, where do we go from here? The solution, Giridharadas writes, is “to return to politics as the place we go to shape the world.” Don’t try to change the world on your own, Chiara Cordelli, a philosopher, advises. “Support institutions that can, in the name of everyone, secure certain conditions for a more decent life.”

An Air-tight Case?

Is it even possible to disagree with that analysis? I would say that Giridharadas captures the mood of the moment well, at least in the United States. There, real median wages haven’t risen in almost 40 years, and capitalism has become an unchecked and all-encompassing force. Giridharadas eloquently exposes this “charade,” as he calls it, well.

But if there is one criticism to make, it is that he brushes the situation elsewhere in the world with the same brush. In only one chapter, he extensively quotes some leaders from other parts of the world than the U.S., like Argentina, the U.K. and Italy. But he fails to notice — or mention — that the society built in places like Germany or Scandinavia is completely different from that in the U.S.

The premises on which, for example, the World Economic Forum was initially built on, had much more to do with the German post-war model of Mitbestimmung, or co-decision between employees, management and shareholders, than the pre-eminence of shareholders alone. That kind of model is precisely one Giridharadas now suggests is a possible solution.

He’s wrong also to state that in international institutions and business conferences, “inequality” cannot be spoken of, because doing so would reveal the system issues with the current market economy, and its win-lose reality. The World Bank regularly publishes data and reports on inequality. And income inequality has featured prominently in my organization’s Global Risks Report for years.

What is more, the World Economic Forum a few years ago launched its flagship Inclusive Development Index. According to the report’s author, Richard Samans, it did so precisely because “GDP growth cannot in and of itself be relied upon to generate inclusive socioeconomic progress.” He therefore introduced new ways to measure the wealth of a nation, focusing on … inequality.

All of that is not to say that Giridharadas doesn’t make a compelling point. There are plenty of examples I could think of that corroborate rather than disprove his analysis. That is perhaps also why Professor Stiglitz, although having been part of this “MarketWorld” for decades, now also speaks out in favor of Giridharadas’ point of view.

But in the end, Giridharadas takes a few too many shortcuts. The “MarketWorld” he speaks of is not as black and white — not as much of a “charade” if you will — as he portrays it to be. His book is an eye-opening read, and one that much deserves to be read by the elites it calls out. But to be most powerful, it should have spent more time focusing on policy responses than on laying easy blames.

Superstar companies also feel the threat of disruption

Turnover at the top means market competition may work better than we thought

Rana Foroohar

A couple of years ago, I interviewed an executive at a major US technology platform, who told me something that made me scoff.

I was pressing him on the fact that, in the “superstar” economy of today, in which a small number of companies, sectors and cities take more and more of the overall economic pie than they did 20 years ago, businesses like his were winnowing out competition, and thus decreasing innovation. He replied that, in fact, his company — large and powerful though it was — felt it was always in danger of being disrupted. At the time, I wrote the remark off as self-serving cognitive bias.

But an interesting piece of new research on the superstar economy has made me question that first reaction. According to a McKinsey Global Institute report, which will be released on Thursday, there is much more mobility in the winner-take-all world than we might have thought.

The report analyses nearly 6,000 of the world’s largest public and private companies, each with annual revenues greater than $1bn and which together make up 65 per cent of global corporate pre-tax earnings.

Among this group, the top 10 per cent (the “superstar” companies) take 80 per cent of economic profit — defined as a company’s invested capital multiplied by its returns above the cost of that capital. The top 1 per cent alone takes 36 per cent of the pie.

We know who some of the top 10 per cent are — they include the high-margin Faang companies (Facebook, Apple, Amazon, Netflix and Google) as well as others who have been able to exploit the value of intangible assets such as software, data, patents, and brands. We also know that the network effect allows such companies to ringfence markets quickly and at scale, giving them big competitive advantages.

But what the MGI report shows is that there is much more churn among that top 10 per cent than we might have expected. In fact, the report shows that about half of the top 10 per cent of companies fell out of that top tier every business cycle — and that 40 per cent of those dropouts fell all the way down to the bottom 10 per cent.

Meanwhile, a scrappy few were able to climb all the way from the bottom decile to the top during the same period. “Firms at the very top of the scale are capturing a lot of profit,” says MGI director James Manyika, who led the research. “But there’s also a fair bit of competition at the top.”

The diversity of both the top 10 per cent and 1 per cent is far greater today than it was 20 years ago. These companies include not just the usual suspects from Silicon Valley but also those from many other sectors (a number of global banks and manufacturing companies are in the top tier) and geographies (there are plenty of western multinationals on the list, but also many fast-growing Chinese businesses).

Why is it that companies can rise so fast, and fall so much further, faster, than they did a couple of decades ago?

Part of the answer clearly has to do with globalisation — when an idea hits, the potential market for it is much greater than in the past, and the access to global capital to scale up that idea is greater, too.

It is worth thinking about this point at a time when the value of globalisation is being challenged. If profitability is predicated on being able to quickly and easily access global markets, reversing those forces will surely change the picture dramatically.

But the churn in the superstar economy also reflects the fact that certain individual companies, no matter their sector, are able to leverage the tools of the new economy — networks, data, and ideas — and others are not. One of the more worrisome details revealed in the report is that the bottom 10 per cent of businesses is destroying as much value as the top 10 per cent is creating.

While there are still many questions to be asked and answered about why this might be, one point seems clear. The losers tend to own more things — tangible assets like factories and equipment — whereas the winners are concerned with leveraging intangible assets.

To understand this idea better, take a look at The Seventh Sense: Power, Fortune, and Survival in the Age of Networks, by Joshua Cooper Ramo, the co-director of consultancy Kissinger Associates. The book is a particularly readable parsing of the economic, political and social effects of this shift.

The idea that there is turnover in the superstar economy is important. It means that forces of economic competition may be working better than we have assumed. And yet, the churn at a company and sector level is not being spread equally within countries. In fact, we are seeing more geographic bifurcation than ever before. In the US, for example, just 10 per cent of all counties take 90 per cent of the GDP.

The result is a handful of cities that are like “luxury products”, in the words of former mayor of New York City Michael Bloomberg. It also produces a growing crop of left-behind cities that could become like Detroit or Minneapolis — places where forgotten populations and polarised politics are the norm.

If we cannot find a way to bridge that divide, more competition within the top corporations will not matter.

America divided

Why the mid-terms matter

Politicians are making Americans miserable. The elections offer a chance to change

AS AMERICA PREPARES to go to the polls on November 6th, the country is more divided and angry than it has been in decades. Campaigning for the mid-terms has been marred by politicians routinely treating each other as rogues, fools or traitors. In recent days a supporter of President Donald Trump has sent bombs to 14 of his opponents and a white supremacist has murdered 11 worshippers at a synagogue, in the worst anti-Semitic act in America’s history.

Toxic federal politics is America’s great weakness. It prevents action on pressing real issues, from immigration to welfare; it erodes Americans’ faith in their government and its institutions; and it dims the beacon of American democracy abroad. The mid-term elections are a chance to begin stopping the rot—and even to start the arduous task of putting it right.
Mr Trump did not begin this abasement. But he has embraced it as enthusiastically as anyone and carried it to new depths of his own devising. All politicians stretch the truth. Mr Trump lies with abandon—over 5,000 times since he was inaugurated, according to the Washington Post.

His deceit is so brazen and effective that many of his supporters take his word above any of his critics’, especially those in the media, and seemingly in the face of all the evidence. That suits Mr Trump because, once nobody is believed, he cannot be held to account. But it is disastrous for America. Once reasoned debate loses its power to win arguments, democracy cannot function.

Mr Trump is also wilfully divisive. All politicians attack their opponents, but presidents see it as their duty to unite the country after a tragedy. Only Mr Trump would think the Tree of Life synagogue shooting a chance to hit back at the media and the Democrats for criticising him. Only he would suggest that, rather than tone down his explosive rhetoric, he might just “tone it up”. Such divisiveness matters because, when your opponents are simply bad people, the compromise that is the foundation of all healthy politics becomes hard within parties and almost impossible between them.

Mr Trump is not the only politician to wallow in division—just the most powerful and one of the most accomplished. Before he was elected, more than half of Democrats told pollsters that they were afraid of Republicans and almost half of Republicans said the same about Democrats. After a Republican congressman was shot by an unstable gunman last summer, leading Democrats expressed “outrage” at the idea that their rhetoric had played any part. Yet they used the attempted bombings and the synagogue shooting to begin a debate about the precise degree of presidential responsibility for domestic terrorism.

America’s democracy is robust—it was designed to be. However, one by one, its institutions are being infected with toxic polarisation. Congress caught the bug in the 1990s, when Newt Gingrich was Speaker. The media have also fallen victim to partisan scepticism—certainly among audiences, if not also among contributors. Just 11% of strong Trump supporters believe the mainstream media, whereas 91% of them trust Mr Trump, a CBS News poll found in the summer. Among Democrats those beliefs tend to be reversed. Now the Supreme Court is perceived to be partisan, too. Democrats see the recent confirmation of Brett Kavanaugh to the court as the ramming through of a partisan who has lied, possibly about a sexual assault, and who will be incapable of putting the law above his party.

Republicans, by contrast, see it as a triumph over a monstrous Democratic conspiracy to keep a decent man down. A dishonest executive, conniving with a fawning legislature and empowered by a partisan judiciary: were it to come to that, America truly would be in grave trouble.

What is to be done? Just as American politics did not sour overnight, so the route forward is by many small steps, beginning with next week’s elections. And the first of those steps is for the House, at a minimum, to switch to Democratic control.

This matters because Mr Trump should be subject to congressional oversight. He shows contempt for the norms that, to varying degrees, constrained past presidents—whether by refusing to release his tax returns, mixing official and private business, or bullying officials working in, say, the justice department who should be independent. Congress should hold hearings to investigate such behaviour.

But House Republicans have repeatedly failed to do this, neglecting their constitutional responsibility. Faced with the judgment of the intelligence services that Russia intervened in the presidential election, for instance, they subpoenaed the officials overseeing the investigation so as to make their work harder. Their abdication of responsibility means that a continued Republican majority in the House would eventually imperil the rule of law.

For Democrats to win control of the House would, in the long run, benefit both parties. Defeat would encourage some Republicans to start putting forward a conservative alternative to Trumpism. Defeat in the Senate, too, would turbo-charge that effort, though it looks unlikely.

The status quo, by contrast, would cement Mr Trump’s takeover of the party.

The calculation for the Democrats rests on the danger of defeat. Even now, they are in the midst of an argument between the centre and the radical wing of the party. Another loss could send them careering leftward. If the Democrats once again won a majority of votes but ended up with only a minority of seats, the party could be tempted to build a platform on norm-busting policies, like expanding the size of the Supreme Court or impeaching justices. By contrast, a House takeover would embolden the party’s moderates.

Nor has divided government always led to gridlock. Even now the president and congressional Democrats agree on some things, such as building infrastructure, confronting China and fighting the opioid epidemic. Let them fight over everything else, but put aside their mutual contempt in pursuit of policies for which they can both claim credit. A single example might show there can be value and dignity in compromise.

America will not mend its politics in a single election. At a minimum, progress will take more votes, a renewal of the Republican Party and a different president with a different moral compass. But the right result next week could point the way.

The Long Struggle for America’s Soul

Apparently, the self-evident truth that all people deserve life, liberty and the pursuit of happiness is far from settled.

By Andrew Delbanco

CreditIllustration by Joan Wong; Photographs via The New York Public Library, Boston Public Library, and New England Historical Society

Like many Americans, I’ve been following events at our southern border — the separation of children from their parents; the president’s denigration of nonwhite migrants as criminals, rapists and animals; his bluster about denying birthright citizenship to their children; and his pledge to send federal troops to intercept a dwindling caravan of frantic refugees.

To my ears, it all sounds eerily familiar. This is not the first time America has been torn apart over how to respond to people of color desperate to escape inhuman conditions. Nor is it the first time a president has threatened to deploy federal troops to return them to the horrors from which they fled.

I’m thinking, of course, of African-Americans, who were regarded for much of American history not as human beings but as a species of animate property no different from cattle and sheep. Their circumstances under slavery were certainly different from those of illegal immigrants today. For one thing, the authorities in their “homeland,” the American South, wanted to keep them rather than lose them. Slave owners worked hard to prevent their slaves from running away. South Carolina adopted its first “Act to Prevent Runaways” as early as 1683. A hundred years later, Georgia established a nightly slave patrol in its main port city that came to be known as the “Savannah Watch.” In the waning years of British rule, colonial officials favored draining wetlands in order to prevent “deserting slaves and wild beasts” from finding shelter in the swamps.

Yet despite such efforts, when delegates from the former British colonies convened at Philadelphia in 1787, the problem of runaway slaves posed a serious threat to the project of creating a new nation. If a durable union was to be forged between the South, where slavery was the bedrock of economy and culture, and the North, where it appeared headed toward extinction, slaves running for freedom across America’s internal border would have to be stopped. In Article IV, Section 2, Clause 3 of the Constitution, the founding fathers attempted to stop them:

No Person held to Service or Labour in one State, under the Laws thereof, escaping into another, shall, in Consequence of any Law or Regulation therein, be discharged from such Service or Labour, but shall be delivered up on Claim of the Party to whom such Service or Labour may be due.

Charles Cotesworth Pinckney, delegate from South Carolina, exulted that “we have obtained a right to recover our slaves in whatever part of America they may take refuge, which is a right we had not before.” 
Pinckney spoke too soon. Stating the principle proved much easier than carrying it out — just as chanting “Build the Wall!” has proved easier than building it. From the Southern point of view, citizens in any state, Northern or Southern, were obliged to return runaways just as they would be obliged to return stray livestock or stolen cash. But as the nation expanded westward, the boundary between slavery and freedom became longer and more porous. Northern states put up barriers to enforcement, including “personal liberty” laws guaranteeing jury trials for fugitives and prohibiting state officials from assisting in returning them to the South.

Slave owners tried to cut off the problem at the source. Shoes — issued to field slaves to prevent foot injuries that could sideline them from work — were collected at night to discourage slaves from taking flight. From Georgia and the Carolinas to Virginia and Tennessee, runaways resisting arrest could be killed with impunity — and the only witness might be the killer himself. 

A Massachusetts antislavery poster from 1850.CreditBoston Public Library

Under such conditions, most fugitives never made it very far. Some were mutilated — tendons cut, faces branded — as warnings not to try again, and to others not to try at all. Still, they kept on trying, just as in our own time the immigrants keep on coming. In 1841, when Charles Dickens came to the United States on a lecture tour, he was amazed by newspaper notices, “coolly read in families” as “a part of the current news and small-talk,” offering rewards for returning runaways:

Ran away, a negro woman and two children. A few days before she went off, I burnt her with a hot iron, on the left side of her face. I tried to make the letter “M.”

By the 1840s, despite all measures to contain them, the flow of runaways had made the fugitive slave problem, in the words of Senator John C. Calhoun of South Carolina, “the gravest and most vital of all questions, to us and the whole Union” — so grave that calls for secession arose throughout the South.

In an effort to blunt the rising sentiment for disunion, Congress tried to solve the problem once and for all by shifting enforcement responsibility from the states to the federal government. In August of 1850, it passed a bill “to provide for the more effectual execution of the third clause of the second section fourth article of the Constitution of the United States” — known ever since as the Fugitive Slave Act. In September, President Millard Fillmore signed it into law.
It was a law without mercy. To accused fugitives arrested under its authority, it denied the most basic right enshrined in the Anglo-American legal tradition: habeas corpus — the right to challenge, in open court, the legality of their detention. It forbade them to testify in their own defense. It ruled out trial by jury. Except for proof of freedom, such as emancipation papers signed by a former owner, it disallowed all forms of exonerating evidence, including evidence of beatings or rape while the defendant had been enslaved. It criminalized the act of sheltering a fugitive and required local authorities to assist the claimant in recovering his lost human property. It put the power of extradition in the hands of “commissioners” appointed by the federal government and limited the disputed issue to confirming the identity of the person who had tried to flee to freedom. If the accused could be shown to have belonged to the claimant according to the laws of the state from which she had fled, she was ordered back to captivity.

Even free black people in the North — including those who had never been enslaved — found their lives infused with terror of being seized and deported on the pretext that they had once belonged to someone in the South. The Fugitive Slave Act forced them to dread every footstep on the stairs and every knock on the door. As for the millions still in bondage in the South, it deepened the despair of the already desperate. In Ohio, one black minister who had escaped from slavery 20 years earlier remarked that Satan could now “rent out hell and move to the United States,” where he would feel more at home.

In early 1851, in concert with white abolitionists, free black people began to organize resistance. In Boston, slave catchers seized a young man known as Shadrach who had escaped a few weeks earlier from slavery in Norfolk, Va., and found work in a Beacon Hill coffeehouse. While serving breakfast, he was seized with his waiter’s apron still on and taken to the nearby courthouse. As news of the arrest spread, a mostly black and angry crowd gathered in Court Square.

Led by Lewis Hayden, a fugitive from Kentucky, a group of men rushed the courtroom and hustled Shadrach into the crowd outside, which, like a “black squall” (the words of the white antislavery attorney Richard Henry Dana), swirled around him. Whisked from Boston to Cambridge, then through Concord, Leominster and Fitchburg, he eventually made it to Canada. Theodore Parker, a white clergyman who became known as “Minister at Large for Fugitive Slaves,” declared that “if I were a fugitive and could escape in no other way, I would kill [the slave catcher] with as little compunction as I would drive a mosquito from my face.” 

The storming of a Boston court house in 1854 failed to release Anthony Burns, who was accused of violating the Fugitive Slave Law. He was eventually freed and became a minister. CreditHulton Archive/Getty Images

Parker proved prophetic. In Lancaster County, Pa., a Maryland slave owner who tried to force a fugitive to return with him to Maryland was shot and killed by a local black man. In Syracuse, a biracial crowd attacked a police station where an accused fugitive was being held. Armed with clubs, axes, and a battering ram, they smashed into the building and spirited away the prisoner, who, like Shadrach, found refuge in Canada. In Milwaukee, a fugitive named Joshua Glover, who had escaped from St. Louis, was held in jail until, as one his rescuers later remembered, “twenty strong and resolute men seized a large timber some eight or ten inches square and twenty feet long and went for the jail door; bumb, bumb, bumb, and down came the jail door and out came Glover.”

These events took place, of course, in a world vastly different from our own. In the United States of 1850, more than three million black people were still legally enslaved within the country’s own borders. Politicians — even those with qualms about slavery — did not hesitate to express frank racist contempt for African-Americans, and if called out for doing so, they did not deny it. Senator Henry Clay of Kentucky, who favored gradual emancipation, denounced Shadrach’s rescue by black Bostonians as an outrage perpetrated “by African descendants; by people who possess no part” in “our political system.” The chief justice of the United States, Roger Taney, declared that blacks “have no rights which the white man was bound to respect.”

There is an aphorism attributed to Mark Twain (though no evidence exists that he ever said it) that while history does not repeat itself, it does rhyme. The story of the fugitive slave crisis is a rhyming story filled with echoes in our own time.

For one thing, Boston; New Bedford, Mass.; Syracuse; Cincinnati; and Rochester, among other places, became “sanctuary cities,” where the domestic illegal immigrants of their day sought safe haven. The left, which had once decried the principle of states’ rights, began to see the federal government as an evil force controlled by the right. Black people feared the sight of law enforcement officers in the streets. For large sectors of the public, the legitimacy of Congress and the courts collapsed. Politics became radically polarized. The leading intellectual of the North, Ralph Waldo Emerson, reacted with horror at the thought that a man “who has run the gauntlet of a thousand miles for his freedom” must now, by law, be hunted down and sent “back again to the dog-hutch he fled from.” Meanwhile, a leading newspaper in the South, the Georgia Citizen, declared it past time to send “a naval and military force” sufficient “to batter down the walls of Boston and lay it in utter ruin” as reward for its sedition.

But the strongest “rhyme” between fugitive slaves in the 19th century and illegal immigrants today is their shared anguish — the “degenerating sense of nobodiness,” in the Rev. Dr. Martin Luther King Jr.’s devastating phrase — inflicted by a society that treats them as non-persons. People demeaned in this way forced Americans then, and force us now, to confront the central question of our history: Who is — or isn’t — recognized as fully human? Our Declaration of Independence was supposed to answer this question with the proposition that “all men are created equal” and “endowed by their creator with certain unalienable rights,” including “life, liberty, and the pursuit of happiness.” 

A group of people who had escaped slavery at Foller’s house, Cumberland Landing, Va., in 1862. CreditJames F. Gibson, via Library of Congress Prints and Photographs Division

At certain decisive moments in our history, attempts have been made to extend this principle beyond the cadre of the propertied white males who first articulated it. In 1854, as the crisis over slavery deepened, Abraham Lincoln called upon America to “readopt the Declaration of Independence, and with it the practices and policy which harmonize with it.” By destroying slavery, the Civil War brought what he called a “new birth of freedom” for black Americans. The postwar constitutional amendments sought to guarantee the rights of citizenship — notably the right to vote — to all American men, including former slaves and naturalized immigrants. The New Deal tried to protect vulnerable citizens from the destructive effects of dynamic capitalism. The Civil Rights movement of the 1950s and ’60s tried to dismantle the legacy of slavery in the form of Jim Crow.

But if we’ve learned anything in the age of Trump, it’s that rights can also be constricted and rescinded. The self-evident truth that all people deserve life, liberty and the pursuit of happiness is a long way from settled in the American mind. The question of who is considered fully human has returned with a vengeance.

Andrew Delbanco is a professor of American studies at Columbia and the author, most recently, of “The War Before the War: Fugitive Slaves and the Struggle for America’s Soul From the Revolution to the Civil War,” from which this essay draws.

On the economy and rate hikes, the Fed looks lost in the stars

Getty Images/iStockphoto  

President Donald Trump must regret that he didn’t renew Janet Yellen’s contract to head the Fed for another four years. She probably would have been more accommodating to his supply-side policies. They both are populist do-gooders at heart. They want as many people to get jobs as possible.

Instead, Trump appointed Jerome Powell to be the new Fed chairman at the start of this year.

Powell had been the vice chairman under Yellen. Trump appointed Richard Clarida to fill Powell’s vacant position after he was promoted. Both are all for continuing to raise interest rates. Both see strong economic growth and a tight labor market as potentially inflationary. So they want to raise interest rates to avert this scenario, by slowing the economy down.

No wonder that the Wall Street Journal reported that Trump directly accused Powell of endangering the U.S. economy by raising interest rates: “I’m just saying this: I’m very unhappy with the Fed because Obama had zero interest rates.” He also complained that “[e]very time we do something great, [Powell] raises the interest rates.”
I am convinced that last month’s stock market rout started on October 3, when Powell said in an interview with Judy Woodruff of PBS: “The really extremely accommodative low interest rates that we needed when the economy was quite weak, we don’t need those anymore. They’re not appropriate anymore.” CNBC also reported that Powell said: “Interest rates are still accommodative, but we’re gradually moving to a place where they will be neutral. We may go past neutral, but we’re a long way from neutral at this point, probably.”

The CNBC report was alarmingly headlined as follows: “Powell says we're 'a long way' from neutral on interest rates, indicating more hikes are coming.”

The S&P 500 SPX, -0.72%  dropped 9.1% from the close on October 2 through last Friday as Fed officials continued to hammer home Powell’s narrative.

For example, in his first public speech as vice chairman last week on Thursday, Clarida explained why he thinks higher interest rates are in order. Sadly, it’s the same old party line that Fed officials have been spouting for a while to explain their gradual normalization of monetary policy. Here it is in brief:

1. Star struck and star stuck: Clarida, along with other Fed officials, is star struck. The Fed is stuck on the fanciful notion that the federal funds rate should be set relative to “the longer-run neutral real rate, often referred to as “r-star,” or “r*.” Clarida acknowledges that it is an “unobservable and time varying” variable. However, fear not: It is “computed from the projections submitted by Board members and the Reserve Bank presidents.” The real rate is the nominal rate minus the inflation rate, Adjusting an overnight rate using a one-year inflation rate is just one of the many mind games Fed officials like to play.

It gets worse: Clarida admits that r* “must be inferred as a signal extracted from noisy macro and financial data. That said, and notwithstanding the imprecision with which r* is estimated, it remains to me a relevant consideration as I assess the current stance and best path forward for policy.”

He then goes on to quote a reputable authority on matters of economic astronomy (astrology, actually): “The reason for this is because, as Milton Friedman argued in his classic American Economic Association presidential address, a central bank that seeks to consistently keep real interest rates below r* will eventually face rising inflation and inflation expectations, while a central bank that seeks to keep real interest rates above r* will eventually face falling inflation and inflation expectations.” (Friedman, of course, was the father of monetarism, which has been mostly relegated to the dustbin of economic history.)

All this suggests that the best measure of whether the real (and nominal) federal funds rate is too low or too high relative to the phantom r* is the actual inflation rate. So by Clarida’s own logic, if inflation remains subdued around the Fed’s 2.0% target, as it continues to do so, why should the Fed raise interest rates at all?

2. The new abnormal: The Fed’s house view is that monetary policy has been set on a course of “normalization,” with the aim of raising the nominal federal funds rate to a more normal and neutral level of 3.00%, after interest rates were near zero from 2009 through 2015. The problem is that no one really knows if that’s the right level after so many years of abnormally easy monetary policy. What if the neutral federal funds rate is 2.0% rather than 3.0%? In that case, further rate hikes will be restrictive even though inflation remains subdued. (See the tables on the FOMC September 2018 Summary of Economic Projections, September 2018-2021 & Beyond.)

That’s why the stock market plunged in October. Instead of setting the course of normalization on autopilot with 25 basis-point hikes following the March, June, September, and December meetings of the FOMC, why not try a more gradual pace of increases with longer pauses to assess whether the course of normalization needs to be recalibrated?

3. Accomodative or not? Recall that the latest, Sept. 26 FOMC statement deleted the following language that had appeared in previous statements: “The stance of monetary policy remains accommodative.” This sentence had been in every FOMC statement since December 16, 2015, when the Fed started its latest rate-hiking program. In his press conference that same day, Powell minimized the import of this development, saying that the language simply had outlived its “useful life.” He contradicted that assessment on October 3, helping to set the stage for October’s stock market meltdown.

Furthermore, how does that square with Clarida saying that the federal funds rate needs to be raised some more because it is still below r*? There certainly is a big inconsistency between the change in the Sept. 26 statement and Clarida stating, “However, even after our September decision, I believe U.S. monetary policy remains accommodative.”

4. Phillips’ disciples: Now that the unemployment rate is down to 3.7%, the lowest since December 1969, Fed officials seem most concerned that the tight labor market will boost inflation. They’ve mostly admitted that the Phillips curve trade-off between unemployment and inflation has flattened out. Yet they still fear that it will make a big comeback unless they continue to raise interest rates. Granted wage inflation has risen recently to 3.0%, but it might well be justified by a long-awaited rebound in productivity growth.

Nevertheless, Fed officials figure that by raising the nominal federal funds rate to a neutral rate of 3.0%, they will keep price inflation around their cherished 2.0%. However, their latest dot plot shows that the FOMC’s median estimate of the longer-run unemployment rate — a.k.a. “NAIRU,” the nonaccelerating inflation rate of unemployment — is 4.5%.

In other words, they are saying that to keep a lid on inflation, they have to raise the federal funds rate — up to a restrictive 3.40%, they currently reckon according to the latest dot plot — until the jobless rate rises back from 3.7% to 4.5%. That would imply a sharp economic slowdown indeed. So they figure that they could then lower the federal funds back to 3.0%, i.e., the nominal version of r-star.

Yet Clarida admits that NAIRU might be lower than 4.5%. So far, it certainly seems to be lower given that a 3.7% jobless rate isn’t boosting inflation much at all. In his speech, Clarida said that NAIRU “may be somewhat lower than I would have thought several years ago.” He added: “With unemployment falling and wage gains thus far in line with productivity and expected inflation, the traditional indicators of cost-push price pressure are not flashing red right now.” You think?
5. Raising rates to lower them: I believe Powell is more of a pragmatist than Yellen. His unspoken game plan may simply be to raise the federal funds rate to 3.00% or even 3.50% so that when the next recession occurs, the Fed will have 300-350 basis points of leeway between the federal funds rate and zero. That’s fine, but longer pauses between rate hikes may increase the odds of raising the federal funds rate that high without triggering a financial crisis and a recession.

Trump’s regrets: It’s no wonder that Trump said in his Oct. 23 Wall Street Journal interview: “To me the Fed is the biggest risk, because I think interest rates are being raised too quickly.”

As for why he thought Powell was raising rates, Trump said: “He was supposed to be a low-interest-rate guy. It’s turned out that he’s not.” Does Trump regret nominating Powell? It’s “too early to say, but maybe,” the President said. Think of Powell and Clarida as Trump’s regrettables.

I was on CNBC last Friday. My message was: “We need the Fed to pause here and just take a breather. Let’s see how the economy plays out, and that will help the stock market a lot.” I concluded: “Fed officials have been talking like mission accomplished — that it’s the best economy that we’ve ever had. If it’s the best economy that we ever had, why raise interest rates? Why not leave it be if it’s growing with low inflation?”

Ed Yardeni is president of  Yardeni Research Inc. , a provider of global investment strategy and asset allocation analyses and recommendations. He is the author of  Predicting the Markets: A Professional Autobiography  (2018). Follow him on  Twitter and  LinkedIn .

The US Rivalry With China Gets Closer to Home

By Allison Fedirka


Central America and the Caribbean have found themselves in an exceptional position lately. Though these subregions don’t typically figure into global power dynamics, an intensifying trade war between China and the United States has two of the world’s leading powers vying for their partnership. And Beijing has already turned some heads in the area. A growing number of steadfast U.S. allies have turned toward China by breaking with Taiwan. In June 2017, Panama rescinded its recognition of Taiwan’s independence and adopted a “One China” policy. The Dominican Republic followed suit this May, as did El Salvador in August. In response, the U.S. recalled its chief diplomats serving in the three countries Sept. 7 for consultations. Later that month, U.S. Vice President Mike Pence warned Central America of the dangers of getting too close to China.

That China is coming into Latin America and buying up natural resources is well-known. But the extent of China’s influence and its potential threat in these areas remains in question. This Deep Dive looks at how the U.S. and China stack up against each other in Central America and the Caribbean and at why Beijing’s recent advances have gotten Washington’s attention.
China’s History in Central America and the Caribbean
Compared with its presence in other parts of the world, China’s strategic engagement with Central America and the Caribbean is a relatively recent phenomenon. Beijing started establishing diplomatic ties with many countries in the Americas only during the 1970s and 1980s, after concentrating on domestic affairs for the first few decades after the Chinese Revolution to build its economy and cement its political system. In the 1990s, China’s trade with Central America and the Caribbean increased, and since then Beijing has solidified its economic and political influence there. Even so, it didn’t formulate a coherent policy for dealing with the subregions until 2008 – a telling omission considering how much Beijing likes publishing policy papers.

China’s initial activities in the Americas focused on exploiting loosely shared and complementary interests. The government’s 2008 policy paper highlighted the region’s untapped natural resources, a particular draw for China given the ravenous demand for commodities its large population and developing economy created. As emerging markets, states in Latin America (including Central America) and the Caribbean boasted much higher growth potential than did countries with developed economies, and their need for development translated to investment opportunities for Chinese companies.

But Beijing’s interest in the subregions wasn’t purely economic. The 2008 policy also emphasized that its partners in Central America and the Caribbean should abide by the One China principle by recognizing Taiwan as a part of China, rather than as a sovereign state, and treating it accordingly. The text describes the One China principle as the “political basis for the establishment and development of relations between China and Latin American and Caribbean countries and regional organizations.” Once the countries and organizations had satisfied that requirement, and once China had established the political ties necessary to support its economic endeavors there, they could move on to strengthening their cooperation in defense and security.
China has since updated and elaborated on its regional policy, but the foundations are largely unchanged. In 2014, a second policy paper on Latin America and the Caribbean revealed that Beijing had made the political inroads it was after and affirmed that its main focus in the region was still economic. Chinese President Xi Jinping debuted a new cooperation framework for them in July of that year, dubbed “1+3+6.” The name referred to Beijing’s strategy for the region, the China-CELAC Cooperation Plan (represented by the number one), along with the three economic drivers underlying the collaboration – trade, investment and financial cooperation – and the six industries prioritized for funding and attention. (Those industries – energy and resources, infrastructure construction, agriculture, manufacturing, scientific and technological innovation, and information technology – run the gamut of China’s strategic interests.) Most recently, in September of this year, China unveiled four guiding principles specifically intended to enhance its ties with Central American and Caribbean states. Chinese State Councilor and Foreign Minister Wang Yi reiterated his country’s special interest in the area, calling for renewed cooperation in education, technology, tourism, media and sanitation. He also took the opportunity to encourage local states to stand together against unilateralism and protectionism, a not-so-subtle dig at the U.S.
How the U.S. and China Stack Up 
Yet despite China’s diplomatic and financial investment in Central America and the Caribbean – and its efforts, verbal and physical, to undermine U.S. influence in the subregions – the United States still holds more sway there. The U.S., in fact, holds its own in the three economic drivers highlighted in Xi’s 1+3+6 policy.

We’ll start with trade, but first a word on terminology. Reporting on Central America and the Caribbean frequently lumps them with Latin America into a single category, consisting of 33 countries that include states with large populations and economies, such as Brazil and Mexico, alongside many small nations, some of them islands. The result paints a misleading picture. Consider, for instance, that the Dominican Republic, Panama and Guatemala – the three largest economies in Central America and the Caribbean – have a combined gross domestic product equivalent to just one-fifth of Mexico’s, and one-tenth that of Brazil. For our purposes, we will focus on Central America and the Caribbean, exclusive of the North and South American countries that often get thrown in under the banner of Latin America. The corresponding trade figures for these countries will be commensurately modest, given their size.

For the countries of Central America and the Caribbean – developing economies that by and large rely on exports of raw materials, agricultural products and basic manufactured goods – the United States is by far the most important trade partner. It supplied approximately one-third of the $30.77 billion worth of goods regional trade bloc the Caribbean Community, or Caricom, imported in 2017 and purchased an equivalent share of its $16.8 billion in exports. China, on the other hand, supplied only 6 percent of Caricom’s imports, though it is the bloc’s third-largest source for them. (Because of the number of countries in the subregions, the most efficient way to measure trade is to look at trade blocs.) The situation was much the same for the Central American Integration System last year: Of the bloc’s $78.8 billion in imports, the U.S. accounted for just over 43 percent and bought 48 percent of its $51.58 billion worth of exports. China, at a distant second place, furnished just 18 percent of the bloc’s imports and purchased less than 1 percent of its exports.

The U.S. has several advantages over China in the area, and it can use these strengths to maintain its dominance in the Central American and Caribbean markets. Its proximity to these subregions, for example, helps keep logistics costs down and supports just-in-time delivery models. By contrast, the distance separating China from the area means that imports, whether food or manufactured goods, will have a heftier price tag than they would in the U.S. In addition, American consumers can more easily purchase Caribbean or Central American goods because the U.S. has more free trade agreements with regional countries relative to China – something Beijing hopes to change. Finally, Central American and Caribbean countries produce and export many of the same low-cost manufactured goods that Chinese companies make at home. China’s push toward high-tech manufacturing is still a work in progress, and much of what it produces would have to compete with imports from the Caribbean or Central America. Since trade in part determines Beijing’s ability to influence events in the subregions, China’s reach there is limited compared with that of the U.S.
Similarly, for all the talk of Chinese firms buying up resources in Latin America, the U.S. is still outpacing China in foreign direct investment in the Caribbean and Central America. The importance of FDI to the area cannot be overstated. Most Central American and Caribbean countries depend on outside funding to spur and sustain economic development. And though sources of FDI in Latin America vary from subregion to subregion, the U.S. leads the pack in Central America and the Caribbean. It invested more in Central America and in the Dominican Republic in 2017 than any other country, increasing its share by 9 points over the previous four-year average. Other Latin American countries were the second-largest FDI contributor to the subregion, followed by European states. China’s contributions trailed so distantly that they were included only under the “other” category.
China has, of course, been investing heavily in nearby energy and transportation projects, but mainly in South America, not in Central America or the Caribbean. It also led investments in the region when measured by the total value of mergers and acquisitions. Once again, though, South America (namely Brazil) accounted for the vast majority of that activity. Chinese investments in Central America and the Caribbean begin to register as significant only when measured over the course of several years.
The reason foreign investment in the subregions attracts so much attention worldwide is that FDI there is growing, while FDI in Latin America overall is declining. In 2017, FDI in Central America jumped 4.4 percent year-on-year to hit $13.08 billion, and in the Caribbean, it increased by a whopping 22 percent to a total $6.07 billion. The rest of Latin America, meanwhile, experienced a 3.6 percent contraction year-on-year in foreign investment, marking the third year in a row that FDI fell. Most of the FDI growth in Central America and the Caribbean comes from increased investment from U.S. and European firms in manufacturing and services following the collapse of the commodities market in 2014. The trend does have exceptions, however; most of Jamaica’s FDI last year came from China and went to tourism and mining.
Like investment, finance is critical to Central American and Caribbean states that otherwise would struggle to pay for major development projects. China started actively financing projects in the broader region in 2005, primarily through the Chinese Development Bank and China Eximbank. Since then, Trinidad and Tobago, Jamaica and Costa Rica have been the leading recipients of Chinese funding in the Caribbean and Central America (though South America has been the main focus of Bejing’s attention and assistance). Xi even set aside $3 billion in 2013 to fund projects in nine Caribbean states, including hospitals, transportation infrastructure and an industrial park.

Chinese financing appeals to Central American and Caribbean states for a couple of reasons. For one thing, China isn’t afraid of lending to risky borrowers that have trouble accessing international capital markets. For another, its loans, albeit typically made at slightly higher interest rates, don’t come with the policy conditions institutions such as the International Monetary Fund frequently attach to their finance deals. China will even drop its interest rates under the right circumstances, as it has recently promised to do for Cuba with its offer of interest-free, concessional financing for infrastructure projects in the country. These factors help explain why even with a decline in lending over the past few years, China’s total financing in Latin America since 2005 outstrips that of the World Bank, the Inter-American Development Bank and the Andean Development Corporation for the same period.
Why All the Fuss?
All told, the U.S. seems to have little cause to worry about China’s activities in Central America and the Caribbean. In trade and investment, after all, it still leads Beijing comfortably. And even in finance, China does not have a decisive edge. But Washington clearly finds Beijing’s advances and promises of increased cooperation in the area unsettling. That’s because of where and how China is upping its involvement.

Since gaining independence, the U.S. has worked to keep foreign powers away from the Americas. It adopted the Monroe Doctrine in 1823 to discourage more European colonization nearby and added the Roosevelt Corollary some 80 years later to deter European states from seizing or intervening in South American countries to settle debts with them. In the intervening years, the U.S. went to war with Spain, stripping it of most of its remaining territory in the Western Hemisphere. With Spain out of the picture, a modern navy at its disposal and much of the rest of the continent in disarray, the United States emerged as the uncontested power in North America, a status it has enjoyed ever since.

Washington rarely encounters outside powers vying for influence in its near abroad. When it does, though, its response is strong and swift. (Think: Cuban Missile Crisis and the Bay of Pigs.) China’s growing presence in Central America and the Caribbean is close to setting off the alarm, reminding Washington perhaps too vividly of the Soviet Union’s attempts to chip away at U.S. influence in the area during the Cold War. Beijing may not have the economic clout with these subregions that Washington does, but the mere presence of a rival in the area is something the United States won’t tolerate.

Furthermore, the kinds of projects China targets in Central America and the Caribbean have raised hackles in the U.S. What Beijing’s investments in the area lack in scale, they make up for in strategy. The most illustrative example of this tactic is Panama. The Chinese government is positioning itself to secure land holdings at both ends of the Panama Canal, a critical artery for facilitating and expediting maritime trade. After Panama rejected its proposal to build an embassy on the Amador Peninsula, near the mouth of the canal, Beijing struck out to find the next-best location. It is also trying to build a cruise port near the strategic waterway and considering constructing oil facilities off Panama’s Pacific coast. And on the Atlantic side of the canal, Chinese companies are helping to fund electricity projects and to get a free trade zone off the ground in Colon.

These plans don’t sit well with Washington. The U.S. has been protective of the Panama Canal ever since its construction, serving as the de facto guarantor of all that passes through it. It took Washington until 1977 to agree to turn the canal over to Panama and another 20 years to actually relinquish it. Under the terms of the canal neutrality deal, moreover, the United States can intervene in Panama if it determines that the waterway’s security is at risk. China’s interest in the canal doubtless has put that portion of the agreement front and center in the minds of Panama’s leaders, who must walk a fine line to reassure Washington without jeopardizing their country’s ties to Beijing.

Elsewhere in the area, China has plenty of other irons in the fire. For example, it is heavily invested in building ports and maritime facilities, such as La Union, a commercial port in El Salvador. Its participation in the project has ignited debate over whether China could eventually use the port for military purposes, much as it has done with the ports it helped finance in the Indian Ocean and along the Horn of Africa. Beyond maritime infrastructure, Beijing has its sights set on energy opportunities in the region, expanding its presence in Trinidad and Tobago’s upstream oil refining and liquefied natural gas operations. The two islands have been eyeing China as a possible replacement for the U.S., which has decreased its energy imports from Trinidad and Tobago as its domestic oil and natural gas industry has become more self-sufficient. China’s growing involvement in the area’s energy resources could enable it to help provide oil and natural gas to Central American and Caribbean countries in desperate need of an affordable supply line. Many of China’s projects in the subregions serve the needs of the host countries in some way, a characteristic that makes them all the more valuable to the target states.

Aware of China’s encroachment in the Caribbean and Central America, Washington has taken steps to try to stop it. The U.S. Congress has introduced legislation to allow the State Department to downgrade, suspend or alter U.S. assistance to any government that revokes its recognition of Taiwan’s independence. The measure would give countries in Central America and the Caribbean that still recognize Taiwan a reason to think twice about welcoming China with open arms, since many of them still depend on the U.S. for economic and security aid. In addition, Congress also recently passed the Better Utilization of Investments Leading to Development Act in a bid to keep up with China’s development lending around the world. The bill proposed measures to modernize and streamline U.S. lending procedures for energy and infrastructure projects.

The response from Central American and Caribbean countries has been mixed. States like Panama and Costa Rica are bearing their commercial and security ties with the U.S. very much in mind and working to stay on good terms with Washington. El Salvador is divided on the issue: Some groups see promise in partnering with China, while others think the move would sell out their country by setting it up to fall into another Chinese debt trap. Other states are trying to turn the U.S.-China rivalry to their advantage. In September, the Honduran president invoked Beijing and its burgeoning interest in his country and in the same breath bemoaned Washington’s policies toward Central America, including changes to temporary immigration protections and funding cuts.
Another Weapon in China’s Arsenal
Therein lies the beauty of the Caribbean and Central America, from China’s perspective: The subregions give Beijing yet another way to gall Washington as their trade war wears on. China can’t go dollar-for-dollar with the United States in tariffs, and its domestic economic considerations limit the array of tools it can use to counter the U.S. But its activities in the regions surrounding the U.S. give it a bargaining chip it can use with Washington. To that end, it will keep tailoring its activities in the area to best ruffle the U.S., rather than trying in earnest to eclipse the country’s economic presence in Central America or the Caribbean.

Likewise, the local states understand that the U.S. is in no danger of losing its sway with them. Still, the U.S. now finds itself in the unusual position of needing to devote more resources to Central America and the Caribbean. And where it might once have resorted to military measures to get the job done, today Washington prefers economic interventions to exert and project its power. To keep China from muscling in on its turf in Central America and the Caribbean, the U.S. may have to reach deep into its pockets.