China, India and the rise of the ‘civilisation state’

This illiberal idea is also appealing to some on the American right

Gideon Rachman

The 19th-century popularised the idea of the “nation state”. The 21st could be the century of the “civilisation state”.

A civilisation state is a country that claims to represent not just a historic territory or a particular language or ethnic-group, but a distinctive civilisation. It is an idea that is gaining ground in states as diverse as China, India, Russia, Turkey and, even, the US.

The notion of the civilisation state has distinctly illiberal implications. It implies that attempts to define universal human rights or common democratic standards are wrong-headed, since each civilisation needs political institutions that reflect its own unique culture. The idea of a civilisation state is also exclusive. Minority groups and migrants may never fit in because they are not part of the core civilisation.

One reason that the idea of the civilisation state is likely to gain wider currency is the rise of China. In speeches to foreign audiences, President Xi Jinping likes to stress the unique history and civilisation of China. This idea has been promoted by pro-government intellectuals, such as Zhang Weiwei of Fudan university. In an influential book, The China Wave: Rise of a Civilisational State, Mr Zhang argues that modern China has succeeded because it has turned its back on western political ideas — and instead pursued a model rooted in its own Confucian culture and exam-based meritocratic traditions.

Mr Zhang was adapting an idea first elaborated by Martin Jacques, a western writer, in a bestselling book, When China Rules The World. “China’s history of being a nation state”, Mr Jacques argues, “dates back only 120-150 years: its civilisational history dates back thousands of years.” He believes that the distinct character of Chinese civilisation leads to social and political norms that are very different from those prevalent in the west, including “the idea that the state should be based on familial relations [and] a very different view of the relationship between the individual and society, with the latter regarded as much more important”.

Like China, India has a population of well over 1bn people. Theorists for the ruling Bharatiya Janata party are attracted to the idea that India is more than a mere nation — and is, instead, a distinct civilisation. For the BJP, the single most distinctive feature of Indian civilisation is the Hindu religion — a notion that implicitly relegates Indian Muslims to a second tier of citizenship.

Jayant Sinha, a minister in Narendra Modi’s government, argues that modern India’s founding fathers, such as Jawaharlal Nehru, mistakenly embraced western ideas such as scientific socialism, believing them to have universal applicability. Instead they should have based India’s post-colonial governance system on its own unique culture. As a former McKinsey consultant with a Harvard MBA, Mr Sinha might look like the archetypal bearer of “globalist” values. But when I met him in Delhi last year, he was preaching cultural particularism, arguing that “in our view, heritage precedes the state . . . People feel their heritage is under siege. We have a faith-based view of the world versus the rational-scientific view.”

Civilisational views of the state are also gaining ground in Russia. Some of the ideologues around Vladimir Putin now embrace the idea that Russia represents a distinct Eurasian civilisation, which should never have sought to integrate with the west. In a recent article Vladislav Surkov, a close adviser to the Russian president, argued that his country’s “repeated fruitless efforts to become a part of western civilisation are finally over”. Instead, Russia should embrace its identity as “a civilisation that has absorbed both east and west” with a “hybrid mentality, intercontinental territory and bipolar history. It is charismatic, talented, beautiful and lonely. Just as a half-breed should be.”

In a global system moulded by the west, it is unsurprising that some intellectuals in countries such as China, India or Russia should want to stress the distinctiveness of their own civilisations. What is more surprising is that rightwing thinkers in the US are also retreating from the idea of “universal values” — in favour of emphasising the unique and allegedly endangered nature of western civilisation.

Steve Bannon, who was briefly chief strategist in the Trump White House, has argued repeatedly that mass migration and the decline of traditional Christian values are undermining western civilisation. In an attempt to arrest this decline, Mr Bannon is helping to establish an “academy for the Judeo-Christian west” in Italy, designed to train a new generation of leaders.

The Bannonite argument that mass migration is undermining traditional American values is central to Donald Trump’s ideology. In a speech in Warsaw in 2017, the US president declared that the “fundamental question of our time is whether the west has the will to survive”, before reassuring his audience that “our civilisation will triumph”.

But, oddly enough, Mr Trump’s embrace of a “civilisational” view of the world may actually be a symptom of the decline of the west. His predecessors confidently proclaimed that American values were “universal” and were destined to triumph across the world. And it was the global power of western ideas that has made the nation-state the international norm for political organisation. The rise of Asian powers such as China and India may create new models: step forward, the “civilisation state”.

China’s Stimulus Muddle Deepens

Beijing is going to find it increasingly difficult to achieve its twin aims of cutting debt while keeping growth on track

By Nathaniel Taplin

A Chinese military conductor is hit by a camera flash as he instructs his music band members during a rehearsal for the opening session of China's National People's Congress at the Great Hall of the People in Beijing, March 5.
A Chinese military conductor is hit by a camera flash as he instructs his music band members during a rehearsal for the opening session of China's National People's Congress at the Great Hall of the People in Beijing, March 5. Photo: Andy Wong/Associated Press

Li Keqiang, China’s premier, has a few ideas for 2019: keep overall debt growth in check, cut taxes, accelerate government bond issuance, and boost lending to small businesses.

If that sounds like a lot to ask—and contradictory—it is.

Some of these goals will fall by the wayside. Getting banks to lend more to small businesses without overall credit growth accelerating will be near impossible. And significantly higher government debt sales will require more banking system liquidity to keep rates from rising and further damaging growth. That means more monetary easing: probably not a 2015-like flood, but definitely a rising tide.

Beijing rightly recognizes that its two previous rounds of stimulus in the past decade, funded largely off the government’s books through state bank loans to state-owned enterprises, created a lot of bad debt for the buck. This time, the jolt is coming more from Beijing’s balance sheet: The government’s annual work report, delivered by Mr. Li on Tuesday, highlighted business tax and fee cuts totaling nearly 2 trillion yuan ($298 billion) for 2019 among other measures designed to keep Chinese growth between 6% and 6.5% this year. It also gave local governments a 2.15 trillion yuan quota to issue municipal “special purpose bonds” that are often used for infrastructure funding—a nearly 60% higher quota than for 2018.

All that new official debt will need buyers—and that means higher banking-sector liquidity, since banks own nearly the entire Chinese municipal bond market. Mr. Li did call for lower reserve-requirement ratios at smaller banks to boost lending, and using “interest rate, quantitative and price tools” as appropriate.

He also said, however, that total credit outstanding should grow at the same rate as nominal gross domestic product. Since nominal GDP growth was just 9.7% last year and seems certain to slow further in 2019, that would mean total credit growth—about 10% currently—would also need to fall further. It seems unlikely, to say the least, that Chinese policy makers will be able to impose even tighter monetary policy, while simultaneously flooding the bond market with new government issues—and somehow magically arresting the growth slowdown at the same time.

In short, Beijing is still holding on to contradictory goals: boosting growth and formal government debt issuance while keeping overall indebtedness in check. The result is likely to be a relatively weak stimulus by past standards—although still enough to boost overall leverage—and a weak recovery, at best, some time in the second half.

After Hanoi: North Korea, the US and Japan

As the United States alters its strategy, the others will follow suit.

By George Friedman


The Hanoi talks ended in deadlock. Both sides – represented by U.S. President Donald Trump and North Korean leader Kim Jong Un – showed their anger by refusing to shake hands. The media labeled the talks a failure. But I’ve been involved in a number of negotiations in my life, and I see this as a normal part of the process. At some point, all parties will take positions designed to test the other side’s hunger for a deal, and prudent negotiators know that showing hunger can be devastating. So, ending the negotiation, particularly with a show of anger, is routine. At the same time, mutual rejection can be genuine, and now each side is trying to figure out how serious the other is. Establishing that you are prepared to walk away from the table is important – but sometimes the deal falls apart as a result.
Where Things Stand
War with North Korea is not a good option for the U.S. There’s the danger of artillery fire close to Seoul, the uncertainty of the location of North Korea’s nuclear weapons, and the U.S. aversion to the idea of getting bogged down in another war this century. North Korea, on the other hand, knows that one thing that would trigger a U.S. pre-emptive nuclear strike would be to develop weapons that can reach the U.S., and it wants to avoid such a strike at all costs. So, this failed negotiation leaves a reality in which war is not likely, giving both sides room for obstinacy.

The other major players in the region must now calculate their courses. For China and Russia, there’s little downside to the United States’ attention being diverted to North Korea. The more the U.S. feels under pressure to attend to other issues, the less it can focus on China and Russia. But it’s not clear whether the Hanoi outcome helps or hurts these two. On the one hand, the U.S. and North Korea are furious at each other. On the other hand, if this results in a frozen conflict, the U.S. can spare attention for others. The logic is that China and Russia will push North Korea to more overt moves to draw Washington’s focus. But North Korea has created room to maneuver for itself, and a cold distance from the United States serves it well.

For the U.S., the years since 9/11 have forcibly displayed the limits of its military power. The U.S. is very good at destroying enemy armies, but it is very bad at occupying enemy countries where the citizens’ morale has not been crushed (think Germany or Japan during World War II). In Iraq, for example, the U.S. expected Iraqis to welcome the Americans. Some did, some were indifferent and some resisted. The resistance was prepared to absorb substantial casualties; this was their country, and they had nowhere else to go. The U.S., quite reasonably, was not prepared for high casualties, as Iraq was not a fundamental, long-term, American interest. The local forces understood the social and physical terrain, while the U.S. had limited familiarity. The initial attacks were successful. The occupation was a mess.

Thus, out of necessity, the U.S. has adopted a strategy that draws down its forces and that is extremely cautious about engagements where it cannot crush civilian morale through World War II-style bombing and blockade. Even if confident in its ability to break a conventional or nuclear force, the U.S. has no appetite for occupation. The strategy since World War II, built on the assumption that U.S. conventional forces can defeat any foe and pacify the country, is being abandoned. And in the case of the Hanoi talks, the U.S. is following a new strategy of diplomatic deadlock without recourse to the insertion of force.

We understand therefore the North Korean, Chinese, Russian and U.S. positions. (South Korea, of course, wants a stable balance on the Korean Peninsula.) The country whose strategy is uncertain is Japan.
Japan’s Next Move
The major question that has emerged from the Hanoi talks is what Japan will do now. Japan is the world’s third-largest economy. It has a stable and homogeneous population, a substantial military force and an enormous capacity to increase that force.

The U.S. has decided to accept that North Korea is a nuclear state, so long as none of its nuclear weapons can reach the U.S. mainland. This completely destabilizes Japan’s strategy. Under that strategy, first imposed by the U.S. and happily embraced by Japan, the U.S. guarantees Japanese national security. The U.S., in exchange, has been able to use Japan as a base from which to project force across the Korean Peninsula, threaten China and block Russia’s Vladivostok fleet from accessing the Pacific Ocean. Japan, unencumbered by defense expenditures and any responsibility in American wars, could focus on the monumental task of its dramatic post-World War II recovery. Most important, the U.S. nuclear umbrella has guaranteed that any nation that might attack Japan with nuclear weapons would face retaliation from the United States. In reality, the United States’ willingness to launch a massive nuclear exchange if China or Russia hit a Japanese city was always uncertain. But since it was uncertain to potential aggressors too, it served its purpose, which was more psychological than military.

The Hanoi talks subtly shift that guarantee. The new U.S. position is that it cannot accept a North Korean nuclear program that threatens the United States. Implicit in that position is that it can tolerate one that threatens Japan. The U.S. nuclear umbrella is notionally still there, but the United States’ reluctance to engage raises the question of whether North Korea will be deterred. So, the U.S. nuclear deterrent still guards Japan – but can the guardian be trusted?

Japan lives in a rough neighborhood. The Russians hold islands to which the Japanese lay claim, and while it’s not a real threat now, the Russian future is always unknown. China is challenging Japan’s control of islands in the East China Sea and is threatening to potentially take control of the Western Pacific, which is currently in the hands of the United States. China has a long memory of Japanese occupation and atrocities committed during the Sino-Japanese War.
The Korean Peninsula, too, has a long memory of Japanese occupation, exploitation and abuse. So apart from the current geopolitical reality, Japan lives in a region that resents it for historical reasons.

In this context, the Japanese continue to struggle internally over defense policy. Japan’s current policy is to build a substantial force while minimizing its capabilities, saying it is only for national defense purposes. The alternative is for the world’s third-largest economy to normalize its international status by abandoning the constitutional prohibition on military force (already ignored for the most part) and create an armed force congruent with its economic might and strategic interests.

The Japanese public is on the whole comfortable with its postwar strategy. But with the rise of China, North Korean nuclear weapons and a potentially aggressive Russia, it cannot remain so for long. As the U.S. puts pressure on its allies to carry their own burdens, the Japanese strategy is becoming increasingly untenable. It cannot undergo a serious shift until the public does, and that means there will be an internal political crisis over the matter. But public opinion is already shifting, and the Japanese will face their reality.

Behind all this is an inevitable shift in U.S. foreign policy, visible in its stance on North Korea and elsewhere and rooted in the failure of U.S. warfare since World War II. The Korean War was a costly tie. Vietnam ended with Hanoi’s flag flying over Saigon. The wars in Iraq and Afghanistan failed to establish viable, pro-U.S. regimes. The only 20th century wars in which the U.S. fared well were those in which U.S. allies bore a massive part of the burden. These wars only ended well when there was no U.S. occupation or when the ruthless execution of the war shattered the morale of the enemy and permitted the U.S. to reshape the societies. And very few wars will be like that.

That U.S. strategy had to shift was obvious to me a decade ago when I wrote “The Next Decade.” The shift has arrived, and that means nations, enemies and allies are repositioning themselves. In Asia, the Chinese and Russians will mostly hold their positions. North Korea will exploit the shift to the extent it can.
But it is Japan that will have to undergo the most radical change.

Releasing the Renminbi

China’s authorities are committed to advancing the shift toward a market-driven economy, with a fully flexible exchange-rate regime. That means that, while it can credibly commit not to keep the value of the renminbi artificially low, it must reject US demands to keep the exchange rate stable against the dollar.

Yu Yongding

renminbi dollar bills

BEIJING – The United States is reportedly pushing China to agree to keep the value of the renminbi stable, as part of a deal to end the trade war between the world’s two largest economies. It is a demand that China must think twice about before accepting.

The renminbi was undoubtedly undervalued for many years, including through a peg to the US dollar that was established in 1998. A undervalued renminbi was an important contributing factor to the trade surplus that China has run consistently since 1993, when its per capita income stood at just $400. In other words, even when China was a very poor country, it was exporting capital to the rest of the world, especially the US.

Though running a trade surplus benefits some sectors of the economy for some period of time, it is unclear that it benefits the economy as a whole in the long run. Still, two decades of maintaining a current-account surplus (which includes trade), together with a capital-account surplus (fueled by large inflows of foreign direct investment), enabled China to accumulate huge foreign-exchange reserves and a large stock of FDI. As a result, though China is one of the world’s largest creditors, it has run an investment-income deficit for more than a decade.

But, over the last 15 years or so, China has been working to correct its trade imbalances. Since 2005, when the renminbi’s dollar peg was eliminated, it has appreciated steadily. By the end of 2013, its exchange against the dollar had strengthened by 35%. In the same year, China’s current-account surplus fell to just 2% of GDP, from its 2007 peak of 10.1%.

Moreover, since 2014, when looser capital controls left China’s capital account more responsive to broader changes in the global economy, the country has started to run significant capital-account deficits from time to time. Sometimes, those deficits are large enough to put the entire balance of payments in deficit, despite the trade surplus.

On August 11, 2015, China took a major step to boost exchange-rate flexibility: instead of setting a daily midpoint for the renminbi independently, the People’s Bank of China began basing the midpoint on the previous day’s closing prices. Initially, there was only slight downward pressure on the renminbi in the foreign exchange market. But the poorly timed move ended up fueling expectations of currency devaluation, spurring a surge in capital outflows that drove down the renminbi’s value further.

Some – including former US Federal Reserve Chair Janet Yellen, in a recent interview – have suggested that China devalued its currency that summer, in order to offset the effects of an appreciating dollar on the economy’s international competitiveness. The truth is that China, precisely because it feared that a depreciation would trigger even stronger expectations of further devaluation (ultimately endangering China’s financial stability), abruptly canceled the reform just days after it was initiated and began to intervene heavily in the foreign-exchange market to arrest the currency’s decline.

When those interventions slowed in 2016, the renminbi began to depreciate again, spurring the PBOC to resume intervention. The PBOC spent some $1 trillion of China’s foreign-exchange reserves in less than two years to stem downward pressure on the exchange rate. In 2017, thanks to the tightening of capital controls and a fall in the dollar index, the renminbi exchange rate finally stabilized.

There is no evidence that China has intervened to weaken the renminbi since – not even to offset the impact of higher US tariffs on Chinese exports – even as the exchange rate has fluctuated in response to fears about the trade war. The Chinese government knows that it is not in its best interests to manipulate its exchange rate. And, given China’s financial vulnerabilities, devaluation is particularly unappealing.

So, while the Trump administration’s fear that China is manipulating its exchange rate to gain a trade advantage is not irrational, it is unfounded. Still, China cannot commit to keep the renminbi stable against the US dollar.

China’s economic cycles are not synchronized with those of the US. The Federal Reserve may raise the federal funds rate at a time when the PBOC needs to cut its interest rate, which would spur capital outflows and drive down the renminbi’s value. It is a country’s sovereign right to decide its exchange-rate policy, and the US cannot expect to dictate China’s. So, even as it listens humbly to America’s complaints, China must retain full authority over its approach to the renminbi and be able to loosen monetary policy when economic conditions dictate, regardless of whether that causes the renminbi to depreciate.

The US would disapprove, but what other choice would China have? It cannot forfeit its monetary independence, and it is not in China’s interest to block capital outflows to offset depreciation pressure. Nor can it continue to use its hard-earned – and limited – foreign-exchange reserves to prop up the renminbi’s value. How can China be sure the balance is enough to maintain exchange-rate stability indefinitely?

Complicating matters further, the relationship between the renminbi’s value and the US dollar is not just bilateral. China has already committed to cut its trade surplus with the US – which comprises the majority of China’s overall trade surplus. If the US dollar rises in this context, China’s current account is likely to swing into deficit. Again, is China supposed to cut its imports from the rest of the world by whatever means necessary, or sacrifice its foreign-exchange reserves? This is not a purely bilateral issue – exchange rate misalignments often require international coordination to resolve.

China’s authorities are committed to advancing the shift toward a market-driven economy, with a fully flexible exchange-rate regime. So, in the current trade negotiations with the US, it can credibly commit not to keep the value of the renminbi artificially low. But under no circumstances should it promise to keep the exchange rate stable against the dollar.

Yu Yongding, a former president of the China Society of World Economics and director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences, served on the Monetary Policy Committee of the People’s Bank of China from 2004 to 2006. He has also served as a member of the Advisory Committee of National Planning of the Commission of National Development and Reform of the PRC.

Modern Monetary Nonsense

A number of leading progressive US politicians advocate using the Federal Reserve's balance sheet to fund expansive new government programs. Although their arguments have a grain of truth, they also rest on some fundamental misconceptions, and could have unpredictable and potentially serious consequences.

Kenneth Rogoff  

CAMBRIDGE – Just as the US Federal Reserve seems to have beaten back blistering tweets from President Donald Trump, the next battle for central-bank independence is already unfolding. And this one could potentially destabilize the entire global financial system.

A number of leading US progressives, who may well be in power after the 2020 elections, advocate using the Fed’s balance sheet as a cash cow to fund expansive new social programs, especially in view of current low inflation and interest rates. Prominent supporters of this idea, which is often referred to as “Modern Monetary Theory” (or MMT), include one of the Democratic Party’s brightest new stars, congresswoman Alexandria Ocasio-Cortez. Although their arguments have a grain of truth, they also rest on some fundamental misconceptions.

Fed Chair Jerome Powell could barely contain himself when asked to comment on this new progressive dogma. “The idea that deficits don’t matter for countries that can borrow in their own currency I think is just wrong,” Powell insisted in US Senate testimony last month. He added that US debt is already very high relative to GDP and, worse still, is rising significantly faster than it should.

Powell is absolutely right about the deficit idea, which is just nuts. The US is lucky that it can issue debt in dollars, but the printing press is not a panacea. If investors become more reluctant to hold a country’s debt, they probably will not be too thrilled about holding its currency, either. If that country tries to dump a lot of it on the market, inflation will result. Even moving to a centrally planned economy (perhaps the goal for some MMT supporters) would not solve this problem.

On Powell’s second point, that US debt is already high and rising too fast, there is far more room for debate. True, debt cannot rise faster than GDP forever, but it may do so for quite a while. Today’s long-term, inflation-adjusted interest rates in the US are about half their 2010 level, far below what markets were predicting back then, and far below Fed and International Monetary Fund forecasts. At the same time, inflation has also been lower for longer than virtually any economic model would have predicted, given current robust US growth and very low unemployment.

What’s more, despite being at the epicenter of the global financial crisis, the US dollar has become increasingly dominant in global trade and finance. For the moment, the world is quite content to absorb more dollar debt at remarkably low interest rates. How to exploit this increased US borrowing capacity is ultimately a political decisión.

That said, it would be folly to assume that current favorable conditions will last forever, or to ignore the real risks faced by countries with high and rising debt. These include potentially more difficult risk-return tradeoffs in using fiscal policy to fight a financial crisis, respond to a large-scale natural disaster or pandemic, or mobilize for a physical conflict or cyberwar. As a great deal of empirical evidence has shown, nothing weighs on a country’s long-term trend growth like being financially hamstrung in a crisis.

The right approach to balancing risk and reward is for the government to extend the maturity structure of its debt, borrowing long-term instead of short-term. This helps to stabilize debt-service costs if interest rates rise. And if things get really difficult, it is far easier to inflate down the value of captive long-term debt (provided it is not indexed to prices) than it is to inflate away short-term debt, which the government constantly has to refinance.

True, policymakers could again resort to financial repression, and force citizens to hold government debt at below-market interest rates, as an alternative way of reducing the debt burden. But this is a better option for Japan, where most debt is held domestically, than for the US, which depends heavily on foreign buyers.

Having the Fed issue short-term liabilities in order to buy long-term government debt turns policy 180 degrees in the wrong direction, because it shortens the maturity of US government debt that is held privately or by foreign governments. Contrary to widespread opinion, the US central bank is not an independent financial entity: the government owns it lock, stock, and barrel.

Unfortunately, the Fed itself is responsible for a good deal of the confusion surrounding the use of its balance sheet. In the years following the 2008 financial crisis, the Fed engaged in massive “quantitative easing” (QE), whereby it bought up very long-term government debt in exchange for bank reserves, and tried to convince the American public that this magically stimulated the economy. QE, when it consists simply of buying government bonds, is smoke and mirrors. The Fed’s parent company, the US Treasury Department, could have accomplished much the same thing by issuing one-week debt, and the Fed would not have needed to intervene.

Perhaps all the nonsense about MMT will fade. But that’s what people said about extreme versions of supply-side economics during Ronald Reagan’s 1980 US presidential campaign.

Misguided ideas may yet drag the issue of US central-bank independence to center stage, with unpredictable and potentially serious consequences. For those bored with the steady employment growth and low inflation of the past decade, things could soon become more exciting.

Kenneth Rogoff, Professor of Economics and Public Policy at Harvard University and recipient of the 2011 Deutsche Bank Prize in Financial Economics, was the chief economist of the International Monetary Fund from 2001 to 2003. The co-author of This Time is Different: Eight Centuries of Financial Folly, his new book, The Curse of Cash, was released in August 2016.

Federal Reserve’s fundamental rethink about inflation

Can monetary regime prevent US from morphing into eurozone or Japan in next recession?

Gavyn Davies

The most influential members of the FOMC believe the Phillips Curve is 'alive and well' © Kevin Lamarque/Reuters

The US Federal Reserve has announced that it will conduct a root and branch review of its monetary policy framework in the next 18 months. The results could be of first order importance for financial markets, especially the bond market.

Richard Clarida, the Fed’s vice-chairman said last month that the motivation was not any great dissatisfaction with the present policy. Both of the twin objectives — maximum employment and stable prices — were close to target.

Instead, the Federal Open Market Committee seems concerned that inflation is failing to respond to recovering economic activity, implying that it might be difficult to cope with even lower inflation when the economy next enters a recession.

The fact that US inflation has not responded to sharply falling unemployment levels, sometimes known as the disappearance of the Phillips Curve, is often described as a puzzle. However, that word is misleading, since a great deal of recent research has established the main reasons for the loosening of this relationship.

Structural factors such as the effects of the internet and Chinese imports on goods prices have been important. But a key conclusion is that the growing credibility of the Fed’s 2 per cent inflation target has anchored inflation expectations, so that any temporary fluctuations in inflation and economic activity are ignored. In the decades before 1990, inflation shocks were often “accommodated” by monetary policy, altering expectations, and causing substantial spikes in inflation.

This change in the inflation mechanism is a good thing, but it means that the FOMC cannot rely on easily controlling inflation by adjusting economic activity and unemployment, via interest rate policy. In an extreme case where inflation does not respond at all to unemployment, inflation becomes indeterminate, spelling the end of monetary policy as we know it.

The Fed does not believe that the US has reached this extreme state. The most influential members of the FOMC believe the Phillips Curve is “alive and well”. But they think that the flattening in the curve emphasises the importance of keeping inflation expectations anchored to the 2 per cent target, whether inflation shocks are upwards or downwards.

At present, there is no sign of any upward shift in inflation expectations but the FOMC is concerned that expectations may drop well below the 2 per cent target during the next recession.

This is because the effective lower bound on nominal interest rates is fairly close to zero, while the equilibrium level of interest rates (r*) is also lower than before. Because of this combination, it may be hard to offset a large deflationary shock by lowering interest rates far enough below equilibrium. Eventually that might lead to a permanent drop in inflation expectations, as has occurred in Japan and more recently the eurozone (see box).

The main focus of the Fed’s review can therefore be loosely summarised as follows: how can the monetary regime prevent the US from morphing into the eurozone or Japan during the next recession?

One idea for avoiding the Japanese deflationary trap is simply to raise the existing inflation target from 2 per cent to 3-4 per cent, but Mr Clarida has specifically ruled this out. The current mechanism always aims for 2 per cent inflation in the period immediately ahead, and does not compensate for any shortfalls in the past. This leads to a downwards bias in the actual path for inflation over long periods.

Instead, the central bank could target the average inflation rate at 2 per cent in the long term.

When prices fall below the long-run 2 per cent target during a recession, the Fed would credibly commit to compensating for this error during the subsequent recovery.

Forward guidance would be reinforced, and policy would be kept easier for longer, until prices got back on to the 2 per cent track. This would mean that the short run inflation rate may exceed 2 per cent while the catch-up to the long-term path occurs.

The FOMC is already moving in this direction with recent policy decisions. The main question is how they should formalise the new regime, such that it survives the difficult political tests when inflation temporarily rises to more than 2 per cent during the catch-up periods. Former Fed chairman Ben Bernanke has made influential suggestions about this but the details are open for debate.

There will also be discussion about new policy instruments to make the effectiveness of the new regime credible, especially at times when interest rates are at the effective lower bound, and quantitative easing is fully utilised.

The leading idea appears to the imposition of Japanese-style bond-yield ceilings, enforced by unlimited central bank buying of bonds.

Remarkably, that would take the Fed back to its pre-1951 regime, under which it committed to support the war effort by buying enough Treasury securities to keep long bond yields under 2.5 per cent, whatever the stance of fiscal policy. That nuclear option will not be used outside a big economic emergency, but it is interesting that it is even mentioned as the review gets under way.

What would be the market consequences of long-term “average” inflation targeting?

- The tail risk of endemic deflation would decline, and long-term inflation expectations might be slightly higher than before. This would help risk assets.

- The volatility of inflation and bond yields would decline still further.

- The average level of nominal bond yields might be little changed, but inflation break-evens would rise while real yields decline, reflecting the longer periods of easier monetary policy that would be needed to allow the phases of inflation catch-up to occur.

The bigger the next deflationary shock, the greater these effects would be.

The collapse in inflation volatility after 1990 in advanced economies

Inflation volatility in the US has plummeted, with core inflation settling close to the 2 per cent target.In the eurozone, inflation has become stuck at 1 per cent, well below target.In Japan, the situation is even worse, with inflation fixed permanently at zero.

 In the eurozone, inflation has become stuck at 1 per cent, well below target.

In Japan, the situation is even worse, with inflation fixed permanently at zero.

The allure of financial tricks is fading

There are dozens of examples of companies making Faustian bargains to please Wall Street

Rana Foroohar

It was only a matter of time before Apple issued a credit card. The world’s first company to reach a $1tn market value has more cash on hand and more global reach than most banks, so why shouldn’t it act like one? The move, which is in partnership with Goldman Sachs, is something that many of its shareholders have long advocated. Carl Icahn, who dumped the stock a few years ago over concerns about the company’s China sales, told me Apple should be a bank way back in 2013. But it is also an example of a market trend known as financialisation.

That is a wonky term used mostly by academics to describe the rise of finance and financially-oriented behaviour throughout our economy. This catch-all covers everything from criticisms that companies are prioritising value for shareholders, to claims that some executives are manipulating balance sheets to boost their short-term results. It also takes in companies that focus more on finance than their core businesses and those that load up on corporate debt. The trend is ubiquitous.

Apple is not alone in trying to act like a bank: academic research shows that the share of revenues coming from financial relative to non-financial activities in US corporations began to climb in the 1970s and then increased sharply from the 1980s onwards. This mirrors the rise of finance in the economy itself.

Such financialisation has been a key driving force in the global economy for several decades. But I now believe we have reached what I call “peak Wall Street”, the apex of that trend, and there will be diminishing returns for companies that choose to focus more on markets than the real economy.

The evidence is all around us. Consider the decline of Kraft Heinz. The company demonstrates how a strategy focused on short-term financial results can backfire.

The packaged foods group is partly owned and run by Brazilian private equity group 3G, which made its name through extreme cost-cutting and zero-based budgeting that focused on profit margins rather than growing sales. The private equity group has been accused of eschewing longer-term investment while employing short-term financial tricks such as paying suppliers late in order to improve free cash flow. Kraft Heinz has lost more than half its equity value since its creation in a 2015 merger.

Then there is the US shale industry. Activist investors — or barbarians at the gate to their critics — have been swarming, looking for companies with bloated budgets that need trimming. There are plenty of targets, thanks to an overexpansion funded by investors seeking higher yields.

The energy bond market has tripled in size in the past decade, but much of the money has funded higher executive salaries and an output glut. Debt-laden companies are now ripe for forced consolidation by private equity and other investors.

You could come up with dozens of other timely, high-profile examples of companies that have stumbled after making Faustian bargains to please Wall Street. (General Electric comes to mind: it was forced last year to commit more than $15bn to support losses from a long since spun-out insurance division.)

The multiyear explosion in share buybacks, which increase earnings per share by reducing the number of shares, reflects the trend. Warren Buffett may argue that buybacks are a welcome use of spare cash. But I think they are best done at the start of a credit cycle, rather than at the end, which is where we appear to be now. Most companies are buying back shares not as a vote of self-confidence in their own future, but as a way to boost their share prices — a classic financialised move.

The US Federal Reserve’s surprise decision in January to pause interest rate increases may keep buybacks coming for a bit longer. That is because lower rates make it cheaper to borrow money to pay for all those shares. But the fact that the Fed was forced into a U-turn by choppy markets is another sign of too much financialisation. Easy money has become a morphine drip that too many companies and investors can’t seem to do without, even though we are nearly 10 years into an economic recovery.

In fact, low interest rates have papered over myriad political and economic problems not just for 10 years but for several decades. Total financial assets are now more than triple the size of the real economy. The corporate bond market is now worth $13tn — twice as much as in 2008.

Debt is, of course, the lifeblood of finance. But it is also the biggest indicator of future crises.

The OECD, the Paris-based club of mostly rich nations, last week warned about the record amount of debt in the corporate bond market in its historically low ratings. More than half of investment grade bonds issued in 2018 were of the lowest possible quality.

This may amplify the effects of an economic slowdown that many feel is imminent. “The amount of corporate bond investments that may be expected to default in the case of an economic downturn may be considerably larger than that experienced in the financial crisis,” the OECD said.

Already heavily indebted sectors such as energy are experiencing higher levels of default. Financialisation has risen for nearly five decades now. But like much else in the markets today, it seems ripe for a correction.

Central Bank Independence Doesn’t Matter—Until It Does

Philippine President Rodrigo Duterte has appointed a central banker from the cabinet. Investors may rue the decision one day.

By Mike Bird

Philippine President Rodrigo Duterte appointed a political ally as head of the country’s central bank.
Philippine President Rodrigo Duterte appointed a political ally as head of the country’s central bank. Photo: mark r cristino/Shutterstock

Central bank independence is under threat as politicians around the world meddle more in monetary policy. Investors, so far, haven’t seemed to care too much. By the time they miss it, it may be too late.

Philippine President Rodrigo Duterte—no stranger to controversy—on Tuesday handed control of the Asian country’s central bank to a political ally, Benjamin Diokno. Mr. Diokno is a professional economist and technocrat. But he’s also the first person to go directly from the Philippine cabinet to helming the central bank since it became independent in 1993, having previously been Mr. Duterte’s budget supremo.

In that role, he advocated for a larger budget deficit, so it’s little wonder Mr. Duterte would back him for the job. Central bankers who are likely to keep interest rates low to facilitate borrowing are music to the ears of populist leaders who want to keep on spending.

Still, if the appointment poses a threat to economic stability in the Philippines, markets seem little bothered. The dollar rose marginally against the Philippine peso on Tuesday, gaining 0.7% to 52.2. The country’s benchmark equity index, the PSEi, fell 0.1%.

Likewise, investors cared little when India’s former central bank head resigned late last year after months of tension with the government, to be replaced by someone more to Prime Minister Narendra Modi’s taste. Closer to home, the market has largely shrugged off President Donald Trump’s public disagreements with Federal Reserve Chairman Jerome Powell.

In recent years, some markets even rallied when a political leader appointed a like-minded ally to run the central bank. Japan’s benchmark Nikkei Stock Average surged about 80% during Japanese Prime Minister Shinzo Abe’s two-year first term, during which he elevated Haruhiko Kuroda to head of the Bank of Japan .

Investors should care more about this erosion of central bank autonomy even so. For sure, when a major economy like Japan is struggling to escape deflation, investors rightly care more about returning it to strength than the country’s institutional integrity.

The Philippines, which clocked an inflation rate of as high as 6.7% in 2018, doesn’t have that problem though. A more relevant warning for Manila comes from Turkey, where a politically compromised central bank’s lack of action against raging inflation and a tumbling currency left the MSCI Turkey index down 45% in dollar terms last year.

When an economy comes under pressure, investors need a monetary authority they can trust to do the right thing, regardless of political pressure. In those circumstances, knowing that a central bank will take necessary and painful measures to stem capital outflows and protect the value of a currency matters a great deal.

Investors may not feel able to price in a future monetary emergency today. They should still worry about what this latest chipping away of central banks’ independence means for the future.

The Fed Faces a New World

By Matthew C. Klein

Central bankers have no popular mandate. They are not elected and are only indirectly accountable to the public. Yet they are granted the “independence” to take unpopular decisions, at least up to a point. Their independence isn't guaranteed, nor does it always mean the same thing at different points in time. Rather, it is contingent on circumstances.

As Philipp Carlsson-Szlezak and Paul Swartz of Bernstein Research put it in a recent note, “Central banks cannot escape their political underpinnings.”
In the years after the financial crisis, the political environment probably constrained the Federal Reserve’s ability to boost the U.S. economy. Things may now be shifting in the other direction.

Consider Fed Chairman Jerome Powell’s latest experience testifying before Congress, which occurred this past week. On Tuesday and Wednesday, he took questions from the Senate and the House, respectively. While many of the questions focused on technical issues, such as the implementation of the new Current Expected Credit Loss accounting standard, the optimal level of bank reserves held on deposit at the Fed, and the Fed’s process for vetting proposed bank mergers, several members from both parties pushed Powell and his colleagues to focus on raising wages and altering the economic split between workers and investors.

Sen. Sherrod Brown (D., Ohio) told Powell that he believed “the Fed has the authority and the duty to be creative, to help workers share in the prosperity they create.” Sen. Tom Cotton (R., Ark.) wanted to know why “we’re seeing more income going into the hands of owners in this country and less into the hands of workers.” He then went on to clarify that he wanted “more of that economic pie going into the hands of our workers.”

Rep. Denny Heck (D., Wash.) wanted to know whether Powell and his colleagues would be “willing to let wage growth climb to 4% to begin to recover some of the decline that we’ve experienced in the labor share of income.” Heck also declared that “we need to place a greater emphasis on wage growth.” Rep. Roger William (R., Texas) warned Powell to “be careful when you start raising the interest rates because it can affect the economy.”

These are only a few legislators, but they could be a harbinger of a shift compared with the recent past. It wasn't long ago that prominent politicians criticized Ben Bernanke for “printing money” and Janet Yellen for keeping interest rates too low. That external pressure could help explain why the Fed has been more willing to err on the side of undershooting its inflation objective by limiting the size of its asset-purchase programs and raising interest rates in response to strong employment data. Its efforts to boost the economy always came with caveats about upcoming exit plans.

The Fed’s hawkish critics have been replaced by a bipartisan coalition in favor of faster wage growth and a cautious approach to monetary tightening, with President Donald Trump the most obvious member.

The new perspective would be a return to normal. For most of the Fed’s history, U.S. politicians have preferred to push the central bank to lower interest rates to boost growth even if that would theoretically risk excess inflation. The first, and most extreme, example was in the 1930s, when President Franklin D. Roosevelt restructured the Fed’s governance and operations in response to the failure of the Depression. Reflation was the priority, which eventually included an explicit promise to cap interest rates during and after World War II.

The Fed temporarily regained some of its autonomy—and an anti-inflationary mind-set—in the 1950s, but by the mid-1960s it was once again being pressured by politicians to focus more on growth. President Lyndon Johnson accosted Fed Chairman William McChesney Martin and claimed that interest-rate increases were an affront to the men fighting in Vietnam. While Martin did raise rates after that meeting, his efforts were not nearly sufficient to arrest America’s inflationary trend.

President Richard Nixon successfully pressured Arthur Burns—with the help of Alan Greenspan, Burns’ former Ph.D. student—to boost the economy in advance of the 1972 election. Paul Volcker’s disinflationary campaign faced relentless attacks from across the political spectrum during his tenure. He eventually felt compelled to leave the Fed after it became stacked with officials he disagreed with.

Greenspan, who had gotten the Fed job in 1987 in part because of his reputation as a loyal political hack, soon found himself facing severe criticism for his perceived unwillingness to respond to the recession of the early 1990s. (Unlike his predecessors, Greenspan had the political smarts to cultivate allies in Congress and the business community.) By the mid-1990s, however, he was self-censoring.

Even though he believed it would ultimately hurt the economy, Greenspan felt the Fed lacked the political capital to lean against the stock market bubble. Despite being at the peak of his prestige, he therefore chose to do nothing. “Independence” was only worth so much.

The changing political environment could cause a shift in Powell’s stated priorities. He has repeatedly claimed that wage growth should equal inflation plus productivity growth, but not exceed it. That, however, is a recipe for keeping the labor share of income constant. It would not reverse the decline since 2000. The only way to raise workers’ pay relative to the value of what they produce is for wages to grow by more than inflation plus productivity.

Paul McCulley, then Pimco’s chief economist, made this point in 2014, citing his colleague Richard Clarida and dubbing the labor share of income “Rich’s Ratio.” After years in which workers bore the brunt of the Fed’s “war” on inflation, McCulley judged that the time had come for a “peace dividend.” Shortly thereafter, Clarida argued that real wages could rise faster than productivity without risking inflation because the growth would manifest in a higher labor share of income. Clarida, of course, is now the Fed’s vice chairman.

Europe’s Leaders Are Aiding Italy’s Populists

The fact that Italy’s public debt has a lower credit rating than private debt is a reflection not of public debt’s intrinsic inferiority but of a political choice made by European leaders. And, by bolstering an authoritarian politician, that choice is now blowing back on them.

Yanis Varoufakis

ATHENS – Italy is now the frontline in the battle of the euro. Deputy Prime Minister Matteo Salvini is being propelled by a political tailwind that may, after the European Parliament elections in May, enhance his capacity to inflict serious damage on the European Union. What is both fascinating and disconcerting is that the xenophobia underpinning Salvini’s ever-increasing authority is being generated by the eurozone’s faulty architecture and the ensuing political blame game.

In its recent report on the economic imbalances afflicting each EU member state, the European Commission blames the Italian government for its failure to rein in debt, which, it says, results in tepid income growth. According to the Commission, the government’s reluctance to cut its budget deficit has spooked the bond markets, pushed interest rates up, and thus shrunk investment.

Salvini could not be more pleased. The report presents a splendid opportunity to blame the Commission itself for Italy’s travails, by arguing that it was actually the EU’s fiscal austerity policies which constricted growth, pushed the economy to the brink of a new recession, and led to the election of the populist government now dominated by Salvini. And, as if that were not enough, it was the Commission’s threats of penalizing Italy unless it imposed even greater austerity that unnerved bond traders and pushed interest rates up.

Italy’s tragedy is that the Commission and Salvini are both right – and also both wrong. It is correct that Salvini’s announcement that the government would rescind its promise to impose pre-agreed levels of austerity alarmed investors, made Italian debt less viable, and caused capital flight. But it is also correct that the Commission’s fiscal rules, were they to be implemented fully, would have caused a recession that would have made Italian debt less viable anyway.

When two clashing explanations of the same phenomenon are both correct, they must be incomplete, even if they capture different aspects of observed reality. In such cases, it is useful to adopt a new vantage point from which to take a fresh look at the problem. When it comes to the Brussels-Rome clash, I believe, that vantage point is on the other side of the world: Tokyo.

Italy is, in an important sense, Europe’s Japan. Both economies are typified by a strong export-oriented industrial sector, a current-account surplus, similar terms of trade, terrible demographics, and, following years of imprudent lending, zombie-like banks. Moreover, they are also alike in the composition of their financial liabilities, featuring relatively low private debt and very high public debt.

Unlike Italy, Japan’s political center is still holding because median incomes have risen a little as the economy was being stabilized by a central bank that printed money as if there were no tomorrow and governments that implemented one fiscal stimulus after another. Had Japan’s government labored under the type of restrictions imposed on Italy by the EU treaties and the eurozone’s fiscal and monetary rules, Japanese society would now be in tumult.

Indeed, if financing for Japan’s economy and banking system had been provided by an external central bank bent on enforcing fiscal austerity by threatening to withhold liquidity, then a doom loop of insolvent banks, rising bond yields, and recessionary forces would have been inevitable. Politically toxic populism would not lag far behind, occasioning the same kind of clashing-though-compatible narratives that we now hear from the European Commission and Italy’s government.

An intra-European comparison sheds additional light on the conundrum facing Italy and the eurozone. Spain and Italy have almost identical debt-to-GDP ratios (298.3% and 301%, respectively). So, why is everyone talking about Italy’s debt and not Spain’s? The answer is that 67% of Spain’s debt is private, whereas 64% of Italian debt is public.

In theory (and in law), the European Central Bank is not allowed to monetize any debt, public or private. In practice, however, the ECB has been able and willing to monetize private debt fully, simply by accepting as collateral private debt not even worth the paper it is printed on (for example, stressed Italian mortgages and Greek banks’ IOUs). In contrast, the ECB spent years refusing to buy government debt and, when it did, chose to exclude large swaths of bonds from its asset-purchase program. Put simply, any country whose debt was tilted toward the private sector, like Ireland and Spain, did much better than a country like Italy.

The eurozone’s defenders will reply that it is right that countries are penalized for allowing a high proportion of public debt. The ideological bias against anything public is not limited to the realm of utilities and railways. The credit rating agencies’ readiness to downgrade the bonds of any government that challenges conventional wisdom reinforces the neoliberal assumption that private debt is, by definition, less problematic than public debt.

But even free-market fundamentalists should realize how unsafe this assumption is. If the 2008 financial crisis taught us anything, it is that risks are too endogenous for comfort. Even if no corruption is involved, credit ratings and political choices are co-determined: If the ratings agencies get a whiff that the ECB will choke off Italian liquidity, they have a duty to their customers to downgrade Italian bonds. And if the ECB predicts that Italian bonds will be downgraded, its rules instruct it to diminish liquidity in the Italian banking sector.

When some infrastructure project is to be built, why should it matter whether it is the state or private developers that borrow to fund it? In the eurozone, this matters, because the ECB has much greater leeway to refinance stressed private debt than public debt. But this is a political choice, not an economic reality. The fact that Italy’s public debt has a lower credit rating than private debt is a reflection not of public debt’s intrinsic inferiority but of a political choice by European leaders. And, by bolstering an authoritarian politician, that choice is now blowing back on them.

Yanis Varoufakis, a former finance minister of Greece, is Professor of Economics at the University of Athens.

Quantitative easing was the father of millennial socialism

Federal Reserve’s bid to stave off depression sowed the seeds of a generational revolt

David McWilliams

Former Federal Reserve chair Ben Bernanke’s quantitative easing scheme spawned a new generation of socialists, such as Alexandria Ocasio-Cortez © Bloomberg/Getty

Is Ben Bernanke the father of Alexandria Ocasio-Cortez? Not in the literal sense, obviously, but in the philosophical and political sense.

As we mark the 10th anniversary of the bull market, it is worth considering whether the efforts of the US Federal Reserve, under Mr Bernanke’s leadership, to avoid 1930s-style debt deflation ended up spawning a new generation of socialists, such as the freshman Congresswoman Ms Ocasio-Cortez, in the home of global capitalism.

Mr Bernanke’s unorthodox “cash for trash” scheme, otherwise known as quantitative easing, drove up asset prices and bailed out baby boomers at the profound political cost of pricing out millennials from that most divisive of asset markets, property. This has left the former comfortable, but the latter with a fragile stake in the society they are supposed to build.

As we look towards the 2020 US presidential election, could Ms Ocasio-Cortez’s leftwing politics become the anthem of choice for America’s millennials?

But before we look forward, it is worth going back a bit. The 2008 crash itself didn’t destroy wealth, but rather revealed how much wealth had already been destroyed by poor decisions taken in the boom. This underscored the truism that the worst of investments are often taken in the best of times.

Mr Bernanke, a keen student of the 1930s, understood that a “balance sheet recession” must be combated by reflating assets. By exchanging old bad loans on the banks’ balance sheets with good new money, underpinned by negative interest rates, the Fed drove asset prices skywards. Higher valuations fixed balance sheets and ultimately coaxed more spending and investment. However, such “hyper-trickle-down” economics also meant that wealth inequality was not the unintended consequence, but the objective, of policy.

Soaring asset prices, particularly property prices, drive a wedge between those who depend on wages for their income and those who depend on rents and dividends. This wages versus rents-and-dividends game plays out generationally, because the young tend to be asset-poor and the old and the middle-aged tend to be asset-rich. Unorthodox monetary policy, therefore, penalises the young and subsidises the old.

When asset prices rise much faster than wages, the average person falls further behind. Their stake in society weakens. The faster this new asset-fuelled economy grows, the greater the gap between the insiders with a stake and outsiders without. This threatens a social contract based on the notion that the faster the economy grows, the better off everyone becomes.

What then? Well, politics shifts.

Notwithstanding Winston Churchill’s observation about a 20-year-old who isn’t a socialist not having a heart, and a 40-year-old who isn’t a capitalist having no head, polling indicates a significant shift in attitudes compared with prior generations.

According to the Pew Research Center, American millennials (defined as those born between 1981 and 1996) are the only generation in which a majority (57 per cent) hold “mostly/consistently liberal” political views, with a mere 12 per cent holding more conservative beliefs.

Fifty-eight per cent of millennials express a clear preference for big government. Seventy-nine per cent of millennials believe immigrants strengthen the US, compared to just 56 per cent of baby boomers. On foreign policy, millennials (77 per cent) are far more likely than boomers (52 per cent) to believe that peace is best ensured by good diplomacy rather than military strength. Sixty-seven per cent want the state to provide universal healthcare, and 57 per cent want higher public spending and the provision of more public services, compared with 43 per cent of baby boomers. Sixty-six per cent of millennials believe that the system unfairly favours powerful interests.

One battle ground for the new politics is the urban property market. While average hourly earnings have risen in the US by just 22 per cent over the past 9 years, property prices have surged across US metropolitan areas. Prices have risen by 34 per cent in Boston, 55 per cent in Houston, 67 per cent in Los Angeles and a whopping 96 per cent in San Francisco. The young are locked out.

Similar developments in the UK have produced comparable political generational divides. If only the votes of the under-25s were counted in the last UK general election, not a single Conservative would have won a seat. Ten years ago, faced with the real prospect of another Great Depression, Mr Bernanke launched QE to avoid mass default.

Implicitly, he was underwriting the wealth of his own generation, the baby boomers. Now the division of that wealth has become a key battleground for the next election with people such as Ms Ocasio-Cortez arguing that very high incomes should be taxed at 70 per cent.

For the purist, capitalism without default is a bit like Catholicism without hell. But we have confession for a reason. Everyone needs absolution. QE was capitalism’s confessional. But what if the day of reckoning was only postponed?

What if a policy designed to protect the balance sheets of the wealthy has unleashed forces that may lead to the mass appropriation of those assets in the years ahead?

The writer is an economist, author and broadcaster

Trump’s China Deal Could Punish U.S. Allies

America first in a U.S.-China trade pact could deal a serious blow to the economies of friends around the world

By Nathaniel Taplin

Beijing and President Trump appear near to a trade deal: China buys a lot more U.S. stuff, gives some ground on auto-industry protections and intellectual property, and mostly ignores other U.S. complaints.

What would that mean in practice? Mainly, a boost to already-competitive U.S. industries like natural gas, agriculture and autos—and a big hit to other major exporting nations.

Some details emerged Sunday. As part of any deal, China could commit to buying $18 billion worth of gas from U.S. exporter Cheniere . LNG -0.70%▲ The period isn’t clear, but liquefied natural gas purchase agreements are often signed for 10 years or longer.

China might have ended up purchasing a lot of Cheniere’s gas anyway. Spot LNG prices in recent months have ranged between $6 and $12 per million British thermal units: Cheniere has previously estimated its break-even costs for Asian delivery from future projects at $7.50 to $8.50. If the purchase agreement is confirmed, Cheniere should be able to greenlight its sixth LNG train at Sabine Pass, La., which would lift the terminal’s annual capacity to 27 million metric tons—around 10% of current global demand.

So sorry, Australia.
So sorry, Australia. Photo: Lindsey Janies/Bloomberg News

The losers would be other big exporters that have invested or plan to invest billions in LNG, among them U.S. allies Australia and Canada. After years of waffling, investors approved a $30 billion LNG plant in British Columbia in 2018, and in eastern Canada another big project awaits a final investment decision. Australia, a dominant LNG supplier to China, has been banking on rising exports to offset falling coal revenue.

If the U.S. and China do conclude a deal, U.S. friends in Asia could get hit as well. An extra $1.35 trillion in U.S. exports to China over five years—close to the $1.2 trillion figure cited by Treasury Secretary Steven Mnuchin in December—would cost Japan $28 billion annually (3% of its exports), Barclaysestimates. Korea could lose $23 billion (3.1% of total exports); Taiwan, $20 billion (3.2% of exports).

Such a large diversion of trade may be impossible near-term. And some Japanese cars previously headed to China, for instance, would head to the U.S. instead. But the risk is that the U.S.-China pact will severely damage to the economies of the very allies the U.S. is counting on to help balance China’s rise in Asia.

For Beijing, that sounds like a very good deal indeed.