Full Capitulation

Doug Nolan

April 16 – Bloomberg (Rich Miller and Craig Torres): “Federal Reserve Chairman Jerome Powell and his colleagues have made an important shift in their strategy for dealing with inflation in a prelude to what could be a more radical change next year. The central bank has backed off the interest-rate hikes it had been delivering to avoid a potentially dangerous rise in inflation that economic theory says could result from the hot jobs market. Instead, Powell & Co. have put policy on hold until sub-par inflation rises convincingly.”

April 15 – CNBC (Thomas Franck): “Chicago Federal Reserve President Charles Evans said on Monday that he’d be comfortable leaving interest rates alone until autumn 2020 to help ensure sustained inflation in the U.S. ‘I can see the funds rate being flat and unchanged into the fall of 2020. For me, that’s to help support the inflation outlook and make sure it’s sustainable,’ Evans told CNBC’s Steve Liesman.”

April 15 – Reuters (Trevor Hunnicutt): “The U.S. Federal Reserve should embrace inflation above its target half the time and consider cutting rates if prices do not rise as fast as expected, a top policymaker at the central bank said… ‘While policy has been successful in achieving our maximum employment mandate, it has been less successful with regard to our inflation objective,’ Federal Reserve Bank of Chicago President Charles Evans said… ‘To fix this problem, I think the Fed must be willing to embrace inflation modestly above 2% 50% of the time. Indeed, I would communicate comfort with core inflation rates of 2-1/2%, as long as there is no obvious upward momentum and the path back toward 2% can be well managed.”

It's stunning how dramatically the Fed’s perspective has shifted since the fourth quarter.

There’s now a chorus of Fed governors and Federal Reserve Bank Presidents calling for the central bank to accommodate higher inflation. Watching the inflation data (March CPI up 1.9% y-o-y), it’s not readily apparent what has them in such a tizzy. And with crude prices surging 40% to start 2019, it takes some imagining to see deflationary pressures in the pipeline.

The Fed’s (and global central banks’) dovish U-turn was clearly in response to December’s global market instability. Quickly, the global system was lurching toward the precipice. Acute fragility revealed – and central bankers were left shaken. And witnessing the speculative fervor that has accompanied central bankers change of heart, the backdrop is increasingly reminiscent of Bubble Dynamics following the 1998 LTCM bailout. A Bloomberg headline from earlier in the week caught my attention: “Evans Sees Lessons From 1998 Rate Cuts for Fed Policy This Year.” It said, “For the Chicago Fed president Charles Evans the situation recalls the Asian financial crisis of 1998. According to Evans, ‘The risk-management approach taken by the Fed is not unusual. It served us well in similar situations in the past.’”

Historical revisionism. For starters, the Asian crisis was in 1997. The Fed aggressively reduced rates from 5.50% to 4.75% in the Autumn of 1998 in response to the simultaneous Russia and Long-Term Capital Management (LTCM) collapses.

From Evans’ April 15, 2019 speech, “Risk Management and the Credibility of Monetary Policy:”

“Later, in the autumn of 1998, the fallout on domestic financial conditions from the Russian default led to a downgrading of the economic outlook and an aggressive 75 basis point easing in the funds rate over a two-month period. When making the first of those cuts, the FOMC noted that easing would ‘provide added insurance against the risk of a further worsening in financial conditions and a related curtailment in the availability of credit to many borrowers.’”

Clearly many borrowers – and the system more generally - should have faced much tighter Credit Availability by late-1998 – certainly including those aggressively partaking in leveraged speculation (equities, fixed-income and derivatives) and debt gluttons in the real economy - including the highly levered telecom companies (i.e. WorldCom, Global Crossing, XO Communications and a long list) and others (i.e. Enron, Conseco, PG&E, etc.).

Evans, not surprisingly, skips over LTCM. That the Fed orchestrated a bailout of this renowned hedge fund sent a very clear message that the Federal Reserve and global central banks were there to backstop the new financial infrastructure that was taking control of global finance (Wall Street firms, derivatives, the leveraged speculating community, Wall Street structured finance and securitizations). If the Fed had allowed the system take the harsh medicine in 1998 the world would be a much safer place today.

Evans: “How did this risk-management strategy turn out? In the end, the economy weathered the situation well. Productivity accelerated sharply, and by early 1999 growth was on a firm footing. Subsequently, the FOMC raised rates by a cumulative 175 basis points by May of 2000.”

Evans leaves out the near doubling of Nasdaq in 1999, along with what I refer to as “terminal phase” Bubble excess. The bottom line is the Fed aggressively loosened policy while the system was in the late-stage of a significant Bubble, and then failed to remove this accommodation until mid-November 1999.

And let’s not forget that the subsequent bursting of the so-called “tech bubble” led to what was, at the time, unprecedented monetary stimulus – including Dr. Bernanke’s speeches extolling the virtues of the “government printing press” and “helicopter money.” These measures were instrumental in fueling the mortgage finance bubble that burst in 2008. That collapse then led to a decade-long – and ongoing - global experiment in zero rates, open-ended money-printing and yield curve manipulation.

This whole fixation on deflation risk and CPI running (slightly) below target gets tiring - after a few decades. Clearly, the evolution to globalized market-based finance has profoundly altered the nature of inflation. CPI is no longer a paramount issue – especially with the proliferation of new technologies, the digitization of so much “output,” the move to services-based economies and, of course, globalization. There is today a virtual endless supply of goods and services – certainly including digital downloads, electronic devices and pharmaceuticals – that exert downward pressure on aggregate consumer prices. Importantly, consumer price indices are no longer a reliable indicator of price stability, general monetary stability or the appropriateness of central bank policies.

Central bank officials today lack credibility when they direct so much attention to consumer price inflation while disregarding the overarching risks associated with unrelenting global debt growth, highly speculative and leveraged global financial markets, and deep global economic structural maladjustment. In the grand scheme of things, consumer prices running just below target seems rather trivial. What’s not trivial are central bankers that now appear to have accepted that they will accommodate financial excess and worsening structural impairment. At this point, it appears Full Capitulation.

In the same vein (and same day) as Evans’ speech, former President of the Federal Reserve Bank of Minneapolis, Narayana Kocherlakota, posted a Bloomberg editorial: “The Fed Needs to Fight the Next Recession Now. Its tools are limited, so the central bank must compensate by being aggressive.”

“Almost 10 years after the Great Recession ended, the growing threat of a new economic slowdown raises a troubling question: When the next recession strikes, what can the world’s central banks do? With interest rates low and their balance sheets still loaded with assets bought to fight the 2008 crisis, do they have the tools to respond? ‘What, then, can the Fed do?’ In my view, it needs to be much more aggressive in using the limited tools that it has. For one, if your medicine chest is nearly empty, you want to keep your patient as healthy as possible. That means cutting interest rates now to lower the unemployment rate even further. Doing so could also boost demand during any recession: If people come to expect stronger recoveries, they will be more likely to keep spending even in downturns. A pre-commitment to strong growth could also help. In the last recession and ensuing slow recovery, the Fed treated its low-interest-rate policy largely as an emergency step that would be removed within the next year or two. Instead, the Fed should publicly commit now to maintain maximum stimulus after a recession until the unemployment rate falls below 3%, as long as the year-over-year core inflation rate remains below 2.5%. Such a promise, much stronger than any used or even suggested during the last recovery, would help minimize the damage and speed up the rebound.”

It’s simply difficult to believe such analysis resonates – yet it sure does. These are strange and dangerous times. Kocherlakota: “If your medicine chest is nearly empty, you want to keep your patient as healthy as possible.” Noland: If you’re running short of medicine, you better not encourage your patient to live a reckless lifestyle. You certainly don’t want to convince the foolhardy that you possess an elixir that will cure whatever ails them. These central bankers have really lost their minds: What they administer is anything but medicine.

Such central bank crazy talk should have longer-term bonds beginning to sweat. But, then again, bond markets are confident that central bankers from across the globe will be buying plenty of bonds over the coming months and years. When central bankers talk about accommodating higher inflation, bonds hear “more QE”. And while safe haven bonds may not be overjoyed at the thought of CPI creeping higher, they remain more than fine with bubbling risk markets – prospective bursting Bubbles ensuring only more expansive QE programs. The so-called U-turn marked an inflection point from a meek attempt to return central banking to sounder principles - to a decisive breakdown in any semblance of responsible monetary management.

I was convinced in ‘98 the Fed was committing a major policy error. Like today, the Fed and global central bankers were afraid of global fragilities. Yet markets and economies do turn progressively fragile after years of excess. These days, I worry about what central bankers have unleashed with their ultra-dovishness in the face of historic late-stage global Bubble “terminal excess.”


Bond maturities are the result of a tug-of-war

On one side is cost; on the other, uncertainty

IMAGINE TWO countries that differ only in the scale of public debt. In Vulgaria it is 50% of GDP; in Freedonia it is 5%. Vulgaria used the proceeds of its extra debt-raising to buy land for public parks. Because of these assets, it is regarded as being as good a credit risk as Freedonia. Taxes do not affect incentives to work or save in either place (they are a bit higher in Vulgaria). Inflation is low and stable.

How should each country manage its debts? Specifically, how much should it raise by selling short-term bills, and how much by selling long-term bonds? A strain of public-finance theory, developed by Robert Barro of Harvard University, says it does not matter. Debt is deferred taxation. A dollar of debt will cut today’s tax bill by a dollar, but at the cost of raising it by a dollar tomorrow. If the debt is a one-year bond, the tax bill will come sooner. If it is a ten-year bond, it will come later. In this frictionless world the maturity of public debt is irrelevant.

The real world is messier. The economy fluctuates, and so do interest rates. Taxes affect how willing people are to work. In such conditions, the maturity of debt is a tug-of-war between two influences. The government wants to keep today’s taxes low: that pulls it towards short-term bonds, the cheapest to issue. But it is wary of sudden increases in interest rates: that pushes it to issue long-term bonds, to limit “rollover” risk when bonds come due. The balance of these forces decides debt maturity. Certainty matters more to high-debt countries like Vulgaria. Cost matters more to low-debt countries like Freedonia.

The IMF’s “Fiscal Monitor”, a health check of public finances, shows lots of variation around the world (see chart). A tendency for high-debt countries to issue long-term bonds is nevertheless evident. In Europe, high-debt Belgium has an average debt maturity of ten years; in low-debt Sweden the average is less than five.

Rollover risk is a bigger concern for emerging markets. So although they have a lower debt-to-GDP ratio (the average is 53%) than rich countries do (104%), the average maturity of debt is similar, at around seven years. A big debt burden financed at short maturities can spell trouble (ask Egypt). Long-term debt might keep you out of it. South Africa’s debt is also high by emerging-market standards—and its stubborn budget deficit means that debt is rising quickly. Its economy is sluggish. A saving grace is that much of South Africa’s public debt is long-term. That buys the country time to address its problems.

Still, the rule linking high debt to long maturity has many exceptions. America is one. Its debt-to-GDP ratio is above the rich-world average, but its debt maturity is towards the bottom of the scale. As a general rule bond-buyers prefer money-like securities, such as short-term bills, which is why they are cheaper to issue. By their nature, they are more liquid: they can be readily bought or sold. That makes them ideal collateral in transactions where each party fears the other might default. And because a lot of the world’s trade, derivatives and financing are in dollars, demand for America’s short-term debt is especially strong. That is why it can issue lots of it safely as well as cheaply.

At the other end of the maturity spectrum, the big outlier is Britain. Despite a modest debt burden by rich-country standards, it has the longest term to maturity of any country in the IMF’s database. In contrast to America, it is long-term bonds that are prized in Britain—as outlined in a paper by Stéphane Guibaud, Yves Nosbusch and Dimitri Vayanos of the London School of Economics. Legislation in 2004 obliged pension funds in Britain to match their assets to the long-term promises they made to retirees. That spurred demand for long-dated bonds, driving down yields. Britain’s debt-management office responded by issuing lots more of them.

This pension-fund effect is especially marked in Britain, but it is discernible in other countries, too. A recent study by Robin Greenwood of Harvard University and Annette Vissing-Jorgensen of the University of California, Berkeley, shows that countries with larger private pension systems are able to issue long-maturity bonds more cheaply.

There are lessons for the hypothetical debt-managers of Vulgaria and Freedonia. Vulgaria might want to encourage a private pension system to stoke demand for long-term bonds.

Freedonia might consider increasing its debt load a little to take advantage of the latent demand for money-like securities. It shouldn’t cost much. And the taxpayers of Freedonia might appreciate a public park.

Say Goodbye to the Stock Market’s Secret Sauce

A multidecade rise in profit margins may already be in the process of reversing, taking the wind out of the stock market’s sails for years to come

By Justin Lahart

Say Goodbye to the Stock Market’s Secret Sauce
Illustration: Mikel Jaso

It isn’t how much you make but how much you keep.

Most investors grasp that concept when it comes to their own finances, but they also need to consider how it applies to the companies they own. A long-term tailwind to stocks from expanding profit margins is at risk of flipping into reverse.

Steady increases in margins have been the stock market’s secret sauce since the 1980s, allowing earnings to grow at a much faster clip than sales and pushing share prices higher as a result. If profit margins were merely to return to their levels of 20 years ago, then earnings—and share prices—might be 40% lower than they are today.

For the first time in over two years, corporate profit margins are falling. In a shifting economic and political environment, this may be only the beginning of a long slide. The S&P 500’s forecast first-quarter profit margin—or earnings as a share of sales—is 10.7%, according to FactSet. While down nearly a percentage point from a year earlier, that would, with the exception of 2018, still count as a record high.

The decadeslong increase in profit margins was the result of many things going right at once, including a steady decline in labor costs, increases in global trade, lower taxes and gains in market share. Unfortunately for companies, each one of these trends seems at risk to at least partially reverse itself in the years ahead.

Start with labor costs. One way to consider these is to look at the income earned by U.S. workers as a share of gross domestic income—a sum of all wages, profits and taxes the economy. This has been falling for decades, dropping to about 53% in the first three quarters of last year from about 58% in 1980 according to the Commerce Department. Among the reasons for this downtrend: a diminution of employees’ bargaining power as union membership declined and an expansion of global trade that allowed companies to shift production to countries where labor costs are cheaper—particularly China.

Next, taxes. Last year’s tax cut was just the most recent in a series of actions that have dramatically lowered companies’ tax bill. Taxes came to about 11% of before-tax U.S. corporate profits in the first three quarters of last year, according to the Commerce Department. In 2000, the tax share was about 32%. Additionally, U.S. multinationals appear to have steadily shifted more of their domestic profits to tax havens such as the Cayman Islands since the 1990s, effectively reducing their tax rates by even more than the Commerce Department data show.

Big companies, like those in the S&P 500, also have gained market share. This hasn’t only given them a larger share of the profit pie, but it’s also allowed them to reduce costs through greater scale. It also has reduced competition for labor, some economists argue, adding to big companies’ power to set wages. As of 2016—the most recent year with available data—about 47% of U.S. workers were employed at firms with 1,000 or more employees. That compared with about 42% in 1996.

But all of these trends—the reduction in labor’s share of the economy, the decline in corporate taxes and big companies’ amassing of increased market share—seem unlikely to persist.

Worries about inequality are on the rise and, with Democrats vying for their party’s 2020 presidential nomination viewing it as a hot-button issue, proposals to combat it through higher taxes and other redistributive policies are gathering momentum. Meanwhile, the U.S. trade fight with China and the fact that Chinese wages have steadily risen may give U.S. multinationals second thoughts about shifting more production abroad.

Criticism of large companies’ power has risen, too. As part of his beef with Amazon.com Chief Executive Jeff Bezos, President Donald Trump has argued that the giant internet retailer’s business practices are unfair. Massachusetts senator and presidential hopeful Elizabeth Warren earlier this month proposed breaking up Google, Amazon.com and Facebook .

At the very least, this is an environment in which companies will struggle to squeeze out much more from these favorable trends. It seems unlikely workers’ income share will continue to decline. Corporate taxes probably aren’t heading even lower. The forces of globalization that helped bolster earnings are on the wane. Profits will come under pressure if companies can’t enjoy the marginal benefits of these trends.

Climbing margins have given investors a sweet ride. The downhill portion could be bumpy and highly unpleasant.

Magical thinking crosses party lines in America

The left may prefer white magic to Donald Trump’s black, but everyone is dabbling

Edward Luce

Elizabeth Warren has vowed to scrap the electoral college. Alas, amending the US constitution is a pipe dream © AP

When Barack Obama launched his White House bid 12 years ago, he already had a library of well-crafted policies. Some were bold. Others were small-bore. Behind each position was a bench of experts. The same went for John McCain, Hillary Clinton, John Edwards, Mitt Romney and other 2008 contenders. Now we could be living in a different century. With the exception of Elizabeth Warren, whose campaign has yet to catch fire, today’s Democratic aspirants are content with a brassy slogan. Policy wonks might as well join the Mississippi gopher frog on the endangered species list.

The shift has little to do with ideology. Moderate Democrats, such as Beto O’Rourke, are as allergic to detail as are their rivals on the left. What marks the field out is comfort with post-literate politics. Who can blame them? Donald Trump has altered what it means to run for high office. No White House contender ever came near his blend of fantasy and falsehood. He won all the same. He may well do so again. The least bad thing you could say about Mr Trump’s fabulism is that he paid no price for it. But the truth is uglier: it may well have brought him victory.

Little wonder the habit is spreading. It was only a few months ago that Mr Trump dropped his magical claim that Mexico would pay for the border wall. There is little sign that voters who believed Mr Trump in 2016 hold him to account for failing to shake down America’s southern neighbour. Quite the reverse. They blame Democrats for keeping the US taxpayer off the hook. Good intentions are a weak differentiator. The left may prefer white magic to Mr Trump’s black. But everyone is dabbling.

Even the scholarly Ms Warren is not immune. Her latest vow is to scrap the electoral college. If America were to begin anew, few people would devise such a byzantine system. Rather than pander to the small populations of Iowa and New Hampshire, candidates would pitch to the whole nation. Unlike in 2016 and 2000, the verdict would always reflect the popular vote.

Alas, amending the US constitution is a pipe dream. Ratification requires two-thirds of each chamber of Congress and three-quarters of US states. There is no reason to think the smaller states would agree to their demotion.

So why does Ms Warren talk this way? The grander the promise, the likelier it is to go viral. In 2008, Facebook, Twitter and YouTube were not yet large enough to dominate the agenda. Most Americans still got their news from television. Today, social media is the news. The starker your claim, the stronger the feedback loop. Facebook’s algorithm rewards magical thinking. The Democratic variety comes in two forms. The first is the Oprah Winfrey school of positive thinking. The second is from Merlin’s bag of financial wizardry. Some of their magic overlaps. Both Bernie Sanders (Merlin), the socialist in the race, and Mr O’Rourke (Oprah), who is centrist, want to talk about reparations for slavery.

Common sense would ask why America should only now compensate descendants of a system abolished more than 150 years ago. Would reparations only be for blacks who descended from slaves? How would descendants of more recent Irish and Italian immigrants feel about their ancestral culpability? What about Asian-Americans? Even to pose such questions underlines their explosiveness. But airy talk is as far as it is likely to go. Any nominee who beat Mr Trump and took the White House would quickly drop the idea. Reparations are as likely to heal America’s wounds as Mr Trump.

On other questions, the schools of magic diverge. Oprah Democrats talk of America’s better angels. Should Joe Biden enter the race, he would join Mr O’Rourke, Cory Booker and Amy Klobuchar on that side. US politics has a soft spot for Kumbaya. But in today’s context, lofty sweet talk is misleading. Should he lose, Mr Trump will not retire quietly. The Merlin camp is less forgiving. Its magic is in the numbers. Mr Sanders comes close to promising money for nothing. Free college, healthcare and stronger social insurance are important goals. But there are not enough rich people to pay for them. Imitating Denmark would have to extend to its middle class tax rates.

Which leaves Ms Warren. My bet is that she would win a ballot of policy analysts. But they have always been thin on the ground. During his doomed 1956 White House bid, Adlai Stevenson, the professorial Democrat, is said to have been reassured that all thinking Americans were behind him. Yes, he replied, but I need a majority.

China’s New GDP Data Shows the Economy’s Biggest Vulnerability Is Growing

Property investment is accelerating in China, which will boost economic growth but restrain the country’s long-term potential

By Mike Bird

Chinese economic growth is holding up surprisingly well, driven by a bump in retail sales and industrial output. But Beijing’s recent stimulus is filtering into real estate, damaging the country’s long-term prospects.

First-quarter economic data show property investment again playing a major role as a driver of growth. It rose by 11.8% in the first three months of the year, the largest year-over-year gain in more than four years, easily outstripping the 6.4% increase in gross domestic product.

Residential buildings in Chongqing, China. Property investment helped buoy China’s economic growth in the first quarter. Photo: Qilai Shen/Bloomberg News

The rise in investment wasn’t as rapid as in earlier years, when growth of 20% or more was common, but the sector has grown far larger, so the expansion comes from a higher base.
Property has become an albatross around the neck of economic policy makers. Beijing is understandably uneasy about clamping down: housing is the main savings vehicle for the Chinese middle class and is vital to the health of the economy, so prices cannot be allowed to decline.

But pouring an ever-greater share of resources into the sector will drag on China’s long-term potential. Last September, research by International Monetary Fund economist Yu Shi pointed to the extent of the problem. Encouraged by the property boom, productive manufacturing firms increasingly shifted resources to the profitable real-estate sector, shaving 0.5 percentage point off productivity growth a year.
Even investors without a particular interest in the country would be wise to keep an eye on what’s happening in Chinese property: as the world’s largest trading economy, what happens in China rarely stays at home for long.

Xi and Trump Miss Their Chance

A successful US-Japan agreement on structural reforms three decades ago could potentially serve as a useful model for the current China-US trade negotiations. But Chinese President Xi Jinping appears to care only about maintaining political control, while US President Donald Trump seems to care only about himself.

Jeffrey Frankel

trump xi jinping

CAMBRIDGE – President Donald Trump has postponed until at least April the supposed deadline for concluding the United States’ current trade negotiations with China. A good outcome for both sides would be reached if China agreed to protect property rights better and reduce the state’s role in its economy; the US agreed to strengthen national saving and public investment; and both sides agreed to reverse their recent tariff increases. Unfortunately, this is not the deal that is likely to materialize.

For starters, Trump fixates on the bilateral US merchandise trade deficit. The Chinese could probably deliver on the verifiable – but worthless – step of committing to buy more US soybeans, natural gas, and other commodities. But this would have little or no effect on the overall US trade balance, because the US would export less soybeans and natural gas to other countries. Congressional Democrats would rightly point out that the gain was illusory, again highlighting the irrelevance of bilateral trade balances. The more meaningful measure – the overall US trade deficit – widened last year, the predictable result of Trump’s budget-busting fiscal policy.

The US and other countries have more legitimate complaints against China regarding technology transfer and intellectual property rights. The effective way to pursue these grievances would have been in cooperation with allies, via multilateral institutions such as the World Trade Organization or the Trans-Pacific Partnership. But Trump has gone out of his way to take the opposite approach, making progress difficult.

It is not easy to detect a coherent rationale for US trade policy under Trump. If one exists, it most probably involves pushing China to restructure its economy by providing a greater role for the market, shrinking the state sector, and lessening pervasive government control.

Certainly, this has been the overall approach of previous US administrations.

Generally speaking, pro-market reforms would tend to be in China’s interest, too – as many Chinese economists also recognize. A good example is government subsidies for steel mills and other heavy industry, particularly in the form of cheap loans from state banks. This was one component of China’s fiscal expansion in response to the global recession a decade ago. The subsidies left China with tremendous excess steel capacity – bad for economic efficiency and foreign competitors.

Although the Communist Party of China endorsed a pro-market shift in late 2013, little or no progress has been made since. On the contrary, it has become clear that President Xi Jinping is not interested in reducing the size or role of the state. Inefficient state-owned enterprises continue to enjoy easier access to bank loans than more dynamic private firms. Nicholas Lardy of the Peterson Institute for International Economics points out that Xi has rolled back market reforms. This may reflect Xi’s failure to appreciate the potential economic advantages of free markets, or his belief that maintaining political control over Chinese society is worth the economic cost.

The US has also long used free-market rhetoric in criticizing the renminbi’s exchange rate. Since 2003, US politicians have complained that the Chinese authorities intervene in the foreign-exchange market to keep the renminbi unfairly undervalued. Although the US objective was to help its companies compete against lower-cost Chinese producers, it pursued this under the guise of pressing for a market-determined exchange rate.

For ten years, this position made sense. But in 2014, market forces changed direction. Since then, the People’s Bank of China’s has had to spend almost $1 trillion to stem the depreciation of its currency. Had the PBOC let the market work, as US politicians demanded, the renminbi would have fallen even further.

Trump, as candidate and as president, has attacked China for manipulating the exchange rate. A strong renminbi is apparently still a key US demand in the current negotiations. The Chinese authorities, for their part, have no desire to let their currency fall freely. But all now recognize that the goal of stabilizing the renminbi’s exchange rate is no longer consistent with US rhetoric about reducing government influence and letting the market work.

The structural-reform component of the current US-China negotiations recalls similar talks with Japan three decades ago, which were prompted by congressional anger at the large US trade deficit with that country. In June 1990, under the Structural Impediments Initiative (SII), the Japanese government agreed to a detailed set of policy reforms requested by President George H.W. Bush’s administration.

The SII aimed to correct the bilateral trade deficit with more fundamental and effective measures than tariffs. Japan, for example, agreed to tighten enforcement of its competition laws, loosen ties among its keiretsu (industrial groupings), make it easier for large retail chains to open stores, and reduce the bias toward using land for rice farming. The US, meanwhile, agreed to domestic reforms intended to increase its household saving rate, reduce the tax bias toward debt-financed home ownership, and strengthen investment in education and training.

These reforms were designed to reduce the countries’ trade imbalances, especially by narrowing the gap in their national saving rates. But a noteworthy feature of SII was that both the US and Japan requested measures that would make the other’s economy more efficient.

As it happened, the “Japan threat” began to melt away soon after the SII, but not because of US or Japanese trade policy. Instead, Japan’s three-year financial bubble burst in 1990, and its economy has never quite recovered since.

Still, SII was a success, because it led to some modest steps toward mutually beneficial reforms and avoided destructive tariffs and quotas. In theory, it could serve as a useful model for the current China-US negotiations, if they were in similarly competent hands.

Unfortunately, the two countries’ leaders may not have such a firm grasp on economic principles. Xi appears to care only about maintaining political control, while Trump seems to care only about himself.

Jeffrey Frankel, a professor at Harvard University's Kennedy School of Government, previously served as a member of President Bill Clinton’s Council of Economic Advisers. He is a research associate at the US National Bureau of Economic Research, where he is a member of the Business Cycle Dating Committee, the official US arbiter of recession and recovery.

The Emergence of Homo Sapiens

'Those Who Obeyed the Rules Were Favored by Evolution'

Interview Conducted By Johann Grolle

Eastern chimpanzee

British anthropologist Richard Wrangham believes our humanity began with the murder of a tyrant. In an interview with DER SPIEGEL, he explains why homo sapiens are so murderous, while also being among the most peaceful species.

DER SPIEGEL: Professor Wrangham, you're interested in aggression. Why did you go to the Ugandan jungle to research it for it?

Wrangham: The jungle is full of aggression. One of my favorite things is to go for a walk in the forest, close my eyes and just listen. I hear the trills of birds, the chirping of insects, the calls of monkeys, sometimes even the sound of an elephant. And what is it that is so soothing and pleasant for us? Most of it is produced by males shouting out their maleness, their dominance. In other words, it is the language of aggression.

DER SPIEGEL: In your studies of chimpanzees, did you always focus on aggression?

Wrangham: No. First, I studied how these animals feed - -- which is a completely different subject. But when you follow a chimpanzee from dawn till dusk, the importance of aggression just hits you in your face. Compared to us humans, the rate of their aggression is enormously higher.

DER SPIEGEL: Can you give an example?

Wrangham: Take the behavior of males on the threshold of adulthood: They almost ritually attack one female after the other until each one shows signs of submission. Only when a male has achieved physical dominance over every single female is he able to enter the male hierarchy and compete there for the highest possible rank.

DER SPIEGEL: And does this brutality enable them to succeed?

Wrangham: Absolutely. Once a male is fully adult, he continues to attack females even when they give submissive signals to him. The male who beats a particular female the most is the most likely to be the father of her next offspring.

DER SPIEGEL: How do you feel when you watch something like this?

Wrangham: It upsets me. I do love chimpanzees, and I am fascinated by them. I appreciate the wonderful moments I experience with them. But they also have nasty sides. Watching a male beating up a female is horrendous - -- just as it is horrendous watching these animals tearing the guts out of a monkey that is still alive. The essential violence of chimpanzees' carnivory is thoroughly off-putting. It is why I haven't eaten meat for 40 years.

DER SPIEGEL: Is it fair for a scientist to describe this behavior as "nasty"?? Is aggression evil?

Wrangham: It would seem inhuman not to recognize that some of the chimpanzees' behaviors are deeply unpleasant. And is aggression evil? Yes, I think so, at least when it involves physical violence that is inflicting pain. Violence is the opposite of virtue. I think that a major object of human endeavor and societal ambition should be to reduce violence.

DER SPIEGEL: In this sense, at least, we humans seem to have taken a step away from chimpanzees.

Wrangham: Yes. If you trapped 300 chimpanzees who did not know each other in a plane for eight hours, many of them probably wouldn't leave it alive. People, on the other hand, barely touch each other on a long-haul flight. The level of violence has been monitored in a group of hunters and gatherers in Australia. These Aborigines suffer from strong social upheavals, alcohol abuse is high. Still, even under these conditions, the frequency of violence among these people is 500 to 1,000 times lower than among chimpanzees.

DER SPIEGEL: Though people are also capable of torturing each other, and our history is replete with war and genocide. Given this, how can you speak of the placidity of human nature?

Wrangham: You're right, it seems paradoxical. But it is important to understand that there are two different types of aggressiveness. Violence in war is mostly planned, deliberate and cold-blooded. The everyday aggression of chimpanzees, on the other hand, is spontaneous, short-tempered and born directly from the moment. Here we have one of the great mysteries of human nature: Why do we treat each other so peacefully in everyday life when we are capable of such a degree of deliberate cruelty?

DER SPIEGEL: Is this deliberate, planneding form of aggression a peculiarity of humans?

Wrangham: Not at all. You find it among chimpanzees as well. Konrad Lorenz believed that animals do not kill each other. But he was proven wrong. I was part of Jane Goodall's team, who first observed how chimpanzees attacked members of neighboring groups to kill them deliberately. The discovery of warlike patterns of aggression among chimpanzees was one of the big surprises of our research.

DER SPIEGEL: In other words, we have inherited the brutal part of our nature from our ancestors, whereas the peaceful part distinguishes us from them?

Wrangham: Yes, that's one way of putting it.

DER SPIEGEL: You write that humans owe their placidity to their own domestication. What do you mean by that?

Wrangham: We humans exhibit a number of biological characteristics that are more typical of pets than of wild animals, including a very low rate of face-to-face aggression. The reason that I attribute our peaceableness to our having been domesticated is because we share with our pets and farm animals some of these other characteristics, which we now call a domestication syndrome. Charles Darwin was already fascinated by this phenomenon. He studied domestic animals, and he noticed that they share a multitude of peculiarities not found in wild animals.

DER SPIEGEL: Like what?

Wrangham: Many pets have white spots in their fur. They often have floppy ears, a short face or a curved tail. All these traits are rare among wild animals, but common among pets. And the interesting thing is that humans didn't select their pets specifically for these traits.

DER SPIEGEL: How do you know? Maybe Stone Age farmers were fond of pigs with floppy ears or cows with spots.

Wrangham: We know it thanks to the ingenious experiments of the Russian geneticist Dmitri Belyaev. He bred silver foxes with only one trait in mind: he He selected the most tame and peaceful individuals from each generation. And behold, many of the other typical characteristics of pets emerged on their own.

DER SPIEGEL: Cuddly foxes sound cute. Have you seen them yourself?

Wrangham: No, unfortunately I haven't. But my student Brian Hare went to Novosibirsk, where Belyaev's team continues to work. He wondered why dogs understand human signals better than wolves. He assumed that it might be a result of targeted selection by humans. But then he examined Belyaev's foxes and found that they also know how to interpret human signals. So the ability to understand human signals seems to be another trait, like white patches of fur, that emerges as a side effect of selection for less aggression.

DER SPIEGEL: You claim humans are also domesticated. What makes you think that? We don't have white spots, or floppy ears, or a curly tail.

Wrangham: You're right. We have no tail, so it can't bend. But if you look at our skeleton, you will find a lot of peculiarities that are characteristic of pets. Four of them stand out compared to our ancestors: a shorter face; smaller teeth; reduced sex differences, with males becoming more female-like; and, finally, a smaller brain. This latest development is particularly fascinating. In fact, the evolution of humans is naturally characterized by a continuous increase in brain size. But it turns out this trend has reversed in the last 30,000 years.

DER SPIEGEL: How could a package of traits like that develop when it was not under any selection pressure?

Wrangham: We are still not sure what biological mechanisms produce the domestication syndrome. But we have circumstantial evidence. It is noticeable, for example, that many of the domestication traits are typical for young animals ...

DER SPIEGEL: ... in other words, dogs resemble wolf pups, just as we resemble Neanderthals who never reached adulthood?

Wrangham: Yes. Young animals are usually characterized by a lower level of reactive aggression. One way nature might evolve reduced aggressiveness is by allowing creatures to reach adulthood while still being emotionally juvenile. All the other juvenile traits are then nothing but side effects of the reduction of aggression.

DER SPIEGEL: You said earlier that our brain began shrinking 30,000 years ago. Is this when humans started getting tamed?

Wrangham: No. We can follow the process of domestication pretty thoroughly in the fossil record. According to that, the development started about 300,000 years ago. Brain size only began to decrease at the very end.

DER SPIEGEL: Obviously, we domesticated dogs, horses and cats, but who domesticated us?

Wrangham: The word "domestication" is somewhat misleading. It implies a relationship with humans. But Belyaev's fox experiments show us that only the selection of non-aggressive behavior is important. Whether this selection happens in captivity or the wild doesn't matter. While some species have been domesticated by humans, others have been domesticated, in the sense of reducing their aggressiveness, on their own. We are one of the species that domesticated ourselves.

DER SPIEGEL: What kind of domesticated animals are there in the wild?

Wrangham: The best example can be found among our closest relatives: the bonobos. They look very similar to chimpanzees, but their skulls show the characteristics of domestication: a shorter face, smaller teeth, a smaller brain, and reduced differences between the sexes.

DER SPIEGEL: And their behavior is more peaceful?

Wrangham: Dramatically so. When a bonobo male attacks a female, she will call for help, and within minutes the male will face an alliance of females who put him in his place.

DER SPIEGEL: Females bonobos domesticated the males?

Wrangham: Yes, probably. The bonobos live in a habitat that allows females to travel together all the time, unlike chimpanzees. This has favored social alliances among the females.

DER SPIEGEL: Are bonobos the better chimpanzees?

Wrangham: They're much nicer to each other, that's true. But of course bonobos also have some dark sides. There was this guy in France who started a commune based on the principle of living the bonobo way. He ended up in prison for pedophilia.

DER SPIEGEL: What about humans? Did women civilize us men as well?

Wrangham: That seems unlikely. There are many mythological memories of an era in which power was in the hands of women, but today there is no such thing as matriarchy anywhere in the world, and we have no evidence that there ever was.

DER SPIEGEL: If it wasn't women, who tamed men?

Wrangham: Here we enter the terrain of speculation, because fossils don't tell us exactly what happened. What we have to do instead is to see how today's hunters and gatherers treat individuals that behave aggressively. There are, in fact, even in these generally peaceable peoples, some individuals who, like alpha chimpanzees, try to dominate the others by violence. How do the members of such a community react - -- without prisons, without military, without police? There is only one way for them to defend themselves against the determined perpetrator: He is executed. The killing is done by agreement among the other men in the society.

DER SPIEGEL: You argue that this is how aggressiveness was systematically eradicated from the gene pool of mankind?

Wrangham: Well yes, aggressiveness was reduced, even if it was not eradicated. Virtue seems to have evolved from something as violent as killing. But don't misunderstand. I am not advocating executions in today's world. Justice is fallible, so the death penalty inevitably leads to the killing of innocent people; furthermore, there is no evidence that it really effectively deters people from committing crimes.

DER SPIEGEL: It is quite a daring hypothesis to argue that the death penalty has made us what we are. How did you come up with it?

Wrangham: It was when I read a book by Christopher Boehm entitled "Hierarchy in the Forest". In this book, he describes how aggression in communities of hunters and gatherers is controlled by executions. My goodness, I thought when I read this, maybe this mechanism has even shaped our evolution?

DER SPIEGEL: If anyone who strives for power is killed, does that mean there are no chiefs in communities of hunters and gatherers?

Wrangham: Yes, hunter-gatherers are very egalitarian in their relationships among men.

DER SPIEGEL: So when the fathers of the American constitution famously proclaimed, "All men are made created equal,", they were really just reanimating a principle that has shaped our species over many millennia?

Wrangham: Yeah. Isn't that fascinating? And even the fact that the Declaration of Independence only mentions men, but not women, corresponds to the situation in communities of hunters and gatherers. Egalitarianism among them only applies to men. Women, on the other hand, are dominated by men.

DER SPIEGEL: And how do you think it all began? Why did the men of lower rank eventually join together to kill the tyrant?

Wrangham: Well, it's quite dangerous to rebel against the alpha male. The one who throws the first stone will risk his life. No lion or chimpanzee would dare to do that. Only humans were able to squat together and whisper: "Let's meet at the big stone, then attack and kill him."

DER SPIEGEL: In other words, language facilitated the rebellion of the underdogs?

Wrangham: Yes, because only by discussing and planning how to kill the tyrant could they be sure that they wouldn't be harmed themselves.

DER SPIEGEL: Unlike all animals, man is capable of moral action. In your book, you claim that this is another consequence of the beta male's uprising against the alpha?

Wrangham: Yes. At some point the community of beta men united against the powerful. Then they realized that from now on they themselves had the power to kill everyone in the group. They established rules for living together, and anyone who violated them had to fear death. In this way, those who obeyed the rules were favored by evolution.

DER SPIEGEL: Submission made us moral beings?

Wrangham: You put it in a handy phrase. It may be disillusioning. But I'm afraid it was like this: Morality was born in an effort not to be targeted by the justice of the community.

DER SPIEGEL: And little by little, cowardice wrote itself into our genes.

Wrangham: Yes. And the fossil record suggests that the domestication process even accelerated.

DER SPIEGEL: Is it now complete? Or is man still taming himself?

Wrangham: There is, at least, no indication that the process has come to a halt.

DER SPIEGEL: What will we humans look like after another 10,000 generations?

Wrangham: That's speculative, of course. But if the domestication process continues as it has, we will probably look even more childlike than we do nowadays. The juvenile features will be even more exaggerated: the high forehead, the big eyes, the narrow chin.

DER SPIEGEL: The ultimate in anti-aging.

Wrangham: That's one way of looking at it.

DER SPIEGEL: Professor Wrangham, thank you for this interview.