Why Debt Won’t Spark Inflation

By John Mauldin


Modern technology was supposed to make travel less necessary. We can meet by phone, video, and now in virtual reality. But we’re still traveling more than ever. I certainly am.

The reason is simple: Technology can’t yet replace face-to-face conversation, and especially group conversations. It is genetically hardwired in our species. We spend more time on the phone and Skype than ever but technology also makes information more complex and nuanced. Conveying it often requires a personal presence, so we fly around and talk in person.

I thought of that last week at the Strategic Investment Conference. I’ve been writing about “Japanification” of the developed world economy, explaining what I mean by that as best I can in these letters. But in talking to conference attendees, I found that I have not effectively communicated some of the nuances.

To be clear, I don’t want Japanification, nor do I think it will deliver the desired results. I believe that in the next recession…

  • Policymakers will respond with massive fiscal and monetary stimulus, and

  • Instead of producing growth, it will depress growth and leave us all in the same morass Japan has endured for almost three decades.

In other words, I believe that both government and central banks will try Japanification (of course under other names) but I don’t expect it to work in the way they would hope.

When faced with the imminent possibility of recession, depression, or even a crash, authorities will try to do something but they will have very few choices. The “default” option of ever larger stimulus will kick in. So, like Japan, the US will see yet more quantitative easing and extraordinarily low interest rates, along with annual federal deficits of $2 trillion and higher. Alternatives like restructuring the tax code and balancing the budget will be nowhere in sight.

At best, this “process” will result in an even slower-growing economy and avoid total meltdown. That’s the optimistic view. Given what I understand today about the political and economic realities as I see them, I also believe that it is the most likely scenario. The others are much darker.

However, I also believe there is an “off-ramp” that could short-circuit the Japanification effect, leading to something closer to “normal.” More on that below.

Today I want to go deeper into the intellectual and academic rationale behind this outlook. Dr. Lacy Hunt has long been an enormous influence on my understanding of economics. In this letter I’ll discuss his latest ideas. I should note that any errors are mine and not his fault.

Lacy briefly presented two theorems at the SIC. After his scholarly lecture (that’s really what it was), I brought up my favorite central banker and former BIS chief economist Bill White. The three of us had possibly the most stimulating discussion of the whole conference (at least for me). You can (and should) view it all on our Virtual Pass but I’ll share some highlights below.

This is important and you need to understand it, because it is the exact opposite of what many people think.

Missing Inflation

Let’s start with some facts that may be inconvenient for some, but are nonetheless facts.

Back in the 1980s and 1990s, many of us in the conservative and “gold bug” movements (me included) thought excessive government spending and the resulting debt would eventually bring inflation or even hyperinflation. We wanted a hawkish Federal Reserve or, better yet, a gold standard to prevent it. (I have many friends, close friends, who still deeply believe in a gold standard. But that’s a discussion for another day…)

Reality turned out differently. Federal debt rose steadily, inflation didn’t. Here’s a chart of the on-budget public debt since 1970, using actual dollars instead of the more usual percentage of GDP, and with a log scale to eliminate the hockey-stick illusion.

Source: St. Louis Fed

Here is the same data in terms of debt to GDP. Note the brief shining moment when the US was growing faster than the debt rose and actually ran surpluses in the late 1990s. These were also times when GDP grew faster than the deficits and debt. But the general trend is from the lower left to the upper right. There was a significant jump during the Great Recession.

You can see the debt growth started to level out in the late 1990s but then took off again. Yet the only serious inflation in this whole period occurred in the first decade. Paul Volcker stamped it out in the early 1980s.

I am not saying we had no inflation at all. Obviously we did, and in many parts of the economy significantly more than the official “average” measures reflect. Some of it manifested in asset prices (stocks, real estate) instead of consumer goods. We like that and typically don’t consider it inflation, but it is. But there was nothing remotely like the kind of major inflation that this level of government debt should, theoretically, have caused based on what we understood in the 1970s and 1980s. Remember Ross Perot and his charts? It hasn’t happened.

One argument is that technology reduced production costs enough to offset the higher debt burden. That’s probably part of it, but I think a minor part. The real answer is twofold.

  • First is the way high government debt interacts with interest rates, over long periods and with a time lag, but almost inexorably.

  • Second, but no less understood, is the demand for certain currencies even as government debt and obligations rise.

A little reminder: Interest rates and inflation are really two sides of the same coin. Interest is the cost of money/liquidity. That cost is heavily influenced by the risk of money being devalued, i.e., inflation expectations. If lenders expect higher inflation then they expect to be repaid in cheaper dollars, and thus demand more of them via higher interest rates. So inflation drives rates higher, while lack of inflation keeps them low, as we’ve seen since 2008.

This brings us to Lacy Hunt’s SIC session in which he presented two important theorems. They are related but I will discuss them separately.

I’ll start by just quoting Lacy, then explain what I believe he means.

Federal debt accelerations ultimately lead to lower, not higher, interest rates. Debt-funded traditional fiscal stimulus is extremely fleeting when debt levels are already inordinately high. Thus, additional and large deficits provide only transitory gains in economic activity, which are quickly followed by weaker business conditions. With slower economic growth and inflation, long-term rates inevitably fall.

That first sentence should come with a little “Boom!” cannon icon. It will shock many people who think rising federal debt raises interest rates through a “crowding out” effect. That means the government, because it is the most creditworthy borrower, sucks up capital and leaves less available to private borrowers who must then pay more for it via higher interest rates or a weakened currency.

That is the case for most countries in the world.

Yet clearly it has not been the case for some countries in recent decades, specifically larger developed economies. That’s not to say it never will be, but actual experience supports Lacy’s point, and not just in the US. Here are four charts he showed at SIC.

In the US, Japan, the eurozone, and the UK, sovereign rates fell as government debt rose. That is not how Keynesian or most other macroeconomic theories say debt-funded fiscal stimulus should work. Additional cash flowing through the economy is supposed to have a multiplier effect, spurring growth and eventually raising inflation and interest rates. This has not happened.

The reason it hasn’t happened is that we have crossed a kind of debt Rubicon in recent history. Past performance really is not an indicator of future results. Today, in much of the developed world, the existing debt load is so heavy that additional dollars have a smaller effect. The new debt’s negative effects outweigh any benefit. The higher taxes that politicians often think will reduce the deficit serve mainly to depress business activity. We see the result in slower economic growth, plus lower interest rates and inflation.

Note we are talking here about fiscal policy, i.e., government spending on jobs programs, infrastructure, etc., when financed by issuing new debt. Central banks aren’t directly involved until they start financing the government debt via QE or some version of MMT (which Lacy and the rest of the speakers at the SIC will hasten to point out are not equivalent).

Velocity Falling

Lacy’s second theorem supports the first.

Monetary decelerations eventually lead to lower, not higher, interest rates as originally theorized by economist Milton Friedman. As debt productivity falls, the velocity of money declines, making monetary policy increasingly asymmetric (one sided) and ineffectual as a policy instrument.

Irving Fisher’s equation of exchange (M2*V=GDP) says GDP is equal to the money supply times its turnover, or velocity. The Federal Reserve heavily influences the former but not the latter. That, it turns out, is a serious problem.

The Fed’s Phillips Curve fixation gives it the illusion that every macroeconomic problem is a nail and monetary policy is the ideal tool/hammer to fix it. Of course, that’s not true. Looser financial conditions don’t help when the economy has no productive uses for the new liquidity. With most industries already having ample capacity, the money had nowhere to go but back into the banks. Hence, velocity fell 33% in the two decades that ended in 2018.

Now, if velocity is falling then any kind of Fed stimulus faces a tough headwind. It can inject liquidity but can’t make people spend it, nor can it force banks to lend. And in a fractional reserve system, money creation doesn’t go far unless the banks cooperate.

Later in the conference, Bill White observed that this is why monetary policy is increasingly ineffective. The banks respond to each crisis the same way, and every time they find that it takes more aggressive action to produce the same effect. Obviously, that can’t go on forever. Bill called it a “fundamental intemporal inconsistency.”

The result is that public and private debt keeps rising but also becomes less productive. Lacy showed how, in a world of falling monetary velocity, the amount of GDP growth produced by each additional dollar of debt fell 24% in the last 20 years. That’s why we have so much more debt now and yet slower growth.

This also explains why (this year’s first quarter notwithstanding) growth has been so sluggish since 2014. That was when money supply peaked. So for five years now, we’ve had both a shrinking money supply and slowing velocity. That’s not a recipe for inflation. And the more recent jump in federal deficit spending is making matters worse, not better.

In our Q&A, Lacy and Bill discussed how linear economic models are just not working and nonlinear  analysis is so critical. A lot of practical people are turned off by this, thinking it shouldn’t be so complex. But, these same people would never tell a physicist to avoid nonlinear concepts.

The economy is complex and getting more so as the world adds new, seemingly critical variables. (I should also note that Lacy only had 30 minutes for his presentation and had to make a complex argument in an abbreviated time. There are scores more corollary points we could explore.)

The Complex Debt and Currency Dance

Astute readers will quickly point out that rising debt in places like Venezuela has brought extraordinary inflation and currency devaluation. Historically, that’s what rapidly rising government debt does. I simply point you to Rogoff and Reinhart’s This Time Is Different where they examine every debt and currency crisis for the last few centuries. The circumstances may have been different, but the result was the same.

Yet today, things do indeed seem different. Japan, the US, the UK, and other countries seem able to expand their government debts beyond historically acceptable levels and “get away with it.” Interest rates have stayed low, often getting lower and going negative, while currency valuations have remained relatively stable (the operative word here is relatively).

What is different is the international demand for currencies and debt denominated in those currencies. A globalized economy yielded a surplus of savings that seeks a home in what is perceived as “safe” assets. Nobody thinks Venezuela is safe. That is why, in a global crisis, money flies to the US and other “reserve” currencies. These “safe haven” currencies have the exorbitant privilege of running large fiscal deficits.

Thought experiment: If Italy were to remove itself from the euro and reissue the lira, does anybody really think that Italy would keep today’s low rates? Ditto for Greece and other countries. Left on their own, these currencies would devalue relative to stronger ones like Germany, and their interest rates would rise.

This is not necessarily a bad thing. The “safety valves” of currency devaluation and bond market vigilantes saved Italy numerous times before it joined the euro. What most people don’t realize is that Italy grew faster than Germany in real terms for the 20–30 years prior to joining the euro, despite its inflation and devaluations.

How long can this go on? The Japanese experience suggests much longer than we would think. Forever? No. There is a point where the zeitgeist, the perceived global narrative about a country and currency changes, and currencies and interest rates become unhinged. It can happen seemingly overnight.

Again, how long can this go on? We simply don’t want to know the answer to that question. We will only know after the fact, and it will be a horrible, painful fact to experience. Better to find a viable exit ramp.

“Too High and Getting Wider”

I’ll wrap up with a direct quote from Lacy Hunt, which you will probably want to read several times. His academic prose takes a little time to sink in. But when it does, you should be concerned… if not terrified.

The parallels to the past are remarkable, but there appears to be one fatal similarity—the Fed appears to have a high sensitivity to coincident or contemporaneous indicators of economic activity, however the economic variables (i.e. money and interest rates) over which they have influence are slow-moving and have enormous [time] lags.

 In the most recent episode, in the last half of 2018, the Federal Reserve raised rates two times, by a total of 50 basis points, in reaction to the strong mid-year GDP numbers. These actions were done despite the fact that the results of their previous rate hikes and monetary deceleration were beginning to show their impact of actually slowing economic growth. The M2 (money) growth rate was half of what it was two years earlier, signs of diminished liquidity were appearing, and there had been a multi-quarter deterioration in the interest rate-sensitive sectors of autos, housing, and capital spending.

Presently, the Treasury market, by establishing its rate inversion, is suggesting that the Fed’s present interest rate policy is nearly 50 basis points too high and getting wider by the day.

A quick reversal could reverse the slide in economic growth, but the lags are long. It appears that history is being repeated—too tight for too long, slower growth, lower rates.

The Fed waited too long to raise rates and then overshot the mark when it finally got around to it. I was calling for rate hikes in 2012 and 2013. The Fed could have hiked 50 to 75 basis points per year, “normalizing” interest rates and letting the economy adjust slowly rather than all at once, late in the cycle. Having realized it, FOMC members then paused, but too late and possibly for the wrong reasons. Now they’re trapped. Lacy thinks an immediate 50 bp cut might help, but he’s not optimistic they will do it, or that it will work if they do.

If that’s right, then we are in for slower growth and probably recession sooner rather than later. In a debt-laden, highly leveraged economy, it probably won’t be a mild one, either.

I mentioned earlier that I believe there is an “off-ramp” exit for the US economy. In the coming weeks, I’m going to respond to Ray Dalio’s recent two-part letter and then his third longer piece seemingly endorsing Modern Monetary Theory (MMT). It will probably be a multipart series and will allow all of us to have a much larger thought experiment, a potentially educational experience, than we have been having.

In the spirit of Dalio’s own “radical transparency” philosophy, maybe it is time to start thinking the unthinkable.

Before we move on, at least in this letter from the Strategic Investment Conference, let me gently suggest that you take advantage of our Virtual Pass. You can see most of the 33 speakers on video, listen to them on audio, and read the transcripts of the sessions. I’m getting many responses raving about the conference from people who weren’t even there. They watched on the Virtual Pass, which is the next best thing.

And maybe think about joining us next year at The Phoenician in Scottsdale, Arizona on May 11–14. As my friend Kent K. wrote,

“One of the best things about attending SIC is not only the information learned from these “rock star” speakers, you get to actually have a drink with them and sometimes dinner and pick their brain. From a financial context, it would be like seeing the Rolling Stones or Paul McCartney perform and then having a casual conversation with them afterwards. I have never attended any other conference that provides this kind of experience.”

They Shall Not Grow Old

On the five-hour flight from Dallas to Puerto Rico this past weekend, I decided to watch a movie. Scrolling through the seemingly endless choices, I came across the documentary by Peter Jackson (of Lord of the Rings fame) called They Shall Not Grow Old. Jackson and his team went through World War I film archives to assemble an extraordinarily moving view of the reality, total brutality, and utter inhumanity of war. The entire documentary consists of actual film from the era, starting out black-and-white and eventually becoming colorized. It is a well-done homage to these soldiers’ bravery and patriotism. Over 10 million died during that single war and the civilian death toll was almost as large.

In the US, it is Memorial Day weekend, where we annually pay tribute to those who lost their lives to keep countries free and democratic. Spending less than two hours watching They Shall Not Grow Old would be a good way to honor their sacrifice. It is a window into times and events simply not imaginable to most of us.

And while you’re watching, remember that European bond markets were very calm almost up to the last moment. No one really thought war was coming. But then the unthinkable happened.

It’s time to hit the send button. And to those of you who served your country, wherever and whenever it was, thank you. I wish you a truly great week!

Your reflecting on the unthinkable analyst,

John Mauldin
Chairman, Mauldin Economics

The global race for 5G supremacy is not yet won

It is important which countries build their networks first, but it’s not the only factor in success

Rana Foroohar

I find it amazing how quickly conventional wisdom about new technology can harden. It is commonly assumed today that 5G, the fifth generation mobile technology that has yet to become a large scale commercial reality, will be dominated by China.

Proponents argue that China is moving ahead quickly to build out the necessary infrastructure, while the US and particularly Europe lag behind. China’s homegrown telecoms company Huawei is busy making deals in multiple countries, while the US chip champion, Qualcomm, has been bogged down in a multiyear, multi-continent legal battle with Apple, which came to an end last week.

Finally, many believe that it will be easier for a surveillance state such as Beijing to own and harness the data that will be transferred via the 5G chips that will exist in all sorts of products from tires, to tennis shoes, to foetal heart monitors. The key idea behind this thinking is that we’ve left the “innovation” stage of artificial intelligence use, and the only thing that matters is the data.

I challenge this entire premise. Let’s start with the chip wars. Qualcomm, the pre-eminent American innovator in 5G, outspends its domestic peers on innovation, pouring a whopping 25 per cent of revenue into research and development. That focus was cited by the Committee on Foreign Investment in the US last year when they pushed back against efforts by Broadcom to push through a hostile takeover of the chipmaker. (Qualcomm supporters argued that the US shouldn’t permit a foreign company to acquire a world-beating innovator in a key technology area.)

The tri-continental battle with Apple over the appropriate licensing fee for Qualcomm’s chips really did hurt the company: licensing revenues plunged by $2.5bn during the fight.

But now the two sides have settled and dropped all litigation. Apple gets access to Qualcomm’s patents, but the chipmaker is the bigger winner. Not surprisingly, its share price has soared, and management expects profits to return to roughly pre-dispute levels.

The deal also means that the world’s most successful smartphone maker and the first company to launch a 5G chip set — both American — can get on with the business of rolling out next generation services. Their return to business as usual will also make it more attractive for Europeans to buy their 5G chips from Qualcomm rather than Huawei, which oddly has yet to make a deal in mainland China. Not only is the US company’s future no longer in doubt, but the Chinese provider has faced sustained criticism from the administration of President Donald Trump in the US, which argues that the use of Huawei equipment threatens American and European security.

Secondly, China has been stacking the international telecom standards bodies with their own representatives over the past few years, and they have a head start on 5G network construction. But that does not equate to a lasting technological advantage. China was late to adopt 3G, but that did not stop their progress in 4G, for example. There is no reason to think that the US, or even Europe, cannot catch up in 5G.

The Chinese government does have the advantage of being able to direct state-owned operators to build infrastructure, and its companies don’t have to purchase spectrum before offering 5G services. Yet the first country to have an operational 5G network will not be China, but South Korea.

It’s important which countries build their networks first, but it’s not the only factor in success.

The real advantages of 5G are going to come from the way in which individual companies and industries exploit the potential gains from mining all the data 5G will allow them to collect. Right now, it is impossible to say exactly where those advantages will come from. “Just as no one predicted that one of the major uses of 4G would be a new way of calling taxis, the most important uses for 5G technology are also difficult to predict before it’s actually available,” Dan Wang, an analyst for Gavekal Dragonomics, wrote recently.

Just consider the magnitude of the information that is going to be generated by 5G. According to IDC, more than 5bn consumers globally interact with data every day and, by 2025, that number will be 6bn, or 75 per cent of the world’s population. In 2025, each connected person will have at least one data interaction every 18 seconds, it predicts. Many of these interactions will come via the “internet of things”, those 5G chips in everything from vending machines to medical devices.

It is hard for me to believe, given that amount of change, and the variety of industries and companies involved, that we have left the innovation phase of AI. When has innovation ever stopped? Even the most expert prognosticators rarely get technological evolution completely right.

Consider how the industrial revolution developed: the big things came first, like electricity and the combustion engine. But they were followed by spates of innovative products and services, ranging from automobiles and domestic appliances to wind turbines. There is no reason to think this time will be different — or that China, the US, and Europe can’t all have a piece of the pie. The battle for 5G isn’t set — and it doesn’t have to be a zero-sum game.

Risk of more political shenanigans keeps investors on edge

Concerns remain that tariff dispute between US and China will escalate

Michael Mackenzie

Beijing’s sale of US Treasuries last week amounted to China’s largest retreat from the market in more than two years

Market shocks often erupt after a long period of slowly heating up, otherwise known as the boiling frog syndrome. The mortgage and credit excesses were simmering back in 2005, for instance, only for investors to stay focused on squeezing markets for a little extra return.

For more than a year the deteriorating broad economic and political relationship between the US and China has provided plenty of action for investors. Tariff hikes have been exchanged and while markets have certainly not enjoyed these bouts of slightly higher temperatures, the ensuing dips in shares and credit have been limited and bought.

Investors still take comfort in the general view that neither the US nor China wants to break the global economy and trigger a resoundingly negative market reaction. They are also keeping the faith that China will maintain its economic stimulus, and that major central banks will keep juicing up the financial system, including corporate earnings, until the second half of the year.

This week’s burst of share market selling should be viewed in the context that in broad terms, the MSCI All World equity index has only slipped 4.5 per cent from its late April high and remains about 10 per cent firmer in the year so far.

But during the past 12 months, marked by the steady rise of trade tension between the big two, the MSCI World index has gone sideways, with defensive sectors outperforming, a trend that has only strengthened this month.

The flip side of this rotation has been pressure on emerging markets and trade sensitive sectors, with global chipmakers for example, nursing a hefty double-digit loss during May. By that measure, the frog is getting hot.

This represents an indicator that as China and the US turn up the tough talk on trade, the gloves may truly come off and at a vulnerable time for the global economy.

The US and other countries have long and rightfully singled out China’s flouting of trade agreements and theft of intellectual property from companies. Moving from applying tariffs to blocking China’s technology via Huawei and other companies does represent a troubling long-term shift for financial markets.

Investors face the prospect of companies that have enjoyed the benefits of global supply chains and squeezing the best out of technological progress, may have to radically alter their business models. While hopefully a short-term disruption, that entails a weaker pace of earnings growth and at a time when the business cycle has entered a delicate period, buffeted by rising costs such as wages.

Andrew Milligan, head of global strategy at Aberdeen Standard Investments says there is a growing likelihood that investors face a world where “a higher political premium must be priced into the outlook for corporate earnings”.

Hardly helping this situation would be a pronounced shift towards separate Chinese and US technology standards, along with both countries pushing national champions, resulting in the duplication of research efforts that inserts more barriers across the global economy.

Sitting uncomfortably in the middle of this are US allies, including the likes of Europe, the UK, Japan, South Korea, Canada and Australia, along with their big multinational companies. Here investors should recognise that a template already exists for how challenging this type of world could become. The Department of Justice in recent years has gone after foreign banks for trading with countries like Iran within a global financial system dominated by the US dollar.

Alan Ruskin at Deutsche Bank poses a pertinent question for anyone who thinks and has invested across markets with the idea that China and the US will eventually resolve their differences or at least find some common ground.

“In the coming decade will China’s military operate on US software, and will the US’s military operate on ‘made in China’ hardware?”

Banning Huawei may be just another bargaining chip for the White House trade hawks. Indeed, President Trump on Thursday suggested that the Chinese telecommunications network company could be part of trade deal.

Under that scenario, the reluctance of equity markets to really hit the panic button will be vindicated and investors can return to gauging whether a firmer global economy later this year helps extend the current business cycle.

Clearly, the G20 meeting in late June marks a key moment for investors, or as Mr Ruskin says, “not in delivering an overarching deal, but in revealing how much President Trump is willing to walk back measures on Huawei after meeting President Xi”.

Investors are already trying to figure out the long-term impacts of climate change, the shift towards alternative energy sources, the rise of artificial intelligence, increasing use of robots and the sharing economy.

A hardening of the geopolitical battle lines over technology means that even more deep thinking about their portfolio exposure is required.

Can China Take Care of Its Elderly?  

Beijing is facing a pension crisis of its own making.

By Phillip Orchard

China’s elderly may soon be grumbling. Last week, the Chinese Academy of Social Sciences released a study estimating that China’s main state pension fund could be exhausted by 2035 – in other words, before workers born in the 1980s retire. The previous day, Beijing announced that China’s seven wealthiest provinces will, for the first time, start helping foot the bill for local pension funds in poorer regions already running dry. The immediate issue may be fixable. But the underlying problems will get worse before they get better, cutting to the heart of the Chinese Communist Party’s predicament on how to preserve its compact with its people.

Where’d the Money Go?
For a nominally communist state, China doesn’t actually have a particularly strong social safety net. Historically, the bulk of the social welfare burdens have fallen either to state-owned enterprises or a patchwork of pension systems run largely by provincial and local governments. A job with a state agency or state-owned enterprise, for example, was long referred to as having an “iron rice bowl” – meaning a guaranteed pension and virtually free healthcare and housing. Until China’s first labor law came into effect in 1995, unproductive state workers were difficult to fire, meaning they essentially enjoyed these benefits for life. Over the past two decades, however, China has sought to gradually pare down the state sector. By 2017, partially as a result, state-owned enterprises accounted for around 15 percent of employment across China, down from about 80 percent in 1978.

As jobs moved increasingly to the private sector, provincial and local government pensions were expected to pick up much of the pension slack. But this created a fragmented, underfunded system plagued by loopholes, conflicts of interests, corruption and notoriously poor collections enforcement. A 2018 survey by 51Shebao, a social insurance information provider, claimed that more than 70 percent of Chinese firms were behind on their social insurance contributions.

Adding to this problem, a shift triggered by China’s state-sector reforms and China’s resulting accession to the World Trade Organization has hammered provincial and local funds. As the most lucrative private sector industries sprouted up in the export-centric provinces along China’s southeastern coast, Chinese migrant workers followed. Yet, China has been slow to abandon its Mao-era “Hukou” household registration system, which forces most migrant workers to obtain health, education and pension services only in their home province. As a result, the firms employing migrant workers are often paying pension contributions to coastal governments, while poorer, interior governments are still often on the hook for these workers’ retirement. According to the Chinese Academy of Social Sciences, just seven of China’s 32 provinces account for nearly 70 percent of all pension contributions. Guangdong alone receives as much funding as the rest of the ten wealthiest provinces combined.

Already, pension systems are in crisis across China’s interior provinces and in the industrial “rust belt” in the northeast. Last year, for example, a funding shortfall forced authorities in Heilongjiang province to delay pension payments. The Chinese Academy of Social Sciences estimates as many as 16 provinces will fall short this year. The social risk associated with this problem has been made starkly clear over the past four years by a surge of protests by People’s Liberation Army vets, many of them upset about being denied pensions and other benefits.

The issue is likely to get quite a bit worse, thanks in no small part to China’s infamous one-child policy. In short, China is getting old before it gets rich, with more than a third of China’s population expected to be older than 60 within 30 years. And retirees are living longer, too. The predictive power of demographics is often overstated. Nonetheless, China’s population curve poses staggering problems for the pension system. In 2018, there were 2.8 contributors for every retired person. By 2050, according to official estimates, this ratio will fall to 1.3 to one. With China facing a prolonged economic slowdown, Beijing will find itself increasingly having to choose whether to rob Peter or to pay Paul. Last month, for example, Beijing moved to address a private sector credit crunch with a $300 billion package of tax and fee cuts – including sharp cuts to pension contribution requirements.


Bigger Problems
Narrowly speaking, the pension issue itself still may be fixable; it’s effectively a policy transmission problem. There’s enough money floating around, at least for the time being; China just needs to iron out major kinks in the system to get the funds where they’re needed. Toward this end, it has initiated some Hukou reforms, including new measures making it somewhat easier for migrant workers to register in second- and third-tier cities (where the government wants more workers to move anyway). It’s gradually doing away with family planning controls. It’s forcing state-owned enterprises to transfer 10 percent of their shares to government pension funds, while also allowing the funds to start investing overseas. Meanwhile, China has been taking steps toward more streamlined, centralized pension systems. On Jan. 1, for example, it created a national contributions pool and transferred responsibility for collections away from local governments, paving the way for the provincial transfers announced last week. To soothe disaffected PLA veterans, it launched a national-level veterans affairs administration last year.

China’s situation is not entirely unique. U.S. Social Security is likewise facing a funding shortfall stemming, in part, from demographics. And in nearly every country, wealthier regions are forced to subsidize livelihoods in poorer ones. In 2015, New York received 83 cents for every dollar its taxpayers sent to Washington, while Mississippi got $2.13.

But two broader challenges highlighted by the pension crisis are particularly intractable in China. One is the central government’s historical struggle to keep the wealthier coastal regions aligned with the rest of China – one of the country’s core geopolitical imperatives. The more acute coast-interior disparities become, the more wealth the coasts will be asked to transfer to the interior, and the more coastal resistance to Beijing’s writ there’s likely to be.

The second is the scope of the grand bargain the Communist Party has made with the Chinese public – and the extraordinary degree of risk embedded in this social contract. Essentially, Beijing gets full rights to micromanage the Chinese people. In exchange, it takes on full responsibility for the welfare of the people. In other words, when the state demanded they do so, hundreds of millions of Chinese citizens gave up the right to have multiple children who, in keeping with core Chinese values, would see to their care in their golden years. Now, they’re finding the state may force them to spend these years destitute and alone. When Beijing scaled back the state sector, hundreds of millions left the interior to work in manufacturing on the coasts, propelling China toward untold wealth and global influence. Now, they’re finding that the state has neglected to make those who’ve gotten rich off their labor contribute their share to the social safety net – and that Hukou, a system designed for social control, is preventing them from getting what’s theirs.
Risky Bargain
Beijing can make a persuasive enough case that an economic slowdown is inevitable due to forces beyond its control. It’s capable of lowering public expectations of infinite growth and deflecting the responsibility of party mismanagement for the hard times to come. Xi and other senior leaders are constantly warning that China is not yet rich, that the project of national rejuvenation means constant preparation for hard times ahead. But Beijing cannot easily explain away problems plainly rooted in policy myopia, corruption and systemic dysfunction. And polls routinely show that what Chinese people want most from the party is not a headlong pursuit of national prosperity, but rather clean and responsive governance tailored to preserving the grand bargain.

This is why, under Xi, Beijing’s emphasis has shifted toward things like “quality growth,” pollution, corruption and social welfare. Xi has approached these sorts of issues with a heavy hand, focusing primarily on purifying the system of corrupt and recalcitrant elements. This is, in part, because so many other factors darkening China’s outlook are outside his control. He also presumably realizes that, as China’s external woes intensify, the party will need to prove that the power it has appropriated from the people is being wielded in service of their demands.

Ironically, though, this has meant strengthening the role of what Beijing can most directly control – the machinery of the state – and further narrowing space for political, civil and economic freedoms. Under Xi, Beijing has been strengthening state-owned enterprises, centralizing the bureaucracy, embedding party watchdogs at private firms and exploring new ways to supervise society. This, in turn, means the state is implicitly agreeing to shoulder ever more responsibility for the public’s welfare – and more of the public’s ire when it falls short.

Financial Markets To Federal Reserve: Time To Start Cutting Rates

by John Rubino

In late 2018 the US stock market tanked, in effect holding a gun to its own head and threatening to pull the trigger unless the Fed stopped raising interest rates. The Fed, painfully aware that an equities bull market is an existential threat in today’s hyper-leveraged world, quickly caved, promising no more rate increases if the market would just put down the gun.

This worked for a little while. Stocks jumped to new record highs and unicorn tech IPOs started pouring out of Silicon Valley. Normal, which is to say booming, markets were back.
But of course it couldn’t last. An overleveraged economy is not just addicted to new credit, but to ever-increasing levels of new credit. So stable interest rates won’t stave off withdrawal. From here on out only steadily (or steeply) falling interest rates will delay the inevitable crisis.

That’s the signal the financial markets are now sending the Fed, as stocks begin to roll back over …

S&P 500 markets tank Fed caves

… bond yields tank …

10 year Treasury yield markets tank Fed caves

… and demands grow for not just patience but acquiescence. Now the question is not if but when the Fed responds with the required cut.

At the moment – mostly because the stock market hasn’t fallen very far — there’s still some resistance to lower rates:

Federal Reserve is reluctant to cut interest rates, latest minutes show 
(CBS News) – According to minutes released Wednesday, Fed officials noted that economic prospects for the U.S. and global economy were improving, while inflation had fallen farther below the Fed’s 2% target.  

Some officials “expressed concerns that long-term inflation expectations could be below levels consistent with” the Fed’s target of 2%. However, officials still believed a return of inflation to the Fed’s 2% target was “the most likely outcome,” according to the minutes. 
“Patience persists,” Ian Shepherdson, chief economist at Pantheon Macroeconomics, said in a note. “Most, perhaps all, FOMC members are content to leave rates on hold for some time yet.” 
At its last meeting, the Fed kept its key policy rate unchanged in a range of 2.25% to 2.5%, where it has been since the Fed hiked rates for a fourth time last December.  
That end-of-year hike contributed to a nosedive in financial markets as investors began to worry that the central bank was in danger of sending the country into a recession. 
In January, the Fed did an about-face in response to a worsening global outlook and other risks to growth and began signaling it would be “patient” in changing interest rates. While Fed officials had projected in December two more rate hikes for 2019, they now expect to hold steady for the year. 
The most recent minutes indicate that, despite recent economic improvements, the Fed remains cautious and prefers to act slowly.

But patience is a luxury afforded by stability, and that’s already changing. The Atlanta Fed’s GDPNow report, for instance, shows both the Fed’s and the Blue Chip Economist consensus for Q2 growth at levels that are too low to generate positive year-over-year corporate profit comparisons. Falling earnings will probably cause falling stock prices, leading the Fed to conclude that cutting interest rates is the only way to head off a global financial contagion.

GDPNow markets tank Fed caves

This cycle – recurring financial instability forcing the steady ratcheting down of interest rates – will continue until lower rates become the problem rather than the solution. Which is another way of saying until there are no more solutions.