Abject Monetary Disorder

Doug Noland

A market week that began with a U.S./China trade “truce” ended with much stronger-than-expected (224k) June non-farm payrolls data. There were new intraweek record highs in equities and no let up in the global yield collapse. Lacking was increased clarity as to prospects for trade negotiations, economic growth and central bank policy.

Almost a week after Presidents Trump and Xi agreed to restart trade negotiations, there are few details as to what was actually discussed and agreed upon. The ratcheting down of tensions was widely expected in the markets. As anticipated, President Trump chose not to impose additional tariffs on Chinese imports. The softening of sanctions (allowing purchases from U.S. suppliers) on Huawei was the major surprise, although even on this point there is murkiness.

After push back from U.S. security “hawks,” the administration stated the Chinese tech powerhouse remained blacklisted and had not been granted “general immunity.” Little wonder there was no mention of the Huawei concession from Chinese state media, only warnings of the U.S. propensity for “flip-flops.”

Analysts have generally responded cautiously to the “truce” and to prospects for an imminent trade deal. Equities, in the throes of speculative impulses and record highs, celebrated the reduced odds of near-term negative trade surprises during at least a temporary cooling off a vitriol.

Global bond markets, enjoying their own speculative melee and attendant unprecedented low yields, were fazed neither by either the “truce” nor surging risk markets. German 10-year bund yields were down eight bps at Thursday’s lows, to a record negative 0.41%. French yields were down 13 bps for the week at Thursday’s record low negative 0.14%, with Swiss yields down another 12 bps to Thursday’s record low negative 0.67%.

As spectacular as it’s been at Europe’s “core,” the yield collapse at the “periphery” has been nothing short of astonishing. Italian 10-year yields traded as low as 1.55% Thursday, down a stunning 112 bps from the end of May. At Thursday’s 2.01% low, Greek yields were down 150 bps since May 15th. Portuguese 10-year yields were as low as 0.27% in early Thursday trading, after trading at 2.0% in November and 1.16% in May. After beginning the year at 1.41%, Spanish yields traded Thursday at 0.20%. At Friday’s close, Denmark’s 10-year yields were at negative 0.30%, Austria’s negative 0.13%, Netherlands’ negative 0.22%, Finland’s negative 0.10%, Belgium’s negative 0.02%, Sweden’s negative 0.02%, Slovakia’s 0.05%, Ireland’s 0.07%, Slovenia’s 0.11%, Cyprus 0.45% and Croatia 1.09%.

I’ve witnessed a lot of “crazy” in my three decades of closely following various Bubble markets (i.e. Japan’s Nikkei ending 1989 at 38,916 (closed Friday at 21,746); manic early-nineties buying of Mexican tesobonos; late-1993 collapsing U.S. yields and Bubble excess that portended the 1994 rout; speculative Bubbles in SE Asian securities and Russian bonds; LTCM with $2 TN notional derivatives exposures; Internet and tech stocks in 1999; and $1 TN of new subprime CDOs in 2006; etc.). Yet nothing compares to the ongoing global yield collapse.

The global bond market speculative melt-up has brought new meaning to phrase “indiscriminate buying.” I know it’s heresy to suggest as much, but we’re witnessing history’s greatest speculative Bubble go to absolutely “crazy” extremes (it will all have been obvious in hindsight).

According to Bloomberg, the amount of negative-yielding debt globally jumped Thursday to a record $13.4 TN. Rising almost $2.2 TN over the past month, “negative-yielding debt now comprises 25%” of the total investment-grade universe.

July 5 – ETF Trends.com: “According to the latest report on exchange-traded fund (ETF) flow data from State Street Global Advisors, fixed income exchange-traded fund (ETF) inflows were out of this world in the month of June, garnering over $25 billion. ‘Even with a 6% rally in global equities, investors allocated a record amount to fixed income ETFs,’ wrote Matthew Bartolini, CFA Head of SPDR Americas Research State Street Global Advisors… ‘Equity ETFs did garner $20 billion of inflows. However, inflows to bonds were truly out of this world with over $25 billion –a more than 45% increase over the prior record from October of 2014.’ The record number of inflows into bond ETFs allowed for record capital allocations into the fixed income space. ‘Bonds’ record June haul pushed the first-half figure to $74 billion, which is also a record amount for a first half,’ Bartolini noted.”

What others celebrate as a “fantastic bull market,” I see as Abject Monetary Disorder. With global bond prices spiking parabolically upward, how much systemic leverage and resulting liquidity is being created in the process? What quantity of global fixed-income has been purchased on leverage? More importantly, what is the scope of derivative-related leverage that has accumulated throughout global bond markets and fixed-income, as seller/writers of myriad strategies are forced to purchase the underling debt securities to hedge derivative contracts previously sold.

In contemporary derivative-dominated markets, upside market dislocations create the outward appearance of endless liquidity. Indeed, the higher markets spike the more previously “out of the money” options (swaps, swaptions, etc.) move “in the money,” requiring more aggressive “dynamic” buying to hedge rapidly escalating derivative-related exposures. Such “melt-ups” are powerfully self-reinforcing, with buying on leverage exacerbating liquidity excess and eventually culminating in panic buying.

There is increasing evidence of market dislocation and associated Monetary Disorder. While “money” supply data has lost relevance over the years, it’s worth noting M2 “money supply” has surged almost $210 billion over the past six weeks (up $638bn y-o-y) to a record $14.773 TN. Money market fund assets have gained $150 billion in nine weeks to an almost decade high $3.192 TN (retail money market funds included in M2). And in another indication of liquidity abundance, outstanding Commercial Paper has jumped almost $80 billion in five weeks to an eight-year high $1.164 TN. Where’s all this “money” coming from?

This week had somewhat of a capitulation look to it. After ending last week at 2.10%, Italian 10-year yields had sunk an incredible 55 bps at Thursday’s 1.55% low. Greek yields were down 42 bps for the week at Thursday’s 2.01% low. Elsewhere, Hungary’s 10-year yields were down 36 bps - India 31 bps, Turkey 70 bps, Lebanon 61 bps, Mexico 27 bps and Brazil 24 bps – at Thursday’s lows. Turkey’s dollar bond yields were down 39 bps at Thursday’s 6.88% low.

The problem with speculative melt-ups – especially when dominated by speculative leverage and derivative-related buying – is reversals tend to be sharp and problematic. In derivative “dynamic” trading strategies, virtual panic buying to hedge exposures during the market upside blow-off phase can abruptly reverse into aggressive selling as market prices turn lower. Market liquidity, seemingly so permanently abundant during the ascent, is prone to quickly becoming almost non-existent into the decline.

Global bond markets reversed sharply after Friday’s stronger-than-expected 224,000 gain in June non-farm payrolls (we’ll see Asia’s response Monday). Two- and five-year Treasury yields jumped 10 bps in Friday trading (to 1.86% and 1.83%). Ten-year yields rose eight bps to 2.03%. Ten-year yields jumped 10 bps in Canada, seven bps in Italy and Greece, eight in Spain and 10 bps in Portugal.

A Friday afternoon Bloomberg headline: “Fed Debate Shifts From Large Cut to Whether to Cut at All.” While it did dip slightly in early-Friday trading, by the end of the session markets were back pricing a 100% probability of a rate cut at the Fed’s July 31st meeting. Fed funds futures imply a 1.81% Fed funds rate at the end of the year, up from Wednesday’s implied 1.63%.

Curiously, the market is still highly confident of a rate cut this month, this despite record stock prices, a trade “truce,” and a sharp snapback in job creation. Markets are clamoring for a rate cut and few believe the Powell Fed will risk a repeat episode of disappointing the markets. Yet there’s a strong case for the Fed to hold steady on rates.

July 2 – Bloomberg (Christopher Condon and Brian Swint): “Loretta Mester has laid out the argument against a rate cut this month, while many of her colleagues are leaning hard toward it and investors assume it’s on the way. The president of the Cleveland Fed… said her baseline forecast calls for slower, but still solid, growth of around 2% in 2019 -- even as she acknowledged that downside risks are on the rise. ‘Cutting rates at this juncture could reinforce negative sentiment about a deterioration in the outlook even if this is not the baseline view,’ she said. A cut ‘could also encourage financial imbalances given the current level of interest rates, which would be counterproductive.’”

A Reuters article (Marc Jones and Navdeep Yadav) quoted Mester: “The markets have priced in rate cuts, my interpretation is that they have put a lot of lean on that weak growth scenario. We don’t want to throw away what the market is telling us... You want to infer a signal from that but some of it is noise and some of it is signal, and the markets have shown they are not always correct about where the economy is going.”

It's a quandary. When markets go into speculative melt-up mode, the signaling process turns dysfunctional. Technology stock prices in March 2000; record high equities prices in July 1998 and October 2007; sinking bond yields in late 1993. Never before have so many securities (bonds and stocks) been held by passive index products; and never have algorithmic trading strategies played such an impactful role in the marketplace. Moreover, never have global securities and derivatives markets been so closely interconnected. And perhaps most consequential, never have central bank policies had such a profound impact on global bond prices, market perceptions and speculative trading dynamics.

Central bankers are now faced with the predicament of having nurtured distorted markets (with aberrant signals) that will throw a frenetic tantrum if central banks don’t follow the markets’ directive. There is bold discourse aplenty these days regarding the merits of an “insurance” rate cut. Chairman Powell himself has stated “an ounce of prevention is worth a pound of cure” – a comment markets have interpreted as guaranteeing a July cut. Pundits, including former central bankers, have been speaking as if there is essentially no risk to a cut they believe would offer protection against bad outcomes. This, however, completely disregards the risks associated with adding monetary stimulus to dislocated global securities markets already in dangerous detachment from fundamental realities.

With a rate cut cycle commencing imminently, the view is the fixed income investment cycle is closer to the start of something than the end. Yet it sure has the look of the craziness that comes at the end of a long cycle. That central banks are prepared to further loosen monetary policy with global securities markets absolutely booming should be sounding the alarm bell. Central banker will either hand over the keys to the asylum – or try to regain control. Either way, there is market uncertainty and volatility on the horizon.

It used to be that seasoned market players would fret late-cycle excess (appreciating associated fragilities). But that was before “whatever it takes” QE and $13 TN of negative-yielding global bonds. Why not buy 10-year Treasuries at 2.0% when bunds trade at negative 0.37%. Why not own U.S. investment-grade bonds at historically (highly) elevated prices that appear attractive relative to negative-yielding European corporates? Junk, even better. MBS, why not. Basically, virtually the entire fixed-income universe is expensive on a fundamental basis - yet cheap relative to negative-yielding foreign bonds. And how high can U.S. stocks trade if Treasury yields go negative?

Market speculation used to be grounded in “the greater fool theory”. Who needs a fool when markets have central bankers with the wizardry of their QE tool. Bonds have been around for centuries, but we’ve finally reached the point where there is no longer a ceiling to bond prices.

This is a precarious juncture for global markets, and the Fed should think twice before it feeds this beast.

Currency warrior: why Trump is weaponising the dollar

Businesses in countries such as Russia are testing the power of the reserve currency but it could benefit from any global instability

Sam Fleming in Washington

In an industry long dominated by the dollar, it was a move that carried obvious symbolic weight.

Last summer Russian diamond miner Alrosa tested a new system for selling its rocks in roubles to clients in countries such as China and India, as an alternative to the US currency.

Since then the company has conducted about 50 transactions under the mechanism, using a range of currencies, says Evgeny Agureev, Alrosa’s director of sales, who says avoiding dollar conversion allows transactions to be conducted more speedily.

“The number and volume of these transactions is relatively small . . . but we think it is valuable for our clients to have a variety of options for settlement to choose from,” he says in an email, adding that the “world changes and we need to respond”.

Though under consideration for several years, the initiative by the partly state-owned miner is a sign of a growing appetite to find ways of shaking off the stranglehold the US dollar has long held on global commerce and finance. Those efforts have taken on high urgency given Donald Trump’s increasingly aggressive use of US economic and financial weaponry to get his way in foreign affairs.

The president has thus far engaged in minimal military conflict, but he has proved an unusually pugnacious currency warrior, as he pairs a tendency to talk down the dollar’s value in his quest for a smaller trade deficit with an unusual willingness to use the currency’s global heft as a tool of foreign policy.

Critically, sanctions, which can block foreign officials or corporations from accessing vast swaths of dollar-dominated commerce and finance, are being deployed against Russia, Iran, North Korea, Venezuela and a host of other countries, alongside tariffs and other restrictions on key companies such as telecoms manufacturer Huawei. As a result, economies including China and Russia are examining mechanisms to curtail their reliance on the dollar, while European capitals are seeking ways of circumventing America’s new barriers on dealings with Iran.

To date the initiatives amount to less than a pinprick in the US currency’s hegemonic status, as underscored by the modest scale of Alrosa’s foreign exchange innovation. But Mr Trump’s unilateralist approach has unquestionably unleashed a phase of experimentation elsewhere, prompting some analysts to ask whether, in the longer term, the US dollar’s supreme position in the global financial system could be shaken as other nations revolt against what they see as Mr Trump’s arbitrary use of American power.

Adam M Smith, a former Treasury and White House official who is now a partner at law firm Gibson, Dunn & Crutcher, says the manner in which Mr Trump is wielding America’s economic power is unprecedented, as he uses sanctions, tariffs, trade negotiations and export controls interchangeably.

“He is using the importance and attractiveness of the US market to the rest of the world as a coercive tool to get others to bend to his will,” says Mr Smith. “Does the very aggressive use of these economic tools make it more urgent for countries to find ways to avoid the US market? Probably. However, the urgency may not mean that most countries will be successful in finding effective workarounds.”

Chief economist at the IMF Gita Gopinath points to the decline of the euro rather than the dollar, with a reduction in euro invoicing and international financial transactions

America has long enjoyed a singular economic arsenal thanks to the ubiquity of the dollar and the centrality of its economy and financial system to global commerce. Although America’s share of global gross domestic product may have declined, its currency still accounts for over 60 per cent of international debt, according to a speech by European Central Bank official Benoît Cœuré in February, and leads the euro both as a global payment currency and in foreign exchange turnover. It dominates pricing of commodities such as oil and metals and accounts for about 40 per cent of cross-border financial transactions.

The dollar’s share of global foreign exchange reserves has slipped in the 10 years since the financial crisis, but at 62 per cent of the total it still dwarfs all rivals. The euro has lost greater ground over the same time, now standing at just over 20 per cent. The Chinese renminbi is just a few per cent of global reserves, and a mere 2 per cent of international payments, according to the global transfer network, Swift.

This unique place at the heart of the global economic system gives the US government enormous power. Using the dollar almost invariably means touching a US financial institution, says Eswar Prasad, a professor of economics at Cornell University. This immediately puts you within the reach of US government and regulators.

The US toolkit is particularly potent thanks to the use of “secondary” sanctions. Normal US sanctions aim to prevent American citizens from dealing with a given country or party, but secondary measures allow the government to penalise third parties that do business with a sanctioned country.

The consequences for non-US institutions of failing to comply with US rules can be severe. In 2014, for example, BNP Paribas was hit by a penalty of nearly $9bn by the US authorities in connection with sanctions violations, as well as being forced to temporarily suspend part of its US dollar clearing work.

Republican senator Marco Rubio wants to examine closely China's ready access to US finance

While Washington’s use of sanctions has been on the rise for decades, Mr Trump has emerged as a particular enthusiast. Data compiled by Gibson Dunn show 1,474 entities were subject to sanctions designations in 2018 — 50 per cent higher than in any previous year for which it has kept records.

The power of these tools has been felt across markets. The Treasury’s decision to sanction metal groups Rusal and parent company En+ led to a surge in aluminium prices, before it agreed to ease its stance if its major shareholder, Oleg Deripaska, gave up control. Sanctions were lifted in January.

Last August Turkey was plunged into a currency crisis as the US imposed swingeing tariffs on its steel and aluminium exports, on top of sanctions on senior ministers.

The US Congress has equally been aggressive in pushing sanctions. In April a cross-party group of senators led by Republican Marco Rubio and Democrat Bob Menendez demanded sanctions against senior Chinese Communist party officials in response to alleged human rights abuses against Uighurs and other Muslim minorities in the northwestern province of Xinjiang.

This month senators demanded the more rigorous enforcement of US regulations against Chinese companies that seek access to US markets. Hawks such as Mr Rubio want to take matters further and more closely examine China’s ready access to US finance.

A worker at Alrosa inspects a diamond. Last year the Russian mining company tested a new system for selling its rocks in roubles rather than dollars © Bloomberg

“China poses the greatest long-term threat to US national and economic security. At a minimum, American investors should be aware of where their money is going when it comes to Chinese investments,” said Mr Rubio.

The Trump administration’s aggressive use of sanctions carries multiple risks. It is not only rivals who are upset: the US has at times also incensed close allies, which for decades have viewed Washington as a reliable steward of orderly global markets.

In the longer term it could accelerate a trend in which other countries wish to reduce their reliance on the dollar for its main three purposes — as a store of value, a unit of account and a medium of global exchange. In the very long run, some specialists fear the US dollar’s totemic status at the centre of the global economy could be eroded, or even supplanted, just as the British pound was by the dollar during the interwar period.

Richard Nephew, a former US government sanctions specialist who is now programme director at Columbia University’s Center on Global Energy Policy, says that for at least the next five to 10 years the world is locked into the dollar as the default currency.

But he argues there will be an evolution towards a system where the US is not the sole significant trading currency. US policy today “will increase the speed with which that transition takes place”.

A recent report from the Center for a New American Security think-tank argues that a host of factors could conspire to weaken the impact of America’s economic policy arsenal over the longer term. Critically, it says that if the US attempts to reduce its economic, financial and trading connections with key overseas economies, “over time US coercive economic leverage over those economies will diminish”.

Russia has been at the forefront of attempts to de-dollarise, spurred on by the punishing impact of US sanctions on its economy. “We are not ditching the dollar, the dollar is ditching us,” Russia’s president Vladimir Putin said late last year. “The instability of dollar payments is creating a desire for many global economies to find alternative reserve currencies and create settlement systems independent of the dollar.”

Russia’s central bank last spring sold $101bn worth of dollars from its reserves, shifting the holdings into renminbi, euros and yen, according to official data published in January with a six-month delay. Fifteen per cent of Russia’s reserves were in the Chinese currency last summer, the data showed, three times the proportion at the end of the first quarter of 2018.

For its part, China has experimented with denominating oil futures in its currency as well as working on its own international payments system.

In June Russia agreed with China at a summit between Xi Jinping and Mr Putin to do more trade in their respective currencies. The rouble and renminbi’s share of Chinese imports into Russia edged up from 17 per cent in 2017 to 24 per cent in 2018, according to economist Dmitry Dolgin of ING.

Xi Jinping and Vladimir Putin after a summit at the Kremlin in June in which both presidents agreed to do more trade in their respective currencies © AP

Yet for all the political attention, the two countries’ attempts to reduce the dollar’s role remain in their infancy. For example, China and Russia set up a non-dollar direct settlement plan to help with their gas pipeline deals around 2015. However, in practice, the Chinese side uses it as little as possible, in part because of the risk of rouble volatility.

China has also harboured aspirations to turn its Belt and Road Initiative into a platform for boosting the international use of the renminbi. But it would in practice have to dramatically liberalise its capital controls to gain widespread acceptance as a reserve currency.

In Europe, frustrations have been growing at the continent’s faltering attempts to boost the euro’s global role alongside the dollar. Top French officials including François Villeroy de Galhau, governor of the Banque de France, have called for greater use of the euro in international transactions in a bid to challenge the dollar’s dominance. European Commission president Jean-Claude Juncker last year said it was an “aberration” that the EU paid for more than 80 per cent of its energy imports in dollars despite only 2 per cent of imports coming from the US.

Yet the pattern since the financial crisis has if anything been a decline in the euro’s international role. Gita Gopinath, the IMF’s chief economist, points to a reduction in euro invoicing and international financial transactions. “The dollar on the other hand has gained relative to the euro in the last 10 years,” she says.

Meanwhile progress on a high-profile mechanism backed by major European countries that aims to sustain trade with Iran despite newly imposed US sanctions has been painfully slow.

Sigal Mandelker, the Treasury official in charge of enforcing sanctions, points out that despite European efforts to keep their businesses invested in Iran following Mr Trump’s withdrawal from the nuclear deal, the companies “got out in droves”.

“There are people out there who argue we have overused the tool,” says Ms Mandelker, “[but] if you look at our objectives and how we are using the tool, you will see that what we have been doing systemically is to change behaviour, to disrupt the flow of bad money, and to go after entities and individuals who pose national security and illicit finance risk.”

For all the warnings that the US will undermine its own currency by being so aggressive, there is little sign of any diminished appetite for using the greenback. Kevin Hassett, the outgoing chairman of Mr Trump’s Council of Economic Advisers, says: “If you thought that the Trump policies were imperilling the status of the dollar, then your case would be stronger if you showed that the dollar had collapsed a lot under Trump policies . . . But the move in the dollar has been kind of the opposite of that.”

Ms Gopinath is sceptical about the chances of near-term change. “You are hearing more noise right now for other currencies to become truly global currencies. But the data do not show a more forceful dynamic in this direction and it would take a lot more than what we’re seeing now for there to be a switch.”

Indeed, the irony is that if the president ends up triggering global instability via his policies, investors may end up flocking all the more enthusiastically towards dollar assets. That was after all the phenomenon during the financial crisis, when a mortgage meltdown that was made in the US prompted global investors to scamper for the safety of government bonds, and it has been the same story more recently as Mr Trump’s trade wars drove down US bond yields.

“Anything Trump creates to foment uncertainty and instability will only end up strengthening the dollar,” says Mr Prasad. Over time, other countries will indeed get tired of this and shift away from the dollar as a unit of account and a medium of exchange, he adds, but “in the foreseeable and longer future the dollar’s role as the dominant store of value is unlikely to be challenged.”

Additional reporting by Lucy Hornby in Beijing and Henry Foy in Moscow

How Matteo Salvini could blow up the eurozone

If Brussels corners Italy’s government over its fiscal plans, it will resort to dangerous fiscal tricks

Wolfgang Münchau

The Palazzo Montecitorio in Rome, where Italy's chamber of deputies voted last week to introduce a parallel currency © Bloomberg

A curious thing happened in the Italian parliament last week. The chamber of deputies voted unanimously in favour of a motion to introduce a parallel currency in Italy — the so-called mini-BOTs. It was a non-binding motion. I suspect that many of the MPs in the lower house probably did not know what they were voting for when they called on the Italian coalition government to consider the creation of “government bonds in small denominations”.

Mini-BOTs would look like real money. Their denominations would be the same as euro notes. Depending on how they are designed, Italians could even pay their taxes with them. For this reason they would stand a good chance of becoming an accepted means of payment. Mario Draghi, the European Central Bank president, gave his view last week: “Mini-BOTs are either money and then they are illegal, or they are debt and then the stock of debt goes up. I don’t think there is a third possibility.”

I am not sure I agree with Mr Draghi on this point. The mini-BOTs could be both at the same time — debt with money-like characteristics.

You might want to dismiss this development in Rome as an eccentric vote by an eccentric parliament. But consider the political context and Italy’s confrontation with the EU.

Matteo Salvini is only deputy prime minister but his League party captured 34 per cent of Italy’s popular vote in last month’s European elections. A simulation shows that his party, with a rightwing ally, would win a majority of seats in a general election. And Italy’s first-past-the-post system could leverage Mr Salvini’s power beyond his share of the vote.

In Brussels, meanwhile, the European Commission has triggered the early stages of what is known as an excessive deficit procedure against Italy. It is the first of a number of steps that could eventually end up in a financial penalty. The commission’s complaint relates to the 2018 rise in Italy’s debt to gross domestic product ratio.

It is possible that EU finance ministers will put the procedure on ice. But the stand-off is almost certain to recur in the autumn when Italy is due to present its 2020 budget. Mr Salvini is insisting on big income tax cuts that could push up the fiscal deficit by another 1 or 2 percentage points.

On economic grounds, one could probably justify a moderate short-term fiscal boost. But a big permanent tax cut would translate into an increase in Italy’s structural deficit. It would certainly breach EU rules.

This smacks of a looming conflict, possibly accompanied by a financial crisis. How would it play out and would the government collapse? The political situation is different from 2011, when Silvio Berlusconi was forced out in favour of a technocrat after losing his parliamentary majority The current government has a large majority. If it were to collapse, new elections could end in a landslide victory for Mr Salvini.

This is where the discussion on the so-called mini-BOTs comes in. Italy cannot leave the eurozone in a single dramatic act. Any politician who tried this would bring themselves down. But we do not know what Mr Salvini really wants.

Does he really want Italy to leave the eurozone? If so, the mini-BOTs are almost too good a vehicle to be true. The extra funds would allow him to cut taxes. And they would serve as an indispensable intermediate step for an eventual exit.

But if he does not want to leave the eurozone, he should not touch them. There is not much the EU could do to stop the issuance of mini-BOTs. Fiscal policy is within the domain of national sovereignty. But the European Commission will count these instruments as part of Italy’s official deficit and debt. It can argue that if people used mini-BOTs to pay their taxes, then surely the Italian government’s future euro tax revenues would decline. So would the country’s capacity to service its debt, which is denominated in euros. Mini-BOTs will not allow Italy to escape the excessive debt procedure. Their announcement could even precipitate an immediate financial crisis.

From an EU standpoint, mini-BOTs are more than just an instrument of fiscal irresponsibility. They would take the confrontation between Rome and Brussels to a new level. The eurozone would lose its cohesion if member states started to issue their own money — however fake it may be. After all, mini-BOTs were originally designed by Italian Eurosceptics for that very reason.

The EU should also tread with caution. There is a strong case not to proceed with an excessive deficit procedure right now and to wait until the autumn. The danger is that the more Mr Salvini is politically cornered, the more likely he is to resort to this instrument. When he does, the eurozone crisis will return. And the ECB may not be able to come to the rescue this time.

How to Reduce the Ballooning U.S. Debt — With Bipartisan Support

Economist William Gale discusses his new book about reducing the burgeoning national debt in the U.S.

It is well-recognized that the U.S. will face a day of reckoning for its burgeoning debt, which hit a record $22 trillion earlier this year. The ballooning indebtedness will send America into decline unless steps are taken to address the structural imbalance between spending and revenue. Politics has been a big hindrance to implementing a plan to reduce the national debt.

In his new book, Fiscal Therapy: Curing America’s Debt Addiction and Investing in the Future, economist William Gale provides a plan that he believes both conservatives and liberals can embrace. Gale, chair of Federal Economic Policy at the Brookings Institution and co-director of the Urban-Brookings Tax Policy Center, joined the Knowledge@Wharton radio show on SiriusXM to share his ideas.

An edited transcript of the conversation follows. 

Knowledge@Wharton: We all know that the country has rising debt and that it’s a significant problem, yet there isn’t enough being done to address it. Why?

William Gale: Well, that is an understatement. Indeed, there are active efforts to oppose doing anything about it right now, but even in the best of times for dealing with fiscal problems — long-term issues in particular — politicians are hesitant to jump in.

Knowledge@Wharton: Where are your greatest areas of concern about the debt?

Gale: In terms of the debt itself, we are on an unsustainable path. That doesn’t mean we’re going to face a crisis anytime soon, but something’s got to give. We need to adjust spending downward and raise taxes. The idea behind the book is these are necessary changes, but we can use them as an opportunity to do a lot of good things.

Knowledge@Wharton: In the book, you discuss taxes and investing in the future. Can you touch on those?

Gale: There are these twin problems I focused on. If you just think about the budget, then you’re naturally led to spending cuts and tax increases. But when you start thinking about the way we tax and the way we spend, it’s pretty obvious we’re not doing the right structural changes even apart from the level of taxes and spending.

On spending, we need to be doing more on the investment side. On taxes, we need to be taxing things that have less deleterious economic effects, like a consumption tax and a carbon tax. So, we need to change the structure of taxes and spending, as well as the levels of taxes and spending.

Knowledge@Wharton: Let’s talk about entitlement spending because that’s obviously a concern with health care. Where do we need to go with entitlement spending with the different programs that are in play here?

Gale: The two major entitlements are Social Security and Medicare. Lots of times people say entitlements as a polite way of saying Social Security and Medicare. They create different situations. Social Security has always been a program that stood on its own two feet. A couple of years ago, I was on a commission that the Bipartisan Policy Center ran, and it came up with a bipartisan Social Security proposal that would, among other things, raise the retirement age, raise the payroll cap and provide a balanced reform to put Social Security on a long-term, financially firm ground.
On Medicare, the problem is a little different. Health care spending, which is huge, needs to be reined in. There’s a lot of spending in health care that, according to empirical research, is not justified. There are a lot of ways that we pay providers based on their inputs rather than the quality of the outcome. Medicare pays 25% more for the same drugs than Medicaid or the Veterans Affairs health program, and there’s no reason for that other than politics. So, I believe we can save some money there, too.

On health, the primary budgetary concern is cutting spending, controlling spending, but at the same time, we want to be sure that we’ve extended health insurance coverage as far as we possibly can. I don’t think those goals are contradictory, but they make the problem harder.

Knowledge@Wharton: There’s been a lot of discussion about the potential of Social Security becoming insolvent around 2034. What are your concerns about that program?
Gale: That might be the good news in all of this, because the trust fund running out of money in 2034 for Social Security or 2026 for Medicare might be the type of thing that forces policymakers to take action.

You never want to wish for a crisis, but the problem politically with this long-term fiscal issue is their backs are never really against the wall. They can always wait one more day. They can always put it off. The trust fund exhaustion dates provide hard constraints where they have to do something. They may not do the right thing at that point, but they have to do something.

Knowledge@Wharton: Where do you see the most reasonable and acceptable, but also possible and positive, investments in the future for this country?

Gale: There are three things that are critical to do. First, invest more in children — their education, preschool programs, families with kids, child care — the whole panoply of programs and options for investing in children. The argument there is both an equity one, where the kids’ status in life does not really depend on things they do. It depends on their parents and their community, and so on. But it’s also an efficiency argument. We, as a nation, are wasting resources by not making sure that our kids are getting the best education and child care possible.

Investment in infrastructure is No. 2. Everybody knows we have lagging infrastructure issues. Everyone can think of their favorite example, whether it’s John F. Kennedy Airport or a bridge or a road somewhere.

The third thing is that we need to start financing those things with a carbon tax, for example, which would help in dealing with climate change but would also help on the fiscal side. If I had to choose three of the many proposals in the paper to do now, those would be the most urgent ones.

Knowledge@Wharton: If we can put together a plan that addresses these areas, are we talking about slowing the national debt, stopping it or reducing it?

Gale: The current baseline projection is that the debt will rise from about 80% of [gross domestic product] now to about 180% of GDP in 30 years, by 2050. The proposals in the book get it down to 60% by 2050, which is less than it is now, more than it has been in the past. But it gets it down to a steady, sustainable 60% of the GDP. I think it’s the right long-term goal.

If somebody told me the long-term goal should be 80% or 100%, I couldn’t prove them wrong. But the notion that it would be going to 180% and rising after that seems definitely wrong, and I don’t know anyone who doesn’t think that.

Knowledge@Wharton: You also examine this from a historical perspective. For many decades, the national debt was under control and really only had a rise when we saw a war of some kind, then we were able to get it under control again. But it was really around the time of President Reagan when we started to see debt going up for something other than military conflict.

Gale: That’s right, and there are two aspects of this that I think are important from the fiscal history side. By the way, I wrote the fiscal history chapter because I thought if I looked back over a couple of hundred years of history, I would find the answer as to what we need to do. And that turned out to be wrong.

There are two aspects of the history. One is that debt can be useful. We use it to finance big spikes in national defense or big initiatives or to fight recessions and so on. It’s not like all debt is bad. Two is that the situation we face now is totally different from any historical debt situation we’ve faced in the past. That’s kind of what I was disappointed about when I wrote the fiscal history chapter, because right now we’ve got this built-in, chronic imbalance between taxes and spending.
There’s no war that’s going to end that will bring the budget back into line. There’s no recession that’s going to end that will boost revenues. We’ve just got the government spending more than it’s taking in revenues — basically now and into the future — and by increasing amounts into the future. That creates a different set of concerns, a different set of constraints than ending a war or ending a depression.

Knowledge@Wharton: We are spending more than we’re taking in right now, which is important in the context of the tax cuts enacted by the current administration. Where we are headed in the future with this?

Gale: The economy is booming right now and has grown the last couple of years, yet the deficit has gone up, not down. Normally, the deficit goes down as the economy booms because revenues come in and government safety-net program spending goes down. But because of the tax cuts and other things, deficits have continued to rise.

We’re in the midst of good times — at least in the economy as a whole — and the debt is high relative to historical standards. We’ve never had deficits this high on a sustained basis when the economy was so strong, so if and when the economy turns down, then we’re in real trouble. That’s why looking ahead a little bit right now, which is what I’m trying to do in the book, is a useful exercise.

Knowledge@Wharton: How do we start to think about reducing the debt? As you said, it’s really not a consideration right now.

Gale: The first step is to disavow people of the notion that there are easy ways to do this. Cutting foreign aid, cutting government workers’ salaries, reducing the subsidy to public TV or Big Bird — it’s just not going to do it. That’s a rounding error in the budget. We need to reform Social Security and Medicare in ways that respect the anti-poverty roles that those programs play. I don’t want to decimate those programs. I want to reform them but keep the crucial elements.

The other is, and there’s no way around this, we need to raise taxes. In the process, we need to reform taxes as well. But the big moving parts here are a value-added tax, which is a national consumption tax, a carbon tax, and then changes to existing taxes — the income tax and the corporate tax.

Knowledge@Wharton: How will this mix of ideas affect the average citizen in the next five, 10, 15 years?

Gale: I don’t have formal estimates of this, but everything that I understand and everything that I was trying to push in the proposal leads to the following: Low-income households are going to be better off. There is a variety of programs for them that will help them invest in their own career and future. High-income households will be paying significantly more in taxes, which I think is justified on several grounds, namely the fact that it’s the only way to get them to share in the fiscal burden, and their income has gone way up even though their tax rates haven’t.
The big moving part is the middle class. I think that the middle class will have to pay more taxes under these proposals. What they would get in exchange for that would be a stronger economy, more economic mobility, less diffuse income distribution. But the issue is that the fiscal problem is so big that we can’t finance it just on the backs of the wealthy. It’s the middle class that’s been benefiting all these years from many of these programs, and there’s just no way to get there from here just by raising taxes on high-income households.

Knowledge@Wharton: The idea of where we want to see the economy down the road with some of these elements playing in, can you go back in history and pinpoint a similar time?

Gale: Some of the elements have been the same in the past. For example, after Reagan cut taxes, there was this series of bipartisan deficit reduction proposals that took place starting in 1982 and going all the way through 1997. They turned the deficit situation in 1982 — which [Reagan’s first budget director] David Stockman described as “deficits as far as the eye can see” — to a situation by the end of the century where we had surpluses as far as the eye could see.

That’s a model for what we could do now in the future, but it’s the best we’ve done in the past. But even if we did that, it would not be enough because the debt is so much higher right now to begin with. The demographic forces were moving in our favor in the 1980s and 1990s as the baby boomers moved into the labor force and bought houses and had kids. Now demographic forces are working against us as the baby boomers are retiring.

Knowledge@Wharton: We also need to stay away from something as large and destructive as the Great Recession.

Gale: That’s right. This is an interesting point. The economy is more important than the budget, right? Saving the budget and destroying the economy in the process would not be what most people consider a win. We have to respect the fact that the budget is part of the bigger economy and think first of what’s best for the economy, and then try to control the budget.

Knowledge@Wharton: You mentioned people being left behind, and that’s been a concern for quite some time. Again, it speaks to what is going on in Washington, D.C. We know that people are being hurt, yet not enough is being done to address some of these issues.

Gale: I agree totally. We have widening income distribution. We have lagging wages at the bottom. We have whole groups of families and kids and neighborhoods that are cut off from the economic advancement that the rest of the country is experiencing. I think this is important, not just for raw economic reasons, but broader political, cultural, social and moral reasons. If we’re going to be the greatest economy in the world, it needs to be that way for almost everybody, not just for a few.

Swiss Bank Loses Client’s Gold

Egon von Greyerz

gold bars

Don’t let your bank hold your gold. They might not find it. A gold investor told us recently that his Swiss bank had moved the client’s gold from the bank’s safe to a private vault in the name of the bank, in Zurich. The client was aware of this move. But then the problems started. The gold was allocated and the client had the bar numbers. The client wanted to store the gold through our company and instructed the bank. But the gold wasn’t there any more. The gold was supposed to be segregated but the bank had stored it in the collective vault. And the client’s allocated, numbered bars were not to be found anywhere.

Presumably, the bank will accept liability and buy new bars for the client. But again this proves that it is not safe to keep your gold in a bank. We have regularly experienced similar problems with many different Swiss Banks, big or small.


In normal times when there is still physical gold available, the bank will clearly rectify the problem.

But when there is a shortage of gold and the bank comes under pressure, they could easily “borrow” client gold. If at that point there is no gold available, the bank could have a liability that it couldn’t meet, especially if the gold price rises fast.

So again, I warn gold investors, not to hold physical gold in a bank vault or in a bank safe deposit box. When the next financial crisis starts, you will not get your gold back from the bank’s vault and you will not get access to your safe deposit box. The bank will obviously tell you that the gold in the box is yours, but I wouldn’t trust them. Also, the bank doors could be closed for a very long time. So even if you did eventually get access, that might take years.

Much better to store gold privately in secure vaults which you have physical access to at any time.


Total government bond market is around $50 trillion. Out of that, $13 trillion carries negative interest. To me it is totally incomprehensible that anyone can lend bankrupt governments money.

Firstly, since most currencies have lost 97-99% of their value in real terms after the Fed was created in 1913, you are guaranteed to get back less real money than you invested if you hold a sovereign bond for more than a few months

Secondly, no government will be in a position to pay back their debt in coming years. And soon they will reach a point when they can’t even pay the interest.

How can then investors lend governments $13 trillion of money and pay for the privilege of the state holding your money. That is totally absurd. You give money to an insolvent country and you must pay them for that great honour.


Take little Portugal as an example. They have a massive debt to GDP of 125% and they also have negative yields from 2-5 years. What would you do? Would you lend money to a country that will never repay it and also pay them for the pleasure or buy gold?

Gold is the only money that has survived for 5,000 years and also the only money that has maintained its purchasing power. It is also no one else’s liability and totally unencumbered. In addition, it is totally liquid and can be used for barter. I doubt that anyone would accept a Portuguese bond as payment in say 2025 when it will be totally worthless. But I am totally convinced that everybody will accept a gold coin or gold bar.


Many people in the Far East prefer to hold gold or foreign currency to cash. The Bangkok Post reported recently about using gold for house purchases in Vietnam. A shopkeeper in Hanoi bought a new $138,000 condo with half gold, half cash. He said: “We did it because we and the seller didn’t want to do a bank transfer. We are so used to buying things with gold and cash.”

The newspaper stated that Vietnam is one of the world’s fastest growing economies, yet “it is still in the dark ages when it comes to joining the global trend toward cashless transactions.”

Hmmm! It seems that the shopkeeper understands a lot more than the journalist. The shopkeeper understood and trusted the timeless value of gold rather than paper money that is likely to become worthless in the next few years.

Seems like the journalist will be more likely to go back to the Dark Ages when paper money dies in the next few years.

The shopkeeper confirms the wisdom of the East that we often talk about. The people in India, China, Vietnam, Thailand and many more Eastern countries all put a major part of their savings in gold since they know that this is by far the best way to preserve wealth. Had the people in Zimbabwe, Argentina or Venezuela done this, it would have saved them from poverty and misery.


As asset prices collapse and gold appreciates, you will be able to buy a house for a fraction of the cost today, especially if you have your savings in gold, just like the Vietnamese shopkeeper.

Let us look at the coming collapse of the price of a new house in the USA. Today the median price for a new house is $335,000. In 1963 it was $17,000 – a 20x increase. As asset bubbles implode, a return to the 1985 level at least seems likely. That would mean a 75% fall in house prices. As credit dries up and interest rates surge, I would expect that this will be the minimum fall.

At the same time, let’s assume a very likely increase in the gold price to $5,000 in today’s money. In my view this is the very minimum and $10,000 or much higher is more likely.

As the table above shows, a new home today costs $335,000 or 235oz of gold. In 2025 with average house prices down 75% to $84,000 and gold up 254% to $5,000, a house would cost only 17oz of gold. That is a 93% fall in gold terms. Sounds unrealistic today but still very likely.


As the next global financial crisis unravels in the coming few years, we will see massive money printing, total debasement of most currencies and hyperinflation. The only way to protect yourself from the total destruction of paper assets is to hold physical gold and some silver.

There are three kinds of money, Worthless, Soon Worthless and Eternal. Since all fiat money has always gone to ZERO throughout history, the same will be the case for the dollar and all other currencies in coming years.

In 1971, you could buy 100 grams of gold (just over 3 oz) for the $100 bill in the picture above.

Today the $100 gram bar costs $4,500 and for $100 you would only get a small corner of the gold bar.

So, since 1971 the value of the dollar has lost 97.5% against gold. This means that only 2.5% of the real purchasing power remains. The fall of the dollar to its intrinsic value of ZERO is only a matter of time. But remember that this coming fall means that the dollar will lose 100% from today in the next few years.

All central banks have destroyed the value of money in the last 100 years with most people being totally unaware since they don’t understand that gold is constant purchasing power and eternal money and reflects governments mismanagement of the economy.

The coming collapse of the dollar and other currencies will be catastrophic for the world and have devastating effects on the US and global economy.


Gold has moved $130 in a short time and thereby broken decisively the 6 year Maginot Line at $1,350. Gold should reach $1,650 fairly quickly and then later move to new highs.

Very important changes will soon take place in markets with the 2007-9 crisis returning with a vengeance. The final phase up in US stocks could last a few weeks and most likely not more than 2 months. Thereafter a secular bear market will start that will be devastating for the world economy, the financial system and paper money. Wealth preservation is today more important than anytime in history.

Egon von Greyerz

Founder and Managing Partner

Matterhorn Asset Management

The Fog of Trade War: Can China Outlast the US?

Both sides are digging in, but Washington can’t ignore the costs of tariffs forever.

By Phillip Orchard


Last week, in response to mounting trade pressure from the U.S., Chinese President Xi Jinping called on the Chinese people to prepare for a “new Long March.” On Tuesday, Chinese state media cited the Korean War in touting China’s ability to dig in and grind down U.S. resolve. If it’s not clear, Beijing expects the trade war to devolve into a protracted, bloody slog.

Indeed, since the dramatic collapse of trade negotiations in early May, both sides have made moves of the sort you make only if it’s no longer necessary to prep the public for painful concessions, avoid collateral damage, and let the other side save enough face to ink a deal. China’s surge of nationalist rhetoric, for example, is a departure from previous efforts to tightly manage public anger, thus raising the political risks of backing down. On Tuesday, it announced the start of a process to ban exports of rare earth elements to the U.S. – a card it wouldn’t play if it didn’t think it had to, lest it risk diminishing its dominance over the sector by sparking a surge of investment in operations outside China. It announced plans to draft a list of “non-reliable” foreign firms and individuals, spooking investors already taking a long look at alternative low-cost manufacturing hubs and shaken by China’s retaliatory arrests of two Canadians.

The U.S., meanwhile, increased tariffs on $200 billion in Chinese goods and threatened to raise duties on another $300 billion in products, upending markets and provoking retaliatory tariffs, thus raising the impetus to exact greater Chinese concessions to justify the cost. The Trump administration also moved to slap tariffs on Mexico over non-trade issues, likely making it harder to persuade China to make painful concessions to get out from under U.S. tariffs (lest they just be reimposed over an unrelated issue six months from now). Most notable, three weeks ago, Washington launched the process of starving Chinese telecommunications giant Huawei of critical U.S.-made components.

In short, both sides are digging in. But we still believe conditions are ripening for a partial deal on trade that ends tariffs. If and when it comes, it will hinge foremost on two of the trickiest geopolitical elements to forecast – the exact timing of the next U.S. recession and the mood of U.S. voters ahead of the next election.
Going Big on the Tech War
In our 2019 forecast, we said Washington would settle for a trade deal with China that would do little to address core U.S. concerns or ease bilateral tension. The underlying logic was fairly simple: Caving to core U.S. demands would be more painful for Beijing than unilateral U.S. tariffs, limiting Chinese concessions largely to things it needs from the U.S., or reforms it wants to push forward anyway. It would quickly become clear what tariffs could achieve in the short window before the 2020 campaign season kicks into high gear. And the economic and political costs of the duties would compel Washington to accept a lesser deal and shift focus to a more targeted, defensive strategy – one wielded with non-tariff measures – to blunt Chinese technological threats.

The U.S. is indeed going big – very big – against Chinese tech with non-tariff measures, and there’s little incentive for it to back down anytime soon. Unlike its effort to curb Chinese trade practices, the U.S. doesn’t need Chinese concessions on the tech front. In fact, there’s not a lot that China could do to ease U.S. concerns. The U.S. can’t, for example, trust Chinese pledges that it won’t use Chinese telecommunications infrastructure to spy on foreign governments or threaten U.S. military logistics networks. Nor can it trust Chinese pledges to refrain from channeling state support to its tech firms. (China won’t concede this, anyway.) There’s just not much to negotiate, meaning the U.S. doesn’t need to seek leverage through measures like tariffs that harm the U.S. economy as well.

Rather, the U.S. can lean on unilateral moves to protect its own networks and blunt the creeping dominance of Chinese firms like Huawei. The U.S. doesn’t have to ask for permission to ban Chinese tech from U.S. networks or to impose more stringent reviews of Chinese investment, the hiring of Chinese scientists, and China-backed research undertaken at U.S. universities. And since Huawei is fully dependent on certain U.S.-made chip designs, semiconductors and software, U.S. export controls may cripple the firm for good.

To fully address its tech concerns, the U.S. likely will still need to persuade allied countries to ice out Chinese telecommunications firms, which is proving to be a tough ask, since doing so would hinder their own telecommunications development and risk Chinese retaliation. And unilateral U.S. measures will still carry costs and risks. Loss of access to the Chinese market, for example, will certainly sting for U.S. tech firms, even if the Chinese firms buying U.S. tech are emerging as long-term competitors. Loss of collaboration between Chinese and U.S. firms will hinder the development of new technologies and drag on global growth. And Chinese retaliation by, say, banning rare earth exports will be highly disruptive, at minimum. Moreover, if the effort to deprive Huawei of critical chip technologies leads to the development of homegrown Chinese alternatives, then the U.S. could inadvertently accelerate China’s rise to telecom dominance. Nonetheless, there’s broad, bipartisan recognition in Washington and some allied capitals that Chinese tech poses enough of a threat to make the potential costs worth bearing.

Rising Costs of the Trade War
The picture is quite a bit different in the U.S. offensive against abusive Chinese trade practices. This is why, despite the events of the past month, there’s still hope for our forecast that a deal removing tariffs gets done.

Most likely, the White House will blink first, given the economic and political toll the tariffs will take on the United States. The U.S. tariffs alone won’t tip the economy into recession. If the current 25 percent duties on $250 billion in Chinese goods remain in place, most estimates expect an annual 0.3 percent-0.5 percent hit to gross domestic product and the loss of up to a million jobs. In a vacuum – in a $20 trillion economy humming along at the peak of the business cycle and boasting historic lows in unemployment – this would be manageable.

But the U.S. has been overdue for a downturn, anyway, and the tariffs are certainly capable of accelerating its arrival. Before the announcement of the Mexico tariffs and the threat to tax another $300 billion in Chinese goods, the Fed said it was expecting growth to slow to 2.1 percent this year, down from 2.9 percent last year. The yield curve is showing signs of inverting, and private sector hiring plummeted in May. If the White House follows through with its threat to more than double the value of Chinese goods getting taxed – and stays the course on monthly tariff increases on Mexico – the slowdown will be all the more pronounced. The trade war will inevitably hit the U.S. economy in other ways as well, including by saddling U.S. firms that have manufacturing operations in China with added costs, by closing opportunities for U.S. exporters to the world’s second-largest consumer market, by raising the cost of consumer goods in the U.S., and by pinching off Chinese investment that has created millions of jobs in the U.S.

Indeed, a slew of recent studies, including one by the International Monetary Fund, have made the case that the bulk of the U.S. tariffs thus far have been passed on to U.S. firms and consumers. The Fed, meanwhile, found that the 2018 tariffs imposed an annual cost of $419 for the typical household. It expects the jump in May from 10 percent to 25 percent tariffs on $200 billion in Chinese goods to raise this figure to $831 per household. And there’s growing evidence that a healthy majority of the U.S. public doesn’t believe President Donald Trump’s claims that, actually, it’s China that is eating the full cost of the taxes on its imports.

In general, polling on trade has been pretty volatile, but the White House’s trade policies have typically fared poorly. It’s not unreasonable to assume public attitudes will sour further as costs mount. If Trump slaps tariffs on yet another $300 billion in Chinese goods, it’ll target consumer goods that have thus far largely been spared. The sticker shock of the trade war will be impossible to hide. And in the American system, where aggrieved interest groups like farmers, automakers and retailers can dominate media attention and wield outsize power in the legislature, the impact of tariffs is likely to be magnified further.
Diminishing Returns
None of this would matter if the tariffs were bearing fruit in the Trump administration’s two main goals: extracting major concessions from China and bringing jobs back to the U.S. But these don’t appear to be the case. Rather, while the costs of U.S. tariffs are increasing, the returns may be diminishing. Beijing, as a result, appears to believe that it can instead hold the line until the U.S. reaches the conclusion that the political and economic costs of tariffs have outpaced their utility.

The tariffs have succeeded in sharply reducing exports from China, but according to the IMF, third countries have been the biggest winners. Of the estimated $850 million in Chinese exports lost between August and November compared to a year earlier, less than $100 million were offset by U.S. producers in targeted industries. And as noted, China itself is paying only a fraction of the tariffs on its exports that are still flowing to the U.S., with little evidence that Chinese firms have had to lower prices to account for the tariffs. Meanwhile, the depreciation of the Chinese currency caused by the trade war has further mitigated the impact on Chinese competitiveness. Beijing has also made good use of tools like tax cuts and subsidies for affected firms, stimulus, and transshipments through third countries to circumvent tariffs. As a result, there’s been scant evidence that Beijing is willing, much less preparing, to back down on core U.S. demands for changes to the state’s role in the Chinese economy. If anything, it’s going the other direction, intervening more forcefully to manage the fallout of the tariffs. The political and economic risks of a rapid liberalization in line with U.S. demands are just too high.

This doesn’t necessarily mean Beijing has the upper hand. China’s ability to shrug off tariffs in the short term notwithstanding, its immense structural economic problems and rigid political system give it less room for maneuver over the long term. The effect on Chinese firms of the 15 percent increase in tariffs in May isn’t yet clear, and tariffs on another $300 billion in Chinese exports will certainly make Beijing nervous. But to push China to full capitulation, the U.S. would have to keep extremely high tariffs in place for an extremely long time. Moreover, if Beijing concludes it can’t stomach yet another U.S. escalation, we’d expect it to just agree to whatever makes the tariffs go away and then stall on implementation or renege later. The U.S. doesn’t have many good options for ensuring that Beijing follows through with its pledges.

If the overriding U.S. goal is to fundamentally blunt China’s rise and decouple the two economies, then it wouldn’t make sense for the U.S. to strike any deal that’s reasonably attainable in a short timeframe, costs be damned. All wars, whether fought with tanks or tariffs, have immense costs, and yet countries fight them anyway when they think they have to. At minimum, from a tactical perspective, the U.S. needs Beijing to believe in U.S. resolve to keep tariffs in place as long as it takes to force a capitulation. But the outlines of the draft deal that had emerged before talks collapsed suggested the U.S. was willing to settle for far less than full capitulation – reportedly dropping even core demands on state subsidies and cybersecurity – betraying an urgency to keep political complications from tying its hands.

Ultimately, what strikes a chord with U.S. voters ahead of 2020 is unpredictable. But if the downturn comes before then, it’s reasonable to assume that the Democrats will do everything possible to pin the blame on Trump’s tariffs for accelerating it – however valid this line of attack. Of course, Trump would also presumably get flack from some sectors for backing down. But trade policy is esoteric. It’s far easier to declare victory around a limited deal that removes tariffs and mutes criticism from affected industries than to defend a damaging fight that has yet to bring Beijing to heel or restore U.S. manufacturing’s lost glory. As it stands, there’s certainly enough Chinese concessions on the table to fill a stump speech. Besides, as noted, the tech war isn’t going away, nor are U.S.-China tensions over myriad other flashpoint issues. Trump will still have plenty to point to when claiming to have made good on his 2016 campaign pledge to get tough on China.

Of course, if the economy holds, tariffs could stay through the election, and the key variable in the trade war will once again become Beijing’s ability to hold out. But costs are constraints, and the U.S. won’t ignore them forever. Eventually, the U.S. will turn to a more targeted, defensive strategy for managing challenges posed by China’s rise.