One Extraordinary Year

Doug Nolan

Confirmed coronavirus cases almost doubled over the past week to 67,000. Part of the spike was the result of including a group diagnosed through CT imaging scans rather than with typical coronavirus testing. The ballooning number of patients with viral symptoms has overwhelmed the capacity for normal testing.

Troubling news came Friday of 1,700 Chinese healthcare workers having been infected (with 25,000 deployed to Hubei Province). Also, quarantines were further tightened in Wuhan as well as Beijing. Returning Beijing residents are to remain isolated in their homes for 14 days. As the NYT put it, “It was the latest sign that China’s leaders were still struggling to set the right balance between restarting the economy and continuing to fight the coronavirus outbreak.”

Staring at a rapidly unfolding economic and financial crisis, Beijing has made the decision to move forward with efforts to get their faltering economy up and running. This comes with significant risk.

Global markets, by now fully enamored with aggressive monetary and fiscal stimulus, are predisposed to fixate on potential reward (keen to disregard risk). That future students of this era will be more than a little confounded has been a long-standing theme of my contemporaneous weekly chronical. Booming market optimism in the face of what has been unfolding in China will ensure years and decades of head-scratching.

China is definitely not alone in gambling with aggressive late-cycle stimulus, as it desperately tries to postpone the unavoidable dreadful downside after historic Bubble Inflations. Coming at this key juncture of end-of-cycle fragilities, it’s a challenge to envisage more delicate timing for such an outbreak – in China and globally. Clearly, when global markets hear “stimulus” they immediately salivate over the thought of bubbling liquidity and ever higher securities prices. Critical nuances of global Inflation Dynamics go unappreciated.

February 9 – Bloomberg: “China’s consumer prices rose the fastest in more than eight years last month, with the outbreak of the coronavirus and subsequent shutdowns of transport links across the country making further gains in the coming months likely. Consumer prices rose 5.4%, with food prices jumping the most since 2008 in January. Even before the coronavirus, prices were likely to have risen sharply due to the normal spike in demand around the Lunar New Year and the effects of the African Swine Fever outbreak which has killed millions of pigs and damaged pork supplies. Pork prices gained the most on record.”

China has an escalating consumer price inflation problem, one manifestation of intensifying Monetary Disorder. It’s a fundamental Credit Bubble Analytical Postulate that inflationary fuel will gravitate to areas already demonstrating the strongest inflationary biases. As we’ve been witnessing globally, dump stimulus into a backdrop of powerful securities market inflationary psychology and the upshot will be more intense speculation, acute asset price inflation and increasingly destabilizing market Bubbles.

China, facing its own particular Inflationary Dynamics, has now embarked on a course that never ends well: aggressive fiscal and monetary stimulus in an environment of rising consumer inflation and general monetary and economic instability.

China’s CPI Food Index posted a 20.6% y-o-y increase in January, the highest since March 2008. For many of its citizens, food purchases make up a significant percentage of monthly expenditures (some estimates as high as 30%). While the doubling of pork prices is inflating price aggregates, even vegetable prices were up a notable 17% y-o-y. And this was before the escalation of the coronavirus outbreak.

Beijing has acknowledged the risk to social stability from the coronavirus. Policymakers as well face a challenge in trying to stimulate a faltering maladjusted economy without exacerbating the hardship inflicted upon much of its population from surging consumer prices. Stimulus measures are working well for global market participants. For Chinese citizens, the jury is out.

Meanwhile, China’s Credit mechanism is in disarray. Over the past two years in particular, stimulus measures stoked China’s consumer borrowing and spending boom. This upsurge was integral in sustaining China’s Bubble economy in the face of mounting manufacturing overcapacity and associated corporate Credit issues. It comes with a steep cost. In particular, China’s apartment Bubble went to even more precarious extremes.

February 10 – Bloomberg: “Home sales in China have been dealt a huge blow by the spreading coronavirus with figures showing transactions plunged in the first week of February. New apartment sales dropped 90% from the same period of 2019, according to preliminary data on 36 cities compiled by China Merchants Securities Co. Sales of existing homes plummeted 91% in eight cities where data is available. ‘The sector is bracing for a worse impact than the 2003 SARS pandemic,’ said Bai Yanjun, an analyst at property-consulting firm China Index Holdings Ltd. ‘In 2003, the home market was on a cyclical rise. Now, it’s already reeling from an adjustment.’”

The above “apartment sales dropped 90%” Bloomberg article was confirmation of the dramatic upheaval the coronavirus is having both on China’s economy and Credit system. And while Beijing stimulus will surely have significant economic impact, it will not easily replace the flow of household mortgage finance that evolved into a powerful force for Chinese and global economies.

China’s aged apartment Bubble was increasingly vulnerable prior to the coronavirus. At this point, it would appear there is a clear catalyst for the piercing of one of history’s greatest Bubbles. I’ll assume easier lending terms and additional borrowing will bolster the gargantuan - and highly indebted - Chinese homebuilders.

Yet sustaining China’s highly inflated apartment prices will prove a much greater challenge.

Estimates have as many as 60 million unoccupied apartment units throughout China. Homes for “living in and not speculation”? When risk aversion begins to take hold generally in Chinese housing (a break in inflationary psychology), there is potential for far-reaching economic and financial disruption.

China will inevitably face its first housing and mortgage finance bust, a painful bursting Bubble episode made much worse by Beijing repeatedly resorting to stimulus measures. It’s difficult to overstate ramifications for China’s economy, financial system and social stability.

February 9 – Bloomberg: “Just as it looked like Beijing was starting to get a handle on its regional banking crisis, a much more severe threat is engulfing the world’s largest banking system as a deadly new virus hits the country’s economy. The impact of the spreading coronavirus risks bringing to life the worst-case economic scenarios contained in China’s annual banking stress tests. Last year’s exercise envisaged annual economic growth slowing to as low as 4.15% -- a scenario which showed that the bad loan ratio at the nation’s 30 biggest banks would rise five-fold. Analysts now say that the outbreak could send first-quarter growth to as little as 3.8%. Banks are already suffering record loan defaults as the economy last year expanded at the slowest pace in three decades. The slump tore through the nation’s $41 trillion banking system, forcing the first bank seizure in two decades and bailouts of two other key lenders.”

China’s protracted Bubble aroused delusions of grandeur - within the communist party as well as throughout its population. It’s incredible to ponder what’s at stake. Beijing is in no way willing to cede its global ambitions.

An assertive American administration only strengthens their resolve. Communist leadership will reject any challenge to its control and dominance.

Meanwhile, a bursting Bubble will throw everything into disarray.

Beijing has declared a “people’s war” against the forces of Bubble deflation. And this explains why markets so confidently operate under the assumption a bust won’t be tolerated.

Extraordinary fragilities only ensure epic stimulus; Chinese and global Punchbowls Runneth Over. “Washington will never allow a U.S. housing bust.” “The West will never allow Russia to collapse.” There are monumental presumptions that underpin historic boom and bust cycles. “The Beijing meritocracy has everything under control.”

February 12 – Associated Press (Joe McDonald): “China’s auto sales plunged in January, deepening a painful downturn in the industry’s biggest global market and adding to economic pressures as the country fights a virus outbreak. Sales of SUVs, sedans and minivans fell 20.2% from a year earlier to 1.6 million, an industry group, the China Association of Automobile Manufacturers, reported… ‘Enterprises are under huge pressure,’ it said…”

Over the past decade, China’s domestic auto industry grew into a behemoth. It is another critical sector both from economic and financial standpoints. And while I don’t view it in the same context as the vulnerable apartment Bubble, it is another market that could suffer lingering effects.

I am well aware of the market view that the coronavirus crisis will soon pass. We can expect Beijing stimulus measures to help shore up GDP figures and stock prices. At least in the near-term, it will support confidence. Hopefully the outbreak has peaked, with stimulus measures and an accommodative banking system helping China’s economy to muddle through. Global equities markets have been content to “look across the valley.”

Disregarded are China’s acute financial and economic fragilities, the of risk stimulus measures exacerbating monetary disorder and mounting risks to social stability. How quickly does the Chinese population bounce back – again eagerly taking on debt, buying apartment and cars and dreaming of a bright and prosperous future?

That equities can run higher in the face of mounting risks is not as confounding as it might first appear. Credit drives the global Bubble – and Credit in the near-term is further benefiting from the outbreak. Overheated securities (speculative) Credit is really benefited.

Global monetary stimulus is further assured - rate cuts and more QE. One can now add aggressive PBOC liquidity injections to the Fed and global central bank QE throwing gas on a speculative fire raging throughout global fixed-income markets.

February 13 – Bloomberg (Gregor Stuart Hunter): “Investors who poured money into bond funds last year are showing little sign of stopping in 2020… Inflow to fixed-income assets nearly doubled last year to $1 trillion, according to… Morningstar Inc. With fears about the coronavirus outbreak dimming growth prospects for the global economy and prompting a search for haven assets, bond funds are on track to exceed this haul in 2020. ‘We’re in uncharted territory,’ Nikolaos Panigirtzoglou, a JPMorgan... strategist, said… ‘Based on January flows, it’s going to be another very strong year for bond fund flows.’”

Equities at record prices garner all the attention. Yet the manic behavior in global bond markets is more extraordinary and consequential. U.S. fixed income ETFs attracted another $7.3bn this week (, as “money” keeps rolling in.

The $64 TN question is how much speculative leverage continues to accumulate throughout global bond and derivatives markets. Here again, the timing of the coronavirus outbreak is of great consequence – inciting speculative excess and attendant leverage when global fixed-income was already engulfed by powerful Inflationary Biases.

Added leveraging works to inject additional liquidity into already over-liquefied global markets. And the last thing overheated global risk markets – with such powerful Inflationary Biases - needed at this point was additional liquidity.

I view the equities Bubble as an offshoot of the greater Bubble that continues to inflate in global debt, securities Credit and derivatives markets. On the one hand, it is extraordinary to see equities markets essentially dismiss such consequential developments in China. It does, however, present important support for the Bubble Thesis.

Equities rallied to record highs just months before the LTCM/Russia collapse in 1998.

Stocks rallied to record highs in 2007 even as the mortgage finance Bubble faltered.

It’s only fitting that global stocks rally to record highs as the faltering China Bubble places the global Bubble in serious jeopardy. If the coronavirus stabilizes over the coming weeks and months, attention can then turn to November U.S. elections. It’s poised to be One Extraordinary Year.

A Friday CNBC headline: “White House Considering Tax Incentive for More Americans to Buy Stocks, Sources Say.” A strong equities market boosts optimism of a Trump reelection - bullishness that spurs further stock gains.

Yet there is potential for self-reinforcing dynamics to the downside. A break in stock prices would incite election nervousness and heightened market risk aversion.

Can this game sustain for another nine months?

What if the economists are all wrong on productivity?

Deflation may be hiding big gains from technological improvements

Glenn Hutchins

Shoppers carry purchases as they look at their smartphones on the main shopping district on Oxford Street in London on December 13, 2018 less than two weeks before Christmas. (Photo by Tolga Akmen / AFP) (Photo credit should read TOLGA AKMEN/AFP/Getty Images)
Productivity gains, which allow an economy to grow faster than its population, determine increases in national wealth © Tolga Akmen/AFP/Getty

A few years ago, pundits were confidently forecasting that the US Federal Reserve would soon “normalise” monetary policy by gradually raising interest rates and paring back its holdings of Treasuries and mortgage-backed securities. This would give it the freedom to reduce rates in a future crisis.

Two years on, monetary policy seems anything but normal. As rates began to trend up and the balance sheet down, the markets and the underlying real economy could not digest the change. Instead, central banks around the world have had to apply yet another dose of unconventional monetary policy — ultra-low interest rates and quantitative easing — to keep growth going.

There has been considerable hand-wringing about why productivity growth is anaemic and inflation is stubbornly low. This is important because productivity gains, which allow an economy to grow faster than its population, determine increases in national wealth. Similarly, inflation erodes wealth, so we must adjust output for it to be certain that gains are real rather than simply reflecting higher prices.

Yet there is today a “dialogue of the deaf” between Silicon Valley and the economics profession on this critical issue. Economists point to longitudinal data that shows productivity has been rising at a lethargic pace and say it shows the lack of true technology breakthroughs such as flying cars. But the tech industry looks at a world economy that is rapidly transforming from industrial to digital and argues that the changes must be causing productivity to hurtle forward at warp speed, creating widespread financial benefits.

Tech leaders also point out that they are on a mission to eradicate costs from everything everywhere. Rapidly doubling processing speeds and the use of algorithms have combined to let us use software to replace many physical activities at vastly lower expense to producers and consumers alike. Meanwhile, smartphones, ecommerce and global supply chains are driving prices down.

Digital disruption, the tech industry argues, with its ruthless efficiencies, improved price transparency and “creative destruction” of existing business models, is obvious and natural. In their eyes, what can possibly be wrong with delivering ever more value at continually lower cost? Any data that suggests otherwise must be indicative of yet another flaw of the old economy.

With that in mind, let’s go back to the question of why the global economy proved allergic to a modest tightening of interest rates. If the traditional economists are right, and real interest rates (actual levels minus inflation) are in fact hovering near zero, history would suggest that rates could have increased materially without a hitch.

Now consider the view of the techies that we do not live in an economy characterised by little productivity growth, low inflation and modest increases in gross domestic product. What if they are right that we live in an economy with rapid productivity growth, burgeoning output and relentless price drops? If such deflation was running at around 2 per cent today, real interest rates would be roughly equal to historic levels and the stubborn resistance of economic activity to increases would be unsurprising. Does this alternative view fit reality better?

Moderate deflation is not necessarily pernicious. The US economy endured bouts of deflation in the 19th century partly due to two economic shifts — the mechanisation of farms and transport, and later as industry displaced farming. In both cases, the transition substantially raised both output and living standards. But the 19th century was also afflicted by numerous severe recessions, pointing to the urgent need for a monetary policy toolkit and ultimately the creation of the US Federal Reserve.

What would we do differently in a deflating economy? First, we would prepare — operationally and psychologically — for the topsy-turvy world of negative rates in which lenders pay borrowers. The Fed’s current mandate of targeting specific inflation rates would be replaced with new measurements of purchasing power that take into account “better, faster, cheaper” technology. We would probe markets to discern the levels of nominal interest rates at which activity stalls. And we would talk about real rather than nominal rates.

Paradigm shifts require radical rethinking. Today’s economy is undergoing an epochal shock driven by technological change and globalisation. That suggests that the negative nominal rates now common in much of the world may be normal and could be with us for a long time. Policymakers must adapt their world view and tools accordingly.

The writer, a private equity investor, is chairman of North Island


Looking at the world through the eyes of options traders

The action that matters is not in the middle but in the fringes

Every stoner knows, or has bored you silly, about the third eye. It is the imaginary oracular organ you develop as a side-effect of taking hallucinogens. The data from hazy late-night discussions in college dorms in the 1960s are quite clear on this.

The strait-laced are too middle-of-the-road to grasp what is really going on in the world. The third eye allows you to see what they simply cannot.

Every investor could use a third eye. But there is one type who can claim to need it the most: options traders. They have to keep one eye on the most likely outcome and one eye on each of the best and worst scenarios. A lot of the time, the middle outcome—the average, the midpoint, the most common—is a good predictor.

But for some things, some of the time, the middle lies on shaky ground. This is the world in which having options—or the right to buy or sell assets at a predetermined price—is most valuable. And the action that matters is not in the middle but at the fringes.

To understand why, imagine you had to bet on the height of the next man to walk into the coffee shop you are sitting in. A good guess would be 1.75m (5ft 9in), which is the average height of an adult male in America.

It is likely that you would be wrong, but not by a whole lot. Many of the men who could walk in will be close to average height; very many will be an inch or two below or above it; and only very few will be a lot shorter or taller. The middle—the average—is a good predictor of how something entirely random will turn out.

A throw of two dice is similar. There are 36 possible pairs of numbers. Some throws are more likely than others: there are six ways to throw a seven, but only one way to throw either a two or a 12.

If you display each possible throw by how often it occurs, it will follow the outline of a special kind of bell curve, known as a normal distribution (see chart). A lot of very different kinds of measures—iq, exam scores, height—also look like this.

A feature is that the values deviate from the average in an ordered way. Two-thirds of dice throws (24 out of 36) are within one standard deviation of the average throw, ie within a range of five to nine. In a normal distribution, 68% of outcomes are within one standard deviation of the average and 95% are within two.

The standard deviation—volatility—is a key concept in options trading. The VIX, or volatility index, is the best-known gauge for it. It is the level of volatility derived from the price of options on the S&P 500 share index. (Put options confer on a buyer the right to sell the index at a specified “strike” price; call options confer the right to buy it.)

Key inputs to the value of an option are expected volatility and the gap between the strike price and the index price. The more violently prices move, the more likely the gap between the two will be bridged—in which case the option pays off. If the VIX says that implied volatility is 14, as it does now, traders expect an annual standard deviation of 14% in equity prices.

The level of implied volatility depends on the weight of buyers and sellers. Vol sellers in effect supply insurance. They are betting on the middle, that the world will stay regular and normal, or become more so.

People active in the options market describe all investment strategies as if they were options trades. To buy corporate bonds with low spreads, for instance, is like selling volatility: you get a low premium and cross your fingers it doesn’t default.

Vol buyers, in contrast, seek insurance. They don’t believe the middle. They think the world will become more disordered. And sometimes they are right.

Asset prices are not distributed in as ordered a way as height is. Extreme events, such as market crashes, are more frequent than normal distributions suggest.

Volatility has been remarkably low—in stocks, bonds and currencies. Viruses, populism, trade wars, papal abdications and royal bust-ups—nothing seems to move the needle much.

But no one can be sure how long the age of placidity will last.

People with squeegee-cleaned third eyes insist that vol must eventually go up. They blame central banks, which have relaxed monetary policy whenever markets panic, for suppressing volatility.

The central bankers have been free to do so because inflation, their main obsession, has gone missing. A revival in inflation will one day force them to stop managing the markets.

That is the big bet of options buyers.

In the meantime, the standard investor will keep his two eyes firmly on the middle.

Why You Shouldn’t Borrow Too Much Money, China Edition

by John Rubino

When the US housing bubble burst in 2007, most observers were focused on the threat to Wall Street banks and their massive derivative books. This was a legitimate fear, since the worst case scenarios involved the death of Goldman Sachs and JP Morgan Chase, with all the stock market carnage that that implied.

But for China the stakes were a lot higher — picture half a billion people taking to the streets and demanding an end to a government whose only claim to legitimacy was its ability to provide millions of ever-more-lucrative jobs.

So while the US was bailing out every bank in sight with lower interest rates and loan guarantees, China upped the ante by ordering pretty much every sector if its economy start building things with borrowed money. The result was the biggest infrastructure binge in history, in which roads, bridges, airports, and — hey, why not — entire new cities sprang up in just a few years, providing jobs for millions of would-be rioters and a torrent of cash flow for foreign suppliers of iron ore, copper, cement, steel, lumber, and pretty much every other industrial commodity you can name.

China boomed, the rest of the world recovered, and today’s longest-ever economic expansion was born. And Chinese debt-to-GDP soared to record-high levels.

Now dial back the perspective to that of a single hypothetical family. Say one of the breadwinners loses their job and the family’s income is cut in half. They can chose to scale back their spending to match their newly-diminished circumstances and accept the resulting turmoil of fewer cars, smaller house, public rather than private schools, etc.

Or they can max out a series of credit cards and just go on as before, avoiding stress in the moment at the cost of bigger bills — and greater fragility — in the future.

The second strategy will work if the unemployed breadwinner gets a new job reasonably soon and — crucially — if no other crisis pops up that requires (now nonexistent) resources. No illness, no new job loss, no leaky roof, no wrecked car … and things might work out.

Now zoom back out to China, which chose strategy number two and is currently “rich” but also way too leveraged to handle another shock to the system. Just in time for a pandemic that shuts down half the country. From today’s South China Morning Post:

Forget Sars, the new coronavirus threatens a meltdown in China’s economy
Never before has China paid such an economic price for an epidemic as it has done already with the coronavirus, which originated in the Chinese city of Wuhan and causes the disease now officially known as Covid-19. And the damage is spreading. 
It is obvious that the economic impact of Covid-19 will be far more severe than that of Sars, or any other previous epidemic. 
Whole cities have been locked down, effectively grinding some local economies to a halt since Beijing declared all-out war on January 23. Currently, 30 of China’s 31 provinces have declared a top-level public health emergency, with all major cities and economic hubs effectively shut for weeks.  
The government has locked down 56 million people in quarantine in Hubei, banned tens of millions more from travelling across the nation, and imposed restrictions on activities in most urban areas. The Lunar New Year holiday has been extended for one or two weeks for most of the country. At the peak, provinces accounting for almost 69 per cent of China’s GDP were closed for business, according to Bloomberg Economics.  
For the millions of small and medium-sized enterprises (SMEs) in China, the nightmare may be just beginning. Many small manufacturers fear foreign customers will shift orders to other countries due to disruptions in production and delivery. In a survey of 995 SMEs by academics from Tsinghua and Peking universities, 85 per cent said they would be unable to survive for more than three months under the current conditions. If the disruption goes on long enough, it could trigger a wave of bankruptcy among SMEs, which contribute more than 60 per cent of China’s GDP, 70 per cent of its patents and account for 80 per cent of jobs nationwide.

A financially solid country might be able to weather this kind of crisis by drawing down reserves and using its stellar credit to take on new, temporary debt. But an already over-leveraged system may not have those options.

As for what part of China’s economy blows up first, check out the repayment schedule of municipal debt. These are the cities and states that borrowed immense amounts of money — much of it in US dollars — to build the previously mentioned roads, bridges, etc.

Much of this infrastructure was already failing to generate cash flow sufficient to cover the related debt. Now those cash flows are drying up.

China, in short, is providing a life lesson for the rest of us in how to respond to a crisis.

Remember it next time you think about maxing out a credit card.  

The Fragmentation of the European Unión

By: George Friedman

At the end of this week, the United Kingdom, the second-largest economy in Europe, will exit the European Union.

Meanwhile, Poland is under intense attack by the bloc for violating EU regulations by attempting to limit the independence of Polish judges; Hungary is also under attack for allegedly violating the rule of law; and one of the major parties in Italy has toyed with the idea of introducing a parallel currency that would allow the country to manage internal debt without regard for EU regulations and wishes.

The founding principle of the EU was the unification of hitherto warring nations into a single bloc, built around common economic and political principles and a common European identity.

The assumption was that given Europe’s history, putting aside differences was a self-evident need for all European countries. But as we see in the case of Italy, it is not clear that there is a common European economic interest.

Given the tensions with Poland and Hungary, it’s also unclear if there is a common political interest. And the U.K.’s decision to leave also raises questions over whether these common interests persist and whether national identity can be subsumed under a European identity.

The tensions within the EU do not reflect marginal disagreements; they represent fundamental questions over whether national interests and identities can be reconciled with poorly defined European interests. The EU, therefore, is moving toward an existential crisis. It may survive, but only as a coalition of nations representing a fraction of Europe.

Self-Determination or Nothing

The fundamental issue is national identity and sovereignty. The U.K., Italy, Poland and Hungary are all European nations, but they have different histories and therefore different sensibilities.

What it means to be Italian is not the same as what it means to be British. They in turn have a different sense of self from the Germans or Romanians.

The question, therefore, is:

What is this European sensibility? The common assumption is that it is liberal democracy.

The problem is that there are many types of liberal democracy and, more to the point, the fundamental principle behind liberal democracy is national self-determination – the idea that the nation must select the government and that the government is answerable to no one other than the nation. If you sever the idea of national self-determination from liberal democracy, you undercut liberal democracy’s fundamental principle and, with it, the European identity.

Liberal democracy is national self-determination or it is nothing.

The governments in the U.K., Italy, Poland and Hungary all have been elected. Some politicians who were defeated in elections have made the claim that these elections were the result of fraud or illegitimate manipulation of public opinion, as was the case with the Brexit vote. But the fact is that those of us who know these countries know that the views the governments hold are not alien to the countries.

Poland and Hungary have their own understanding of what state power should look like; Italy has a long history of complex and fragmented government needing to control its own economy; and the United Kingdom’s constituent parts have national identities that are very different from those of other countries.

Europe’s nations are all different, and while history made each adopt the garb of liberal values beyond just national self-determination, they never gave up their own identities because they could not. They are what history made them, and while German or Soviet occupation shaped them, a few decades of horror – and the adoption of the idea that national self-determination must be determined through elections – was not enough to cause them to abandon who they were. France was France before it held its first election.

In other words, national identity may exist prior to and outside of liberal democracy for some countries. This is not the case for the United States; its very identity from its founding was liberal democratic. German identity, however, has varied dramatically over the decades, and Germans were still German in spite of the variations. Hitler represented the national will well after he abandoned elections.

This takes us to extreme places we need not go, but it also points out that national identity and national self-determination can be expressed in ways that are faithful to the national will but violate the liberal democratic methodology in nations with ancient and complex foundations.

The Illusion of European Identity

If the idea of national identity is so complex, then how can we define the European identity?

The European identity that the Maastricht treaty embodied was a snapshot of a unique moment in European history in which the Anglo-American occupation of Western Europe and the Soviet occupation of Eastern Europe were ending.

The liberal democracy that was imposed on Germany’s destroyed cities seemed to be part of German identity, history notwithstanding. The Poles and Hungarians yearned to be Europeans, and the liberal democracy that emerged from World War II was their template, as it was for Italy.

But I would argue that that European identity was an illusion to which Europe clung, fearing that the only alternative was a return to its own bloody past. After the Berlin Wall came down, there finally appeared to be one Europe, and all would be gathered into it. The problem, as I have said, is that the histories of Italy, Germany, the U.K., Poland and Hungary were all wildly different.

At that moment, they all yearned for the same thing, but as the moment passed, each country recollected what it was, and they are now – without the shame it would have brought in 1991 – resurrecting it. The European invention of technocratic liberalism was alien to them, and the right of national self-determination was both an empirical reality and a moral principle.

And so they begin to go their own way, with EU officials hurling threats and condemnation over frustration that the EU bureaucracy is not only no longer authoritative but also no longer frightening. The British economy grew in January, an indication that the catastrophe Brussels had wished for the U.K. may not visit London, or Italy, if it should decide to go its own way with its currency.

And certainly, neither Poland nor Hungary, having survived Stalin and Hitler, is likely to be cowed into submission by increasingly small EU subsidies. The weakening of the EU has undercut its ability to pay for conformity.

Europe once had a magnificent idea, a free trade zone called the European Economic Community whose main focus was trade, not inventing identities. It was replaced by the European Union, but the EU can now look to another example, the North American trade zone, which has a slightly larger gross domestic product than the EU.

The two are fundamentally different; the North American bloc does not claim to represent a North American identity, its members sometimes dislike each other intensely, and it does not have a secretariat to dictate how they should live.

But then, the North Americans did not live through what the Europeans lived through and they are not trying to suppress who they were and, of course, still are.

How to Prevent the Japanification of East Asia’s Economies

Hong Kong, Singapore, South Korea, and Taiwan were long hailed for their economic dynamism, but now risk following the low-growth path of Japan over the last three decades. To avoid this fate, their governments must adopt a comprehensive set of policies to tackle structural weaknesses.

Lee Jong-Wha

lee42_SAM YEHAFP via Getty Images_taiwanstockmarketeconomy

NEW YORK – At the annual meeting of the American Economic Association (AEA) in early January, former US Federal Reserve Chair Janet Yellen, former European Central Bank President Mario Draghi, and eminent economists warned that Western economies risked “Japanification”: a future of sluggish growth, low inflation, and perpetually low interest rates. Yet, surprising as it may seem, this malaise also threatens East Asia.

Hong Kong, Singapore, South Korea, and Taiwan, once called the “Asian tigers,” now face slow growth and disinflationary pressures. Last year, Hong Kong’s economy contracted by 1.2%, while the other three grew only modestly – Singapore by 0.6%, and South Korea and Taiwan by about 2% each.

Inflation in each of these three countries was about 0.6%. East Asia’s economies suffered from weaker external demand – a result of slow growth in major industrialized countries and China – as well as domestic structural and supply factors. Moreover, their growth potential is trending downward.1

Economically and demographically, these East Asian countries seem to be tracking Japan. For starters, Japan is the world’s most rapidly aging society, with 28% of its population aged 65 and above, up from 14% in 1994. This age cohort’s share of the population in Hong Kong, Singapore, South Korea, and Taiwan now averages about 14%, and is forecast to increase rapidly in the coming decades.

A shrinking workforce will in turn reverse the demographic dividends that previously supported strong regional growth. In South Korea, for example, average annual GDP growth between 2020 and 2040 is forecast to be about one percentage point lower than now.

Moreover, like Japan in recent decades, the four East Asian economies are experiencing slowing productivity growth. Their export industries have encountered fierce competition from low-cost Chinese firms, while low service-sector productivity hampers overall productivity improvements. And because these countries are already at the high-tech frontier, they may find it harder to develop new technologies in the future.

How East Asia’s policymakers respond to these challenges will be crucial. Many economists believe that the Bank of Japan’s timid response to the collapse of the country’s real-estate bubble 30 years ago aggravated the economy’s woes, leading to the lost decades that followed. Mindful of this precedent, the Fed and the ECB have aggressively cut interest rates and injected large amounts of liquidity since the 2008 financial crisis – as has the BOJ under Prime Minister Shinzo Abe’s administration.

Speaking at the AEA meeting, former Fed Chair Ben Bernanke expressed confidence in central banks’ ability to provide further economic stimulus using new policy tools such as quantitative easing and forward guidance. But many economists are skeptical. As former US Secretary of the Treasury Lawrence Summers has noted, leading central banks have failed to meet their inflation targets despite massive monetary expansion. And with interest rates already at record lows, it will be difficult to resolve the next crisis with further aggressive rate cuts.

Furthermore, monetary easing alone cannot tackle major structural economic weaknesses. Summers, for example, argues that excessive saving and low investment in industrialized economies could result in “secular stagnation.” Mohamed El-Erian emphasizes “structural disinflationary forces” such as aging, rising inequality, and a loss of trust in institutions, while economists including Robert J. Gordon highlight slower productivity growth.

Given their significant structural problems, therefore, East Asia’s economies cannot avoid the Japanification solely by loosening monetary policy. In fact, such measures might even do more harm than good over time. Although these economies have not experienced an asset-bubble collapse like Japan, continued monetary easing could pose such a risk. Over the last year, the Hong Kong Monetary Authority and the Bank of Korea have cut their policy rates several times, to 2% and 1.25%, respectively.

Benchmark interest rates in Singapore and Taiwan also remain low, at 1.64% and 1.375%, respectively. As the experience of Japan has shown, expansionary monetary policy can keep the economy afloat, but with asset price bubbles and many zombie-like firms.

To stave off Japanification, the four East Asian economies should adopt a comprehensive set of policies to overcome their structural weaknesses.

First, governments should spend more on productivity-enhancing infrastructure, technologies, and education in order to boost potential growth. Such public investment in productive sectors could complement weak private demand and expand supply capacity.

Governments could finance this increased spending by issuing low-interest-rate bonds, but they must avoid an excessive build-up of public debt – especially the share owed to foreign investors.

Without an international reserve currency, too much debt could trigger a default and foreign-exchange crisis.

Second, East Asian governments must address the issues of population aging and a shrinking workforce. They need to encourage higher labor-force participation among women and seniors, boost worker productivity through lifelong education and skills training, and allow active migrant inflows.

Expanding access to childcare and providing flexible working arrangements would help to raise fertility rates. And governments must tackle inefficiencies in both the financial sector and regulatory policies in order to improve productivity growth.

Finally, East Asia’s governments must focus on increasing economic and social equality and bolstering public trust in institutions. Despite Japan’s prolonged economic stagnation, its society has remained harmonious and stable, providing a solid foundation for managing stable growth.

In East Asia, however, rising economic inequality amid weak growth is eroding public confidence in political institutions. The civil disturbances that have rocked Hong Kong and South Korea over the last year are evidence of this. Without strong public trust and confidence, the next economic calamity, whether a Japan-style slowdown or another financial crisis, could prove difficult to overcome.

The risk of Japanification is clear, and not only in Western Europe. Faced with this threat, East Asia’s aging tigers must take urgent steps to regain their vitality.

Lee Jong-Wha, Professor of Economics and Director of the Asiatic Research Institute at Korea University, was a senior adviser for international economic affairs to former President Lee Myung-bak of South Korea. His most recent book, co-authored with Harvard’s Robert J. Barro, is Education Matters: Global Schooling Gains from the 19th to the 21st Century.