Moral Hazard Quagmire

Doug Nolan

The Nasdaq100 jumped another 3.5% this week, increasing 2020 gains to 32.3%. Amazon gained 4.3% during the week, boosting y-t-d gains to 77.8% - and market capitalization to $1.626 TN. Apple surged 8.2% this week, increasing 2020 gains to 69.4%. Apple’s market capitalization ended the week at a world-beating $2.127 TN. Microsoft rose 2.0% (up 35.1% y-t-d, mkt cap $1.612 TN). Google rose 4.8% (up 18.2% y-t-d, mkt cap $1.073 TN), and Facebook gained 2.2% (up 30.1%, mkt cap $761bn). The Nasdaq100 now trades with a price-to-earnings ratio of 37.4.

This era will be analyzed and debated for decades to come – if not much longer. Market Bubbles, over-indebtedness, inequality, financial instability and economic maladjustment - festering for years - can no longer be disregarded as cyclical phenomena.

Ben Bernanke has declared understanding the forces behind the Great Depression is the “Holy Grail of economics”. It’s ironic. That the Fed never repeats its failure to aggressively expand the money supply in time of crisis is a key facet of the Bernanke doctrine – policy failing he asserts was a primary contributor to Depression-era financial and economic collapse.

Yet this era’s unprecedented period of monetary stimulus is fundamental to current financial, economic, social and geopolitical instabilities.

August 18 – Bloomberg (Craig Torres): “The concentration of market power in a handful of companies lies behind several disturbing trends in the U.S. economy, like the deepening of inequality and financial instability, two Federal Reserve Board economists say in a new paper. Isabel Cairo and Jae Sim identify a decline in competition, with large firms controlling more of their markets, as a common cause in a series of important shifts over the last four decades. Those include a fall in labor share, or the chunk of output that goes to workers, even as corporate profits increased; and a surge in wealth and income inequality, as the net worth of the top 5% of households almost tripled between 1983 and 2016. This fueled financial risks and higher leverage, the economists say, as poorer households borrowed to make ends meet while richer ones shoveled their wealth into bonds… ‘The rise of market power of the firms may have been the driving force’ in all of these trends, Cairo and Sim write in the paper.”

My analytical framework’s “money” and Credit focus is at times lacking in capturing non-monetary macro factors. To blame the Fed and global central banks for all that ails the world (while a valid starting point) represents a too simplified view of complex dynamics. To be sure, technological innovation and advancement along with “globalization” continue to exert momentous influence – arguably at an accelerated pace.

Indeed, analysis with technological and globalization trends at its focal point could offer a plausible explanation of many macro developments - to the exclusion of policymaking and finance. As the above Fed research asserts, it is increasingly tempting to deflect blame for inequality on monopoly power.

Isabel Cairo and Jae Sim’s Fed research paper, “Market Power, Inequality, and Financial Instability,” is a technical research piece:

“A few secular trends have emerged in the U.S. economy over the last four decades…

First, real wage growth has stagnated behind productivity growth over the last four decades and, as a result, the labor income share has steadily declined…

Second, the before-tax profit share of U.S. corporations has shown a dramatic increase in the last few decades…

Third, income inequality has been exacerbated over the last four decades… Fourth, wealth inequality has also been exacerbated during the last four decades…

Finally, the rising household sector leverage has been coupled with rising financial instability…”

“We develop a real business cycle model and show that the rise of market power of the firms in both product and labor markets over the last four decades can generate all of these secular trends.”

“In this paper, we quantitatively investigate the role of rising firms’ market power in both product and labor markets in explaining the six secular trends. In so doing, we are inspired by Kalecki (1971), who… predicted that the market power of the firms would increase over time and consequently, labor share would fall in the long-run.”

Understandably, Amazon lost money in its initial years. Losses mounted steadily from 1995, jumping to $720 million in 1999, $1.4 billion in the year 2000 and $567 million in 2001. The company posted a 2003 profit of $35 million on revenues of $5.3bn.

Net Income jumped to $589 million in 2004 (pre-tax $365 million), earnings not exceeded until 2008’s $645 million (on revenues of $19.2bn). Amazon reported Net Income last year of $13.18 billion on Revenues of $280.5bn.

What impact did loose monetary policies have on Amazon’s evolution to an online retail juggernaut, crushing traditional retailers and online competitors alike? Enjoying limitless access to virtually free finance, there were no constraints on investment spending (or acquisitions). And as competitors increasingly struggled to retain profitability and affordable finance, there was nothing holding back Amazon’s rein of dominance.

Tesla’s stock price closed the week at $2,050, up almost 400% y-t-d, with a market capitalization of $390 billion, exceeding the combined capitalization of five global auto heavyweights (Ford $26.7bn, GM $41.0bn, Toyota $218bn, Honda $45.3bn, and Daimler $51.8bn). Tesla reported losses of $725 million in 2016, $1.8bn in 2017, $742 million in 2018 and $629 million in 2019. After reporting cumulative profits of about $450 million over the past four quarters, Tesla’s stock currently trades with a Price/Earnings ratio of 895.

How would Tesla appear these days if not for ongoing aggressive Federal Reserve stimulus and the resulting loosest financial conditions imaginable? Would it have survived? I’m all for zero emissions vehicles – as well as a proponent for Schumpeter’s “creative destruction.” But zero rates, QE, mispriced finance and market Bubbles have created financial and economic distortions with momentous consequences. Years of ultra-cheap finance, booming securities markets, and a most elongated business cycle have created powerful industry behemoths. Pandemic crisis measures now cement monopoly power.

To be sure, whether it is Amazon, Tesla, Netflix, Apple, Microsoft, Google, Facebook or scores of other market darlings, a hot stock price is essential to achieving market dominance. For one, it provides a currency for acquisitions, purchases that often include fledgling competitors. And as these companies grow increasingly dominant in both the markets and real economy, surging stock prices ensure these heavyweights attract and retain the best and brightest talent (further cementing competitive advantage).

There is today no more powerful factor in exacerbating inequality than the stock market. A position (with stock grants) at one of the hundreds of market darlings is today a ticket to extraordinary riches. While tens of millions have lost their jobs and financial security over recent months, those fortunate to be riding the bull market wave have enjoyed spectacular wealth gains.

August 20 - Bloomberg (Liz Capo McCormick): “The unprecedented speed and scale of the Federal Reserve’s buying of Treasuries and mortgage debt to aid a severely impaired bond market has accomplished that without raising the specter of moral hazard, Federal Reserve Bank of New York researchers wrote… Pandemic-sparked volatility in March caused liquidity in the world’s biggest bond market to plunge to its worst since the 2008 financial crisis. The Fed responded with purchases of Treasuries and mortgage securities that peaked at more than $100 billion a day combined.

It’s still soaking up about $80 billion of Treasuries and at least $40 billion of mortgage securities a month, and some bond veterans warn that the central bank’s involvement in the market could potentially be encouraging risky behavior, such as excessive borrowing. But a post… in the New York Fed’s Liberty Street blog argued against that.

‘The magnitude of the Desk’s purchase program in 2020 ‘to support the smooth functioning’ of the Treasury and agency MBS markets marked those purchases as highly unusual,’ wrote Kenneth Garbade, a senior vice president in the New York Fed’s Research and Statistics Group, and Frank Keane, a senior policy advisor. But they also say that the tool has been used before and ‘the infrequency of Federal Reserve intervention suggests that relying on the Fed on those rare occasions when markets are in extremis has not materially exacerbated moral hazard.”

The Fed’s stunning pandemic response has greatly exacerbated at least two pernicious dynamics – Inequality and Moral Hazard. Only Fed economists could argue the Federal Reserve’s crisis response measures haven’t stoked risk-taking throughout the markets. Indeed, any doubt that the Fed would invoke “whatever it takes” to support the securities markets has been allayed.

It is strangely flawed analysis deserving of a response. “The magnitude of the Desk’s purchase program in 2020 ‘to support the smooth functioning’ of the Treasury and agency MBS markets marked those purchases as highly unusual. From an operational perspective the speed and size of the program were unprecedented, yet as a policy response, as the three episodes discussed here show, it was not unique.”

The Fed economists point to three episodes as evidence recent Fed crisis measures were not unique:

1) Fed purchases of $800 million of Treasuries during September 1939, at the start of WWII.

2) Several hundred million Treasury purchases in response to disorderly markets in July 1958.

3) The purchase of several billion Treasury securities in May 1970, in response to disorderly markets after President Nixon announced a military escalation with large-scale operations in Cambodia – along with anti-war protests and the Kent State tragedy.

The analysis concludes with a bold assertion: “…The infrequency of Federal Reserve intervention suggests that relying on the Fed on those rare occasions when markets are in extremis has not materially exacerbated moral hazard.”

Arguably, the three highlighted historical interventions have little or no bearing whatsoever on today’s Moral Hazard Quagmire.

I would point to more than three decades of serial – and escalating - market interventions and bailouts – including Greenspan’s 1987 post-crash liquidity assurances; early ‘90’s aggressive rate cuts and yield curve manipulation; 1994 GSE quasi-central bank liquidity operations; the 1995 Mexican bailout; Greenspan’s pro-markets “asymmetric” policy responses; the ’98 LTCM bailout to safeguard global derivatives markets; Bernanke’s 2002 “helicopter money” and “government printing press” speeches; the Fed’s post-tech Bubble accommodation of rapid mortgage Credit growth as the primary system reflation mechanism – and the subsequent blatant disregard for mortgage finance and housing excesses; the post-Bubble $1 TN QE program, bailouts and various extraordinary crisis measures in 2008/09; the Bernanke Fed’s coercion of savers into the debt and equities markets; Draghi’s “whatever it takes” 2012 crisis response; Bernanke’s 2013 assurance that the Fed would “push back” against any market tightening of financial conditions (i.e. market corrections); the Bernanke and Yellen Feds’ decade-long aversion to policy normalization; the Powell Fed’s abrupt market instability-induced December 2018 abandonment of policy “normalization”; the September 2019 “insurance” rate cut and QE in the face of record stock prices and generally overheated securities markets.

“Moneyness of Credit” was an analytical focus of mine during the mortgage finance Bubble period. It was a historic Moral Hazard episode, with the government-sponsored enterprises, the Treasury and Federal Reserve all contributing to the perception that federal backing insured mortgage finance would remain safe and liquid (money-like) – irrespective of the risk profile of the underlying mortgages. The view that Washington would never allow a housing (or mortgage finance) bust was fundamental to egregious risk-taking and excess (in both the Real Economy and Financial Spheres).

I coined “Moneyness of Risk Assets” in 2009 upon recognizing that Bernanke was targeting rising equities and corporate Credit markets as the primary mechanism for post-Bubble system reflation. Epic Moral Hazard was unleashed. Markets accurately assumed the Fed had taken a giant leap with respect to market intervention and support – with the greater the degree of Bubble excess the more confident the marketplace became that the Fed wouldn’t risk pulling back.

In the realm of Moral Hazard, last autumn’s “insurance” monetary stimulus was a catastrophic policy blunder. Stress was building in leveraged speculation and within global derivatives markets – air was beginning to leak from the global financial Bubble.

The Fed’s aggressive measures quashed the incipient market correction and stoked only greater speculative excess. This ensured heightened market fragility that contributed to March’s near-financial meltdown.

And the financial crisis spurred an unprecedented $3 TN expansion of Fed market liquidity.

M2 money supply surged an unparalleled $2.9 TN in only six months. But when it comes to Moral Hazard, one cannot overstate the significance of the Fed’s giant leap to purchasing corporate bonds and even ETFs that hold junk bonds.

With rates back to zero and the Fed now directly backstopping corporate Credit, “money” has flooded into perceived safe and liquid bond ETFs (in the face of the steepest economic downturn in decades). A debt issuance bonanza ensued.

Once more for posterity: “…The infrequency of Federal Reserve intervention suggests that relying on the Fed on those rare occasions when markets are in extremis has not materially exacerbated moral hazard.”

Rather than infrequent, Fed intervention has become incessant. Market “extremis” has turned commonplace. And any assertion that Fed policies have not materially exacerbated Moral Hazard completely lacks credibility. In fact, it’s foolish.

Friday afternoon from Bloomberg (Lu Wang):

“Bears Are Going Extinct in Stock Market’s $13 Trillion Rebound.” “Skeptics are a dying breed in American Equities.” “Going by the short positions of hedge funds, resistance to rising prices is the lowest in 16 years… At the start of August, the median S&P 500 stock had outstanding short interest equating to just 1.8% of market capitalization, the lowest level since at least 2004…”

“At 26 times forecast earnings, the S&P 500 was trading at the highest multiple since the dot-com era.” “Consider the internet frenzy 20 years ago. Back then, large speculators, mostly hedge funds, were net short on S&P 500 futures in all but five weeks in 1998 and 1999.

Those mostly losing bets were completely squeezed out in 2000. That’s when the crash came.”

The new state capitalism

Xi Jinping is trying to remake the Chinese economy

Party control is mixed ever more intimately with market mechanisms

Last year Zotye, a carmaker, used it to tackle weak sales, and Wuliangye, a distiller, to improve the quality of its baijiu; it helped Zheshang Bank to digitise its operations and catalysed the development of energy-saving technologies at China National Nuclear Power. “Xi Jinping Thought on Socialism with Chinese Characteristics for a New Era” is, on the basis of these companies’ annual reports, quite the business-practice panacea.

The time when private Chinese companies downplayed their links to the Communist Party is gone. By The Economist’s count, nearly 400 of the 3,900 companies listed on stock exchanges in mainland China paid homage to the Communist Party and its leader in their annual reports this year. References by both state-owned firms and their private-sector peers to Mr Xi’s guidance have increased more than 20-fold since 2017 (see chart 1).

The trend reflects China’s new reality. The Communist Party has greater control over all aspects of life, and Mr Xi has greater control over the party. This does not just mean it is a good idea for companies to butter him up. It means that he is in a position to reshape the economy within which they prosper or fail. What is he doing with it?

Nothing good, say critics at home and abroad. He has brought reforms that liberalised the economy to a halt and has smothered market forces, returning to a top-heavy state-dominated growth model which looks distinctly creaky.

Private companies have rushed to set up party committees with an increasing say over strategy.

Their once-swashbuckling bosses have adopted lower profiles. The title of a recent book by Nicholas Lardy of the Peterson Institute, an American think-tank, sums up the worries: “The State Strikes Back”.

Those observations are right. The conclusion is misleadingly wrong, encouraging a complacent and dangerous underestimate of China’s potential trajectory. Mr Xi is not simply inflating the state at the expense of the private sector. Rather, he is presiding over what he hopes will be the creation of a more muscular form of state capitalism.

The idea is for state-owned companies to get more market discipline and private enterprises to get more party discipline, the better to achieve China’s great collective mission. It is a project full of internal contradictions. But progress is already evident in some areas.

Mr Xi announced his agenda in 2013, vowing that China would “let the market play the decisive role in allocating resources”, while reinforcing “the leading role of the state-owned sector”. When domestic stocks crashed in 2015 the government’s focus shifted to recapitalising its banks, tightening controls on cross-border cash transfers and taming the wildest corners of its financial system. But the party now thinks it has won this “battle against financial risks” and is getting Mr Xi’s agenda back on track in a new, bolder form.

Ever more tense relations with America have persuaded the party that China must be able to get ahead on its own. At the same time, China’s success in stalling its coronavirus epidemic and restarting its economy has reinforced its belief in what Mr Xi calls China’s “institutional advantages”—the idea that, as a strong one-party state, China can pool its economic and social resources to meet critical objectives.

Mr Xi’s push can be broken down into two big segments. The first is to establish clearer boundaries for the fizz and ferment of the Chinese marketplace: a stronger legal system for businesses; simplified rules for day-to-day activities; a financial system better at allocating funds. The second is to make more adroit use of the government’s grip on the economy’s main levers: to make state firms more efficient; and to team them up with private firms in new industrial-policy initiatives.

Entrepreneurs still have considerable latitude, so long as they stay in their lane and move in government-endorsed directions. And they still have powerful incentives. “To get rich is glorious”, a quip attributed to Deng Xiaoping that became a mantra for China in its go-go years, still applies. But only so long as your pursuit of riches also benefits the state.

Many foreign executives and diplomats have little time for the idea that there is real pro-market reform going on; they talk of promise fatigue. Repeated pledges to level the playing field on which Chinese and foreign firms meet have amounted to naught. State firms benefit from reams of subsidies and preferential rules, often opaque. Foreign companies have scant presence in key sectors such as finance and energy.

You may now go bankrupt

They are all well-founded complaints. But they ignore the fact that when Mr Xi talks about market reform, it is order, not fairness, that he is after. He wants to define more clearly how businesses and people can work, and within what limits.

Start with the legal system. It is a tool of oppression, as its extension into Hong Kong is making clearer than ever. Mr Xi has been relentless in targeting anyone standing up for human rights. Yet he has also overseen a partial professionalisation of the judicial system and given courts more authority on non-political matters. The economy is simply too complex, and corruption too prevalent, to rely on local officials to adjudicate disputes as they used to.

These changes to the courts have coincided with an explosion in cases. Administrative lawsuits, which typically involve people suing the government, have more than doubled since 2012, the year that Mr Xi became China’s paramount leader (see chart 2). Bankruptcy filings are up ten-fold. Last year Chinese courts accepted more than 480,000 intellectual property cases, nearly five times as many as they did in 2012, with some going to a new national court devoted to the area. Foreign plaintiffs won 89% of all patent infringement cases, according to Rouse, a consultancy.

Local officials have until now always had the option of simply ignoring court rulings: the head of a medical-services company complains that he was blamed for a health scandal in a small inland city caused by a firm that had stolen his company’s name and continued to use it three years after a court ruled against it. It is partly to patch up such holes that the government is developing its “social credit” system.

The courts can place people on so-called credit blacklists, in effect recruiting automated agents of the state to enforce their judgments. For example, if a court finds that a debtor owes money, its ruling, via the blacklist system, can stop them from buying a plane ticket or getting a loan. As of the end of 2018, some 290,000 business executives were on the blacklist.

It is easy to imagine the system taking a truly dystopian turn if its reach were to become more all-embracing, with access to everything in society made conditional on a history that extends beyond creditworthiness through social-media activity into political reliability. But many in China support it for now. “It’s a price that must be paid to cultivate a healthy business environment,” says Yan Yiming, a lawyer who focuses on corporate malfeasance.

As the law gets more reliable, administration gets simpler. The World Bank has found that the average time taken to start a business, which was 23 days as recently as 2017, is now just nine days—a little faster than Japan, a little slower than America. Construction permits previously took 247 days; now they take 111.

Digitisation has made filing taxes much more straightforward. When a business issues an invoice a copy goes directly to the tax authorities. Indeed, some fear that it is all-too-convenient: back doors in the government-mandated software could give hackers access to a company’s computer network.

The last major focus of Mr Xi’s market-orderliness reforms has been the financial system. For those who think that banking regulation is dry paperwork, his reassertion of government control over banks, brokerages and investment firms has been bracingly hands-on, featuring tactics such as the abduction of Xiao Jianhua, a once-mighty financier, from a luxury hotel in Hong Kong in 2017. Several other tycoons have also disappeared, only to re-emerge either chastened or on trial. The message to bankers has been chilling: fall into line with the new order, or else.

The reform is not purely ad hominem. There is real structural change. Between 2008 and 2016, China’s debt-to-gdp ratio rose by roughly ten percentage points a year; from 2017 to 2019, the annual increase averaged just four percentage points. This year debt will soar as a result of Covid-19. But officials insist that this is a one-off. They are already tapering monetary stimulus as growth rebounds.

A taste for Moonshots

The leverage on which the system is based also looks safer. In the 2010s Chinese banks threw themselves into the lucrative business of repackaging assets into opaque investment products: from 2010 until the end of 2017, banks’ claims on other financial institutions rose 20-fold as they layered credit on top of credit. Over the past two years new rules have forced banks to retrench. The shadow-banking sector, a motley universe of thinly regulated lending and investment companies, has begun to shrink.

The bond market, by contrast, has boomed, going from 50% of gdp in 2012 to more than 100% today, and amended rules have made it somewhat easier for companies to raise capital by issuing shares. In many ways, China’s financial system seems ever more reassuringly normal.

In other ways, though, it is what it was. Banks know that the government almost always bails out state firms, whereas private firms are left to their own devices; they are adept at contriving not to hear official calls for them to help small, struggling firms. Instead they direct most of their lending to state-owned firms—a rational choice in a still distorted market. This points to the other side of Mr Xi’s agenda: remaking China Inc.

Since January 2019 a small Chinese rover has been wandering around on the far side of the Moon, sending back crystal-clear panoramic images of a realm no other nation has reached. But for the economy the image that mattered most was Mr Xi’s meeting with hundreds of the scientists and bureaucrats responsible in the Great Hall of the People—an event at which he hailed their success as emblematic of a “new type of whole-nation system”.

Both China’s boosters and its self-declared victims have long promoted a highly idealised view of its industrial policy. Mandarins decide what the country needs and apply a mixture of cheap capital, well-specified research priorities, intellectual-property theft, protectionism and force majeure to get it done.

In truth, Chinese industrial policy has rarely, if ever, been remotely that coherent. It has promoted industrialisation of more or less any type. Cities compete with each other to attract enterprises. Companies pile into whatever seems ripe for a boom. As a detailed study by Carsten Holz of the Hong Kong University of Science and Technology has shown, these investment patterns have borne little relationship to stated industrial policy, which has often been catching up with the facts on the ground. Sometimes this pans out.

There are fast trains and safe-looking nuclear power plants. But decades of official emphasis on semiconductors and internal-combustion-powered cars have failed to lift China to the premier league in either. Huge growth in sectors such as solar power and shipbuilding was bought with wasteful investment which produced overcapacity, huge losses and brutal consolidations.

Cheap land and capital, excellent infrastructure, inexpensive labour and, for years, an undervalued currency allowed stellar progress regardless of rickety strategy. But times have changed. The population is ageing, the debt burden has risen and the environmental effects of all-industrialisation-is-good-industrialisation have been recognised. China needs new tools with which to create new wealth. Mr Xi’s new type of whole-nation system is intended to make real the focused and foundational industrial policy of myth.

In this respect “Made in China 2025”, a new industrial strategy announced in 2015, has proved crucial—though not in the way originally intended. Covering more or less all of manufacturing industry, it is anything but focused. “Basically, every department in the industry ministry came up with pet projects. But there was no real action strategy,” says Yu Yongding, an economist involved in developing some of China’s five-year plans. However its ambition, coupled with China’s industrial-policy mystique and habitual spying, prompted America to react. And that has provided Mr Xi with the criteria by which to select its true priorities.

What China needs are the things which America might hurt it by withholding: the term kabozi jishu, “stranglehold technology”, is much in vogue. Rather than targeting whole sectors, planners talk of prioritising the mastery of jet turbines, precision photolithography for semiconductors, high-speed bearings for machine-tools and a handful of other key technologies.

State-owned enterprises (soes) are seen as necessary to this process because, though many have some private shareholders, the government’s controlling stake allows it to dictate the firms’ actions. But that is not much of an advantage if they are not up to the job. At present soes consistently lag their private-sector peers in productivity. Their bosses, as political appointees, are wary of risks; and they are often burdened with state duties. During the response to covid-19 officials praised soes such as PetroChina, an oil major, for creating extra jobs.

Mixing it up

Mr Xi has made clear that he does not favour a fundamental overhaul for soes. There will be nothing like the wave of closures and privatisations implemented in the 1990s, a cull that carried a steep social Price in unemployment but also helped to clear the way for buccaneering entrepreneurs. But it is a mistake to view the situation as static. The state is trying both to get more out of soes and to use them to get more out of the private sector.

Last year the government declared that net, not gross, profitability was to be a key measure of an soe’s success, which could encourage them to be more hard-headed about operating costs. “What makes us somewhat optimistic is that they are talking more about shareholder value,” says a strategist with one of China’s biggest hedge funds. Some are clearly better run than others: shares in China Merchants Bank, for instance, trade at 1.5-times book value, compared with just 0.5-times for Bank of Communications.

Potentially more important—and certainly more misunderstood—is the government’s renewed push for “mixed ownership”. It wants more state firms to attract private-sector investors and private firms to find state-owned partners. Cross-pollination along these lines has happened before (notably, when major soes listed on stock exchanges in the early 2000s). But this time it will tie together a wider array of companies, notes Chen Long of Plenum, a research firm. In the past few years, state firms have pulled in more than 1trn yuan ($145bn) of private capital. And in the first half of 2020 nearly 50 private-sector enterprises listed in China attracted chunky investments from state firms.

This is not the only way that the boundaries between the private and state sectors are getting fuzzier. Private companies have always been required to have party committees, but for a long time many did not bother. For the biggest that is no longer an option.

Wang Xiaochuan, ceo of Sogou, an internet-search firm, expressed the truths of the new alignment bluntly in 2018. “If you think clearly about this, you really can resonate with the state. You can receive massive support,” he said. Woe betide any company that tries to go its own way. “You’ll probably find that things are painful, more painful than in the past,” he said.

There is some evidence that these changes are having the kind of impact the government wants. Zhang Xiaoqian, an economist at Zhejiang University, has found that both soes and private firms increase their spending on research and development after being remade as mixed-ownership firms. State firms benefit from an injection of ideas and risk appetite. Private firms benefit from better state connections which make it easier to raise capital.

Take for example integrated circuits, an area perennially targeted by planners without huge success (see chart 3) and which is now of huge significance. The government is funnelling more than $100bn to soes, private firms and, most often, projects that bring the two together. There is a lot of waste. But there are signs of progress.

In April Yangtze Memory Technologies Co (ymtc), a semiconductor company founded in 2016 with both public and private capital, announced that it could now make memory chips as technologically advanced as the best Samsung has to offer, boasting 128 distinct layers of circuitry.

Dan Wang of Gavekal Dragonomics, a research firm, says that ymtc’s chips are probably not actually as good as Samsung’s, but that the achievement nonetheless demonstrates China’s progress in both the design and production of chips. One remarkable element of the ymtc story is that it is based in Wuhan, ground-zero of the coronavirus pandemic.

The government kept its factory open and supplied, ensuring that workers could clock in every day, even when the rest of the city was in total shutdown. It was the “new type of whole-nation system” in action.

Yet the basic tension in the soe sector remains unresolved. Yes, the government has put more emphasis on profitability, but that does not mean decisions get made according to commercial logic. Indeed, under Mr Xi national duty—supporting China’s rise—is more important than ever. And stricter party control is confusing lines of responsibility. An executive with a major state-owned insurance firm says that its party committee now controls all senior personnel appointments and expresses “opinions” on all investments worth more than 20% of net-asset value. Opinion is a euphemism. “It is normally the final decision. No one would go against the party secretary,” he said. “But if something goes bad, the board will be responsible.”

In the private sector, for all the criticism outsiders have of Mr Xi’s increasing reach, it is salutary to note how well some of the biggest players have fared on his watch. China’s ten biggest non-state companies have added roughly $2trn to their market capitalisation since he became party chief. Mr Xi’s strengthening of court decisions and disciplining of the financial system helps incumbents to make acquisitions, to sue firms infringing on their patents and to get financing.

Contradicting history

This all helps underpin the gradual consolidation taking place across a range of industries—a process which demonstrates that there really are strong market forces at play in the economy, and that they are being channelled more effectively than in the past. In the property sector, for instance, the ten biggest developers now have a 34% market share, up from 20% five years ago, according to UBS, a bank.

But Mr Xi’s rule has not just been a time of consolidation. Many startups have grown up under him, including the company that created TikTok, the social-media app now at the centre of its own geopolitical storm; Pinduoduo, an e-commerce firm taking on China’s incumbent, Alibaba; and SenseTime, an ai company in the vanguard of facial-recognition technology.

The worry—for the economy as for those whom SenseTime’s wares may victimise—is what comes next. An insistence on forming party committees in private companies, even if they are mainly window-dressing for now, and on mixed-ownership initiatives, can but drag entrepreneurs more firmly into the grasp of the state. Can technological advances delivered by the whole-nation system in any way make up for the constraints, second-guessing and divergent incentives which inevitably come with it?

It has always been possible for major decisions—investments, lay-offs and branding—in big Chinese companies, state-owned or not, to be subject to government scrutiny. But that possibility is now more clearly communicated and more deeply felt. All companies, whoever owns them, exist for the glory of China.

A flag-bearer of the new model is a company like byd, the world’s biggest maker of electric cars. At one level, it epitomises the can-do entrepreneurial spirit that has fuelled China’s growth. Wang Chuanfu, a chemist, left a poorly paid government job in the mid-1990s to strike out on his own, first developing phone batteries, then cars. Today, his company counts Warren Buffett as its biggest investor.

But byd’s connection to the party is strong. Mr Wang is a party member. Though byd has never discussed the workings of its party committee in formal disclosures to shareholders, state media report that it helps to guide the company’s decisions. And its business decisions are sometimes strikingly well aligned with government priorities. When America hit Huawei, China’s embattled telecommunications giant, with sanctions last year, byd started making smartphones for it.

It is getting harder to distinguish between the state and private sectors. It is getting harder to distinguish between corporate and national interests. And for all its inefficiencies, contradictions and authoritarianism, not to mention its increasingly pious cult of personality, it is getting harder to claim that state capitalism will hobble China’s attempts to produce companies and master technologies that put it on the world economy’s leading edge.

Bolsonaro and the generals: will the military defend Brazil’s democracy?

As his position has come under threat, the president has raised the prospect of political intervention by the army

Bryan Harris in São Paulo and Andres Schipani in Brasilia

© Reuters | Jair Bolsonaro has appointed a number of army personnel to senior roles in his government

Brazil’s armed forces are adopting a new tactic to raise their profile: they are developing a video game for kids, where virtual soldiers can don the olive green of the Brazilian military and shoot at the bad guys.

The objective is to burnish their image among the nation’s youth. But wary of being depicted as rampaging mercenaries, the army leadership has ordered that the game “not show too much blood”. Scenes that could generate an “institutional crisis” are also banned, which means no fighting in Brasília and definitely no coups.

The foray into video games speak volumes about the increasingly ambiguous role the military is playing in Brazilian public life.

In the more than three decades since the end of a violent military dictatorship, the armed forces largely kept their heads down and offered strong support for the country’s democratic institutions.

But that was before Jair Bolsonaro, a rightwing former army captain, was elected president in 2018. Mr Bolsonaro has appointed a large number of former military personnel to senior positions in his government. And now that his own position is coming under threat, he has openly raised the idea of some form of military intervention in Brazilian politics by claiming in June that the armed forces would not accept “absurd decisions” by the nation’s supreme court or Congress.

A Jair Bolsonaro supporter in Manaus protests against lockdown measures proposed by a state governor. Some of the similar nationwide rallies were attend by the president himself
A Jair Bolsonaro supporter in Manaus protests against lockdown measures proposed by a state governor. Some of the similar nationwide rallies were attend by the president himself © Bruno Kelly/Reuters

The comments were seen as a reaction by the president to the multiple criminal investigations he and his family are facing in the nation’s highest court — investigations that have the potential to lead to his impeachment or the annulment of his 2018 election.

Yet it was not the first time the president invoked the military to try to cower his opponents. As the coronavirus pandemic started to rip through Brazil in April and May, the president attended rallies outside military bases, where his radical supporters called for an armed intervention to oust governors, judges and lawmakers who were implementing lockdowns.

“Brazil wakes up every day afraid of aggression to democracy, to the constitution, to the Congress, to the supreme court,” said João Doria, governor of São Paulo, at the time. “President Bolsonaro, stop this endless aggression.”

For now Mr Bolsonaro appears to be trying to reduce the political temperature. He has tried to mend fences with the supreme court and he managed to form a political alliance with a controversial group of parties in Congress known as the Centrão, which analysts say should fend off efforts to eject him from office — at least for now.

Clockwise from top left: Hamilton Mourão, Bento Albuquerque, Augusto Heleno, Eduardo Pazuello © Reuters; AFP/Getty Images

Hamilton Mourão
A retired army general, Hamilton Mourão is viewed as the “adult in the room” in the Bolsonaro administration for his calm demeanour and pragmatic approach to politics. He oversees key policy issues for Brazil, including the protection of the Amazon rainforest and bilateral relations with China.

Augusto Heleno
Another retired army general, Augusto Heleno is one of the more controversial members of the Bolsonaro administration. He has defended Brazil’s military dictatorship and said publicly he believes it is up to the military to “put this house in order”.

Eduardo Pazuello
Eduardo Pazuello was appointed acting health minister, despite having no experience in healthcare or with public health services. Before taking the post, the Major General led Brazil's efforts to handle the arrival of tens of thousands of Venezuelan refugees in the northern state of Roraima.

Bento Albuquerque
A decorated navy admiral, Bento Albuquerque served as a UN military observer in the Balkans and later became commander of Brazil's submarine force.

But with the continuing investigations into the Bolsonaro family, with the economy probably entering a new recession after already suffering a decade of stagnation and with the government widely viewed as having bungled the response to the coronavirus pandemic, Brazil could be about to enter a new period of political turbulence. Deaths from Covid-19 passed 100,000 at the weekend.

This situation has raised urgent questions about what is the role of the military in Brazilian society today and what is its relationship with Mr Bolsonaro. If the Brazilian leader decided to ignore a ruling by the supreme court, what would the armed forces do? Are the former military people around the president an accelerator or a brake on his authoritarian instincts?

Serving and retired officers and soldiers, as well as senior defence figures, are adamant that the armed forces would never again launch the type of military interventions that pockmarked Brazil’s 20th century history. They argue that the military would be committed to safeguarding the country’s democratic order in the event of Mr Bolsonaro forcing their hand.

President Bolsonaro is greeted by supporters in São Raimundo Nonato during the coronavirus pandemic
President Bolsonaro is greeted by supporters in São Raimundo Nonato during the coronavirus pandemic © Alan Santos/Brazilian Presidency/Handout/Reuters

“The army has been quiet for 35 years. It won’t be getting into party politics now,” says Carlos Alberto dos Santos Cruz, a retired army general and minister in the Bolsonaro administration until he was fired after clashing with the president’s powerful sons.

For civilian observers, however, there is cause for concern. More than 6,000 active or reserve members of the military are already embedded in government positions in the Bolsonaro administration — including more in the executive branch than during the 1964-1985 dictatorship — bringing with them a military mindset to civil governance.

The current health minister is an active duty general who followed orders from Mr Bolsonaro to dispense the discredited drug chloroquine to Covid-19 patients. For independent analysts and some politicians, the presence alone of such figures is itself a potential risk to democracy.

“What the president is now saying is: ‘I have the sword by my side and that sword is the military.’ He is always invoking the military, always speaking for the military,” says Raul Jungmann, a veteran centre-left politician who was defence minister in the previous government of Michel Temer. “This is how the president has decided to constrain Congress and the supreme court and to push forward his agenda.”

‘Politics through fear’

The armed forces have roots that spread deep and wide into Brazilian society. When Brazil declared independence from Portugal in 1822, it fell to early iterations of the military to first stamp out Portuguese garrisons and later local rebellions in the far-flung reaches of the fledgling empire.

Further operations then charted the depths of the Amazon rainforest, establishing Brazil’s current borders and instilling in the military a sense of its primacy in the creation of the nation.

“All those events brought a sense of identity to the armed forces because they fulfilled their role for the nation. In all times of political turmoil, the armed forces somehow participated in the government,” says a former top general.

Brazilians gather on the streets in Rio De Janeiro during the military coup of 1964, which ushered in a dictatorship that lasted until 1985
Brazilians gather on the streets in Rio de Janeiro during the military coup of 1964, which ushered in a dictatorship that lasted until 1985 © Universal Images Group/Getty

This interventionist tilt continued throughout the 20th century, culminating with the 1964 coup, which ushered in a violent two-decade-long dictatorship.

Democracy was restored in 1985. But unlike in neighbouring Argentina, where the dictatorship was more brutal and the generals were tried in Nuremberg-style proceedings, the departing Brazilian generals negotiated a broad amnesty and the military was never held to account for crimes including murder and torture.

Facing no obvious threats to national defence, the Brazilian army has in recent years pursued diverse initiatives, including humanitarian aid missions, infrastructure projects, fighting wildfires in the Amazon, and even crisis response to the coronavirus pandemic.

According to World Bank data, the country is home to the largest armed forces in Latin America, followed by Colombia, which for decades had to contend with a fiery Marxist insurgency.

A demonstrator holds a placard reading 'Bolsonaro out, general elections now!' in Rio de Janeiro, as concern rises over the number of military officers in Brazil's administration
A demonstrator holds a placard reading 'Bolsonaro out, general elections now!' in Rio de Janeiro, as concern rises over the number of military officers in Brazil's administration © Pilar Olivares/Reuters

“Our role is to contribute to the development of the country,” says one Brazilian colonel, who served 30 years in the army, in comments that were echoed by several junior soldiers.

It is an attitude that has helped the military rehabilitate its image since the dictatorship. For much of the past decade, opinion pollster Ibope has ranked the military alongside firefighters and the federal police as among Brazil’s more trustworthy institutions.

In 2018, the armed forces had a rating of 62 per cent, compared with 13 per cent for the presidency and 18 per cent for Congress.

That reputation now, however, risks being tarnished by many active and retired officers embracing Mr Bolsonaro in government — especially as the country’s coronavirus crisis deepens.

“They are doing politics through fear,” says Eduardo Costa Pinto, a specialist in military studies at the Federal University of Rio de Janeiro. “This is the problem of having a government filled with military personnel during an institutional crisis. The military will fight tooth and nail to stay in power. And they have guns, which makes political mediation difficult.”

‘Armed forces being used for political purposes’

Mr Bolsonaro’s own military career was characterised by controversy. He spent 15 days in a military jail for insubordination after criticising his superior officers in an interview with Veja magazine 1986. The same magazine accused him a year later of planning a bombing campaign of military units — an allegation that Brazil’s supreme military court ultimately said was unfounded.

Soldiers on the sidelines of an anti-Bolsonaro rally in Rio de Janeiro. 'We see [the president] as a saviour. An icon. He is the man,' a young soldier told the FT
Soldiers on the sidelines of an anti-Bolsonaro rally in Rio de Janeiro. 'We see [the president] as a saviour. An icon. He is the man,' a young soldier told the FT © Mauro Pimentel/AFP/Getty

Ernesto Geisel, the general who presided over Brazil’s dictatorship from 1974 to 1979, once described Mr Bolsonaro as a “bad military man”.

At the rank of captain, Mr Bolsonaro left the army in 1988 and in 1991 he began a political career as a backbench lawmaker in Rio de Janeiro, where he focused single-mindedly on protecting the interests of the armed forces and the state-level military police.

When he ran for the presidency in 2018, he was backed by hundreds of thousands of soldiers and police, who shared his conservative values and applauded his outspoken attitude on everything from race to sexuality.

“We see him as a saviour. An icon. He is the man,” says a 20-year-old soldier, who also spoke on condition of anonymity. “We practically all support him. I would say 95 per cent of us,” says a corporal.

When he was elected, the president rewarded this support by stacking his government with military figures, notably recently retired generals — a move that immediately triggered fears about the resurgence of the military in civil and political life.

“With Bolsonaro the efforts to assert civil prominence over the military have been paralysed. It shows the great fragility of Brazilian democracy,” says Carlos Fico, a professor of military studies at the Federal University of Rio de Janeiro.

The comments are echoed by Alcides da Costa Vaz, director of the Brazilian association for Defence Studies, who says the military had become a pillar of support for the president, but this had cast a “shadow of uncertainty over their political designs”.

Military police disperse anti-Bolsonaro protesters in Rio de Janeiro. Critics are concerned about what the military would do if the president chose to ignore a court ruling
Military police disperse anti-Bolsonaro protesters in Rio de Janeiro. Critics are concerned about what the military would do if the president chose to ignore a court ruling © Bruna Prado/Getty

For some observers, the situation has echoes of socialist Venezuela. Since a 2002 coup attempt that briefly ousted the late Hugo Chávez, himself a parachutist, the country’s government has been stacked with loyal generals in an attempt to create what President Nicolás Maduro, a civilian, calls a “civic-military union”. Analysts say the military assures social control for the benighted Maduro regime, in return for preferential access to goods and hard currency.

The escalating concerns in Brazil have prompted a judicial inquiry, with the federal audit court now investigating the “excessive presence of the military in civil public service.”

“I consider it important that society knows exactly how many military, active and inactive, currently occupy civilian positions given the risks this can represent and the differences between military and civilian regimes,” Bruno Dantas, the presiding judge, said in June.

The fears surrounding the influence of the military have been compounded by the silence of the current leadership. Many of the active top brass are believed not to share the same enthusiasm for Mr Bolsonaro as younger officers, but they have said little in the face of the president’s excesses.

“In the higher ranks, there are officers who see the military as a defence force and who do not welcome this incursion into politics. But it is those military leaders who now need to dispel fears,” says Mr da Costa Vaz.

With little communication forthcoming from the military leadership, attention is instead focused on the attitudes adopted by retired generals now serving in Mr Bolsonaro’s cabinet, including Augusto Heleno, the national security adviser, who in May appeared to threaten judicial authorities when he warned of “unpredictable consequences for the nation” as a result of efforts to investigate the Brazilian leader for corruption.

Mr Jungmann, the former defence minister, said: “The problem is that you have many ministers who are also retired generals, so the tendency is to understand what they say as the speech of the military institution.”

“But that is not the case. The armed forces are being used for political purposes.”

Brazilian army tanks arrive at Guanabara Palace in Rio de Janeiro during the military putsch of 1964
Brazilian army tanks arrive at Guanabara Palace in Rio de Janeiro during the military putsch of 1964 © Humberto Castelo Branco/AFP/Getty

Prof Pinto points out that some of the generals joined Mr Bolsonaro’s administration because they thought they could moderate their former underling and unite the country, which was split sharply along left-right allegiances.

“Bolsonaro was nicknamed ‘the horse’ because everyone thought they could ride him wherever they wanted — they thought they could control him,” he said. “It is now obvious these generals are subservient to the president.”

‘Abject dictatorship’

Throughout his career Mr Bolsonaro never hid his admiration for Brazil’s military dictatorship. During the congressional vote to impeach former president Dilma Rousseff, he dedicated his ballot to one of the regime’s most notorious torturers.

“Who says whether a country will see democracy or not are the armed forces,” he once told the Financial Times.

His rhetoric, however, began turning into action in recent months when he joined rallies calling for a military intervention to close the supreme court and Congress. Some of his supporters adopted paramilitary uniforms. Mr Bolsonaro himself arrived at one rally on horseback, a clear nod to the caudillo — strongman — tradition in Latin American history.

Tensions escalated to the point where Celso de Mello, a supreme court justice, warned that Brazil was in a position akin to Weimar Germany and the president was turning the country into an “abject dictatorship”.

In Brazil, those close to the armed forces vehemently defend the political impartiality of the military.

“I am absolutely convinced that today there is no possibility of military intervention. The commitment of the military today is with the democratic process,” says Nelson Jobim, a former minister of defence under the leftwing governments of Luiz Inácio Lula da Silva and Ms Rousseff.

Soldiers in Brasilia walk past as Jair Bolsonaro talks on the phone, soon after the president announced he had tested positive for coronavirus
Soldiers in Brasília walk past as Jair Bolsonaro talks on the phone, soon after the president announced he had tested positive for coronavirus © Andre Borges/Getty

 The comments were echoed by three active duty soldiers.

Civilian analysts point out that the military should have responded forcefully when Mr Bolsonaro claimed the armed forces would not accept “absurd orders” from the court. But ultimately, many believe the military would not support such a move.

“If Bolsonaro ignored a decision from the supreme court, his government would lose legitimacy and it would mean the end of the rule of law. The impact on Brazil’s institutions would be devastating,” says Hussein Kalout, secretary for strategic affairs during the Temer administration.

“Some military personnel may like it, but their position is irrelevant. The armed forces as an institution would not endorse it.”

The comments were echoed by an army general, who says the president constantly pushes the limits, but is yet to break them.

“The political history of President Bolsonaro has been one of permanent tension,” he says. “But the armed forces will follow the law, as they have been doing for a long time.”

Additional reporting by Carolina Pulice and Emily Costa

America’s Dual Recession

Before COVID-19 shut down entire sectors of the US economy, the US workforce was becoming increasingly polarized along educational, racial, and geographic lines. Now, those trends have been accelerating, underscoring the need for a smart, worker-focused policy response.

Laura Tyson, Lenny Mendonca

tyson93_Joe RaedleGetty Images_uscoronavirusunemployment

BERKELEY – Americans heading into the fall and the new school year are grappling with interrelated upheavals in health, the economy, family life, and race relations. The COVID-19 crisis is falling hardest on the most vulnerable: people of color, people with disabilities, immigrants, women, the less educated, and other workers trapped in precarious, non-standard, and low-wage jobs without health insurance or benefits.

Worse, the jobs susceptible to the pandemic-induced recession overlap with those that will be susceptible to accelerating digitization and automation as the economy recovers.

All of this points to a “dual” recession in which America’s “haves” suffer a much softer blow than its “have-nots.” At the beginning of 2020, workers earning less than the hourly median wage comprised an estimated 44% of all workers, despite record-low unemployment rates and rising wages at the bottom of the income distribution (owing largely to many states’ minimum-wage increases).

Low-wage workers are twice as likely as middle- and high-wage workers to have no more than a high school diploma. Around 54% are women and 45% are people of color, who are overrepresented relative to their share of the total workforce.

Low-wage workers are concentrated in labor-intensive, in-person leisure, hospitality, retail services, and transportation, all of which have collapsed as a result of lockdowns and social distancing. At the same time, the pandemic has fueled the demand for digital services, which have mitigated job losses for those with a college education or higher.

In June, the unemployment rate for those with a high-school education was 12.1% compared to 6.9% for those with a college education.

Surveys from mid-April show that about half of all Americans who are usually employed are now working from home, but high-income workers are six times more likely than low-wage workers to be able to do so. Among low-wage workers who are still employed, many are in essential but high-risk sectors such as meatpacking and food processing.

The pandemic is not only further polarizing the US labor market, it is also imposing costs disproportionately on the most at-risk populations. According to one recent report, 56% of black families, compared to just 44% of white families, experienced job or income losses between March and May. Similarly, deaths from the virus itself have been disproportionately higher in black and brown communities.

Across the country, many workers are facing the impossible choice of caring for their children or showing up at their essential but low-paying jobs. And with fall school plans in flux, childcare is quickly falling back on women, threatening to set back decades of progress in closing gender pay and opportunity gaps.

Reversing the pandemic’s economic injustices and addressing the glaring structural inequalities it has exposed will require a sustainable and inclusive recovery based on good jobs for all workers. The first priority is to roll out an immediate COVID-19 containment and recovery plan that will restore demand for labor.

Even optimistic forecasts do not foresee a return to 2019 employment levels until 2022. There is every reason to expect that many of the lost jobs – perhaps as many as 40% – will never come back. In the short to medium term, the tragic paradox is that employment opportunities are both too few and pay too little.

Second, the US desperately needs to strengthen its social safety net and improve the conditions for low-wage workers through a combination of higher minimum wages, Earned Income Tax Credits, and Medicaid expansion in all states. Third, training and active-labor-market policies are needed to connect workers to better future job opportunities. In an ideal world, former low-wage workers would re-enter the economy in high-wage skilled jobs.

To be sure, upskilling 44% of the American workforce cannot happen overnight. But we already know the core characteristics of successful training programs: strong links to local employers and communities; a focus on specific sectors and occupations; screening to match applicants with target occupations; and individualized services for program completion and job success. The task is to make these programs affordable while also including wrap-around assistance like counseling and childcare.

Many states and cities are already developing successful workforce training models. A total of 31 states participate in the Skillful State Network, and are increasing apprenticeships and skills-training programs based on local economic conditions.

In San Antonio,Project QUEST helps under-skilled adults – 68% of whom are women, and 66% Latino – earn post-secondary credentials, and then connects them to well-paid job opportunities in strong sectors of the local economy (health care, manufacturing and trades, information technology).

In 2018-19, program graduates increased their annual wage by 203%. And according to one recent study, participants’ wages continued to rise for nine years after finishing the program.

Similarly, the employer-led UpSkill Houston is combining skills training and community college programs to equip potential workers for employment in key local sectors including petrochemicals; industrial and commercial construction; health care; and the port, maritime, and logistics industries. Most of these jobs require technical skills training, not a four-year college degree.

Community colleges are by far the most important providers of such training. Already, 17 states (Republican- and Democratic-leaning alike) have introduced some form of “tuition-free” community college, and another 12 states have similar legislation pending. Former Vice President Joe Biden, the presumptive Democratic presidential nominee, has proposed a federal-state partnership to provide tuition-free community college for up to two years.

He also wants to commit $50 billion to support workforce training programs; develop short-term degrees through industry, union, and community-college partnerships; and expand the Registered Apprenticeship Program.

The upheaval in work caused by the pandemic is accelerating the transition from an industrial to a digital economy. That means digital skills training will be essential for most good jobs in the future.

The United States therefore has a choice: it can go digital with even higher levels of inequality than it already has, resulting in a dysfunctional and unsustainable “dual” economy, or it can invest in its workers so that today’s “bad” jobs can become tomorrow’s good Jobs.

Laura Tyson, former chair of the US President's Council of Economic Advisers, is Professor of the Graduate School at the Berkeley Haas School of Business and Chair of the Blum Center Board of Trustees at UC Berkeley.

Lenny Mendonca, Senior Partner Emeritus at McKinsey & Company, is a former chief economic and business advisor to Governor Gavin Newsom of California and chair of the California High-Speed Rail Authority.