The debt bubble legacy of economists Modigliani and Miller

Research laid the intellectual groundwork for a dramatic erosion of corporate creditworthiness 

Robin Wigglesworth 

     Franco Modigliani who carried out groundbreaking work with Merton Miller on the capital of companies © Richard Sobol/LIFE Images/Getty

Half a century ago, two starlets of economics argued that whether companies funded themselves with debt or equity was irrelevant. One legacy of that insight is becoming clearer in the wreckage of corporate failures mounting in the wake of the pandemic.

Franco Modigliani and Merton Miller both later won the Nobel Prize in economics, partly thanks to their groundbreaking work on what became known as the “M & M theorem”. Until then most companies had assumed that too much debt would affect the value of the firm, so their paper was a counterintuitive bombshell.

Their initial findings only held in a world without “frictions” — such as taxes, imperfect information and inefficient markets. But a later revisitation that incorporated the tax-deductibility enjoyed by interest payments showed that the value of an indebted company is actually higher than that of an unleveraged one. It eventually helped lay the intellectual groundwork for a dramatic erosion of corporate creditworthiness. 

If the mix of funding is in practice irrelevant to the overall cost, why not leverage up and increase returns to shareholders that own the business, and, indirectly but no less importantly, corporate executives? Indeed, given that debt enjoys tax breaks in most countries, isn’t it almost irresponsible not to take advantage? When interest rates began to fall globally in the 1980s, many companies did just that. That executive compensation is largely tied to earnings per share was an additional incentive for companies to leverage up.

Later on, other economists would give the corporate borrowing binge more academic legitimacy by arguing that debt was a potent tool to ensure corporate discipline and therefore increase economic dynamism. This gave rise to the idea of “efficient” balance sheets layered with debt.

The result can be seen in the evolving distribution of corporate credit ratings. Four decades ago, Standard & Poor’s had given 65 companies around the world a spotless triple A rating, equal to almost 6 per cent of its total ratings. 

Another 679 companies enjoyed ratings in the A range. Today there are only five — five! — companies with triple A ratings, out of nearly 5,000 companies. And under 14 per cent of all rated companies are in the A range.

Once again, we can see the cost all around us. For sure, the Covid-19 pandemic was an extraordinary shock that could have threatened the solvency of even the sturdiest company. 

But the fact that so many companies around the world are far from sturdy is a major reason why governments and central banks had to go to eye-popping lengths to moderate a tidal wave of corporate bankruptcies. 

Those efforts have largely been successful. Yet the cost has been gargantuan. After 2008, there was a reckoning with banks and how they fund themselves. After 2020, there should be a similar overhaul for companies. 

The aim can obviously not be to immunise every company completely from every crisis. 

But a shift from efficient to resilient balance sheets would be a long-term boon to the health of the financial system and the global economy. 

Ideally, this should happen in response to the signals already being sent by markets: The shares of companies with stronger balance sheets have this year massively outperformed those with weaker ones, according to Goldman Sachs data. 

But if this proves a fleeting phenomenon — as is likely — then more countries should start taking a hard look at the tax advantages enjoyed by debt. Such a draconian move can only be done carefully, over a long period of time. 

But everyone would benefit from a world where companies once again aspire to be more creditworthy.

The Arctic Comes in from the Cold

The more that global warming reduces the ice cover in the Arctic, the greater the need there will be for multilateral arrangements to govern trade, resource extraction, and other issues across the region. Without forward-looking cooperation, a zero-sum scramble will ensue, leaving everyone worse off.

Carl Bildt

STOCKHOLM – Whether we are heading for a future of cooperation or of increasing confrontation in the Arctic remains to be seen. But it is already clear that the region will command far more attention than it has in the past.

The main reason is of course climate change, which is accelerating the rate of ice melt and causing arctic temperatures to rise twice as fast as the global average. Owing to their pace and scale, these changes have obvious geographic, economic, and strategic implications. 

As the vast ice sheet that spans the region has melted, new fossil-fuel reserves and shipping routes have opened up, including the Northern Sea Route (NSR) along Russia’s Siberian coast and the Northwest Passage through Canada’s northern archipelago. However, the same trend has also fueled the loss of permafrost, threatening billions of dollars’ worth of infrastructure that may soon be standing in mud instead of on firm ground.

Moreover, indigenous communities that have lived in the Arctic for millennia are increasingly voicing concerns about the growing threat to their livelihoods. Nearly half of the Arctic’s land area is in Russia, as are around 70% of the four million people who live in the region. 

Most live in the Kola Peninsula area near Norway and Finland, which is also home to Russia’s Northern Fleet and most of its sea-based nuclear deterrent. But other parts of the region are no less important, strategically and demographically. 

Approximately two-thirds of the inhabitants of Canada’s arctic areas are indigenous people, as are the vast majority of the 56,000 people living on Greenland (which itself is the size of a small continent).

This summer, a century-old sailing ship, the Sedov, traversed the NSR without seeing any ice at all. Such journeys still are possible only during the warmest months, whereas transit throughout the rest of the year requires special ships, often escorted by powerful icebreakers. 

Nonetheless, the sea traffic has been steadily increasing, driven so far by the large energy projects that Russia is developing in Siberia. Chinese and French companies each have a 20% stake in liquid natural gas extraction from the Russian-controlled Yamal gas fields, and South Korean-built tankers are shipping this LNG to Europe – and soon will be supplying East Asia. Needless to say, many more projects are in the works.

Since 1996, the eight arctic countries – Russia, Norway, Finland, Sweden, Denmark (Greenland), Iceland, Canada, and the United States – have cooperated through the Arctic Council, mostly to address environmental issues. But now that the Arctic is becoming an increasingly important global theater, other countries are taking an interest.

In 2013, China, India, Singapore, South Korea, and Japan were granted observer status within the Council, in recognition of their scientific research commitments and interest in future shipping opportunities. The potential for trade could be massive: the arctic sea route from Yokohama, Japan, to Hamburg, Germany, is 40% shorter than the current one that runs through the Suez Canal.

Perhaps inevitably, the new climate of great-power competition has increasingly affected Arctic issues. At the Council’s ministerial meeting in Rovaniemi, Finland, last year, US Secretary of State Mike Pompeo shocked everyone when he refused to agree to a final communiqué and work program that mentioned climate change. The Trump administration instead used the occasion to attack China for its own designs on the region.

In May next year, Iceland will pass the Council’s biennial rotating chairmanship to Russia, which is not likely to squander its two years in the driver’s seat. Over the past decade, the Kremlin has devoted significant resources to strengthening its Arctic positions, reviving defunct Soviet military facilities and building new ones. This military build-up has set off alarms within NATO, even though a sober analysis would find that in most cases, such facilities pose no particular threat to anyone – except, perhaps, polar bears.

Still, other points of contention do matter. Russia regulates all of the shipping through the NSR, and thus will enjoy outsize control for as long as other parts of the Arctic remain covered with ice. But as more ice melts, new shipping channels will open up well north of Russia’s jurisdiction, and this will introduce a slew of new legal issues.

In light of these looming issues, a recurrence of the type of confrontation that derailed the Rovaniemi summit would be most unfortunate. With the executive meeting of the Arctic Council taking place in Reykjavik next month, we will soon know what the future holds.

There are more than enough issues for the US, Russia, China, and others to clash over nowadays. But all should recognize a shared interest in preserving and further developing an open, collaborative framework for the world’s northernmost region. One way or another, the Arctic will become an increasingly important theater. It behooves us all to make it one of mutually beneficial cooperation, not war.

Carl Bildt was Sweden’s foreign minister from 2006 to 2014 and Prime Minister from 1991 to 1994, when he negotiated Sweden’s EU accession. A renowned international diplomat, he served as EU Special Envoy to the Former Yugoslavia, High Representative for Bosnia and Herzegovina, UN Special Envoy to the Balkans, and Co-Chairman of the Dayton Peace Conference. He is Co-Chair of the European Council on Foreign Relations. 

Hyperinflation is here 

By Alasdair Macleod

Definition: Hyperinflation is the condition whereby monetary authorities accelerate the expansion of the quantity of money to the point where it proves impossible for them to regain control. It ends when the state’s fiat currency is finally worthless. It is an evolving crisis, not just a climactic event. 


This article defines hyperinflation in simple terms, making it clear that most, if not all governments have already committed their unbacked currencies to destruction by hyperinflation. The evidence is now becoming plain to see. 

The phenomenon is driven by the excess of government spending over tax receipts, which has already spiralled out of control in the US and elsewhere. The first round of the coronavirus has only served to make the problem more obvious to those who had already understood that the expansionary phase of the bank credit cycle was coming to an end, and by combining with the economic consequences of the trade tariff war between China and America we are condemned to a repeat of the conditions that led to the Wall Street crash of 1929—32. 

For economic historians these should be statements of the obvious. The fact is that the tax base, which is quantified by GDP, when measured by the true rate of the dollar’s loss of purchasing power and confirmed by the accelerated rate of increase in broad money over the last ten years has been declining sharply in real terms while government spending commitments continue to rise. 

In this article it is documented for the dollar,but the same hyperinflationary dynamics affect nearly all other fiat currencies. 


In the last ten years I have waged two crusades to bring attention to issues I believe to be in the public interest. From 2011, I wrote a series of articles about China’s gold policy, which had been accumulating physical gold from as long ago as 1983. The meme that gold was moving from west to east became broadly understood and almost a cliché. 

The second crusade was to inform the public that the business or trade cycle was only the symptom of a cycle of bank credit, which inevitably ends in a crisis of credit contraction. 

It is now time for a new campaign, on a subject which I have been writing about in recent months, and that is to inform the wider public that their governments and their fiat currencies are now in a state of hyperinflation. It is not a development on the far horizon as many might think; it is already here. 

What is hyperinflation? 

To understand why hyperinflation is already with us is to know what constitutes hyperinflation. It is not rising prices, or a condition that exists when prices increase above a predetermined rate: rising prices are the consequence of both inflation and hyperinflation. 

As Milton Friedman put it, inflation is always and everywhere a monetary phenomenon, though he spoiled it by continuing, “…in the sense it is and can be produced only by a more rapid increase in the quantity of money than in output.”[i] He was wrong on that last bit, conflating the price effect with the increase in the quantity of money. 

When even so-called monetarists are imprecise about inflation, let alone hyperinflation, it is hardly surprising public confusion is widespread. There can only be one definition of hyperinflation, and that is the one headlined above, which you won’t find in any textbook. There is even no definition of it in von Mises’s Human Action, only of inflation, and that is more a description than a definition. 

And since it is a relatively recent phenomenon of unbacked fiat currencies, hyperinflation was never defined separately from inflation by classical economists. The difference between inflation and hyperinflation cannot be distinguished by degree either. 

Have a look at US M1, the quantity of narrow money in the American economy, shown in Figure 1. 

The progression of annualised monetary inflation from under 6% before the Lehman crisis, to 9.6% subsequently until March this year, and 65% in the thirty weeks since is clear from the chart. 

If the monetary authorities have the knowledge, the mandate, the authority, the ability and the desire to stop inflating the currency, we would not describe it as hyperinflation, instead deeming it to be no more than a brief period of exceptional inflation before a return to sound money policies. 

But sound money was emphatically discarded in 1971, when the post-war Bretton Woods agreement was finally abandoned — not that the monetary regime at that time was in any way sounder than Adam’s fig leaf was an item of clothing. For the fact of the matter is that sound money in America was arguably abandoned long ago, with the founding of the Fed at Jekyll Island before the First World War. 

As a means of funding government deficits, inflation is capable of being stopped by cutting government spending and/or raising taxes. But now, a one-off increase of 65% of narrow money is to be followed by another massive expansion already in the wings. 

The hope is that that will be enough, just as the original 65% increase in M1 was hoped to be enough to ensure a V-shaped recession would be followed by a return to normality. 

The early stages of a hyperinflation are always seen by the monetary authorities as the only policy to pursue. They convince themselves that there are either no consequences, or that they can be controlled. 

An example of the genre is found in a paper by Michael T Kiley, a senior Fed economist.[ii] In August he concluded that the lack of further room to cut interest rates to deal with the coronavirus requires quantitative easing to a total of 30% of GDP, or $6.5 trillion, to offset the lack of room for manoeuvre on interest rates. 

Kiley writes that about $3 trillion had been enacted between end-February and end-June, leaving a further $3.5 trillion to come. If we assume the full $6.5 trillion stimulus is enacted by next February, then the increase reflected in narrow money could be to more than double it. 

Kiley wrote his paper before the second coronavirus wave commenced. He was modelling an economic contraction measured in real GDP of just 10% in the second quarter (actually 9.5% — not to be confused with the annualised rate reported at 32.9%). But, as I pointed out in last week’s article, with monetary inflation running at such a rate, a dollar last February is not the same as an inflated dollar next February, being diluted on Kiley’s figures by $6.5 trillion. 

The consequence is some extremely damaging intertemporal shifts, as described in the Cantillon effect, whereby ultimately both productive workers and the poorest in society lose savings, salaries and social security benefits through loss of the dollar’s purchasing power for the benefit of the government, its agencies, and big business. 

In his economic model, Kiley flattens the Phillips curve, apparently in an attempt to goal-seek a preferred outcome. The Phillips curve is meant to replicate graphically the relationship between inflation and unemployment, the idea being that an increase in price inflation goes along with a reduction in unemployment. Flattening it is the same as assuming that at a deemed level of full employment prices will not rise as much as previously modelled. 

But it is one thing to forecast such a relationship when the inflation “stimulus” is in the order of a few per cent, when arguably the public is more aware of the stimulation effect of monetary inflation than they are of the dilutionary effect on the money, but it is another matter when it is as dramatic as it is today. 

We must resist the temptation to accept a mathematical relationship between prices of goods and services and the rate of employment, such as predicted by the Phillip’s curve. Whatever the level of employment, production adjusts because of the division of labour. In their dismissal of Say’s law, modern economists fail to realise that production and consumption broadly march or retreat together. Other than users of currency being temporarily conned by the initial effects of monetary stimulation, there is no enduring relationship between the quantity of money and employment. 

Errors introduced by the mathematical economists through artifices such as the Phillips curve conceal the consequences of policies based on their forecasts at the outset. Consequently, the recommendations of senior economists at the Fed using economic models based upon macroeconomic assumptions give false comfort to the committees they advise. Furthermore, the annualised rate of the budget deficit since March was about $4.4 trillion, financed entirely through monetary expansion and significantly greater than covered by declining tax income. 

If these conditions persist in the new fiscal year — which seems increasingly certain, Kiley’s calculation of the further $3.5 trillion stimulus underestimates the problem. 

According to an op-ed by Allister Heath in today’s Daily Telegraph, Larry Summers, the US economist and arch-inflationist, believes that the cost of covid-19 will reach 90% of US GDP, substantially more than Kiley’s estimate of 30%.

Over-dramatic perhaps; but can we envisage that the forthcoming stimulus package, and then undoubtedly the one to follow that, will restore normality and set the budget deficit firmly in the direction towards a balance? If the answer is no, then we already have hyperinflation. 

Dispensing with the assumptions of mathematical economists

The error of the Phillips curve was to not understand why there is a point in the course of inflation where the currency’s users suspect that prices will continue to rise, and that a shift away from personal liquidity and saving in favour of consumer spending ensues.

That it is bound to happen beyond a certain point does not mean that the point and the subsequent effect on the general level of prices can be predicted — that is down to human action, the unpredictable response of individual actors to their changing circumstances. 

The Phillips curve is not the only error when it comes to understanding the effects of monetary inflation. Finding that the relationship between the expansion of money and the effect on its purchasing power varied, the mathematical economists introduced a variable factor to ensure the equation describing the money relationship with prices always balanced.

The monetary equation is as follows:

But by introducing a variable factor V to ensure the equation always balances, it disqualifies the utility of the equation itself: anything with two unequal sides can be turned into an equation by this artifice. The imagination of the monetarists brushes over this truth by giving the variable a pejorative name.

By calling it “velocity of money” it creates an image of the circulation of money. From there it is easy to assume that if money is underused, velocity of circulation drops and the economy is declared to stagnate, and if its velocity of circulation increases, it is said to be because money is demanded and circulates more effectively.

Falling velocity is thereby associated with falling prices for which nominal GDP is the proxy (P x T in the equation), and rising velocity is associated with rising prices and rising GDP. This concept is badly flawed, but it explains the fundamental precepts behind current monetary policy. 

The consequences of changes in relative preferences

Nominal GDP is not just the other side of the monetary equation. It is also total production, and the other side of total production is the sum of consumption and deferred consumption. The correct way to regard money is not through the monetary equation and the supposed role of velocity, but to look at nominal GDP as both the total of everyone’s income and profits, and the sum of their expenditures and net savings.

Only then can we consider the impact of changes in the money quantity on prices.

Money is merely a form of intermediation between the production and consumption of goods. People hold a degree of personal monetary liquidity, which when money is stable does not vary by much overall. This liquidity must not be confused with savings, which being consumption deferred, are not primarily held for their liquidity but for anticipated returns. Personal liquidity is held in reserve for personal consumption.

The general level of personal liquidity is the result of recent experiences of the value of money in terms of goods, modified by expectations of any change in the relative value of future goods. Thus, if people think the price of a good might rise, they will tend to buy it sooner than they would otherwise, and if they expect it to fall, they will tend to delay their purchase of it. In generally stable monetary conditions, this is why some prices rise and others fall. 

The trouble comes if for whatever reason people as a whole anticipate a rise in the general level of prices. In that case, they will alter the relationship between their monetary liquidity and goods in favour of goods more generally, driving the purchasing power of the money down and the general level of prices up.

The effect of changes in the general level of personal liquidity is potentially a more important influence on the level of prices than the quantity of money itself. It should be evident that if the increased quantity of money in circulation is simply hoarded, there will be no effect on the general level of prices. Alternatively, if the public decides to abandon a state-issued currency, irrespective of the quantity in circulation it will lose all of its purchasing power. 

The abandonment of a state-issued currency by the public terminates all hyperinflations and once the process is under way it tends to be rapid. In Weimar Germany, it was said this flight into goods and out of money began in May 1923 and lasted to mid-November. In the other European nations, which suffered collapses of their currencies in the early 1920s, the final process was equally swift. 

The form of today’s monetary collapse

The first thing to consider is the current relationship of the quantity of money to the economy. US dollar M3 money supply, the broadest definition of money, has increased along with US GDP: M3 stood at $18.327 trillion last July[iii], while second quarter GDP was estimated at $19.52 trillion[iv].

The closeness of the relationship between these two figures is explained by the nominal GDP total being inflated by increases in the money quantity. The match is never perfect, because there is always some consumer expenditure which is subject to estimates, future revisions, or simply not captured by GDP. To these we can add statistical error. Furthermore, at the beginning of the inflation there would have been a base level for GDP when money was sound from which subsequent inflations occurred. 

The degree of the dollar’s loss of purchasing power is deliberately understated in official statistics. Originally, the policy was to reduce the cost to US and other governments of indexation introduced following the 1970s decade of price inflation. It is remarkable that the statistical suppression of changes in the general level of prices, now adopted in all advanced economies, is rarely questioned.

Consequently, the scale of the fall in the purchasing power of fiat currencies has been ignored with some important consequences, at least for governments and their central banks, which are concealing evidence of the failures of monetary and economic policies.

Figure 2 compares the cumulative increase in the general level of prices measured by the CPI, and the Chapwood index — comprised of “the top 500 items on which Americans spend their after-tax dollars in the 50 largest cities in the nation”.[v] The Chapwood price inflation numbers used in the chart are the arithmetic average of the fifty cities, the last data points being end-June 2020. Additionally, the growth of M3 money supply is included.

It should be clear that changes in the general level of prices are a theoretical concept which cannot be measured, because it is different for every individual. An average is therefore no more than an indication, even assuming the evidence is not manipulated by vested interests. Bearing this in mind, the cumulative price effect of the official cities’ CPI over the last ten years is for it to have risen by only 19%, compared with the Chapwood index which rose 159%, compounding by about 10% annually. By way of confirmation that the Chapwood figures are closer to the truth, we see that USD M3 diluted the dollar by increasing 109% over the period. 

The lower increase in USD M3 relative to that of the Chapwood index suggests that as well as the dilution of the dollar’s spending power in a general sense, holdings of money have also been reduced relative to the commonly bought goods in the Chapwood index. In other words, consumers appear to show a relative preference in their spending for their common purchases over their less common purchases. This could be taken to be evidence of the earliest stages of a reduction of money balances in favour of everyday purchases. It is inconsistent with the official story upon which monetary policy is based, whereby the monetary authorities and their epigones delude themselves that price inflation is contained by the two per cent annual target, with some of them even claiming price inflation is banished for ever. 

Figure 3 further illustrates the ineffectiveness of monetary policy by expressing GDP in 2010 prices adjusted by the CPI (the state’s version of real GDP), by the Chapwood index and finally by M3 money supply. 

The monetary authorities claim that before the coronavirus crisis they had stabilised the US economy following the Lehman crisis. Measured by the CPI, by end-2019 the economy had grown by nearly 22% over nine years “in real terms”.

But because the CPI is a heavily supressed measure of price inflation, the truth is different. The Chapwood index and USD M3 tell us that adjusted by these measures, GDP has more than halved from $15,241bn to $6,818 and $7,309bn respectively, measured by a base of 2010 dollars. 

To be clear, GDP is simply a money total of all recorded transactions. It does not tell us anything about their quality, or indicate the degree of economic progress, or the lack of it. As always, there have been winners and losers. We can only conclude in the most general of terms that the contraction of real values has exposed the failure of monetary and economic policies. 

Where it really matters is for governments, and the purchasing power of the taxes they collect. 

A modern socialising government never reduces its expenditure, and budget deficits arise as a result of a reluctance to increase taxes to match spending. Prima facie it is evidence of an emerging hyperinflation, in that the decline in the purchasing power of the currency is driving the fall in the real value of taxation receipts, while at the same time it is realised that to raise taxes would be harmful to production, consumption, and therefore government finances. 

Then came the coronavirus, an unexpected hit to nominal GDP, upon which government tax income depends. And now we have a second covid-19 wave, the economic consequences of which can only be guessed. Let us not forget that before all this happened, last September there was an emerging liquidity crisis evidenced by the failure in the dollar repo market, indicating, in all likelihood, the end of bank credit expansion. And we should also remember that the trade tariff war between the world’s two largest economies brought the growth of international trade to a sudden halt.

Anyone with an eye for the economic consequences of all these developments can only conclude that in addition to the already growing gap between government spending and tax receipts, governments are not just having to rescue their tax bases from a one or two-off hit from the coronavirus, but further rounds of inflationary expansions will follow at an increasing pace. Purely in terms of money quantities, hyperinflation is already well entrenched for the US dollar and all other fiat currencies subject to the same political and factual dynamics. 

When the public wakes up…

Very few are conscious that hyperinflation is already with us, the majority of people only becoming aware when the consequences for prices become obvious. And as noted above, it is not a linear process, where M x V = P x T. 

V, or velocity, must be replaced by the human factor, where preferences change between holding a reserve of money liquidity and buying goods. The final flight into goods is a rapid process, which once started is impossible to stop. We have seen that the relationship between the rise in prices, as measured by the Chapwood index and the increase in dollar M3, suggests that the earliest stages of preferences for holding money are decreasing in favour of commonly bought goods: the process appears to have been subtly under way for a number of years.

Sceptics of the hyperinflation hypothesis might argue that the US Treasury owns over 8,000 tonnes of gold and could stop the rot at any time by returning to a gold standard.

One would hope so, but there is no sign that anyone in charge has the faintest clue of the true situation. Furthermore, having discarded gold as backing for the dollar forty-nine years ago it is inconceivable that the Fed and the Treasury would willingly put the clock back.

Furthermore, if I am right that the Chinese state not only controls physical gold markets but has a substantial cache of undeclared bullion, reinstating gold’s monetary role would be seen to hand enormous power to America’s enemies. Besides, so long as there is any value left in the dollar foreigners are likely to swap them for gold at the US Treasury. 

And that is before the neo-Keynesian macroeconomists submit themselves for retraining, expunging themselves of all their fallacies. No, the rotten ship USS Dollar is more likely to sink with the loss of all hands. 

Meanwhile, the Fed announced unlimited monetary inflation on 23 March. Shortly after, China began to accelerate sales of dollars in favour of stockpiling commodities, exhibiting the change in behaviour we can expect from the wider American public when it collectively realises it is money going down and not the prices of everything rising. Did 23 March, following which China is reported to have started dumping dollars at an increased pace for commodities, mark the beginning of the final flight into goods? 

It is certainly possible, in which case hyperinflation of the dollar and of most other paper currencies will likely end in a final, unexpected collapse in purchasing power in a matter of only a few months.

[i] Friedman (1970) The Counter-Revolution in Monetary Theory.

[ii] Kiley, Michael T. (2020). “Pandemic Recession Dynamics: The Role of Monetary Policy in Shifting a U-Shaped Recession to a V-Shaped Rebound,” Finance and Economics Discussion Series 2020-083. Washington: Board of Governors of the Federal Reserve System,



[v] See

Whoever wins the White House, there’s a new climate for investors

Shareholders should learn lessons of adaptation from business leaders

Gillian Tett 

© Ingram Pinn/Financial Times

As the US voted on Tuesday, I watched workmen board up businesses in Manhattan to protect buildings from protesters. Some (the offices of PwC) used plain wooden boards; others (Givenchy) had stylish barriers that projected their logo. One (Theory clothing) even featured cheery flowers on the wood.

All signalled three things: first, business leaders know the political climate is (sadly) creating profound new risks; second, many are braced for this to last; third, a few companies are putting a brave face on it and trying to adapt.

Investors should learn from them. Even if there is a clear outcome to the US presidential election soon, this week’s events are not an outlier — this is the culmination of a zeitgeist shift that has been building for a dozen years. Investors must recognise this, since it will not be reversed whoever next sits in the White House.

Think back to early 2007, just before the financial crisis. It was taken for granted by western business leaders and financiers — or “Davos man” — that globalisation, free-market capitalism, innovation and democracy were self-evidently good things that would only spread and deepen.

No, that did not mean investors accepted the “end of history” idea pioneered by historian Francis Fukuyama. But there was an assumption that the world was moving in one direction. That fostered confidence to plan ahead with a vision of time — and time horizons — as consistent as Newtonian physics.

No longer. Since 2008, faith in all four of those ideas has wilted. Globalisation is the most obvious case in point. As an annual metric compiled by DHL and NYU Stern Business school shows, the global integration of money and goods has slowed, even though the movement of people and information (via the internet) has remained more robust.

And in the case of the US, the White House is almost certainly set to keep embracing America-first policies whoever wins. The only difference is that the version of “patriotism” from the Democrats’ Joe Biden would sound cuddlier than Donald Trump’s, embracing global climate change initiatives and promoting a strategy of localisation tightly enmeshed with pro-union policies.

Free-market capitalism is also in retreat. That is partly because the US Federal Reserve has unleashed so many trillions of dollars of quantitative easing that financial market signals are being distorted. The divergence of equity prices from the real economy this year is one example of this.

But remember, too, that even under Mr Trump, politicians have been willing to provide government aid during Covid-19, be that for households or selected industries, such as coal. Meanwhile, the late 20th-century mantra of shareholder capitalism is on the retreat in the US and European business worlds.

That appals fans of Milton Friedman, the economist who laid out this shareholder mantra 50 years ago. However, Friedman’s acolytes should remember this: shareholder-first ideas were developed in the 1970s, when it was assumed that businesses could rely on the US government to solve societal problems, because the latter seemed competent. This is no longer the case.

Innovation is also contentious. The 2008 crisis made unfettered creativity in finance seem dangerous. This decade has demonstrated the dark side of digital innovation: the internet is eroding privacy, social media is undermining democracy and a winner-take-all digital economy is exacerbating income inequality. Investors should brace for more techlash (which matters, given that Big Tech and communications accounts for 45 per cent of the S&P 500).

Then there is the fourth issue that dominates headlines now: democracy. Thankfully, a Gallup poll suggests around two-thirds of Americans trust the judiciary, a level broadly unchanged in the last decade. But current events might yet undermine that. And even before the election sparked allegations of voter fraud, disenfranchisement and power grabs, only a third of voters told Gallup they trust the legislative branch — sharply down.

All this means the US has been sliding towards what the US military calls “Vuca”: volatility, uncertainty, complexity and ambiguity. This week’s events are a symptom of this, not a cause.

So how should investors respond? First, they should expect asset prices to be volatile. Second, they should remember that time horizons can change — and are now shortening. Third, they should note that it pays to embrace businesses with a “just-in-case” mentality, rather than the “just-in-time” philosophy that dominated the expansion of global supply chains in previous decades.

Last, they must realise that the environmental, social and governance trend, and stakeholder mantra, will remain whoever wins the election. That is not because ESG is a tool of activism; the key issue is that it is also a tool of risk management. In a Vuca world it pays to be resilient, and companies can only do so if they track the “externalities” that used to be excluded from economists’ models — such as income inequality or climate change.

Or to put it another way, investors should take a leaf from the book of those Manhattan store owners: batten down the hatches; accept that uncertainty will last; embrace lateral vision, not tunnel vision. Then adapt with some metaphorical flowers. 

As Turkey’s Economy Goes, So Goes Its Ambitions

Dire economic straits have forced the ruling party to reconsider its plans. 

By: Caroline D. Rose

Turkey’s economy is in dire straits. In September, the Turkish lira fell to a 20-year low as investors withdrew billions from Turkey’s currency bond and stock market. In a scramble to keep its currency afloat, the government has blown through almost half the foreign reserves it had at the beginning of the year. 

With little liquidity left and its largest banks on the brink of collapse, Ankara has realized that its current strategy of fueling economic growth through cheap borrowing cannot hold.

The country has been here before, of course. Just two years ago, it burned through its foreign reserves to protect the lira’s value and hid its debt problem behind defaults and bailouts. But this time is different. Turkey is drawing from far fewer reserves, relying only on Qatari currency swaps to keep them afloat, and its banking sector is depleted. 

Turkey is working with far fewer reserves and with a depleted banking system. Unless it fundamentally reforms its decrepit institutions – or receives a generous bailout – its economy is in trouble.

Economic duress can be an agent of change in any country, but in Turkey, with its history of coups and complicated relationship with secularism and Islamism, the ruling Justice and Development Party, or AKP, has even more cause for concern because of the potential geopolitical consequences it carries. Turkey has been quickly expanding its regional presence and influencing the behavior of neighboring countries through aggressive action in the Eastern Mediterranean and in northern Syria. 

But now that the coronavirus pandemic has slammed an economy already in trouble – and with an election just two years away – the ruling party will change its strategy, focusing its foreign policy closer to home and prioritizing regime survival at all costs.

How Did Turkey Get Here?

At the beginning of this year, Ankara had some room to breathe. In December 2019, the economy recorded 0.9 percent gross domestic product growth after a year of recession and debt. GDP growth rates had been fueled by cheap borrowing policies, which created a liquidity crisis and steep bank debt that devalued the lira by 30 percent against the dollar but raised inflation to nearly 12 percent in August. Put simply, the crisis revealed deep structural vulnerabilities in the Turkish economic system.

The problem is that, curiously, Ankara has continued to repeat many of the same mistakes it made before the 2018-19 recession. The government directed Turkey’s central bank to increase cheap loan distribution, which in turn put pressure on the lira and led to increased dollar borrowing from domestic banks to stave off devaluation. As investors began to bet against the lira, the government blew through $65 billion of its foreign reserves from the start of 2020. 

Eventually, interest rates put pressure on selling and drove the lira to all-time lows (roughly 7.7 lira to the dollar in September), even as the government kept rates below national inflation levels of 11.8 percent. President Recep Tayyip Erdogan prevented the ostensibly independent central bank from changing interest rates for months, concerned as he was that relaxing rates would worsen a future recession. Only in mid-September did Turkey finally adjust its interest rate from 8.25 percent to 10.25 percent, giving the lira a temporary boost to 7.62 against the dollar, but many believed it was too little too late. 

Turkey Gross Foreign Exchange Reserves

Naturally, the timing of Erdogan’s long-term plans will suffer. 2023 was supposed to be a big year for Turkey. It’s the country’s 100th birthday and a big year for general elections in which the ruling party was banking on a comfortable win. More important, it is supposed to be a year of promises kept. 

In 2013, the AKP rolled out a series of ambitious goals called “2023 Vision” that would be reached within a decade, including an increase in annual exports to $500 billion, slashing the unemployment rate from 11 percent to 5 percent, bumping per capita income to $25,000, boosting the country’s tourism and finance sectors, achieving full participation in state-operated health insurance programs, putting the country’s domestically made automobile, defense and iron and steel industries on the map, and becoming a top-10 economy, with a GDP target of $2.6 trillion. 

Turkey’s defense industry also set 2023 as its target to roll out eyebrow-raising military technology, promising to domestically produce 75 percent of Turkey’s defense needs, increase defense industry revenues to $26.9 billion, and roll out local drone, naval vessels, armored vehicles, helicopters and main battle tank programs.

It was always a tall order. But not only was it wildly expensive, it lacked attendant economic restructuring and institutional reform that would allow the country to manage high levels of spending. 

Though Turkey made progress on its automobile production industry, naval production, tourism sector and foreign trade volume, its financial institutions began to crumble.

Despite efforts to create the impression that the country was less in debt than it was, the Turkish government understood that it couldn’t forestall the coming recession. 

Time was limited, but the government hoped it could stay afloat until elections, distracting the public with a series of foreign policy ventures and a false sense of economic health. The pandemic made this untenable. 

Just months after it hit Turkey, reports emerged that Erdogan was serious about changing the date of the 2023 presidential election – bumping up the date not by a few days but two and a half years. 

Doing so would insulate him from the consequences of future bank collapses, economic struggle and inevitable fallout from COVID-19, salvaging the base of public support he currently has to keep a grip on power, or so the thinking goes. Calling snap elections would also prevent newer opposition parties from gaining momentum. 

While Erdogan has played coy by denying the idea of early elections and stating that “only the opposition” has circulated these rumors, the country’s economic health could force him to reschedule.

Where Will Turkey Go From Here?

Over the past year, Turkey has taken extensive and at times provocative actions to expand its presence along its periphery in the Mediterranean and the Levant, and outward into the greater Mediterranean, Red Sea and Horn of Africa – a pattern that resembles the country’s mighty predecessor, the Ottoman Empire. 

But to maintain this kind of momentum, Turkey must have a strong economy. If it can weather this financial storm, it can pursue its ambitions of becoming a regional power. 

If not, then Erdogan will have to fight just to maintain the gains Turkey has made so far.

Until election day – whenever that may be – survival will be priority one for Turkey’s government. Expect the government to double-down on its opposition, increase control over institutions of power, raise taxes, cut services and borrow more money. 

Ankara will try to scale back some of its most expensive commitments in faraway theaters – such as the Horn of Africa, the Arab Gulf and the Sahel – and reduce foreign military imports, hoping that its own defense industry will see it through. 

A slowdown on long-term defense projects – particularly conventional projects scheduled to debut in the next 20 years, such as Turkey’s second amphibious assault ship and a line of MILGEM frigates and corvettes – should also be expected.

But don’t think Turkey will stand down in the Mediterranean and the Levant. Turkey will look to politicize opportunities in its periphery to maintain popular support and preserve geo-strategic interests including by increasing the country’s energy independence, preventing violence from spilling over its southern border, defending itself against regional rivals, and so on. 

Even without the conventional equipment planned to debut in the next few years, Ankara can afford to maintain its strategy of gunboat diplomacy in Aegean littoral waters, using fishing, drilling and small naval vessels to keep up the pressure on Greece and Cyprus.

This strategy is, notably, politically popular at home. A majority of Turks want to renegotiate terms with Greece to expand Turkish maritime territory and thus to stake more claims to hydrocarbon resources in the region. They see Turkey’s harassment tactics as a means to those ends. 

Even the ruling party’s staunchest opponents in the Republican People’s Party support Turkey’s Mediterranean campaign. Likewise, Turkey will continue its operations in northern Syria and Iraq: It’s simply too important an issue to Turkish voters, who see it as the preservation of their borders against migrants and militant organizations.

The State of Play in Northern Syria

But none of this will necessarily lessen the pain of Turkey’s economic disrepair. Laborers at nuclear plants and construction sites are working without wages, with some initiating legal proceedings and protesting poor management. 

Many small-business owners have had trouble accessing state-subsidized loans, and workers are unable to obtain financial support, leading to higher poverty rates and food insecurity – largely among the AKP’s conservative, lower-class base. 

These economic conditions will force Turkey to provide some kind of economic relief and impact the future of the ruling party.