(What’s Left of) Our Economy: What’s with Those Financial Markets?

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bonds, bottom-line, budget deficits, central banks, correction, debt, Federal Reserve, Financial Crisis, financial markets, Great Recession, interest rates, leverage, monetary policy, profits, stocks, tax cuts, top-line, {What's Left of) Our Economy

Heckuva week on the world’s financial markets, eh? This post isn’t intended to provide any investment advice, but rather to shed some light on what strikes me as the most interesting question posed by the stock market correction and the related spike in bond yields: Why is it happening as evidence keeps emerging that the world economy (including America’s) is entering its best stretch of growth since the last (Great) recession ended in mid-2009?

Right off the bat, in the interests of full disclosure, the vast majority of my investments are in bonds (mainly munis) and bond proxies (high-dividend stocks whose share prices are relatively stable, so that their main value is spinning off income). This means that my main hope is that bonds keep doing well (notwithstanding their recent slump).

That said, it seems clear to me that the answer is that investors are worried that the stronger growth seen globally isn’t sustainable. Indeed they seem fearful that it’s about to come to an ugly end because the world’s central banks look more determined than in many years to at least limit the easy money conditions they created to fight the financial crisis (and ensuing recession), and to try to spark something of a recovery.

This kind of monetary policy tightening – or even a further slowdown in or halt to the loosening, which is what’s most likely in the near future – could create a pair of closely connected economic and financial dangers. First, slower growth could imperil the sales and profits of companies that issue stocks, which could depress their prices. And P.S.: Despite the record central bank stimulus, growth has been unimpressive enough. How much tightening is needed to tip the economy back into recession?

Of course, businesses all around the world have performed magnificently in boosting profits in a slow-growth environment, and this also goes for non-financial companies that haven’t been able to enjoy the full benefits of borrowing from central banks at super-cheap rates and lending at higher rates. But precisely because growth even during the recovery’s best periods so far has been sluggish despite the gargantuan stimulus, much of the profit improvement has come from improvements in the bottom line, keyed by cost-cutting (including keeping the lid on employee paychecks). Top-line growth – that is, stronger sales of products and services – has been more difficult to come by.

Since costs can’t be cut completely, and possibly not much further, a growth slowdown could greatly reduce these firms’ potential to increase profits going forward, and turn them into much less attractive buys for investors. And tighter monetary policy, including raising interest rates, historically has been pretty effective at slowing growth.

Just as important, low interest rates per se have super-charged stock prices. The reason? They greatly depress the total return on bonds, and thus greatly boost the appeal of stocks.

Of course, this raises the question of why central banks would take such actions, or even think (out loud) about them. The reasons are that they’re worried that all this easy money will ignite a new round of dangerous inflation, and that they’re concerned that, because money has been so cheap for so long, borrowing consequently so easy, and mistakes therefore so easy to withstand, too much capital has been poured into risky investments. Central bankers are rightly concerned that this “mal-investment” eventually could imperil the entire financial system and hence the real economy just as it did during the previous decade. So they’re hoping they can wean the world off this sugary diet.

The challenge they face is making sure “the patient survives,” or doesn’t become gravely ill again. After all, the previous decade’s financial crisis showed that when dubious investments reach a certain level, creditors can start doubting borrowers’ ability to repay or even service their debt even when the cost of money is very low. When they start to pull in their bets, panic can easily set in – and did.

These dangers become much greater when the cost of money starts to rise, which is exactly the situation the nation and world are in now. Just one indication of heavily indebted businesses are: According to Standard & Poor’s, one of the financial ratings agencies, in 2007 (just before the global bubble burst), 32 percent of the world’s non-financial companies were “highly leveraged” (i.e., up to their ears in debt). The latest figure? Thirty seven percent.

This corporate debt, of course, is relatively easy to service and manage when interest rates are very low. In a higher rate environment? Not so much. And don’t think creditors don’t know this. So that’s another reason that companies could start looking less appealing to investors, and if major debt servicing (much less repayment) problems emerge, credit channels could start seizing up just as they did ten years ago. On top of this prospect, all else equal, rising rates tend to be trouble for stock prices, as more and more investors decide to opt for (higher) guaranteed returns on bonds rather than riskier equities.

P.S. If you’re wondering whether higher rates could significantly increase the debt burden on the U.S. government, even without the immense new borrowing that will be needed thanks to the Trump administration’s tax cuts and the new big-spending Congressional budget compromise, the answer is, “You bet!”

Not that reasons for optimism about stocks in particular can’t be identified. Because the big ramp up in federal budget deficits that’s on the way will inject massive new resources into the economy, more growth will result. In principle, that new growth could convince the Federal Reserve to speed up its tightening – but perhaps not enough to offset the fiscal boost. Moreover, anyone who’s positive that the Fed will keep tightening in the face of either future stock market turbulence and/or weaker economic growth hasn’t been paying attention to its record in recent decades. The central bank has been, in the view of many, all too willing to keep the economic party going at all costs, and may well do so again.

One more bullish possibility for stocks – as they did during the previous decade, the leaders of stock-issuing companies decide to use most of their tax cut windfall to buy more shares of their own stock. The result would not only would prop up the share price, but in many cases boost their own compensation (which not so coincidentally is often based on that share price).

The most vexing aspect of both the investment and the economic situation is that, even though both may suffer in the short run, both urgently need to end their addiction to central bank stimulus and create the kind of foundation that will promote healthier, and thus longer-lasting (even if not faster) growth. Moreover, the longer the addiction lasts, the worse the cold turkey experience.

Because I doubt that either the Federal Reserve or the rest of the U.S. government has the spine to administer the needed policy medicine, I remain pretty bearish long-term on both the markets and the real economy, and will stay very conservatively invested. But the short term can be surprisingly long lasting; in fact, I’m surprised that the Fed’s high wire act has lasted this long. So I’m anything but an infallible guide to either. I’m just trying to be prepared for major trouble – whenever it decides to arrive.

 

(What’s Left of) Our Economy: Open Borders, the Goose, and the Golden Eggs

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Bernie Sanders, bubbles, central banks, developed countries, developing countries, Ezra Klein, Financial Crisis, free trade deals, Great Recession, Immigration, imports, incomes, investment, Jobs, New Economy, Open Borders, recovery, Sharing Economy, third world, Trade, Trans-Pacific Partnership, Vox.com, wages, {What's Left of) Our Economy

Since Ezra Klein is still young, he has time to learn what a bad idea it is to try being clever on unfamiliar subjects. Nonetheless, as made painfully clear in a new interview with Democratic presidential hopeful Bernie Sanders, the media wunderkind and Vox.com founder would be well advised to learn this lesson sooner rather than later, at least when it comes to how the global economy works.

Evidently trying to be clever, Klein tried to trip up the Vermont Senator by asking him how he could reconcile his avowed democratic socialism – and its presumed concern about global poverty – with his opposition to “sharply raising the level of immigration we permit, even up to a level of open borders….” Added Klein, “It would make a lot of the global poor richer, wouldn’t it?”

Sanders’ response was good. But he could have really humiliated Klein by reminding him that unlimited immigration would not only slash American living standards, but that it would ultimately backfire on developing countries as well. The reason is the same as that which argues, from a global perspective, against dropping all barriers to imports from the third world, and it springs from a reality as unmistakable as it is apparently unknown to Klein: American consumption is the goose that lays the developing countries’ golden eggs. To paraphrase that immortal adage, it’s “where the money is.”

Yet just as the United States ultimately can’t responsibly finance the consumption of enough third world imports to spur developing country progress unless its own economy remains truly healthy, it can’t ultimately provide opportunity for third world immigrants without maintaining genuine prosperity. And as Klein and other chattering class advocates of much freer immigration and trade policies should understand – but clearly don’t – the financial crisis demonstrated the heavy costs for everyone of forgetting this truth.

As I’ve written, thanks in large measure to more than a decade of U.S. job- and wage-killing trade deals focused tightly on developing countries, a critical mass of American workers lost the incomes they needed to support acceptable living standards by living within their means. Rather than change course on trade policy, the bipartisan Washington powers-that-be decided to enable the working and middle classes to at least run in place economically by borrowing, instead of earning. The economic meltdown and Great Recession that inevitably ensued inflicted damage worldwide.

Just as important, the historically feeble recovery that’s followed has claimed its share of third world victims, too. Slower American growth has helped crimp imports from China and the rest of Asia, thus sapping the vigor of these export-dependent countries. (Although, as this recent post shows, this phenomenon is easily exaggerated.)  The continuing U.S. malaise has also undermined employment opportunities for current and prospective immigrants from Mexico and the rest of Latin America. Meanwhile, because many global investors have become more risk averse since the last decade’s bubbles burst, and because Wall Street regulations have (necessarily) tightened up some, much international capital has forsaken developing country market and fled to the safety of the United States.

Do Klein and his ilk really believe that admitting a flood of overwhelmingly low-wage, low-skill immigrants will turn this situation around and help anyone, at least for any serious length of time? The only possible justification is a belief, contrary to the evidence and common sense, that the newcomers could rise up the U.S. income ladder as quickly as previous immigrant cohorts. The same question applies to boosting American imports from developing countries – which other supposed experts have touted as a prime reason for supporting President Obama’s Pacific Rim trade deal. Moreover, as I’ve just reported, import- and offshoring-friendly American trade policies could also start victimizing recent immigrants – and choking off opportunities for their successors.

In a perfect world, of course, inhabitants from poor countries could move to wealthier countries any time they wished, and they and the native-born populations would all live happily ever after. Alternatively, in a perfect world, third world populations could supercharge their incomes by providing their first world counterparts with an indefinitely growing supply of increasingly advanced products. Americans (and in principle, Europeans and Japanese) would all support themselves by finding themselves jobs in the New Economy, or the Newer Economy, or the Sharing Economy, or whatever fantasy economic utopians conjure up. Or maybe central banks could keep trying to shatter ever-soaring records for money-printing,

In that perfect world, however, we wouldn’t need economics, or economics. And we certainly wouldn’t need economic journalists like Ezra Klein.

(What’s Left of) Our Economy: America’s Real Stake in China’s Stock Meltdown

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central banks, China, China meltdown, China stock markets, currency, currency manipulation, Federal Reserve, financial reform, IMF, monetary policy, Obama, PBOC, reserve currency, TPP, Trade, Trans-Pacific Partnership, yuan, yuan internationalizaton, {What's Left of) Our Economy

Today’s big financial news story was the record daily plunge in China’s main stock market – the Shanghai exchange. (I know the term “market” is a complete misnomer for an arrangement so thoroughly controlled by the government; I just use it as shorthand.) Those who follow such matters know that this latest nosedive is prolonging a vicious bear market Chinese stocks that began in early July, and that could have knock-on effects throughout the world economy in forms ranging from continued downward pressure on raw materials prices, to strengthened overall deflationary forces (which are a major threat to global recovery), to severely damaged prospects for Apple Computer. (This longtime U.S. stock market winner has become ever more dependent on booming sales in China and, just as important, its share prices are ever more dependent on perceived chances of more of the same.)

So clearly, both investors and economists understand that China’s stock market woes will reverberate far beyond China – whether they greatly slow down China’s growth rate or not. I’d like to add one more impact – on China’s plans to internationalize its currency, which greatly affect the yuan’s value and, in turn, U.S.-China trade flows and the fortunes of American manufacturing. And anything that affects a portion of America’s productive economy as important as manufacturing is bound to affect its chances for sustainable prosperity.

One of the biggest challenges facing China’s leaders today is reconciling two goals that at least in the short run seem mutually exclusive. The first is that internationalization of the yuan. This would be a difficult objective even in the best of circumstances for China. The benefits would be considerable: A currency widely used by the rest of the world in trade and other commercial transactions, and even better, one awarded reserve currency status by the International Monetary Fund, would be a currency that would increase China’s monetary and therefore economic independence.

No longer would China’s own price levels, competitiveness, inflation rates, growth rates, and attractiveness to domestic and foreign capital depend so significantly on the whims of central banks from today’s reserve currency countries, and especially the U.S. Federal Reserve. Indeed, China’s own monetary policy could influence over other countries’ economies to a degree. Just as important, reserve currency status would reinforce the idea that China had genuinely arrived as a global power – a status reportedly highly valued by Beijing.

At the same time, these benefits still lie very far in the future, since although the yuan’s use in international business is rising rapidly, it’s still at very low levels. One big reason is that neither Chinese nor foreigners are very free to trade China’s currency, though exchange and trading controls have eased a bit in recent years.

Meanwhile, the yuan internationalization drive is already exacting costs. The small degree of liberalization that has occurred reduced the Chinese government’s once-absolute control of its own financial system – meaning its ability to determine how resources are invested. For an economy that’s still dominated by the state, that’s a big deal.

In addition, because China’s version of a central bank in particular seems to realize that a globally used currency needs to be tradeable, and reportedly views it as an aid to broader financial reform, it has allowed the yuan’s value to rise to levels much closer to those that would be deemed appropriate by market forces – at least judging from the yuan trading markets that have sprung up outside China in recent years. As a result, Chinese goods have lost some price competitiveness in China and other markets against goods made by most rivals – including the United States. For an economy whose growth and job-creation still rely heavily on exports, that’s a big deal, too.

Adding to these yuan internationalization problems – these are not the best of times for China. Far more important than the stock market plunge is a growth slowdown that is widely thought to be more dramatic even than the one revealed by official Chinese economic data. And yet the stock meltdown could turn into another big drag on the broader economy if it begins to undermine the confidence of consumers and businesses, and if it starts creating political turmoil by puncturing the aura of economic competence that’s been at the heart of the government’s perceived legitimacy.

Although the Chinese regime’s future is hardly resting on a knife-edge, any lengthy period of subpar growth – and any lengthy pause in the rise of Chinese living standards – could confront China’s leaders with the kinds of tests they’re not used to taking. That’s why I suspect that if push comes to shove, and the economic falters sufficiently, even a regime representing a culture known for thinking and planning long term will suspend the internationalization campaign and start encouraging yuan weakening again. Indeed, Beijing followed precisely this course during the mid-1990s. The conventional wisdom believes that meaningful devaluation is no longer possible, since it would speed up capital flight that appears already to be unprecedented. But I don’t believe that Beijing would hesitate for a moment to reestablish tight capital controls in response. 

Of course, this kind of Chinese currency gambit would work even in a slow-growing world, by enabling artificially cheap Chinese products to boost their share of foreign markets, and help China expand at the expense of its trade partners. Yuan weakening will fail if the rest of the world, especially the United States, pushes back. President Obama seems an unlikely candidate to lead or even participate in this charge. His administration’s view, as made clear in the debate over fast track trade authority and his Pacific Rim trade deal, is that largely because China (a prospective member) has let the yuan strengthen, no measures are needed in trade agreements to ban the practice. As a result, unless and until Congress changes its mind on the issue, Americans will need to hope that Mr. Obama is right that past won’t be prologue.

(What’s Left of) Our Economy: The Real Economics of Currency Manipulation

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central banks, currency manipulation, currency wars, devaluation, exchange rates, fast track, Federal Reserve, Financial Times, Great Depression, John Plender, Obama, protectionism, QE, Robert Aliber, TPA, TPP, Trade, Trade Promotion Authority, Trans-Pacific Partnership, University of Chicago, {What's Left of) Our Economy

Since Congress is finished with its fight over fast track negotiating authority for President Obama, and the next big trade deal in the offing – the Trans-Pacific Partnership (TPP) – is still being negotiated, issues like foreign currency manipulation have virtually disappeared from the media.

That’s more than a shame, since the effects of China’s longstanding exchange-rate protectionism – which gives Chinese-made goods artificial price advantages in all global markets – still weigh on American manufacturing production and employment.  And let’s not forget that Mr. Obama and Congress’ Republican leadership successfully beat back efforts to include strong disciplines on manipulation in the TPP – even though prospective TPP member Japan looks like another huge manipulator.

Here’s hoping, though, that when these subjects return to the spotlight, decision-makers will read John Plender’s excellent post in yesterday’s Financial Times explaining why this predatory practice needs to be abolished – and not just for America’s sake.

Plender makes two main contributions to the heated currency manipulation debate. First, he explains that the main argument against curbing manipulation is a straw man. It doesn’t much matter whether national currencies weaken because the governments in question are explicitly seeking trade advantages or not. It’s true, as manipulation soft-liners note ad nauseam, that the recent spate of central bank monetary easing policies pursued all around the world generally has been bound to weaken their countries’ currencies. It’s also true that America’s own Federal Reserve has eased massively itself – though the dollar has remained strong over the long run partly because of its unique status as the world’s predominant currency, and partly because the U.S. economy has outperformed that of most other major powers lately.

But as Plender notes, the distortions to trade flows take place all the same. He could have added, as opposed to only suggesting, a point I keep making: Monetary easing by a trade- and export-led economy (like China’s or Japan’s) is much likelier to stem from trade-related concerns than easing by a consumption-led economy like the United States. (Other considerations let America off the hook, too.)

His second contribution: observing that the universally condemned currency devaluations that helped deepen the Great Depression were by no means all made to beggar trade partners. Yet as trade policy critics are constantly reminded, trade flows suffered anyway. In fact, Plender cites this stunning claim from University of Chicago economist Robert Aliber: measured in terms of the worldwide trade imbalances that have resulted, “today’s currency wars are more severe than those of the 1930s.”

Indeed, this is a great opportunity to revive another point I’ve made in the context of of the fast track/TPP currency manipulation debate: The devaluations of the 1930s and the economic and military calamities they brought closer taught the American and other architects of the post-World War II global economic order a seminal lesson: that such currency movements needed to be controlled in order to create and maintain a viable international trade system. Unless Mr. Obama and his fellow globalization cheerleaders now believe that this conviction was wrong, they need to make sure that U.S. policy helps end or severely punish manipulation, and finally treat genuinely free trade like a priority, not a talking point.

(What’s Left of) Our Economy: A Central Banker Who Gets it on the Productive Economy

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Bank of Canada, Canada, central banks, dual mandate, exports, Federal Reserve, Financial Crisis, Janet Yellen, manufacturing, monetary policy, recovery, Stephen S. Poloz, Trade, {What's Left of) Our Economy

I know, I know – what could be more boring (except for Canadians or for a trade or manufacturing geek) about a Bloomberg piece on trade and manufacturing in Canada (which just happens to be America’s biggest trade partner)? But here’s the thing: This article and related material speak volumes about how the economic leaders of America’s northern neighbor value the productive sector of their economy, including manufacturing, and how their counterparts in the United States evidently don’t.

The article is highlighted – at least for me – by passages from a December speech by Bank of Canada Governor Stephen S. Poloz that dealt in part with exports, manufacturing, offshoring, and how they affect Canada’s present and future economic performance. Poloz is Canada’s Janet Yellen. Can you imagine the chair of the U.S. Federal Reserve dealing with these subjects in any depth? I can’t either. (As I recently noted, Yellen did write one trade article – in 1998, when she was a White House economist – but it was overwhelmingly theoretical, and pretty stale at that.)

Trade and manufacturing were by no means Poloz’ main subjects. But he did specify that one big reason for Canada’s continuing need for economic stimulus so many years after the global financial crisis struck was that “we saw significant destruction in our export sector….We have been waiting for a resumption of export growth….”

Moreover, thanks to that Bloomberg article, we know that Poloz went into considerably more depth during the question and answer session. For example, he told his New York City audience that during its last period of low global demand and a strong Canadian dollar, his country lost between 8,000 and 10,000 exporting companies. He also acknowledged that the Bank of Canada’s models overestimated how quickly the country’s exports would recover because its model could not recognize the loss of these producers. Indeed, according to Poloz, “When companies downsize, relocate or close their doors, the effects on the economy are permanent.” And he went on to estimate that lost production from underperforming, non-energy exporters cost Canada about C$30 billion ($24 billion) in 2013.

To me, it’s not only inconceivable that Yellen – or any other Federal Reserve board members or regional bank presidents would know the comparable U.S. data. It’s unimaginable that they would even seek it – much less display any ability to talk about these subjects in any meaningful detail.

In fairness, the Canadian economy is much more export-dependent than America’s. Moreover, Poloz has a high level background in Canadian government export promotion. But the story of the financial crisis and its impact in the United States ultimately is the story of how catastrophe was nearly produced by over-reliance on finance – including crackpot innovations and simple over-borrowing and spending – and neglect of the real economy that turns out everyday goods and services.

As a result, America’s only genuine hope for real recovery is a great strengthening of that real economy. And given the economy’s continuing consumption-heaviness and immense debt levels, promoting net exports is a no-brainer. In particular, every success it achieves reduces the need for unaffordable tax cuts and spending increases, and for the super-easy monetary policies that even Fed officials fear will dangerously distort investment incentives.

In fairness to the Fed, it’s not supposed to make policy outside its mandate of fostering full employment and stable prices, and its responsibilities for regulating finance (which are shared with various federal agencies). But its analytical influence is unmatched, and some sign that the central bank recognized the centrality of the real economy just might give President Obama and the Congress the kick in the pants they need to encourage productive activity. It might also just remind the Fed itself of the long-term importance of normalizing its monetary stance as soon as possible.

(What’s Left of) Our Economy: The Biggest Bubble of Them All

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bubbles, central banks, Federal Reserve, Financial Crisis, investing, stocks, {What's Left of) Our Economy

As all savvy investors are supposed to know, the Dow Jones Industrial Average breaking through the 17,000 mark – as it still could today – means bupkis. That is, it’s one of those round-number psychological levels that only suckers take seriously. Not that that will stop the financial news networks from continuing to obsess about this milestone, or the headlines from trumpeting it, if and when the moment comes.

Still, Dow 17,000 (like the somewhat more distant S&P 500) is a useful occasion for again contemplating the yawning disconnect between record asset prices pretty much all over the world and historically humdrum levels of growth and job creation in the real economy that of course have been artificially juiced by central bank stimulus.

I buy the standard explanation – that the very stimulus that has dramatically depressed interest rates in practically all major countries has spurred investors to seek the higher returns offered so far by equities and by tangible assets like real estate (but not necessarily like gold). I also buy the slightly-less-standard explanation that American businesses in particular have gotten so good at doing more with less that they can keep racking up record profits despite laying off many of their best customers (their workers), and driving down the wages of many others.

And I buy the widespread worry that none of this is sustainable, even with brazen enabling by the Federal Reserve, which artificially props up purchasing power throughout the U.S. economy (although I remain stunned at central bankers’ abilities to keep this high-wire act going as long as they have). But my main concerns are slightly different from the usual, because my analysis of the situation adds one element that’s typically neglected.

As I see it, the U.S. multinational companies that dominate stock trading in America have sold investors on a theme they can’t advertise in public but that’s been consistently and broadly suggested in analysts’ conference calls for two decades. They’ve made clear that they view the U.S. consumers that they’ve employed as being ultimately expendable because literally billions of new consumers in developing countries will steadily take their place.

There’s no doubt that a great deal of wealth has been created since the 1980s in countries like India and Mexico and especially China – along with a new generation of avid shoppers at many income levels.

But here’s the problem: As I showed in this article earlier this year, the best data available show that only 30 percent of third world workers earn the equivalent of $4 per day or more. And that figure is based on a way of measuring incomes across borders that greatly exaggerates their ability to buy products made in high-price/high-cost countries like the United States.

So to me, anyway, the U.S. consumer looks irreplaceable, even for the most efficient multinational company. We’re still a ways from the point where American consumers will have to be entirely or even largely replaced. But we keep moving closer to it thanks to the trade policies that Washington has pushed for roughly two decades – which keep needlessly sending overseas so much of America’s most valuable production, and so many of its family-wage jobs.

Think of it this way: Offshoring-friendly and other shortsighted U.S. trade policies keep sending consumption power to populations that for decades will remain far too poor to consume and import anywhere near what their prodigious numbers would suggest. And they keep stripping the world’s leading consumers – Americans – of much of the income-earning opportunities they need to pay for their consumption responsibly.

The unheard of global trade and investment and credit imbalances created by these trade policies have already blown up in the nation’s face – and indeed, the world’s face – in the form of the 2008 financial crisis whose stage they helped set. With the U.S. trade deficit now rebounding steadily from its recession lows, a repeat seems inevitable without a major policy course correction.

My forecast? (And please – do not take this as investment advice!) There’s no reason to expect that the troubles of the real economy will catch up with roaring financial markets. That is, this biggest bubble of them all will keep inflating. Until it bursts.