Tag: Trade War

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Hope is not a strategy

Bob Doll’s outlook this week at Nuveen Investments is less bearish than my own:

Trade-related risks seem to be growing. President Trump looks to be holding out hope that the U.S. economy will stay resilient in the face of escalating tariffs and rising tensions. So far, the U.S. economy has not faltered, thanks largely to continued strength in the consumer sector and labor market. But if business confidence crumbles (as it has in parts of Europe), it could lead to serious economic damage…..

The president’s recent actions to delay the implementation of some new tariffs show that he is sensitive to the market impact of his trade policies. But the erratic nature of his on-again, off-again approach adds too policy uncertainty. At this point, we can’t predict the ultimate economic impact from these issues. Our best guess is that the U.S. remains more than a year away from the next recession, but risks are rising. In addition to the solid consumer sector, we don’t see financial stress in the system. Liquidity is still broadly available, and fixed income credit spreads are generally stable outside of the energy sector.

With additional Federal Reserve rate cuts already priced into the markets and bond yields falling sharply, the only catalyst for better equity market performance could be improving global economic data. We hold out hope that the global economy will improve, and still think there is a better-than-even chance of manufacturing activity and export levels to grow. But those improvements will take some time, suggesting equities will remain volatile and vulnerable for now.

Where we seem to differ is on the inevitability of the US-China trade war escalating into full-blown disengagement. This week’s events have not helped.

China’s national English language newspaper, Global Times, under the People’s Daily, announced new tariffs.

Global Times

Followed by an admission that the timing of the announcement was intended to cause maximum disruption to US stock markets.

Global Times

The inevitable Twitter tantrum ensued.

Donald Trump

The President also tweeted “Now the Fed can show their stuff!”

He is deluded if he thinks that the Fed can help him here. The best response would be announcement of a major infrastructure program (not a wall on the Mexican border). Otherwise business confidence will decline due to the increased uncertainty. Business investment will contract as a result and slow employment growth.

Retail sales have shown signs of recovery in recent months but will decline if consumer confidence erodes.

Retail Sales

Especially consumer durables such as light motor vehicles and housing.

Consumer Durables Production

The global economy is already contracting, as indicated by falling crude oil

Nymex Light Crude

…and commodity prices.

DJ-UBS Commodity Index

Volatility (21-Day) is rising as the S&P 500 tests support at 2840. Breach is likely and would test primary support at 2750.

S&P 500 Volatility

Bearish divergence (13-Week Money Flow) on both the S&P 500 and Nasdaq 100 (below) warn of selling pressure. The Nasdaq 100 is likely to test primary support at 7000.

Nasdaq 100

The Russell 2000 Small Caps ETF (IWM) is testing primary support at 146. Follow through below 145 is likely and would signal a primary down-trend.

Russell 2000 Small Caps ETF

Fedex breach of support at 150 would also warn of a primary down-trend and slowing activity in the US economy.

Fedex (FDX)

We maintain our bearish outlook and have reduced equity exposure for international stocks to 40% of portfolio value because of elevated risk in the global economy.

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The Long Game: Why the West is losing

Autocracies like China, Russia and Iran are challenging the dominance of Western democracies. Much has changed in the last two decades, fueling this emerging threat to the free world.

China & Global Trade

China joined the WTO in 2001 and disrupted global trade. Subsidy of state-owned or state-sponsored industries tilted the playing field. Manipulation of exchange rates, amassing $4 trillion of foreign reserves, helped to depress the yuan, creating a further advantage for Chinese manufacturers.

Manufacturing employment in the US shrank by more than 5.5 million jobs between 2000 and 2010.

Manufacturing Jobs USA

Europe experienced similar losses.

Manufacturing Jobs UK, France & EU

Output recovered, but through a combination of automation and offshoring labor-intensive activities, manufacturing jobs were never restored. Losses of 4 million US manufacturing jobs (23.5% of total) and an equal 4 million (10%) in the European Union appear permanent.

Manufacturing US & EU

The Global Financial Crisis

The global financial crisis (GFC) in 2008 and the recession caused soaring unemployment and further alienated blue collar workers.

Unemployment US & EU

The $700 billion bailout of the banking system (Emergency Economic Stabilization Act of 2008), with no prosecutions of key actors, undermined trust in Federal government.

The Rise and Decline of Nations

Mancur Olson, in The Rise and Decline of Nations (1982), argues that interest groups — such as cotton-farmers, steel-producers, labor unions, and banks  — tend to unite into pressure groups to influence government policy in their favor. The resulting protectionist policies hurt economic growth but their costs go unnoticed, attracting little resistance, as they are diffused throughout the economy. The benefits, on the other hand, are concentrated in the hands of a few, incentivizing further action. As these pressure groups increase in strength and number, the costs accumulate, and nations burdened by them fall into economic decline.

Olson formulated his theory after studying the rapid rise in industrial power in Germany and Japan after World War II. He concluded that their economies had benefited from the almost complete destruction of interest groups and protectionist policies as a result of the war and were able to pursue optimal strategies to rebuild their economies. The result was that their economies, unfettered by pressure groups and special interests, far outstripped those of the victors, burdened by the same inefficient, protectionist policies as before the war.

Federal government, choked by lobbyists and special interests, failed to prioritize issues facing blue collar workers: global trade, off-shoring jobs and fallout from the GFC. Formation of the Tea Party movement in 2009 created a rallying point for libertarians and conservatives — supporting small government and traditional Judeo-Christian values1 — but it also opened the door for populists like Donald Trump.

Polarization

Exponential growth of social media, combined with disinformation and fake news, has polarized communities.

In 2017, 93 percent of Americans surveyed said they receive news online, with news organization websites (36%) and social media (35%) the most common sources. Trust and confidence in mass media has declined from 53 percent in 1997 to 32 percent in 2016, according to Gallup Polls.

Politics are increasingly dominated by outrage and division, with populist candidates gaining handsomely.

Many Western governments are now formed of fragile coalitions. Greece, Italy, Germany, even the UK.  Others in Eastern Europe — Poland, Hungary, Austria, Turkey — are heading towards autocracy.

The Long Game

China has been quietly playing the long game. Massive investment in infrastructure, subsidy of key industries, controlled access to its markets, upgrading technology through forced partnerships with Western companies in exchange for access to Chinese markets, and industrial espionage have all been used to gain an advantage over competitors.

The CCP exploits divisions within and between Western governments while expanding their influence in universities, think tanks and the media. The stated aim of the CCP’s United Front Work Department is to influence Chinese diasporas in the West to accept CCP rule, endorse its legitimacy, and assist in achieving Party aims. This includes some 50 million who emigrated after 1979 or are PRC students studying abroad. Stepped up surveillance of PRC students, funding of Confucius Institutes on campuses and growing student activism has raised concerns in Australia over academic freedom and promotion of pro-Beijing views3.

Western governments seem unable to present a coordinated response. Absence of a cohesive, long-term strategy and weakened alliances make them an easy target.

Pressure Groups

Governments are also subjected to pressure from within. The latest example is pressure exerted, by US companies, on the White House to lift the ban on sales of US technology to Huawei. From the New York Times a few days ago:

Beijing has also pressured American companies. This month, the Chinese government said it would create an “unreliable entities list” to punish companies and individuals it perceived as damaging Chinese interests. The following week, China’s chief economic planning agency summoned foreign executives, including representatives from Microsoft, Dell and Apple. It warned them that cutting off sales to Chinese companies could lead to punishment and hinted that the companies should lobby the United States government to stop the bans. The stakes are high for some of the American companies, like Apple, which relies on China for many sales and for much of its production.

Short-term Outlook

The problem with most Western democracies is that they are stuck in a short-term election cycle, with special interest groups, lobbyists for hire, and populist policies targeted at winning votes in the next election. Frequent changes of government lead to a lack of continuity, ensuring that long-term vision and planning, needed to build a winning global strategy, are woefully neglected.

Autocrats like China, Russia and Iran are able to play the long game because they enjoy continuity of leadership. They do not have to concern themselves with elections and the media cycle. They own the media. And elections, if held, are a mere formality, with pre-selected candidates and pre-ordained results.

Western democracies will have to adapt if they want to remain competetive in the 21st century.

Focus on the Long-term

Switzerland is one of the few Western democracies that is capable of a long-term focus. Their unique, consensus-driven system ensures stability and continuity of government, with buy-in from all major political parties. The largest parties are all represented on the 7-member governing Federal Council, elected by Federal Assembly (a bicameral parliament) for four-year terms on a proportional basis. There has been only one change in party representation on the Federal Council since 19592.

Cohesiveness and stability provide a huge advantage when it comes to long-term planning.

Conclusion

Regulating global trade, limiting the threat of social media, ensuring quality journalism, protecting academic freedom, guarding against influence operations by foreign powers, limiting the power of lobbyists and special interest groups — all of these require a long-term strategy. And buy-in from all sides of the political spectrum.

We need to adapt our current form of democracy, which has served us well for the last century, but is faltering under the challenges of the modern era, or risk losing it all together. Without bipartisan support for, and commitment to, long-term policies, there is little hope for building a winning strategy.

The choice is ours: a highly-regulated, autocratic system where rule of law is the first casualty; a stable form of democracy that ensures long-term continuity and planning; or continuation of the present melee, driven by emotion rather than forethought, populist leaders, frequent changes in government — and subservience to our new autocratic masters.

Footnotes:

  1. Wikipedia: Tea Party movement
  2. Current Federal Council representation is 2 Free Democratic Party (liberals), 2 Social Democratic Party (social democrats), 1 Christian Democratic People’s Party [CVP] (Christian conservatives) and 2 Swiss People’s Party [SVP] (national conservatives), reflecting 76.2% of the popular vote in 2015 Federal elections. The SVP gained one seat from the CVP in 2003.
  3. The Diplomat: China’s United Front work – Propaganda as Policy
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No US-China trade deal

“On Monday, US President Trump told reporters that he would impose tariffs on an additional USD 300 billion of Chinese goods if Xi Jinping doesn’t meet with him in Japan.” ~ Trivium China, June 12, 2019

Trump is doing his best to kill any chance of a trade deal. He is making it impossible for Xi to turn up for a G20 meeting. To do so would be admitting defeat. Kow-towing to Trump would totally undermine Xi’s standing in China.

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Market uncertainty is likely to persist as US-China negotiations stall | Bob Doll

From Bob Doll at Nuveen:

“There have been several risk-off phases this decade, triggered by economic threats due to politically induced setbacks. However, the current sluggish global economy and weak trade, coupled with escalating trade tariffs and non-tariff barriers, is a worrisome combination. This is especially true because once protectionism has gained momentum, it may prove difficult to stop or reverse. While many risk asset prices are only off modestly from April highs, there’s an ominous undercurrent in global financial markets.

We have assumed that the pro-growth bias of both the U.S. and China would lead to a trade truce. That premise looks increasingly questionable, although a deal is always possible. Given that financial markets have not reacted more significantly, investors are still generally expecting the global economic expansion to persist.

Despite the longer-term power struggle, the constructive case for a trade deal between the U. S. and China was predicated on President Trump focusing on the short-term win, while the Chinese look to the longer-term. This difference in political time horizons made a deal possible. Now, the focus for both parties has shifted to long-term strategic objectives, resulting in a stalemate. A financial market downturn may be needed to break the impasse. An extended period of churning could develop if trade talks resume, but without signs of a resolution.

The current market weakness differs from prior periods of economic uncertainty during this decade. There has always been a path to a positive outcome for growth and risk assets, primarily via additional policy stimulus. However, the economic and market outcome this time has become more uncertain, and time will not work towards a positive outcome unless trade negotiations improve. Business sentiment will erode if mounting trade roadblocks and uncertainty do not diminish. Protectionism tops the list of recession catalysts, and a permanent deterioration in U.S./China trade relations could have adverse long-term revenue ramifications for global trade and growth.”

My thoughts:

  • A trade deal was never going to happen. Long-term objectives of the CCP and the US are in direct conflict and headed for a collision.
  • Trump deserves credit for confronting the issues rather than kicking the can down the road as Obama did (Paul Krugman highlighted the problem in 2010).
  • Trump is the least likely President to negotiate a peaceful resolution to this hegemonic struggle. Diplomacy and building trust are not his forte.
  • Trust is low, eroding any chance of a face-saving public accord.
  • An agreement would simply be a band-aid, not a long-term solution (see my first point).
  • The impact on business will not be catastrophic but earnings growth will slow.
  • The market is unsure how to react. Yet. If it does make up it’s mind that this is bad for business, there won’t be enough room in the lifeboats. A down-turn could be sharp and hard.
  • Sell down to the sleeping point.

” I am carrying so much cotton that I can’t sleep thinking about it. It is wearing me out. What can I do?”
“Sell down to the sleeping point,” answered the friend.

~ Edwin Lefevre: Reminiscences of a Stock Operator (1923)

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S&P 500 and the trade war

We are now headed for a full-blown trade war. Donald Trump may have highlighted the issue but this is not a conflict between him and Xi — it should have been addressed years ago — nor even between China and the West. Accusations of racism are misguided. This is a conflict between totalitarianism and the rule of law. Between the CCP (with Putin, Erdogan, and the Ayatollahs in their corner) and Western democracy.

Australia will be forced to take sides. China may be Australia’s largest trading partner but the US & UK are it’s ideological partners. I cannot see the remotest possibility of Australia selling out its principles for profits, no matter how tempting the short-term rewards (or threatened hardships). We have a proud history of standing up against oppression and exploitation.

Disruptions to supply chains and supply contracts in the US (and China) are going to be significant and are likely to impact on earnings. The S&P 500 reaction is so far muted, with retracement testing medium-term support at 2800. There is also no indication of selling pressure on the Trend Index. Nevertheless, a breach of 2800 is likely and would warn of a test of primary support at 2400.

S&P 500

Falling Treasury yields highlight the outflow from equities and into bonds. Stock buybacks are becoming the primary inflow into stocks.

10-Year Treasury Yields

However, corporate bond spreads — lowest investment grade (Baa) yields minus the equivalent Treasury yield — are still well below the 3.0% level associated with elevated risk.

S&P 500

Profits may fall due to supply disruption (similar to 2015 on the chart below) but the Fed is unlikely to cut interest rates unless employment follows (as in 2007). Inflation is likely to rise as supply chains are disrupted but chances of a rate rise are negligible. Fed Chairman Jay Powell’s eyes are going to be firmly fixed on Total Non-farm Payrolls. If annual growth falls below 1.0% (RHS), expect a rate cut.

S&P 500

This excerpt from a newsletter I wrote in April 2018 (Playing hardball with China) is illuminating: “In 2010, Paul Krugman wrote:

Some still argue that we must reason gently with China, not confront it. But we’ve been reasoning with China for years, as its surplus ballooned, and gotten nowhere: on Sunday Wen Jiabao, the Chinese prime minister, declared — absurdly — that his nation’s currency is not undervalued. (The Peterson Institute for International Economics estimates that the renminbi is undervalued by between 20 and 40 percent.) And Mr. Wen accused other nations of doing what China actually does, seeking to weaken their currencies “just for the purposes of increasing their own exports.”

But if sweet reason won’t work, what’s the alternative? In 1971 the United States dealt with a similar but much less severe problem of foreign undervaluation by imposing a temporary 10 percent surcharge on imports, which was removed a few months later after Germany, Japan and other nations raised the dollar value of their currencies. At this point, it’s hard to see China changing its policies unless faced with the threat of similar action — except that this time the surcharge would have to be much larger, say 25 percent.

I don’t propose this turn to policy hardball lightly. But Chinese currency policy is adding materially to the world’s economic problems at a time when those problems are already very severe. It’s time to take a stand.

Krugman (no surprise) now seems more opposed to trade tariffs but observes:

….I think it’s worth noting that even if we are headed for a full-scale trade war, conventional estimates of the costs of such a war don’t come anywhere near to 10 percent of GDP, or even 6 percent. In fact, it’s one of the dirty little secrets of international economics that standard estimates of the cost of protectionism, while not trivial, aren’t usually earthshaking either.”

Trump has to show that he is prepared to endure the hardships of a trade war and not kowtow to Beijing. But the chances of a reasonable response are unlikely.

Men naturally despise those who court them, but respect those who do not give way to them.

~ Thucydides (circa 400 BC)

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“Stocks rebound but sentiment soft”

From Bob Doll at Nuveen Investments. His weekly top themes:

1. We think the odds of a U.S. recession are low, but we also believe growth will remain soft for a couple of quarters. U.S. growth may bottom in the first half of 2019 following a relatively disappointing fourth quarter and the recent government shutdown. We expect growth will improve in the second half of the year.

Agreed, though growth is likely to remain soft for an extended period. The Philadelphia Fed Leading Index is easing but remains healthy at above 1.0% (December 2018).

Leading Index

2. Inflation remains low, but upward pressure is mounting. With unemployment under 4% and average hourly earnings rising to an annual 3.6% level, we may start to see prices rise. So far, better productivity growth has kept the lid on prices, but this trend bears watching.

Agreed. Average hourly earnings are rising and inflation may follow.

Hourly Earnings Growth

3. Trade issues remain a wildcard. The U.S./China trade dispute appears to be making progress, but the timeline is slipping and significant disagreement remains over tariff levels and intellectual property protections.

This is the dominant issue facing global markets. Call me skeptical but I don’t see a happy resolution. There is too much at stake for both parties. Expect a drawn out conflict over the next two decades.

4. We do not expect Brexit to cause widespread market issues. We think the risk of a hard Brexit is low, since no one wants to see that outcome. Some sort of soft separation or even a Brexit vote redo appears more likely.

Agreed. Hard Brexit is unlikely. Soft separation is likely, while no Brexit is most unlikely.

5. The health care sector may remain under pressure due to political rhetoric. Health care stocks in general, and managed care companies in particular, have struggled in light of talk about ending private health care coverage. We think Congress lacks the votes to enact such legislation. But this issue, as well as drug pricing policies, are likely to remain at the center of the political dialogue through the 2020 elections.

Health care is a political football and may take longer to resolve than the trade war with China.

6. Downward earnings revisions may present the largest risk for stocks. As recently as September 30, expectations for first quarter earnings growth were +7%. That slipped to +4% by January 1 and has since fallen to -3%.

A sharp fall in earnings would most likely spring from a steep rise in interest rates if the Fed had to combat rising inflation. That doesn’t seem imminent despite rising average hourly earnings. The Fed is maintaining money supply growth at close to 5.0%, around the same level as nominal GDP, keeping a lid on inflationary pressures.

Money Supply & Nominal GDP growth

7. Equity returns may be modest over the next decade compared to the last. Since the bull market began 10 years ago, U.S. stocks have appreciated over 400%. It’s nearly impossible to imagine that pace will be met again, but we feel confident that stocks will outperform Treasuries and cash over the next 10 years.

Expect modest returns on stocks, low interest rates, and low returns on bonds and cash.

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China threatened by loss of US trade

The threat of a US-China trade war has rattled investors, with the Shanghai Composite Index breaking primary support at 2700 to signal another decline. Trend Index peaks below zero warn of strong selling pressure. Long-term target is the 2012 to 2014 lows at 2000.

Shanghai Composite Index

Hong Kong’s Hang Seng Index is also under the pump, breaking support at 28,000 to warn of another decline.

Hang Seng Index

Copper prices, a good barometer of the Chinese economy, are also falling. Breach of $6,000 offers a target of $5,500/tonne.

Copper S1

The Yuan has fallen almost 10 percent, testing support at 14.5 US cents. Failure of the PBOC to support the Yuan (by selling some of their $3 trillion of foreign reserves) may cushion the economic impact in the short-term but only invites further escalation from the Trump administration.

Chinese Yuan/USD

There is no easy way out. Trump clearly has the upper hand in trade negotiations.

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Trade Wars: Playing hardball with China

Remember North Korea and the imminent nuclear war? With leaders trading insults on Twitter and bragging: “My nuclear button is bigger than yours.” It may resemble a WWF arena more than international diplomacy but that is how Donald Trump conducts foreign affairs.

The current Twitter war over trade tariffs is no different. Threat and counter-threat of wider and deeper trade tariffs are likely to bounce back-and-forth over the next few weeks. Xi Jinping thinks he has the upper hand because he doesn’t face criticism from a hostile media at home. Nor does he need to front up to a hostile domestic opposition. They’re all safely tucked away in jail. His stock market has already crashed, so there is not too much to worry about on that front either.

Shanghai Composite Index

Xi will do his best to undermine Trump’s shaky support. Targeting Trump’s electoral base with tariffs on soy bean imports (farming states) and steel tubing (Texas) in order to undermine his support. Targeting technology companies like Boeing and Apple, where China is a large slice of their global market, is also likely to elicit strenuous lobbying in Washington. As are well-timed tweets aimed at undermining stock support levels, threatening a major stock market rout.

Dow Jones Industrial Average

Trump probably recognizes that China can withstand more pain, but figures that he has the capacity to inflict more pain. The US has a large trade deficit with China.

Twitter: US-China trade deficit

And exports comprise a larger percentage of China’s GDP.

In 2010, Paul Krugman wrote:

Some still argue that we must reason gently with China, not confront it. But we’ve been reasoning with China for years, as its surplus ballooned, and gotten nowhere: on Sunday Wen Jiabao, the Chinese prime minister, declared — absurdly — that his nation’s currency is not undervalued. (The Peterson Institute for International Economics estimates that the renminbi is undervalued by between 20 and 40 percent.) And Mr. Wen accused other nations of doing what China actually does, seeking to weaken their currencies “just for the purposes of increasing their own exports.”

But if sweet reason won’t work, what’s the alternative? In 1971 the United States dealt with a similar but much less severe problem of foreign undervaluation by imposing a temporary 10 percent surcharge on imports, which was removed a few months later after Germany, Japan and other nations raised the dollar value of their currencies. At this point, it’s hard to see China changing its policies unless faced with the threat of similar action — except that this time the surcharge would have to be much larger, say 25 percent.

I don’t propose this turn to policy hardball lightly. But Chinese currency policy is adding materially to the world’s economic problems at a time when those problems are already very severe. It’s time to take a stand.

Krugman (no surprise) now seems more opposed to trade tariffs but observes:

….I think it’s worth noting that even if we are headed for a full-scale trade war, conventional estimates of the costs of such a war don’t come anywhere near to 10 percent of GDP, or even 6 percent. In fact, it’s one of the dirty little secrets of international economics that standard estimates of the cost of protectionism, while not trivial, aren’t usually earthshaking either.

I believe that Krugman’s original 2010 argument is still valid and that Trump is right in confronting China. The gap between imports and exports of goods is widening, especially since 2014, not shrinking.

Exports and Imports: Value of Goods for China

But let’s hope that Trump has done his homework. At this stage this is just a Twitter war rather than a trade war, intended to soften up your opponent rather than inflict real damage. But for Trump to succeed he must demonstrate that the US is prepared to endure the pain of a lengthy trade war if needed.

Men naturally despise those who court them, but respect those who do not give way to them.

~ Thucydides (circa 400 BC)

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Five Challenges facing President Obama

On his inauguration in 2009, Barack Obama inherited a massive headache from the GFC. With unemployment stubbornly above 9 percent, efforts to create new jobs have so far proved futile.

  • Low interest rates from the Fed failed to stimulate new investment. Richard Koo coined the phrase balance-sheet recession to describe private sector reaction to a financial crisis. Low interest rates have as much effect as pushing on a string. Corporations and households alike have no wish to borrow in the face of falling asset prices and erosion of their own balance sheets — and banks have little desire to lend.
  • Quantitative easing failed to lower long-term interest rates and stimulate employment. Instead it revived inflation expectations, creating a surge in commodity prices.
  • The trade deficit widened despite the falling dollar, reflecting an inability of US exports to compete in offshore markets — and a loss of manufacturing jobs as foreign exporters made inroads into US domestic markets.
  • Fiscal stimulus, whether through tax cuts or spending on education or infrastructure not only failed to create sustainable jobs but has left the taxpayer with a mountain of public debt.
  • The home construction industry, a major employer, remains stagnant. Inventories of new and existing homes amount to more than 12 months sales at current rates — when one includes “shadow inventory” of homes repossessed, in foreclosure, or with mortgages delinquent for 90 days or more.

Deflation threat
When the housing bubble collapsed, households and corporates were threatened by falling values and shrinking credit. Savings increased and were used to repay debt rather than channeled through the financial system into new capital investment. A deflationary gap opened up between income and spending: repaying debt does not generate income as new capital investment does. The gap may appear small but, like air escaping from a punctured tire, can cause significant damage to overall income levels as it replays over and over through the economy. The only way to plug the gap is for government to spend more than it collects by way of taxes, but the result is a sharp increase in public debt.

Five point plan
Companies are unwilling to commence hiring until consumption increases — and consumption is unlikely to increase until employment levels rise. The only solution is to create sustainable jobs while minimizing borrowing against future tax revenues.

  1. Stop importing capital and exporting jobs.
    Japan and China have effectively maintained a trade advantage against the US by investing more than $2.3 trillion in US Treasuries. The inflow of funds on capital account acts to suppress their exchange rate, effectively pegging it against the greenback. Imposition of trade penalties would result in tit-for-tat retaliation that could easily escalate into a trade war. Capital flows, however, are already tightly controlled by China and others, so retaliation to capital account controls would be meaningless. Phased introduction of a withholding tax on foreign investments would discourage further capital inflows and encourage gradual repatriation of existing balances over time. Reciprocal access to capital markets could then be negotiated through individual tax treaties.
  2. Clear excess housing inventories.
    Supporting prices at current levels through low interest rates will prevent the market from clearing excess inventory. Stimulating demand through home-buyer subsidies would achieve this but increases public debt and, as Australia discovered, leaves a “shadow” of weak demand if the subsidy is later phased out. Allowing home prices to fall, on the other hand, would clear excess inventory but threaten the banking sector. Shoring up failing banks also requires funding, although this could be recovered over time through increased deposit insurance.
  3. Increase infrastructure spending.
    Infrastructure projects should not be evaluated on the number of jobs created but on their potential to generate future revenue streams. Whether toll roads or national broadband networks, revenue streams can be used to repay public debt. Projects that generate market-related returns on investment also open up opportunities for private sector funding. Spending on education and community assets should not be funded with debt as they provide no viable revenue streams for repayment. The same goes for repairs and maintenance to existing infrastructure — they should be funded out of current tax revenues. Similarly, research and development of unproven technologies with open-ended budgets and uncertain future revenues.
  4. Raise taxes to fund infrastructure investment.
    Raising taxes to repay debt, as FDR discovered in 1937, has the same effect as a deflationary gap in the private sector and shrinks national output. But raising taxes to fund infrastructure investment leaves no deflationary gap and increases the overall level of capital investment — and job creation — within the economy.
  5. Increase austerity.
    Cutting back on government spending merely re-opens the deflationary gap between income and spending. Reducing regular spending in order to free up funds for infrastructure projects, however, would leave no deflationary gap while accelerating job creation within the economy.

Bi-partisan approach
The magnitude and extent of the problems facing the US require a truly bi-partisan approach, unsuited to the rough-and-tumble of a vibrant democracy. Generational changes are required whose impact will be felt long after the next election term. It will take true leadership to forge a broad consensus and set the US on a sound path for the future.

Published in the November issue of Charter magazine.

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