The Investor April 2018

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Coping with the dreaded Capital Gains Tax

My January column in which I analysed in depth the iniquity of Capital Gains Taxation which, the world over, generates comparatively little revenue for governments but dramatically hamstrings investors and entrepreneurs from making the most efficient capital growth decisions, has produced a lively discussion.

The bottom line was the offering of one reader that; “It is never wise to make business decisions just based on tax consequences”. That’s what I told my clients so I need to tell myself too! Still the pain of paying over the CGT…

The classic dilemma facing long-term share market investors who recognize the probability that one of those oft-recurring market corrections is both inevitable and might shortly be anticipated is that on average, the major market corrections of the past half century have seen declines of around 40 percent whereas the CGT penalty of selling out long-held shares held through a discretionary trust could be as high as 38 percent of the value of the portfolio.

In such circumstances, it is a no-brainer that the average investor will opt to simply ride it out because there is no way of gauging ahead of the event whether an anticipated correction will be bigger or less than average or, indeed, whether it will happen at all. The current bull market on Wall Street which has been the longest-lasting in modern history since it has effectively been entirely manipulated by the world’s central banks and their money-printing processes, so a correction is increasingly probable. There have already been a number of false starts which heighten the probability of a crash someday soon. So please consider the graph below of Wall Street’s S&P500 Index since the bottom of the 2008-9 “Sub-Prime” correction: It is clear that there were small corrections every other year. Between April and June 2010 Wall Street fell 14.4 percent. Then from April 2011 to October 2011 the market fell 19.5 percent. From March to June 2012 the market fell 7.7 percent and again from October 2015 to February 2016 the market fell 11 percent.

Market commentators have, furthermore, been warning for some time that the “Mother of all market corrections” might be expected this year and already between January 25 and February 7 we have seen a dip of five percent in what, most assume, is just the first round of a possible mega correction. In anticipation of this I have, in my Prospects portfolio, steadily disposed of nearly half our shareholdings so as to have cash in hand to be able to buy quality replacements when markets eventually bottom which, if my ShareFinder software is correct, will happen in July this year.

Now, as readers of the Prospects newsletter fully understand, the Prospects portfolio is a virtual event. In other words, we started out with a virtual investment of R1-million in January 2011 and have from time to time since then disposed of various shares which have no longer been top performers in terms of corporate profit growth. I thereafter systematically replaced them with other, better performers.

Since this has been a virtual portfolio with buys and sells based upon the artificial intelligence predictions of the ShareFinder computer program telegraphed ahead of the events in my Prospects newsletter, I have not had to personally worry about CGT. The resultant performance of the portfolio, as illustrated in the graph below was a world record-setting 22 percent a year growth which saw the portfolio rise from its original R1-million to a peak of R3 601 277 on January 24 this year when our market peaked. My graph below documents its actual performance:

Now, I am as averse to paying CGT as most of my readers and so in my own portfolio I have most of the time simply bitten on the bullet and held on to the underperformers. Furthermore, I have drawn off the bulk of the dividend income and so have not been able to provide significant amounts of capital in order to buy the better performers that have been highlighted by the ShareFinder program. And I have clearly paid the price of this because my personal portfolio has thus underperformed the Prospects portfolio achieving a compound annual average growth rate of 19.7 percent as illustrated in the next graph.

However, here is another important difference. In the Prospects portfolio we have accumulated the dividends and as these sums have risen to significant amounts I have used them to buy additional shares whereas in my personal portfolio I have largely spent this income.

So note that the aggregate dividend yield of the Prospects portfolio has been 1.3 percent. Thus, if I subtract 1.3 from the compound annual average price growth rate of the Prospects portfolio of 22 percent in order to make it comparable with my personal portfolio, I am left with a net return of 20.7 and, of course it would have been a lot less than that if I had been obliged to pay CGT on all the transactions that have happened within the portfolio since it was launched in January 2011.

The inescapable conclusion is that the one percent better annual growth of the Prospects portfolio is actually an illusion. I have actually done better in my personal portfolio by not being able to actively manage it.

A further sobering observation is that in one year I did opt to sell a portion of an investment in Sasol which at a Total Return rate of just 4.09 percent had long been dragging down my portfolio and, after paying the CGT I bought Coronation and MTN which have since lost me money. Had I left well alone I would have been significantly better off.

Now it might be argued that my original share selection for my personal portfolio was inspirational and such performances might not otherwise have been as good. However, I think the point has been made, that even with the best tools at one’s disposal, the price of inaction in the face of CGT need not be as severe as most of us imagine.

What actually happens in long-term portfolios like mine where the underperformers are not disposed of because of the CGT consequences is that these underperformers shrink in value relative to the exceptional performers and this dilution effect thus reduces the significance of the underperformance. There is, however, a risk in this phenomenon in that balance is disturbed and so if anything were to happen to the over-performers the negative consequences for the portfolio could be dramatic.

Here the remedy is clear: one should not draw down too large a portion of the dividend income in order that sufficient cash remain within the portfolio to affect purchases of new over-performers and thus constantly widen the spread of share holdings and consequently reduce volatility risk.

Which leads me to the theory that in a world where capital gains taxation is an ever-present problem, the desirable aim in portfolio development is to create sufficient capital such that when one comes in later life to be dependent upon that portfolio to supplement one’s lifestyle, one should have achieved a sufficient sum such that at least 50 percent of the income might be re-investable. By accordingly being able to add the latest top performers on a continual basis from the earliest possible stage one might accordingly bury the laggards.

Noting that The Investor has been a victim of its own success inasmuch as so many new readers have come aboard in recent years that unbeknown to us our transmission system became blocked and many of you have not received some of our recent issues, I have reprinted my January column immediately below since it has been one of the greatest talking points among our readers.

A Wicked Tax Law

Hamstringing South African investors!

By Richard Cluver

With our share market rising exponentially, most experienced investors clearly sense that the end is nigh. My ShareFinder software furthermore predicts that the up-trend could last until February 13 at best.

Meanwhile economists attending the World Economic Forum in Davos were last week warning, in the words of Harvard University professor Kenneth Rogoff “If interest rates go up even modestly, halfway to their normal level, you will see a collapse in the stock market”.

Behind this view is the fact that individuals and corporates have borrowed massively in the current low-interest rate environment and would be unlikely to be able to repay the debt as interest costs rise, particularly in the case of collapsing share, bond and property prices.

The impact is, furthermore, likely to be massively damaging to the world economy because Dollar-denominated debt held by emerging-market economies currently exceeds $5-trillion. The burden of that upon countries like South Africa would seem likely to precipitate a series of recessions across the planet.

My graph below shows how the JSE Overall Index has been rising recently, up 17 percent in the past 12 months and down dramatically yesterday: signs of a market nearing its end!

Clearly it is time for investors worldwide to start taking defensive action. The problem that faces them this time around however, is arguably one of the wickedest pieces of South African tax legislation ever enacted in that it effectively prevents people, who have saved diligently all of their lives so as not to be a burden upon their children and the State, from taking such defensive action by selling their shares ahead of the impending storm.

Unlike the situation in most developed nations where tax does not apply to the gain you have made within an investment portfolio provided the capital so generated is kept intact and paid into another suitable investment, in South Africa any transaction involving such investments is immediately taxed and the process can almost halve the value of an investment portfolio at one stroke.

Sell any shares bought within the past three years and you face Provisional Taxation on the “Profit” at the current marginal rate of 45 percent. If you have held the shares for longer, then if they are held within a family trust, you face a nearly as punitive penalty of 36 percent. Better off is the small investor who holds a few shares in his or her own name and has held them for longer than three years, but the punishment is still 18 percent of the gain.

How this impacts the investor can be well-illustrated if one looks at the performance of the virtual share portfolio that I maintain for readers of my Prospects investment newsletter. The four best performing shares in the portfolio have been Naspers which has risen 941 percent, Capitec which has risen 473 percent, Mr Price 355 percent and Famous Brands 200.7 percent. If these were sold the State would receive nearly half the value of the portfolio in its resultant tax claim.

With most analysts worldwide in agreement that global share markets are very overpriced and expecting that a downward correction might occur anytime soon, investors who follow the Prospects newsletter will obviously be considering selling with the object of being able to buy back again whenever the next correction has completed and share prices are once again at attractive levels. But faced with such a tax burden, most will obviously hesitate. After all, they will surely reason, can I lose as much as that if a market crash happens?

Furthermore, a majority of investors worldwide do not believe a crash is coming. As an example, US Analyst Jake Bernstein has created a daily sentiment image which currently indicates that 97 percent of traders are bullish about US markets. This is the highest figure seen in the past 31 years while a 13-week moving average of bullish positions, at 63.5% is the highest since February 1977. So often before, it has been precisely in such times of overwhelming confidence that market crashes have happened!

So let us consider what the potential loss could be for South African investors if such a crash were to occur? My graph below illustrates what happened to the JSE Overall Index during the 2007 to 2009 crash when the index fell from a peak value of 332 329 on May 22 2008 to a bottom of 171844 representing a loss of 48.29 percent. Here you can see that following the crash the market had not fully recovered until January 2012 though it came within an inch of doing so in February 2011 only to fall back again before trying to do so again a year later.

For individuals who have with equal providence built up an investment portfolio within which, for example, they currently hold Naspers shares bought less than three years ago, taking the example of the Prospects Portfolio which were bought at R357.14 per share and today stand at R3 717.81, the gain on a sale would be R3 360.67 per share and a sale would thus attract tax of R1 512.30 per share.

A large proportion of South African investors have, however, been persuaded over the years that it is prudent to create a family trust within which to house such portfolios because such trusts do not disappear with the death of the founder and so their savings can be preserved for the benefit of their children and grandchildren who, for example, in these difficult times when our education system is rated the worst out of 50 developing nations, might need to be educated in private schools where the fees are relatively high.

Were the Naspers shares to have been bought less than three years ago they would similarly be taxed at 45 percent within the trust. Had they been bought earlier than that, capital gains tax would apply and since in recent years CGT has been raised nearly every successive tax year from 20 percent when it was first introduced in October 2001 to a current 36 percent, one might expect it to become a steadily more limiting problem given the fact that the Government has effectively run out of money. However, taking the current level of CGT on trusts, given a capital gain on a sale of R3 360.67 per share, such a sale would thus attract tax of R1 209.84 per share.

Taking the entire portfolio which grew from an initial investment of R1-million in January 2011 to a current R3 522 216.36, selling would attract tax of R907 997.86.

So, if the 2007 crash were to be precisely duplicated in the near future, it is clear that the penalty for not selling ahead of the crash was nearly the same as it would have been for someone who sold shares held for under three years or out of a trust fund and been forced to pay capital gains tax on the proceeds.

Over the past 33 years South Africa has in fact experienced quite a number of quite severe corrections though, happily, not all have been as severe at the 2007 one. Here in South Africa we were less affected by the Dot Com bubble that burst in January 2000 but nevertheless the JSE All Share Index turned negative on January 17 2000 at a value of 92 260 and continued down until it bottomed on April 14 at a level of 66 320 for a loss of just 28.12 percent as depicted below. Furthermore, for those who simply held on through this phase, their fortunes had been restored by mid-February 2001

But between May 21 2002 and April 25 2003 South Africa experienced another bear market which took the JSE All Share Index down from 116 530 to a low of 73 612 for a 36.83 percent loss which took until September 2004 before investors saw their capital restored as illustrated in my next graph.

South African investors saw another sharp deterioration between April 20 1998 and September 10 the same year when the All Share Index fell 43.8 percent from a level of 83 580 to 46 940 as illustrated below.

In 1987 the market fell precipitously on October 19. From a peak value of 27 340 the JSE All Share Index fell to 19 590 by November 4 and then, after a brief very modest recovery, fell further to bottom at 15 220 representing an overall loss of 44.3 percent.

So, if you care to work it out, the five biggest crashes of the past 33 years on average cost investors 40.27 percent of their portfolio value. Of course that is no guarantee that the next crash will be as modest but from this it is clear that if the shares in your portfolio have been there for less than three years the probability is that it will cost you more in taxes to sell out in anticipation of a market crash than the crash is likely to cost you.

And it would be almost as costly if your shares have been yours for more than three years had you are invested via a family trust and you fear that a crash might wipe you out, the probability is that selling ahead of it might actually cost you almost as much in Capital Gains Tax as the effects of a crash.

The tax is grossly unfair upon those who opted to go without many of life’s little luxuries in order not to be a burden upon their children or the state in their declining years. Other, more progressive countries, do not levy CGT in such circumstances provided you re-invest the capital in an alternative capital preservation vehicle.

If our government really wanted to attract investment into this country it would modify CGT to bring it in line with other progressive countries. So for a moment let us consider what it would mean to investors if CGT were not to be applied; that you could sell ahead of an anticipated crash and subsequently buy back the same portfolio at a one third discount and see it grow back to its full previous aggregate price in an average of a little more than a year! Happily there are some options that allow you to in effect do just that.

You can insure against such a market catastrophe and protect your portfolio by taking out a “Put” which is the right to put a parcel of shares into the hands of another investor at an agreed price. Here the seller of the Put is gambling that the market correction will NOT happen within the agreed period of the Put (usually about three months) while the person taking out the Put obviously gambles that the correction WILL occur within the agree time. The problem with such an approach is that it is quite costly meaning it is really only a possibility in the case of portfolios worth well over R1-million.

If nothing happens, the person taking out the Put looses the cost of it (generally around ten percent of the value of the portfolio) while the person issuing the Put gains the fee. As an alternative and usually for a somewhat lesser fee our investor might take out a Futures position in which case he will only be called on to ante up money if, instead of falling, the market rises. However, in such a futures position, if the market continues rising rapidly the issuer of the future will repeatedly call for the futures buyer to ante up additional money and this could be potentially devastating for a portfolio.

So, the reality facing South African investors currently is that they KNOW that a correction is almost inevitable but the million dollar question is when? If we could know the answer to that one we would all be billionaires! I have accordingly in my own portfolios opted for the conservative approach and to readers of my Prospects newsletter I have for months been advising them to accumulate cash and to sell off a few relative underperformers where the capital gains penalty was not so severe in order to create a “war chest” of cash with which to buy once the anticipated crash has happened. In this manner we have actually accumulated approximately 26 percent of the portfolio value.

Kylie Jerg who administers overseas portfolios on behalf of some of my clients opted to use a futures position to insure these portfolios and, on the face of it, it was the right decision but taken too soon because the portfolios have lost heavily as she has been forced to liquidate shares to meet margin calls. However, once the market turns down, the opposite will happen and the value of the portfolios should be more than restored. Her mistake was to take out such cover too early. But then hindsight is a perfect science. As I have already emphasised, world authorities like Harvard University professor Kenneth Rogoff who is a former US Federal Reserve board member, last week warned the World Economic forum in Davos that a crash is likely soon, and many other authorities have been warning of a crash since the middle of last year.

Overseas markets are dominated by Wall Street and that market is poised to turn down within the next few weeks. The artificial intelligence system within my ShareFinder computer program has proved itself to be 91.07 percent accurate in the market direction forecasts which we publish each week in my Richard Cluver Predicts column, and it now predicts that the London’s FT 100 Index will turn down on February 1 and fall virtually without respite until the end of September as illustrated by the red projection line in the graph below:

Understanding why such a decline could be imminent one needs only to turn to an indicator known as the Cape Ratio.

The Cape Ratio was developed by Yale University Professor Robert Shiller. Described as a Cyclically Adjusted Price-Earnings (CAPE) ratio, it initially came into the spotlight in December 1996 after Robert Shiller and John Campbell presented research to the US Federal Reserve that suggested stock prices were running up much faster than earnings. In the winter of 1998, Shiller and Campbell published their groundbreaking article Valuation Ratios and the Long-Run Stock Market Outlook, in which they smoothed earnings for the S&P500 Index by taking an average of real earnings over the past 10 years, going back to 1872.

This ratio was at a record 28 in January 1997, with the only other instance (at that time) of a comparably high ratio occurring in 1929. Shiller and Campbell asserted the ratio was predicting that the real value of the market would be 40% lower in ten years than it was at that time. That forecast proved to be remarkably prescient, as the market crash of 2008 contributed to the S&P 500 plunging 60% from October 2007 to March 2009.

The CAPE ratio for the S&P 500 has climbed steadily for the past nine years as the economic recovery in the U.S. gathered momentum and stock prices reached record levels. This week the CAPE ratio stood at 49.9, compared with its long-term average of 16.80. The fact that the ratio had previously only exceeded 30 in 1929 and 2000 has triggered a raging debate about whether the elevated value of the ratio portends a major market correction.

Critics of the CAPE ratio contend that it is of little use because it is inherently backward-looking, rather than forward-looking. Another issue is that it uses GAAP (generally accepted accounting principles) earnings, which have undergone marked changes in recent years. In June 2016, Jeremy Siegel of the Wharton School published a paper in which he said that forecasts of future equity returns using the CAPE ratio may be overly pessimistic because of changes in the way GAAP earnings are calculated. Siegel said that using consistent earnings data such as operating earnings or NIPA (national income and product account) after-tax corporate profits, rather than GAAP earnings, improves the forecasting ability of the CAPE model and forecasts higher U.S. equity returns.

Argument aside, analysts are generally agreed that share markets are at record highs and that a correction must come sooner rather than later and with the Cape Ratio standing higher than at any time other than the Dot Com bubble era, it is an indicator one cannot ignore. But what steps you take in anticipation of the inevitable crash is up to you.

Each of the options I have outlined are costly thanks to the Receiver of Revenue and the irony of it is that Capital Gains Tax brings in comparatively little revenue for the fiscus. Given the deterrent it imposes upon investment in this country and the fact that South Africa tops the list of emigrants of wealth, one has to question the wisdom of maintaining it. On the face of it, everyone would benefit if it were dropped. The most recently available SARS statistics indicate that CGT yielded revenue of R2.2-billion out of total revenue that exceeds R1.2-trillion; a tiny fraction that causes such pain to South Africa’s elderly and so deters foreigners from investing here.

US National Debt will top $33-trillion

New York Times

WASHINGTON — The federal government’s annual budget deficit is set to widen significantly in the next few years and is expected to top $1 trillion in 2020 despite healthy economic growth, according to new projections from the nonpartisan Congressional Budget Office.

The national debt, which has exceeded $21 trillion, will soar to more than $33 trillion in 2028, according to the budget office. By then, debt held by the public will almost match the size of the nation’s economy, reaching 96 percent of gross domestic product, a higher level than any point since just after World War II and well past the level that economists say could court a crisis.

The fear among some economists is that rising deficits will drive up interest rates, raise borrowing costs for the private sector, tank stock prices and slow the economy, which would only drive the deficit higher.

“Such high and rising debt would have serious negative consequences for the budget and the nation,” said Keith Hall, the director of the budget office. “In particular, the likelihood of a fiscal crisis in the United States would increase.”

The budget office forecast is the first since President Trump signed a sweeping tax overhaul, then signed legislation to significantly increase military and domestic spending over the next two years. The figures are sobering, even in a political climate where deficit concerns appear to be receding.

The tax overhaul, which includes permanent tax cuts for corporations and temporary ones for individuals, will increase the size of the economy by an average of 0.7 percent from 2018 to 2028, according to the budget office.

But that added economic growth does not come close to paying for the tax overhaul, which the budget office said would add more than $1.8 trillion to deficits over that period, from lost tax revenue and higher interest payments.

Many Republicans have said the tax overhaul would vault economic growth over 3 percent a year for a sustained period, generating more revenue than the tax cuts would cost. But the budget office expects the economy to grow at an annual average rate of 1.9 percent over the next decade. Growth would start strong, at 3.3 percent this year and 2.4 percent next year, but then slow considerably.

And if the temporary tax cuts for individuals are extended past their scheduled expiration at the end of 2025, the price tag for the tax overhaul would be even greater.

Mr. Trump has talked about embarking upon “Phase 2” of tax cuts, which could include making those individual tax cuts permanent.

Democrats jumped on the projections to castigate Republicans over their economic record.

“From Day 1,” the Senate Democratic leader, Chuck Schumer of New York, said, “the Republican agenda has always been to balloon the deficit in order to dole out massive tax breaks to the largest corporations and wealthiest Americans, and then use the deficit as an excuse to cut Social Security and Medicare.”

Representative Nancy Pelosi of California, the House Democratic leader, was equally harsh: “The C.B.O.’s report exposes the staggering costs of the G.O.P. tax scam and Republicans’ contempt for fiscal responsibility.”

What is in a price? And what does it all mean for our standard of living?

By Professor Brian Kantor

Chief Economist and Strategist, Investec Wealth and Investment

Automation, roboticisation and miniaturisation are changing wondrously the way we produce and consume goods and services, including the medical treatments that can keep us alive for longer and with much less morbidity. To which forces of change we could add the internet of things that connects us ever more effectively and commands so much more of our attention.

The benefits of this technological revolution that we can see and feel are not at all obvious however in the measures we use. We are informed that US productivity continues to grow very slowly. And real GDP is growing as slowly, as are wages and incomes adjusted for inflation. Apparently Americans are not getting better off at the pace they used to and are frustrated with their politicians they hold responsible.

Is our intuition at fault or the way we compare the prices of the goods and services we consume over time? All measures of output and incomes are determined in money of the day, calculated and agreed to in current prices. They are then converted to a real equivalent by dividing some sample of output or wages estimated at current prices, by a price index or a deflator. A price index measures the changes in the prices of some fixed “basket” of goods and services thought to represent the spending patterns of the average consumer. The deflator calculates the changes in the prices of the goods and services consumed or produced today, compared to what would have been paid for them a year before.

Both estimates attempt to make adjustments for changes in the quality of the goods and services we are assumed to consume. A car or a pain killer or cell phone we buy today on today’s terms may do more for us than it would have done at perhaps a lower price, or possibly a higher price (think dish washers or calculators) five or 10 years before. It is not the same thing we are making price comparisons with.

A piece of capital equipment today, robotically and digitally enhanced, is very likely to produce many more “widgets” today than a machine similarly described 10 years ago. And it may cost less in money of the day. It is a much more powerful machine and firms may well make do with fewer of them. Their expenditure on capex – relative to revenues – may well decline, indicating (wrongly perhaps) a degree of weakness in capital expenditure. The problem may not be a lack of willingness of firms to invest more, but how we measure the real volume of their investment expenditure – quality adjusted.

There is room for moving the rate at which a price index increases (what we call inflation) a per cent or two or three higher than they would be if quality changes were implied differently and more accurately. And if so GDP and productivity growth would appear as equivalently faster.

It is instructive that the US Fed targets 2% inflation – not zero inflation – because 2% inflation (quality adjusted) may not be inflation at all. And zero inflation may mean deflation (prices actually falling) enough to discourage spending now, to wait – unhelpfully for the state of the economy – for better terms tomorrow.

Over the past three months there have been no increases in prices at retail level in SA. The annual increase in retail prices (according to the retail deflator) fell below 2% in January 2018 and is far lower than headline inflation. (see below). The Reserve Bank would do well to recognise that the state of the economy – coupled with what the stronger rand provides businesses in SA – leaves both manufacturers and retailers with very little pricing power. Nominal borrowing costs – well above business inflation – are in reality applying a significant real burden for them. They could do with relief.

A Chinese elephant in the room

By Robert Maudlin

China is the world economy’s elephant in the room. We can’t possibly ignore it, yet many try anyway. Admitting China’s influence forces us to admit the world is changing—and we all must change with it.

This year, China is in the headlines because President Trump wants better trade terms. That’s important, but it’s only one piece of a much larger Chinese story that has been unfolding slowly for decades. Periodically, I check in on the latest developments. Today, we’ll see where we are, with the help of my trusted sources.

One of the great pleasures of my life is reading Gavekal’s outstanding economic research. I can do this thanks only to a long friendship with the firm’s three founders: Charles Gave, Louis Gave, and Anatole Kaletsky. Otherwise, it’s available only to their clients, and the cost is beyond my normal research budget.

One thing I appreciate about the Gavekal analysts and writers is that they are all independent and free to disagree with each other. Even the founders Charles, Louis, and Anatole often differ significantly—both in public and private messages that I get to read. Frankly, that is often when I learn the most.

Last week, Arthur Kroeber of Gavekal Dragonomics sent around a fascinating presentation about US-China strategic rivalry. It broadly matches my own thinking, but also gave me some “a-ha” moments. This is how I learn, by the way. My mind is a big blender into which I toss info from multiple sources. It whirs and rearranges the ingredients into something new, such as the following thoughts on China. They’re a mix of me, Gavekal, and my many other China contacts (I must hat tip Leland Miller and the China Beige Book). I should point out that any wrong conclusions are my own and should not be blamed on my sources. I am perfectly capable of making my own mistakes, thank you very much…

The first point to recognize: Xi Jinping is firmly in charge. You probably heard about the constitutional amendment that makes him effectively president for life. It doesn’t mean Xi is invulnerable or can do whatever he wants. He has constraints, as all national leaders do. But he doesn’t have to worry about re-election, or rivals trying to shift the agenda, or getting congress to approve his policies and budgets. Xi sets the agenda. Everyone else follows it.

I pointed out about two years into Xi’s presidency that it was clear that he was the most important Chinese leader since Deng Xiaoping. That is no longer the case. He is the most important figure in modern Chinese history since Mao and possibly Sun Yat-sen. From my viewpoint, Mao was a disaster for the Chinese people. Millions died under his disastrous economic policies. Since Deng and subsequent Chinese leadership and continuing with Xi, there has been a remarkable turnaround.

Yes, much of China still lives in deep poverty, but the fact that it moved 250 million+ people from subsistence farming into urban middle-class lifestyles, in less than two generations, is an unprecedented economic miracle. The breathtaking picture at the top of this letter is of Shenzhen, whose population went from 30,000 in 1979 to now 10,000,000+. Sixteen Chinese cities have a population over ten million. These are staggering growth stories most Westerners have never heard. The US has only two metro areas of comparable size.

Say what you will, historians will look back 100 years from now and marvel. And Xi seems determined to make life better for those still in poverty.

Arthur pointed out another, less noticed constitutional change that may help. It extended party discipline down to local officials, for both what they do and what they might fail to do. This gives Beijing a more effective enforcement mechanism and should result in more consistent policies.

My first thought on this was that even more centralized control may not be such a wonderful thing for China. It hasn’t worked so well elsewhere. Arthur agrees China could face problems down the road, but for the next few years thinks the new measures will be a net positive. He expects 6.5% GDP growth this year, as does Beijing (which of course gets what it wants). Last year’s shadow banking crackdown has somewhat contained excess leverage, at least for now.

China’s rapidly growing debt, both private and state-sponsored, is going to be a problem at some point. Xi and the leadership are trying to head off the problem, but debt has its own reality. Increasingly easy access to credit makes it hard to control. Chinese “investors” load up on debt to invest in “sure things” only to find them not so sure.

For now, though, short-term stability gives Xi room to focus on long-term economic priorities, of which he has two: The “Made in China 2025” industrial policy and the “Belt and Road” infrastructure initiative. As we’ll see in a minute, both are much more than they seem.

Meanwhile, the US sees China as both partner and rival. Obviously the two economies are intertwined and depend on each other. President Trump observes, correctly, that China doesn’t always reciprocate the trading rights that the US and other governments extend. China is really quite protectionist—far more so than the other “BRIC” countries, as measured on the OECD foreign direct investment restrictiveness index. Trump is right to press for better trade parity. When China can ship cars to the US for 2.5% tariff, and US cars must pay a 25% to go into China, something is out of balance. There are literally scores of examples like that. And for this, we let them into the WTO and gave China most-favoured nation status? (More on that below.)

But at its heart, the US-China rivalry is not really a trade war. This has been unfolding for a long time. Trump’s tariff threats are only the latest move and won’t be the last.

Two Cards at Play

Beijing has two big economic programs, neither of which it considers negotiable. They are strategic priorities the rest of the world will have to face.

Made in China 2025 is a broad industrial policy with multiple goals:

    • Improve manufacturing productivity
    • Build up technology-intensive sectors
    • Gain 70% self-sufficiency in key materials and components

On the surface, there is really nothing wrong with this policy. Many nations have long done similar, including the United States. But let’s get beyond the surface.

The government, state-owned enterprises and private businesses are all giving ‘Made in China 2025’ truly massive funding. Research & development spending was US$232 billion in 2016 alone. Ominously, a new government commission, founded just last year, is overseeing the “integration” of this technology development with possible military use. And let’s make no mistake, this “funding,” whether equity, loans, or grants, ultimately comes from the state or at the urging of the state.

Note that last goal of 70% self-sufficiency in certain markets. Made in China 2025 is, by its nature, an anti-trade program. Favouring domestic producers necessarily disfavours importers. Other governments, including the US, do the same, of course, but rarely on this rather immense scale. So, it’s inevitably going to be a point of argument.

China’s Belt & Road Initiative looks like a giant infrastructure program, and it is, but that’s not all. It is Xi’s mercantilist version of the US-led post-war Marshall Program. Where we carved out leadership via institutions and trade agreements, while at the same time supplying much-needed money, China seeks to do the same by physically connecting itself with the Eurasian continent. I have said from the beginning that this may be one of Xi’s most profoundly disruptive and transformative policies of his career. There was some skepticism when it was first announced as the scope was so massive, but I think everyone is now a true believer. China is committing to putting its hard dollars into completing this project’s multi-decade vision.

As my friend George Friedman often says, China’s main strategic challenge is that the US controls the seas. Geography means China’s imports and exports must traverse coastal bottlenecks the US could easily close if it wished. That’s intolerable if your goal is to be a superpower, and that’s definitely what Xi wants.

One Belt, One Road is the answer. It will link the Eurasian land mass into a giant trading bloc with Europe at one end and China at the other. The project will open land routes the US cannot interdict, thereby letting China take what it feels is its rightful place of leadership. The scope is breathtaking, but Beijing is determined to make it happen. Again, I would not bet against Xi on this.

Notice all the smaller Asian countries that the One Road goes through. It will give you access to not only East Asia but Europe as well. China is building a “main pipeline” not unlike Eisenhower’s interstate highway system. And that means all those little countries will access that main road. Ultimately, China wants to pay for all the products it buys in Renminbi and have those small countries make it part of their central bank holdings. That is part of the process of becoming a reserve currency, which is something China covets. The same thing is true for the project’s ocean and seaport aspects.

Whatever your feelings about Chinese leadership, you have to admire a country that can undertake such a huge project that will take decades to fulfil. While Xi and his team may be starting it, it is unlikely anyone currently on top will still be on top in 30 years. That is Vision with a capital V.

This world, Beijing envisions, is incompatible with Washington’s priorities. Hence the present clash of titans. US leaders are figuring out China is not going to give them what they want. Why that surprises them, I’m not quite sure. China is ruled by the Communist Party. It’s different than Soviet communism or the various socialist groups in the West. It’s vastly different from Maoist communism. It looks like capitalism in some respects, but it is more about mercantilism and empire-building. This idea that China would slowly transition to American-style free enterprise was always fantasy. I think that’s now dawning on people.

That’s not to say we can’t do business with China, just as we do with Russia and other geopolitical opponents. We can and will continue—but it’s their country and we will do it on mutually agreed terms or not at all. Arthur Kroeber said in the Gavekal presentation we can either “co-exist or conflict.” I think that sums it up well. The problem is getting people on our side to accept it.

So, there is right now a grand struggle in Washington to redefine how we interact with China. Multiple wings are jockeying for position. For the moment, President Trump is the most important player. Despite some of his rhetoric, I don’t believe he is ideologically against trade. I think he just wants a US “win” and is flexible on what that means.

Trade ideologues do exist, though. Steve Bannon and Peter Navarro are two top examples, and Navarro still (unfortunately) has the president’s ear. They also want a “win” but have much different ideas on what it should look like. The US would be much the poorer if their vision won. Some of their ideas are complete non-starters to Beijing but, being ideologues, they are not inclined to compromise. Nor is China, so I don’t expect much movement. There are areas in which I believe that China will compromise (like auto tariffs, etc.), but becoming a US vassal state is not in the cards. And shouldn’t be.

Then you have national security hawks, who don’t mind doing business with China as long as we stay dominant in security matters. I think Defence Secretary James Mattis is in this group. He’d like China’s help in solving the North Korea problem and probably knows the US must give something in return. He advised caution on the recent steel and aluminium tariffs, for instance. The problem is where to stop. Doing business with China necessarily gives China access to Western technology, data, and capital. So, it’s very hard to have it both ways.

Finally, you have US companies. They see a huge market in China and they want access to it. Beijing is glad to welcome them, for the right price, which usually entails sharing software code and other intellectual property. They don’t like this, but most have made peace with it. We know this because we see them setting up operations in China. They’d like the US government to extricate them from that bargain but can’t say so too loudly. They’re in a tough spot.

There being no agreed-upon plan, the US side is more or less flailing against China, whose leadership is 100% unified because that is what Xi has dictated. This side has the president threatening tariffs, business allies like my friend Larry Kudlow saying everyone should calm down, Treasury Department and CFIUS trying to stop technology deals, the Pentagon quietly working with China to contain North Korea, and large businesses doing whatever it takes to stay on Beijing’s good side—all at the same time.

China looks at this mess, frankly, and sees its best strategy is to play it cool, try to look generous and wait. The longer we argue, the more time China has to acquire our technology and convert it to their own use. Combine that with their own research, which is progressing rapidly in certain segments (especially artificial intelligence!), and they have a plausible route to superiority in some areas, or at least parity.

I don’t believe we will see any sort of grand deal that sweeps away all this clutter. If Trump and Xi reach some agreement on tariffs, other issues will remain. Lately, China is “magnanimously” offering to allow foreign companies more ownership of local assets. That sounds great, but it is not clear to me that Beijing and US businesses share the same concept of “ownership.” As I said, they’re communists, autocrats, and even more importantly, mercantilists.

And even if you solve all that, the much larger geopolitical rivalry remains. It would be nice to think that China can be our trans-pacific ally like the United Kingdom is in the Atlantic. I don’t see that happening. We don’t have the same kind of cultural and geographic ties with China.

The current situation vis-à-vis China and the US could go many directions. In the worst case, we could slide into a kind of economic Cold War with China, with both sides deploying aggressively protectionist policies. I am afraid that would spark a global recession. I am not being hyperbolic. It is a dark alley we do not want to walk into.

More optimistically, Beijing might grant enough concessions to satisfy Trump and buy a few more years of relative harmony. But as I said, the underlying rivalry will come back unless Xi makes some massive changes he shows no signs of even considering.

So, I think the likely near-term outlook is lots of noise with only mild tariffs or other restrictions. A real trade war serves no one’s interest. But people make mistakes and do irrational things, so someone could miscalculate. 

Let us hope that wiser and cooler heads prevail.

A Tale of Trade History

As I travel and talk to old and new friends, I hear many fascinating stories from their own backgrounds. Sometimes I can connect them with other stories from different people, and they become even more fascinating. Here’s one that’s been in my head awhile and is now relevant. I can’t confirm all this, but it’s so interesting I wanted to share. It comes from sources I’ve found highly credible and they were familiar with the situation. Maybe some of you will have further insight.

Back in the 1990s, Robert Rubin, a Secretary of the Treasury under Bill Clinton, was negotiating the terms under which China would be allowed into the World Trade Organization. My sources say he was basically asking for many of the exact same things Trump wants now. Who knew that Trump and Rubin were philosophically on the same trade page?

But in 1998, in the middle of the Monica Lewinsky scandal, Clinton wanted a “win.” (Not unlike the current president.) And Rubin wasn’t delivering, holding firm on his demands for market access and guarantees on intellectual property, etc. Clinton then took the Chinese negotiations away from Rubin and gave it to Secretary of State Madeleine Albright with the instructions to get it done.

Not being a trade expert, Albright didn’t understand the underlying issues. The Chinese recognized she was playing a weak hand and held firm. To make a long story short, my sources say she effectively caved. Clinton got his “win” and we got stuck with a lousy trade deal.

When Trump alleges that we got snookered in a bad trade deal, he is correct—although I wonder if he understands the history. Maybe somebody gave him the background, but it never came out in any of his speeches. That WTO access, which finally happened in 2001, let China begin capturing markets through legal means and access US intellectual property without paying for it. My own personal beef with Chinese trade issues is the theft of intellectual property and the lack of property rights. If they want to sell us underpriced T-shirts and other products, then the US consumer benefits. When they do it with what is essentially US intellectual property, US businesses lose. And that means jobs. The US is not the only country in the developed world complaining about that very problem. It is a common theme in the industrialized West.

Does this make a difference now? Probably not. Neither Xi nor Trump was involved back then. But it gets to the rivalry we discussed above. Is it possible for both the US and China to stay in an organization like WTO? Trump seems to doubt it, as he’s threatened to withdraw from WTO. We may someday look back at this period of a single body governing international trade as an aberration—a nice dream that was never realistic. If so, prepare for some big changes.

Uzbekistan, Attempts at Liberalization Aren’t What They Seem

By George Friedman and Ekaterina Zolotova

Since the fall of the Soviet Union, which governed Uzbekistan as a satellite state, the country had had only one ruler: Islam Karimov, a strong-armed, unapologetically clannish dictator. He died in 2016 and was replaced by Shavkat Mirziyoyev.

Shortly thereafter, Mirziyoyev announced reforms meant to open the country up to the outside world economically. He cultivated ties with potential patrons, including Russia, Europe, and China. More important, he began to improve relations with other Central Asian states. Cross-border disputes related to access and usage of energy and water resources are gradually being solved.

Today, Uzbekistan has all the appearances of a country on the rise. It is prosperous and stable by the standards of the region. But appearances can be deceptive. Beneficial though Mirziyoyev’s reforms might be, their uses are merely counterfeit. The cool logic behind them is that they help Mirziyoyev consolidate power and endear him to his subjects. In a place such as Uzbekistan, the tactics a leader uses may be liberal or draconian, but the outcome is the same: Uzbekistan is not going to be anything other than a centralized state where the president has great power.

Evaluating the Reforms

What has the liberalization of Uzbekistan accomplished? Economic prosperity? Not really. The structure of the economy is largely the same as it has always been, dependent as it is on materials and extractive industries and on the countries that buy their wares. Inflation is still high and unemployment artificially low, as millions go abroad for work. The state is still active in the financial sector.

The end of strongman rule? Not so fast. Yes, some of Karimov’s opponents have been released from prison and their power curbed. Yes, the National Security Service, which unofficially controlled all spheres of life under Karimov, has been neutered, and its leader, Rustam Inoyatov, has been dismissed. Yes, purges in the defense and finance ministries have rid the system of Karimov acolytes. But the system, which remains vertical and top-heavy, is still largely intact. Mirziyoyev himself was prime minister before he was president. As prime minister, he practiced the same kind of authoritarianism Karimov did and eschewed the same kind of liberal reforms he purports to pursue now. And now that he is president, he faces the very same situation his predecessor did: He must achieve internal political stability from within and ensure security from without. He can only do that if he stays in power, and he can only stay in power if he wins the support of the people.

Did liberalization open up the country to external markets? In theory, yes. In practice, no. Mirziyoyev does support trade. He visits the countries with which Uzbekistan trades, provides platforms for solving problems, participates in organizations such as the Commonwealth of Independent States, signs bilateral agreements, and reduces transit fees. But these practices precede him. In fact, Uzbekistan has a long tradition of trade. Like all Central Asian countries, Uzbekistan has no access to the sea but has nonetheless been a major trading centre since antiquity. Trade created some opportunities for Uzbekistan, but it also created dependencies on its neighbours and on existing trade routes. China accounts for nearly 19% of Uzbek trade; Russia nearly 18%; Kazakhstan roughly 8%; and Turkey some 6%. These dependencies prevent the government in Tashkent from entering new markets.

Karimov diversified his country’s trade partners as best he could, careful not to rely too much on any one country. Central Asia, after all, is a region in which the interests of East and West overlap. Uzbekistan in particular has recently been courted by countries in the Middle East, including the United Arab Emirates, Turkey, Iran, and Saudi Arabia. Uzbekistan values neutrality above all else and so is careful to find a balance among all its suitors.

Mirziyoyev is following in his predecessor’s footsteps. Having strengthened ties with China and Russia under Karimov, the government under Mirziyoyev has sought to expand contacts with partners such as India, South Korea, and the European Union in an attempt to diversify partners and, more important for his landlocked country, build new transport corridors to other, preferably Western, markets. To that end, Mirziyoyev has already made some changes to convince the world it is high time to invest in Uzbekistan. Government officials have invited several Turkish investors, who were previously expelled from Uzbekistan, back to the country. They have signed contracts with US companies for $2.6 billion, they have come to an agreement on financial cooperation with Germany, and they continue to look for more markets. This is all well and good for Uzbekistan, but it is not especially new.

Cozying Up to Russia?

Has liberalization improved relations within the region? Yes and no. It’s no secret that under Karimov relations with the rest of Central Asia were tense and that Mirziyoyev inherited a number of Karimov’s problems in that regard. There have been territorial disputes, disputes over access to resources, and personal animosities among leaders. The president has indeed endeavoured to resolve some of these issues. But his decision to make nice with the region is less of a paradigmatic shift and more of a pragmatic decision. His country is in a precarious position. It is not receiving as much money from Russia as it once was, thanks in part to Russia’s own financial woes. China is viewed with apprehension. Uzbekistan may be able to forsake one but it cannot afford to forsake both. Solidarity among its neighbours helps dampen the blow.

The final question is: Has Uzbekistan under Mirziyoyev cozied up to Russia? The answer is yes, but only for now, and not because of anything Mirziyoyev has done. The reorientation began under Karimov, who, having rebuked the West when he removed a US air base from his country, repaired relations by reorienting trade and investment to Western states, mainly the US, and to South Korea and Japan. He was, in fact, the first Central Asian leader to spurn Russia. But relations between Uzbekistan and the West soured in 2005 when the Uzbek government killed hundreds of protesters (or thousands, depending on the source) in Andijan province. (The West condemned the government and levied sanctions against it.) Without a partner to turn to, Uzbekistan had to turn back to Russia to avoid total international isolation.

Since then, Russia and Uzbekistan have agreed to implement a variety of joint projects worth more than $15 billion. They have also discussed the possibility of increasing trade ties. Russia already buys agricultural products and foodstuffs from Uzbekistan, and Uzbekistan suspended excises on a wide variety of Russian goods.

None of this is to say that Uzbekistan is set to become a full and faithful Russian ally. Uzbekistan’s loyalty is notoriously hard to secure. Russia is buying less natural gas from Central Asia than it once did. And Tashkent still hasn’t joined the Collective Security Treaty Organization or the Eurasian Economic Union.

Mirziyoyev’s reforms are less radical than they appear. He faces the same challenges Karimov did and he has largely responded to them as Karimov did. There is little to compel him to create the institutions necessary for liberal democracy. There are no real steps to develop the institutions necessary for a market economy. The only real reform has been the purge of the National Security Service—the main competitor to the government.

The reforms in the financial sector and taxation are aimed at improving the business climate in the country and attracting foreign investments to Uzbekistan, not at opening up to new and better markets. Flashes of liberalization are not the same as fundamental, systemic changes.

Hoisington Quarterly Review and Outlook, First Quarter 2018

By John Mauldin

Lacy Hunt is in the very top rank of US economists. He would have made an excellent Fed chairman, if you ask me (no one did who mattered); but he goes on holding down the fort, along with partner Van Hoisington, at Hoisington Investment Management in Austin; and so you and I continue to have the benefit of Lacy and Van’s quarterly updates.

Today’s is an amazing piece of academic economic analysis. Lacy and Van kick it off with this trenchant little summary of our predicament:

Nearly nine years into the current economic expansion Federal Reserve policy actions appear to be benign, as even after six increases, the federal funds rate remains less than 2%. Changes in the reserve, monetary and credit aggregates, which have always been the most important Fed levers both theoretically and empirically, indicate however that central bank policy has turned highly restrictive. These conditions put the economy’s growth at risk over the short run, while sizable increases in federal debt will serve to diminish, not enhance, economic growth over the long run.

That’s it in a nutshell.

Then Lacy leads us a ways into the weeds on interest rates and monetary decelerations and their impact on the Fed’s ability to act – you can get a real economic education reading these Hoisington reviews – and then on pg. 5 Lacy really busts out with some important new thinking. Here’s what he had to say about it in a note a couple days ago:


Please take a close look at the section entitled “The Debt End Game – The Law of Diminishing Returns.” This is a more detailed discussion than I gave at SIC.

I have worked with the debt problem since the 1980s, but it was not until recently that I could describe the end game using an economy’s production function and thus employ the law of diminishing returns. As I consider this my keenest insight, please read and let me know what you think.

The law of diminishing returns is a more direct answer for the debt end game than going from Bohm Bawerk to Fisher to Kindleberger to Minsky to contemporary econometric studies. Very importantly, the two lines of thought yield the same answer.

Warm regards, Lacy

When Lacy Hunt tells me his letter contains the “keenest insight” of his career, I sit up and pay attention – and then read three or four times. I won’t tell you that today’s essay is easy going, but I am definitely trying to absorb it into my own limited economic understanding. It is important enough that you should, too.

Bottom line, friends: The crunch is upon us, or nearly.

Quarterly Review and Outlook, First Quarter 2018

By Lacy Hunt, PhD, and Van Hoisington, Hoisington Investment Management

Nearly nine years into the current economic expansion Federal Reserve policy actions appear to be benign, as even after six increases, the federal funds rate remains less than 2%. Changes in the reserve, monetary and credit aggregates, which have always been the most important Fed levers both theoretically and empirically, indicate however that central bank policy has turned highly restrictive. These conditions put the economy’s growth at risk over the short run, while sizable increases in federal debt will serve to diminish, not enhance, economic growth over the long run.

Interest Rates

Interest rates are not predictable over the short run but are controlled by fundamental forces on a long-term basis. Milton Friedman (1912- 2006) developed the most complete and internally consistent interest rate model to date, which is an extension of the Fisher equation. Friedman’s model reaches two conclusions: (1) although monetary decelerations may lead to transitory increases in interest rates over the short run, they ultimately lead to lower rates; and (2) monetary accelerations result in higher rates. This reasoning is based on what Friedman termed “liquidity, income and price effects”. When the Fed reduces the reserve, monetary and credit aggregates (or what Friedman called monetary deceleration), initially short-term rates are forced upward through the “liquidity (or initial) effect”. As the Fed further tightens monetary conditions, an offsetting “income effect” follows. These restraining actions moderate growth in the economy, and the rise in interest rates continues but at a slower pace. Thus, in Friedman’s terms, the income effect begins to offset the liquidity effect. When the Fed sustains the tightening process long enough, the inflation rate will decrease as incomes fall and ultimately result in lower rates. This is the “price” or “Fisher effect” from the Fisher equation. Observationally, the highly inflation-sensitive long-term yields reflect the changing economic landscape faster than short-term rates, thus the yield curve flattens, serving to strengthen the Fed’s restraint on the reserve, monetary and credit aggregates.

Empirical studies by Friedman and others indicate this process is lengthy, often playing out over several years. This process appears to be well underway. More than two years have elapsed since the Fed initiated the liquidity effect, and restraint is evident in all of the aggregates as well as in the shape of the yield curve, which has attenuated significantly.

Friedman’s logic for monetary accelerations leading to higher interest rates is the opposite of monetary decelerations. When the Fed accelerates growth in the reserve, monetary and credit aggregates, the liquidity effect is initiated. Short term rates drop rapidly relative to long term rates and the yield curve dramatically steepens. If the Fed continues to further loosen monetary conditions, a reversing income and price effect can, but does not always, occur. Friedman assumed the velocity of money was largely stable. Subsequent empirical evidence, however, suggests that this is not the case.

Three important concepts arise from these patterns. First, when the Fed moves in one direction, they ultimately lay the groundwork for reversal. Second, considerable time (generally two or more years) passes before the liquidity effect has any economic impact. Third, these lags grow longer when the Fed tries to overcome a recession, especially in highly leveraged economies like 1929 and 2008.

The Fed’s Ability to Act

The fact that there is such a long lag between policy change and economic impact is critical in analyzing the circumstances today. For instance, suppose the Fed is able to identify the next recession on day one. Also, suppose that on the first day of the recession the Fed drops the federal funds rate to zero. Due to the economy’s extreme over-indebtedness, along with long monetary policy lags, a minimum of one and half years could elapse before even a slight economic recovery is experienced. But, recovering from the next recession, the lag could be much longer since interest rates are so close to the zero bound and indebtedness continues to rise to record levels. Both will interfere with the potency of the liquidity effect. Thus, despite a rapid Fed response, a long recession could ensue.

Monetary Decelerations and Recessions – the Historical Record

Since the early 1900s, money supply (M2) decelerated prior to 17 of the 21 recessions (Chart 1). This strong correlation is remarkable given the complexity of the economy and shifting initial conditions. The lead times between the peaks in M2 growth and the start of the next recession are variable, with many centred around two years; however, some are shorter and others are as long as three years. The variability in lag times is far from surprising due to widely varying initial conditions: degree of leverage, demographics, global conditions and a host of other variables. When an economic model does not fully explain all of the historical experiences, the best approach is to study the cases that appear to contradict the normal pattern. The four deviating instances are labeled A, B, C, and D (Chart 1).

At point A, the money supply did not decelerate prior to the 1923 recession, but money velocity fell as the economy became increasingly leveraged. (This is important because the equation of exchange posits that money times velocity equals nominal GDP (M*V = NGDP).) The treasury yield curve significantly flattened and so did the corporate yield curve, which at the time was a more important indicator.

At point B, M2 did not decelerate prior to the 1958 recession. In this case the rate of growth in the monetary base sharply decelerated along with bank credit. Additionally, the treasury yield curve inverted.

At point C, if the 1980 and 1981-82 recessions are counted as one recession, as many prominent economists suggest, M2 growth did decelerate sharply prior to the downturn. Moreover, all of the monetary variables denote that severe restraint had been initiated to contain double-digit inflation. In other words, no contradiction existed as monetary policy tightened, and then the economy collapsed.

At point D (or prior to 2008), M2 growth did not decelerate until the economy was already in recession. However, the entire set of other monetary variables was restrictive.

Therefore, in the four instances when M2 growth failed to signal the downturn, M2’s closely aligned partners, on balance, pointed to recession.

Using the Brunner-Meltzer Model to Explain Collapsing Money and Bank Credit Growth Rates

M2 is largely measured from the liability side of bank balance sheets. Bank credit, which includes loans and investments or security holdings, is the aggregate of bank assets. Economists Karl Brunner (1916-1989) and Allan Meltzer (1928- 2017) developed the money supply determination model used in all major macroeconomic texts. This algebraically proven model states that M2 equals the monetary base times the money multiplier (m).

Since late 2015, in large part due to the Fed’s actions of raising the federal funds rate and more recently reducing the Fed balance sheet (quantitative tightening or QT), the monetary base has registered a pronounced decline of 6.3%. Excess reserves of the depository institutions fell by more than 16% over this time. Part of this decline may be attributed to other volatile factors rather than to changes in the Fed’s balance sheet. Taking these factors into account and smoothing out fluctuations in excess reserves, it appears that each increase in the federal funds rate required that excess reserves decrease by approximately $68 billion. This accounts for the approximate $410 billion decline in excess reserves. Due to quantitative tightening, the Fed balance sheet was reduced by $57 billion in the past two quarters. Using excess reserves, rather than the fed funds rate, as a measure of Fed tightening, we conclude the Fed has engaged in the equivalent of closer to seven increases in the federal funds rate rather than the six increases reported. This exercise is to highlight that the Fed policy of reducing its balance sheet is measurably more restrictive than their stated policy tool (fed funds).

At the start of the first quantitative easing (QE1), Fed Chairman Bernanke said the Fed was printing money. Due to the Fed’s balance sheet, the monetary base surged, but M2 did not respond due to the decline of m. (Remember, m is the equal partner to the base.) Some might presume that if m declined during QE, it would rise during QT. But currently the determinants of m – excess reserves, time and savings deposits, currency, and treasury ratios – have worked in tandem to cause m to stabilize. Thus, together, reductions in the base and m have caused the rate of growth in M2 and commercial bank credit (the sum of loans and investments) to slow noticeably.

Until the Federal Reserve Act of 1937 is repealed, m will remain algebraically defined. The Fed can neither print money nor reverse the printing press. The Federal Reserve can raise or lower the monetary base, but no certainty exists that there will be a correspondingly desired change in the money supply or bank credit, unless m cooperates. Conclusively, the Fed’s balance sheet and m are of equal importance. The widely held presumption that the Fed policy of QE would work, reflects that the Brunner-Meltzer model was not properly understood.

In the first quarter of 2018, M2 growth decelerated to just above a 2% annual rate. Year- over-year M2 growth slowed to just 3.9% versus the 6.6% long-term average growth. Additionally, bank credit growth declined 0.6% at an annual rate. Loans continued to inch upward but only because the banks’ securities portfolios fell. Loan volume does not typically fall until an economy is in a recession because firms borrow to finance an unintended rise in inventories.

The proposition that the federal funds rate is the major policy tool to control economic activity is greatly flawed. As the past ten years have proven, the Fed faces a difficult task of working with both price (interest rate) and quantity (money supply) to influence economic activity. Present circumstances reveal extraordinarily low money growth, tighter bank liquidity (Chart 2), and the inability of several sectors to borrow due to higher rates. The historical record of these Fed actions points toward a continuing pattern of economic deterioration. While the brunt of monetary policy will impact economic growth increasingly over the next two years, the longer run view of economic conditions will be shaped by the exploding level of government debt.

The Debt End Game – The Law of Diminishing Returns

Federal debt continues to rise at an accelerating pace, a trend reinforced by the bipartisan budget enacted March 23rd of this year and the tax cut and reform legislation that went into effect January 1st of this year. These changes occur at a time when many expenditure items have been moved off-budget, causing a wider gap between the issuance of debt and the reported deficit (note: in the last ten scal years, the cumulative budget deficit has been $8.5 trillion while government debt has increased by $11.3 trillion). Additionally, an aging population is set to greatly boost federal debt over the next 15 years. Gross federal debt was 105.4% at year-end 2017, but it could reach 120% before the end of the next decade.

The economic impact of this explosion in debt has been analyzed through a plethora of academic articles. The most germane might be the Checherita and Rother 2010 study which shows that excessive indebtedness is deleterious for economic growth in a non-linear fashion. That is, the higher the level of debt the greater the restraint on economic growth.

While many believe that surging debt will boost economic growth, the law of diminishing returns indicates that extreme indebtedness will impede economic growth and ultimately result in economic decline. Diminishing returns is about economic growth and thus highly important in economics since the standard of living cannot be raised without increasing output. The application of diminishing returns means a disproportionate growth in debt will produce similar results for all countries in extreme debt, regardless of their idiosyncratic conditions. Thus, no matter how U.S., Japanese, Chinese, European or emerging market debt is financed or owned, and regardless of the economic system, the path is stagnation and then decline. Even central bank funding of debt will not negate diminishing returns.

The law of diminishing returns rests upon the production function that states physical output on either a micro or macro scale is a function of the inputs. These inputs – labor, capital and natural resources – are called the factors of production. When a factor of production input (for instance, debt capital) goes up, output rises at an increasing rate and marginal physical product (MPP) also increases. However, as that factor disproportionally continues to increase, MPP experiences slower gains and diminishing returns occur, followed by flat returns. As debt continues to increase, real GDP starts to fall. At this point, debt has reached the point of negative returns, resulting in the end game of extreme indebtedness. Faltering output will free up substantial credit in more than sufficient volume to overwhelm the impact of the ever increasing supply of new debt. Although the business and financial cycles will continue to operate, low interest rates will prevail as debt is used in ever increasing amounts to boost economic output.

While labour, natural resources and equity capital theoretically could increase proportionately with debt capital, these levers are not easily changed and their trends are not positive. Poor demographics in Europe, Japan, the U.S. and China suggest labour will not be a major positive for almost two more decades, even under the most optimistic of scenarios. Equity capital is moving in the wrong direction due to low net U.S. savings along with corporate preferences. Technology will change, but the more deleterious impact may fall on labour and natural resources. Thus, overuse of debt capital is the path of least resistance.

The law of diminishing returns holds important implications for both recent and future fiscal policy actions that have increased, and will continue to increase, federal debt. Suppose that during the next recession the economic solution is assumed to be an even more massive rise in debt than the $3.5 trillion explosion that occurred during and after the recession of 2008-09. This policy will result in even smaller economic gains than in the current expansion. If debt increases are doubled, tripled, or even quadrupled, the law of diminishing returns indicates economic growth will become even more frail.

Mounting Evidence

The law of diminishing returns is already evident in all major economies as well as on a global scale (Table 1). Global GDP generated per dollar of total global public and private debt dropped from 36 cents in 2007 to just 31 cents in 2017. Diminishing returns is even more apparent in the case of China’s public and private debt, largely internally owned. In terms of each dollar of debt, China generated 61 cents of GDP growth in 2007 and only 33 cents last year. In other words, in the past ten years the efficiency of China’s debt fell 45%. Thus, even in a command and control economy, the law of diminishing returns prevails. The most advanced sign of diminishing returns is in Japan, the most heavily indebted major country, where a dollar of debt in the last year produced only 22 cents of GDP growth. This economic principle applies equally to businesses.

All economies rely heavily on the business sector to lead the growth process. Yet, a sharp decline in GDP per dollar of business debt occurred in the U.S. during the past nine years, reinforcing the underlying trend since the early 1950s. In 1952, $3.42 of GDP was generated for every dollar of business debt, compared with only $1.39 in 2017. In the corporate sector, where capital as well as technology is most readily available, GDP generated per dollar of debt fell from $4.50 in 1952 to $2.50 in 2007 to $2.21 last year. The dismal trend in productivity confirms this conclusion. The percent change for productivity in the last five years (2017-2012) was equal to the lowest of all five-year spans since 1952. It was also less than half the average growth over that period.


Important to the long-term investor is the pernicious impact of exploding debt levels. This condition will slow economic growth, and the resulting poor economic conditions will lead to lower inflation and thereby lower long-term interest rates. This suggests that high quality yields may be difficult to obtain within the next decade. In the shorter run, in accordance with Friedman’s established theory, the current monetary deceleration, or restrictive monetary policy, will bring about lower long-term interest rates.

Van R. Hoisington
Lacy H. Hunt, Ph.D.

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