Waiting for German voters to deliver is like waiting for Godot

There is less to Merkel’s support for Macron’s eurozone reforms than meets the eye

by: Wolfgang Münchau




Estragon: “Let’s go.

”Vladimir: “We can’t.

”Estragon: “Why not?”

Vladimir: “We are waiting for the German elections.”


The German elections are the Godot of 2017. There has hardly been a political debate in Europe this year that does not end with some delusional reference to the September 24 poll. Once the elections are over, everything will become so much easier.

The truth is that right now is as good as it gets. The two largest parties are in government. They are both pro-European. Together they have 80 per cent of the seats in the Bundestag. They have a majority large enough to change the constitution. No matter which of the polls you believe, their joint share of the vote is about to fall dramatically. One possible outcome is that the present grand coalition of Christian Democrats and Social Democrats will return to power with a reduced majority.

Alternatively, chancellor Angela Merkel’s CDU/CSU might form a coalition with the liberal Free Democrats, or with both the FDP and the Greens. The FDP wants to reduce the lending capacity of the European Stability Mechanism, the eurozone rescue umbrella, and phase it out in the long run.

And it wants Greece out of the eurozone. What exactly, I wonder, is going to get easier?

The truth about the German elections is that nothing much will change. Greece did not get debt relief because the German political system as a whole rejects transfers of any kind. Also German legal interpretation of EU law is that debt relief is illegal. There is not one conceivable election outcome that could soften the current position, but one or two that could harden it.

The same goes for reform of the eurozone. When Emmanuel Macron was elected French president in May, he promised to pursue his eurozone agenda — after the German elections. I can see why he wants to focus on domestic policy first, like last week’s labour reforms, but the German vote is, again, entirely irrelevant.

The problem has never been Germany’s lack of interest in reform, but the kind of reforms it wants: stricter fiscal targets, stricter implementation, fewer exemptions, penalties for non-compliance, and outside interference in the policies of countries that do not follow the targets. Berlin wants to reinforce the EU’s no-bailout rules through a sovereign debt restructuring mechanism. That would leave the burden of adjustment with the sovereign bondholders, many of which are the domestic banks and insurers of eurozone member states.

Ms Merkel has expressed support for a European finance minister. By this she means a full-time chairman of the eurogroup of eurozone finance ministers, rather than the part-time one we have now. Not quite as big a deal as it sounds.

President Macron has not yet said what he really wants. His advisers have backtracked on earlier support for a common eurozone debt instrument. This is the crucial issue, not because the eurozone should incur more debt, but because a robust monetary union will, in the long run, require a common safe asset to function.

German government bonds are an insufficient Ersatz. They are neither a common instrument, nor sufficiently available. After the bond purchases by the European Central Bank, there are not enough of them left. And their stock will fall further as Germany continues to run persistent fiscal surpluses.

If one excludes the common debt instrument from the discussion, you are left with a hyperactive public relations exercise that hides the lack of a genuine economic union. I would not be surprised if France and Germany divert some of their domestic spending into a common investment fund, and label it a eurozone budget. I can hardly wait.

The eurogroup and its upgraded chairman will be in charge. The unelected ESM will turn into a monetary fund that will impose conditionality for any financial assistance. It will not answer to the European Parliament because it is an intergovernmental institution outside the scope of the EU treaties.

Wolfgang Schäuble even wants the ESM to disburse disaster relief, but beware a German finance minister bearing gifts: the ESM will become the de facto fiscal authority of any country that takes the money.

Maybe Mr Macron can soften some of the edges of all this. My reading is that the primary purpose of his eurozone agenda is not to fix a suboptimal monetary union but to strengthen the Franco-German partnership. The fact of the agreement will be more important than the content. I expect he will get his deal — but with Germany’s agenda.

Or as Estragon said: “Nothing happens. Nobody comes, nobody goes.”


Shooting over Japan’s head

Japan is alarmed and outraged by North Korea’s missile test

Pyongyang’s provocations raise questions about Japan’s civil-defence readiness and its pacifist constitution
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WHEN the alarm sounded from loudspeakers in the streets and his mobile telephone around 6am on August 29th, Saburo Ito thought it was a warning about an earthquake. But when he read that a North Korean missile was passing overhead the 72-year-old taxi driver panicked and ran out into the garden. The instruction to “evacuate to a sturdy building or basement” was all but forgotten. “I had no idea what to do or where to go,” he says.
 
Japanese have been oddly sanguine about military threats, even as China has grown more powerful and North Korea has tested ever more capable missiles and atom bombs. Japanese refer to this state of mind as heiwaboke, meaning roughly to take peace and security for granted.
 
Such complacency may have been shaken by the North Korean missile that passed over Hokkaido before crashing into the sea about 1,200km to the east. “North Korea’s reckless action is an unprecedented, serious and grave threat to our nation,” said the prime minister, Shinzo Abe.
 
It was not the first time that North Korea had fired over Japan; it had conducted similar tests four times previously (under the guise of satellite launches). But the latest shot was a surprise, not least because recent tensions over North Korea’s testing of long-range missiles had appeared to ease of late. America has grown increasingly alarmed that its bases in Guam, or perhaps America’s western seaboard, could soon be threatened by the regime of Kim Jong Un.
 
Japan has long lived under the shadow of his rockets. What is more alarming is the consensus among analysts that his engineers have probably mastered the technology of making a nuclear warhead small enough to fit on a missile.
 
 
 
The latest test is raising questions about the preparedness of Japan’s civil defences and the ability of its anti-missile systems to keep the country safe. It is also heightening the debate over whether Japan should amend its pacifist constitution.
 
Over the past year the government has tried to reassure citizens of its ability to protect them. It has published guidelines for how to respond to a missile strike: in short, take cover; and, in the event of a nuclear attack, pull a jacket over your head. Twelve towns have held drills for a North Korean missile attack. They have involved children having to curl up under their desks. For some Japanese such measures are not enough. A very small but increasing number have been building nuclear bunkers and buying air purifiers to protect against radiation in case of nuclear attack.
 
Japan enacted civil-defence legislation only in 2004, almost three decades after South Korea. J-Alert, the emergency public-information system, failed to work in some places. Suguru Arai of the disaster-prevention bureau in the town of Erimo, which was under the missile’s trajectory, points to a flaw in the advice for citizens to take cover: “There are no basements and only a few strong concrete buildings in the town.” Chains of command were inadequate in 2011 when an earthquake and tsunami caused a meltdown at the Fukushima Dai-ichi nuclear power plant.
 
Japan has a double-layer of missile defences: destroyers with Aegis missile-defence systems cover the whole country; land-based Patriot batteries (pictured on exercise, after the latest North Korean missile flew over) provide “point defence” for smaller areas. “But just as the threat grows, our defence capabilities must grow,” says Narushige Michishita, an analyst.
 
Raising the shield
 
Yet there are growing doubts about whether this is enough. The defence ministry wants to upgrade the Aegis systems on the destroyers and to acquire a land-based version, Aegis Ashore.
 
Some members of the ruling Liberal Democratic Party are urging the government to use its budget reserves to speed up the acquisition, rather than wait for an increased defence budget next year. The government is unlikely to add a third layer of missile protection, the Terminal High Altitude Area Defence missile shield that America operates in South Korea, on the grounds that it is too costly.
 
Noboru Yamaguchi, a former lieutenant-general in the Self-Defence Forces (SDF), Japan’s army, says Japan should also raise the number of crews to man Aegis destroyers to relieve overstretched personnel.
 
Japan is trying to improve other capabilities too, for instance by buying F-35 jets. But it lacks the wherewithal to strike at North Korean launch sites if it detects signs of imminent attack—something some officials, including the defence minister, Itsunori Onodera, would like to have. Japan’s military strength will remain limited for as long as it spends less than 1% of GDP on defence (South Korea and America spend 2.6% and 3.3% of GDP respectively).
 
Mr Abe has long thought that Japan should become a normal military power. In 2015 he pushed through legislation reinterpreting the constitution to allow the SDF to play a more forceful role in missions such as peacekeeping. This year he announced plans to rewrite the constitution’s pacifist clause by 2020. That will require approval in both houses of parliament, and a referendum. Mr Abe no doubt hopes the outcry over the latest missile shot will make his task easier. Even so, he would have to overcome great public resistance. And his popularity has been slumping of late amid reported scandals.
 
Over the years some in Japan have asked whether the country needs its own nuclear deterrent. Such talk may begin anew, amid growing doubts about America’s commitment to its allies. Mr Michishita, no hawk, says Japan must have a proper debate about the defence capabilities it needs: “Currently we are like a boxer that does not punch.”


Germans on the Eve of the Election

'I've Never Seen So Much Hate'

Interview Conducted by Nils Minkmar

 Protesters greeting Chancellor Angela Merkel in the city of Quedlinburg in August 2017.

 
Psychologist Stephan Grünewald has spent much of his career studying Germans. In a new study, he looked at current political attidudes and discovered raw emotions ahead of the upcoming election.

SPIEGEL: Mr. Grünewald, in the lead up to the election, the Rheingold Institute has once again undertaken a detailed analysis of Germany's political state. How did you proceed?

Gr ünewald: We put 50 voters on the couch. Twenty-six underwent in-depth psychological interviews, the others took part in three group discussions. Seven psychologists took part in the study, with two of them focusing on eastern Germany. It isn't representative, but you can recognize certain traits.

SPIEGEL: What did you find out?

Gr ünewald: On a fundamental level, the voters are totally disappointed in this election campaign. They feel like the things that are important to them aren't being discussed and that many things are being glossed over. We wanted to find out why.

SPIEGEL: What did you discover?

Gr ünewald: In the in-depth interviews, all people wanted to talk about was the refugee crisis, refugee crisis, refugee crisis. Despite being so elegantly left out of the campaign, it is still a sore spot that hasn't been treated by politicians.

SPIEGEL: What exactly is the problem?

Gr ünewald: The crisis two years ago plunged voters into a dilemma for which they still haven't found a clear response. Do I open the door, or do I close it? On one hand, they want to be part of the welcoming culture, but they are also afraid of being overwhelmed by foreigners and of no longer being able to recognize their own country. As a result, they want policymakers to develop a plan, to establish a compromise position. But they haven't, and now voters feel abandoned.

SPIEGEL: What is the consequence of this?

Gr ünewald: Voters are disoriented, full of uncertainties. They describe Germany either as an ailing, run-down country or as a secure island of affluence in a sea of risk. It's all very fragile and leads to emotional outbursts. I have never before seen so much anger and hatred among test subjects.

SPIEGEL: Do you expect growing political radicalization?

Gr ünewald: Not yet, because in reaction to the perceived hardening of the fronts, voters are also taking a step back. They argue that we cannot afford to slip into polarization because we are surrounded by three brutes: Trump, Erdogan and Putin. The anger is being expressed in shadowy digital worlds, but in the analog world, they keep a tighter rein on themselves.

SPIEGEL: Is the refugee crisis just a symbol for their discomfort with the difficult state of the world today?

Gr ünewald: Yes, because long before the refugee crisis people felt alienated by globalization and were also concerned about global security.

SPIEGEL: How is Trump being perceived?

Gr ünewald: He works to Merkel's advantage. Because of him, Putin and Erdogan, she is seen as the person who can tame the brutes. The chancellor is seen as the only one we can depend on, so we have to have a good relationship to her.

SPIEGEL: And her challenger?

Gr ünewald: Amid the skepticism around Merkel, Martin Schulz (of the center-left Social Democrats -- SPD) arrived early this year as a figure seen as down-to-earth with a take-charge attitude. He was seen as a returning father, someone to finally fill the paternal vacancy in German politics -- and it was blown up to almost messianic proportions. Schulz, the person, couldn't fulfill these expectations. He is seen more as a friendly uncle. The SPD faces a potential disaster in this election.

SPIEGEL: Could the right-wing populist Alternative for Germany (AfD) party do better than polls are currently leading us to expect?

Gr ünewald: The AfD channels a lot of this anger but it doesn't have a leadership figure. As such, it was a mistake to remove Frauke Petry from the spotlight. The tendency of voters to keep themselves in check, as I described earlier, won't help the AfD.

SPIEGEL: And the Green Party. Will they do well because climate change is such a critical issue?

Gr ünewald: No, it'll be tight for them. People think their problems lie elsewhere. And the Greens are also seen as arrogant because their fight for nature is often directed against human nature.

SPIEGEL: How do your test subjects see their personal situations?

Gr ünewald: Good but they are also struggling to find their place. Workplaces, daycare spaces, parking spots. Housing is also a big issue. All are symbols for the strong need for structure and orientation.

SPIEGEL: Does the chancellor provide this order?

Gr ünewald: In part. She will win by a wide margin, but it is still little more than a half-hearted expression of loyalty. The tried-and-true will once again be put on probation.

SPIEGEL: If the far-left Left Party, the SPD and the Greens had fielded a different joint candidate and promised a completely different plan of action, would that have been well received?

Gr ünewald: We discussed a variety of possible coalitions with the test subjects. But that one was never mentioned.

SPIEGEL: What came up instead?

Gr ünewald: Merkel with (Christian) Lindner (of the pro-business Free Democratic Party -- FDP).

There was a real love for Lindner in the interviews. The FDP's candidate is seen as a modern TV star, even like a kind of 007, who can engender change. A kind of dream team is the result: the proven Merkel and a mini German Macron that gives her a helping hand. As such, I'm predicting a coalition of Merkel's conservatives with the FDP.


North Korea and US Leadership

Christopher R. Hill

US-NKorea nuclear diplomacy

DENVER – Earlier this month, North Korea went a couple of weeks without launching any missiles or testing nuclear weapons. That short interval, which has since ended, was enough to inspire US Secretary of State Rex Tillerson to declare that North Korean leader Kim Jong-un was showing “restraint.” Perhaps, Tillerson concluded, Kim is ready to engage in dialogue. To some extent, he may be right.
 
To be sure, claims that the North was showing restraint were clearly premature: North Korea has since fired three short-range ballistic missiles from its east coast into the sea, and, more ominously, launched a ballistic missile over northern Japan. Tillerson’s optimism about such a short pause reflects the pressure diplomats face in reassuring allies – and, in Tillerson’s case, his boss, President Donald Trump – and easing tensions with enemies.
 
Nonetheless, Tillerson is probably right that North Korea is ready to talk to the United States – but only as one nuclear-weapons state to another. What the country’s leaders are patently not ready for is to meet America’s own requirement: that negotiations are based on the international commitments made in 2005, at the end of the fourth round of the so-called six-party talks.
 
Chief among those commitments, enshrined in a joint statement released at the end of the talks, is North Korea’s abandonment of “all nuclear weapons and existing nuclear programs.” In exchange, the other five participants in the talks (China, Japan, Russia, South Korea, and the US) were supposed to provide North Korea with energy and economic assistance, respect its sovereignty, and pursue the normalization of diplomatic relations. The five participants stood by their commitments, but North Korea repudiated its own in 2009.
 
According to critics, creating the “precondition” that the North stick to its original commitments amounts to a death blow to new talks. And, indeed, the Kim regime has shown no interest in resuming the six-party process, the stated purpose of which is to denuclearize the Korean Peninsula. In its 2013 constitution, North Korea for the first time even referred to itself as a “nuclear state.”
 
Tillerson rightly refers to a two-track policy toward North Korea. One track is dialogue; the other is pressure, applied through sanctions and other measures aimed at isolating North Korea and convincing its leadership that it has no future with nuclear weapons.
 
After North Korea’s tests of its new intercontinental ballistic missile (ICBM) last month, Tillerson and the US ambassador to the United Nations, Nikki Haley, focused on the second track, working with other Security Council members to impose the toughest sanctions ever against the North. Those sanctions could erode much of North Korea’s trade with China, the Kim regime’s economic lifeline.
 
But the US cannot rely excessively on other countries to constrain the North Korean regime, whose pursuit of nuclear weapons is not a symbolic quest. As its ICBM tests show, the goal is to threaten the US explicitly, in order to compel it to reduce its presence in Northeast Asia – and perhaps even reconsider its alliances with Japan and South Korea.
 
This ambitious goal is not without tacit support in the world: Russia and China have proposed that the US suspend its annual military exercises with the South, in exchange for a freeze of North Korea’s nuclear program. This supposedly fair-minded “freeze-for-freeze” proposal would do more to weaken the US-South Korea alliance than it would to impede North Korea’s development of a deliverable nuclear weapon.
 
The proposal highlights how difficult it is to mount an international response to the North Korea nuclear issue. Though China agreed to the recent sanctions in the Security Council, there is widespread skepticism about whether there is an internal consensus about the future it wants for the Korean Peninsula. Russia, for its part, seems to be pursuing a foreign policy guided more by spite than national interest.
 
America’s allies in the region, meanwhile, are under serious pressure. South Korea’s new government is stuck between the need to manage its relations with the US and the desire to open a dialogue with the North. And, as the North’s latest missile launch shows, Japan’s hosting of US military assets puts it on the front lines of the crisis.
 
This complex situation would require careful and precise diplomacy in the best of times, with the US using the various levers of its power. But this is not the best of times. Trump has been mercurial, given to making unscripted pronouncements on the topic. This has called for assurances from Tillerson, Secretary of Defense James Mattis, and others eager to mitigate the impact of bellicose exclamations – incongruously issued off the cuff from the clubhouse of a golf course – about “fire and fury.”
 
Trump’s statements about China’s role in addressing the problem don’t help, as they imply an interest in effectively outsourcing the job of reining in the Kim regime, in exchange for vague economic and trade assurances. The result is a perception of American unseriousness about this most serious of challenges.
 
The Trump administration has assembled before it all the components of an effective North Korea strategy: cooperation with China; pressure on North Korea through sanctions and isolation; reassurance of allies, including by providing the most up-to-date anti-ballistic missile defenses; and a willingness to talk. But for any of these instruments to have an impact, they must be used in concert and with precision in tone and substance – a quality of statecraft that the Trump administration has been slow to master.
 
In this sense, the challenge in North Korea is not just a nuclear crisis. It is a crisis of the quality of US leadership. Many see the problem, but no one knows yet how to overcome it.
 
 


Indigestion in China’s Economy Spells Trouble for Coal

Investors won’t hit paydirt with China’s big coal firms

By Nathaniel Taplin
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China pumps out machinery, cellphones and smog, but it runs on coal. It is by far the largest burner of the black stuff so, when Chinese factories start slowing down, it is usually time to sell your coal stocks.

A sharp economic reversal in China this year remains unlikely, but July data was strikingly weak after stellar second-quarter growth. That is bad news for coal firms everywhere, and especially for China’s state-owned behemoths like Yanzhou Coal, struggling with crushing debt burdens and fickle Chinese regulators. Yanzhou is roughly half-owned by the Shandong provincial government and its holding companies, but most of the big shareholders in Hong Kong are Western institutions, according to FactSet.

The coal price rebound fueled by Chinese stimulus this year has pushed Yanzhou’s stock up around 40% year-to-date and its first half sales up 82% from a year earlier, but the firm hasn’t used the breathing space to pay off much of its borrowings. Debt still clocked in at a vertigo-inducing 156% of equity in June.


UPPER LIMIT
Chinese data, change from a year earlier




Instead, Yanzhou is pursuing expensive acquisitions in Australia through its subsidiary Yancoal , YAL 8.70%▲ which recently agreed to buy Rio Tinto’s Hunter Valley coal assets for $2.69 billion. Cash-strapped Yancoal is issuing $2.5 billion in new equity to finance the deal over the objections of minority shareholders, with Yanzhou itself on the hook for up to $1 billion. Yanzhou also plans to boost capital expenditures by about 20% in 2017.

None of this would matter that much if China’s economy was poised for another 12 months of above-trend growth. Unfortunately, it is increasingly clear that isn’t the case. Chinese policy makers are tightening credit gradually ahead of an important Communist Party meeting this fall, and that is starting to affect investment and industrial output. Chinese real-estate investment, the biggest driver of global materials demand, including coal, grew at its slowest pace in over a year in July, and infrastructure investment also ticked lower. Industrial output weakened across the board.

Two other bearish factors for coal and electricity demand are about to kick in. First, it has started raining again in southwest China. Dry weather this spring pushed hydropower utilization down the most since 2012 and coal power plants’ run rates sharply higher. That dynamic is now moving into reverse as hydropower ramps up again.

Furthermore, plans to shutter more energy-intensive steel and aluminum plants this winter during the peak pollution season—on top of steel capacity cuts already enacted—could deal another blow to power demand. Metal smelting alone accounts for around 20% of power consumption in China.

Things are looking brighter for the global coal sector following the disastrous price crash of 2015—including the U.S., where the sector is seeing a revival—but things are just about as good as they can possibly be right now. Next year will be tougher.

Investors should take the opportunity to dig out their cash while the digging is good.


American politics

Lobbyists go underground

An apparent drop in their numbers is an illusion
 
 
 
ON A rainy afternoon, two sharply dressed men talk business and clink $40 glasses of wine at the Trump International Hotel, a few blocks from the White House. The recently opened hotel, which offers $65 steaks and a $100 cocktail made with raw oysters and caviar, has become popular among cabinet members, lobbyists and curious journalists. It would seem the swamp monsters, whom President Donald Trump once pledged to purge, are not doing too badly.
 
Lobbying expenses for the first six months of the year amounted to $1.67bn—the most since 2012—according to the Centre for Responsive Politics (CRP), a watchdog. The figure might have been even higher if Republicans had managed to convert their undivided control of Congress and the White House into legislative accomplishments. Instead, repeated attempts to reform Obamacare ran into the sand and the prospects for tax reform are uncertain.
 
Yet, strangely, the number of registered lobbyists has fallen sharply. In the second quarter of 2017 there were just 9,791—a third fewer than the 15,000 milling about K Street and other lobbyist haunts ten years ago. The number of dollars spent per registered lobbyist increases every year. Either the price of persuasion has shot up, or people are not being counted properly.
 
The answer is almost certainly the latter, and the man to blame is Barack Obama. The last president, who had promised to “take the blinders off the White House”, instituted strict rules limiting lobbyists from serving in his administration. Some influencers went underground, dodging registration requirements by not spending more than 20% of their time working for any single client. By one estimate, the official rolls capture only one in two lobbyists. Of the 2,100 lobbyists in 2016 who did not register in the first quarter of 2017, 58% stayed at the same company, according to the CRP. Many still seemed to be working to influence federal policy.
 
Purging lobbyists may be as hard as eradicating illegal drugs, and for the same reason: strong demand. So argue Lee Drutman and Steven Teles, two academics, who reason that Congress is increasingly incapable of creating policies. The number of workers in the Congressional Research Service, Congressional Budget Office and Government Accountability Office, the internal information services that provide unbiased reports to members, has dropped by 40% since 1979 even as legislation has grown more complex. Paid influencers, including those without the word “lobbyist” on their business cards, fill the gap.
 
Since Congress is unlikely to hire many more wonks, the Trump International Hotel will continue to sell fishy cocktails and pricey rooms. Mr Trump’s company had expected to sustain $2m in losses after opening the posh project in the first four months of 2017. Instead, it turned a $2m profit.


The Two Pillars of French Economic Reform

Philippe Aghion, Benedicte Berner

French labor code

PARIS – The French government has just announced the guidelines for a new labor code, its first major reform to boost France’s economy, by giving more flexibility to companies to adapt to the marketplace. The second major reform sought by President Emmanuel Macron’s cabinet – an overhaul of the French state – is set to follow.
 
The changes to the labor code have four goals. First, direct negotiations between employers and employees in small and medium-size firms (accounting for 55% of the workforce) would be facilitated by allowing such companies to negotiate with elected representatives not mandated by the trade unions. Second, social dialogue within larger firms would be simplified by merging separate workers’ committees (for hygiene, health, safety, and so on) into a central body. Third, collective bargaining over wages and employment would be decentralized from national to sectoral and/or firm level. Finally, laying off employees would become easier and more predictable, in particular with the introduction of upper and lower levels on payouts issued by labor courts.
 
The reform of the labor code will soon be accompanied by reforms of the unemployment insurance and job training systems. On the former, the government will take over from the unions, in order to provide unemployment benefits to all categories of workers, including the self-employed and those who voluntarily quit their current job to search for a new one. The cost of reforming unemployment insurance, however, is estimated at €3-5 billion ($3.6-6 billion), which may prove difficult to square with 2018 budget plans, which foresee a €20 billion cut in spending.
 
Altogether, the labor market reform is intended to reconcile more flexibility for firms to hire and shed workers – which is needed in an economy where growth is driven by innovation and creative destruction – with more income security and more training for the unemployed. The French labor market currently suffers from a huge divide between qualified workers under long-term contracts and low-skill workers who shuttle constantly between unemployment and short-term jobs. The government’s reform is meant to close this divide by increasing social mobility.
 
The second pillar of Macron’s economic program, reform of the state, has two major components: a revamp of fiscal policy and an overhaul of the public spending system. Here, too, the reform aims to address four main long-standing problems.
 
First, capital income is too heavily taxed in France, compared to other developed countries, which discourages innovation and entrepreneurship. Second, public money is not invested in the most cost-effective and growth-enhancing way. Third, France suffers from a multiplicity of administrative layers, which generates inefficiencies and redundancies in the provision of public services. Finally, France remains a highly corporatist country, with a multiplicity of health, pension, and family subsidy systems; in an innovation-driven economy where individuals are likely to change jobs and sectors repeatedly over their lifetime, this bureaucratic thicket becomes a source of inefficiency and risk.
 
On the fiscal front, Macron has made two important moves. First, on the revenue side, capital income would be taxed at a flat 30% rate, whereas before capital was taxed more than labor.

Second, the wealth tax on non-real-estate assets will be eliminated – a move meant to encourage entrepreneurs and innovators.
 
The government has not yet decided on a precise course of action for spending, although Macron and his team are looking closely at the reforms carried out by Canada and Sweden in the 1990s. In particular, the government may decide to reduce the number of civil servants by eliminating some administrative layers of regional and local government, and by delegating some administrative tasks to autonomous agencies. Moreover, the government may – and should – merge all existing pensions schemes into a single system (as it should with the social security, health insurance, and family subsidy systems). This would enable the government to invest in education, unemployment insurance, and innovation, while abiding by its European budgetary commitments.
 
After decades during which France experienced slow growth, high unemployment, industrial decline, and rigid corporatist institutions blocking all attempts at reform, a new hope for change has emerged.
 
Decisions made in the coming year will tell us whether this hope is to be fulfilled.
 
 

viernes, septiembre 22, 2017

UNVEILING THE NORTH KOREAN ECONOMY / THE FINANCIAL TIMES

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Unveiling the North Korean economy

A scholarly and important analysis of this reclusive country’s hidden transformation

by: Bryan Harris
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A silk factory in Pyongyang © AFP


For some residents of Seoul, the wall-to-wall coverage granted by western media to North Korea and its ever-expanding arsenal of ballistic missiles and verbal barbs is a source of bewilderment. Hunkered 50km from the most militarised border on the planet, these citizens have for decades lived with the threat of annihilation with stoic reserve.

Pyongyang’s sabre-rattling, meanwhile, has captured the world’s attention, with each new threat sparking reportage, punditry and tweets from Donald Trump. In the process, many have overlooked developments in North Korea that could have greater consequences for the future of the reclusive nation than the words of the US president.

Experts now recognise the North Korean economy is in the throes of a transformation, with the growth of both formal and informal markets, as well as private enterprise, boosting citizens’ wellbeing and defying notions of a state-run basket case. In Unveiling the North Korean Economy, Byung-Yeon Kim provides academic rigour and rare data in a book that should be required reading for policymakers or diplomats studying North Korea.

Kim, a professor at Seoul National University, acknowledges the growing ubiquity of market trading, a phenomenon that took root informally following devastating famine in the 1990s but now becoming increasingly enmeshed in government plans. In 2013, Kim Jong Un set out his “byungjin line” — a policy of simultaneous development of the nation’s economy and nuclear weapons, and has since permitted almost 400 markets with more than 600,000 stalls. These are in addition to countless unofficial markets — or jangmadang — which while technically illegal now account for between 70 and 90 per cent of total household income, according to a host of studies.

While the west has focused on the North Korean leader’s nuclear ambitions, the market reforms, combined with a tacit acceptance of private enterprises, have led to an uptick in wages and the standard of living of many citizens, complicating western efforts to sanction Pyongyang.

The author is most compelling when outlining the longer-term ramifications of these developments for the Kim regime: “Markets will transform the structure of the economy and the mindsets of people . . . our analysis predicts that this subtle balance between the power of the markets and that of the state cannot sustain long term, and economic considerations will ultimately prevail among North Koreans.” Prof Kim believes the North Korean leader will at that point face a crucial decision: risk his own position in an aggressive bid to repress the market or loosen his grasp in what could be the beginning of a Chinese-style transition.

Yet predicting Pyongyang is a fraught business, and part of the reason the North Korean economy has received comparatively little attention comes down to a lack of reliable information and credible macroeconomic data. Growth estimates can vary wildly. One example was gross domestic product per capita calculations for 2015, which ranged between -1 per cent (Bank of Korea in Seoul) and 9 per cent (Hyundai Research Institute).

Last month, the South Korean central bank said the North’s economy in 2016 grew at 3.9 per cent — the fastest pace in 17 years. These findings echo Prof Kim’s of a gradual U-shape recovery of the North Korean economy after its slump through the 1990s. However, he cautions that Pyongyang “is far from recovering to pre-crisis economic performance”.

In addition to macroeconomic analysis, Unveiling the North Korean Economy rewards the reader with fascinating nuggets gleaned from interviews with hundreds of North Korean refugees as well as businesses operating in the border region with China. These put paid to notions that North Koreans are dependent on state rations or that economic hardship is the primary factor motivating defections. Crucially, they also support data on wage growth; Prof Kim estimates the average monthly income from the informal economy is about 80 times that from official state jobs.

The imperfect data are limited by obvious constraints. But for anyone seeking a deep understanding of North Korea, this is essential reading.


The writer is the FT’s Seoul Bureau Chief


Buttonwood

Analysts struggle to make accurate long-term market forecasts

Historically high valuations for equities complicate the task  
 
That is pretty clear with government bonds. Anyone buying a bond with a yield of 2% and holding it until maturity can expect, at best, that level of return (before inflation) and no more. (There is a small chance the government might default.) With equities, the calculations are not quite so hard-and-fast. Nevertheless, it is a good rule-of-thumb that buying shares with a low dividend yield, or on a high multiple of profits, is likely to lead to lower-than-normal returns.
So a sensible approach to long-term investing would assess the potential returns from asset classes, given their valuations and the fundamentals, and allocate assets accordingly. That is what GMO, a fund-management company, has been trying to do for decades. It has made some common-sense assumptions about the fundamental drivers of returns and then assumed that valuations would return to average levels over a seven-year period.
 
In one sense, this process has been a success. The assets that GMO thought would perform well have offered relatively high returns; the assets it thought would perform badly have offered low ones (see top chart). But if the ranking has been correct, the level of return has not been. Assets that GMO thought would yield a negative return of -10% to -8%, for instance, have in fact suffered average losses of only -2.8%.
 
GMO’s forecasts have been pretty accurate for asset classes such as emerging-market bonds and international (non-American) shares; annual returns have been within 1.5 percentage points of its forecasts. But for American equities, GMO was too gloomy, underestimating returns by around four percentage points a year.
 
The reason for this error is pretty clear. Equity valuations have not returned to the mean, as GMO thought they would, but have stayed consistently above their historical levels. GMO was fairly accurate in its forecast for dividend growth, but its erroneous estimation of valuation accounted for all the forecast error.
 
There are two possible conclusions. One is that GMO is simply wrong about mean reversion.

Equities have moved to a new, higher valuation level. This sounds uncomfortably like the famous quote from Irving Fisher, an economist, before the 1929 crash, that stocks had reached a “permanently high plateau”. But there is some justification for a valuation shift: American profits have been high, relative to GDP, for a long period of time. This may be a result of monopoly power in some industries, or perhaps of the reduced bargaining power of workers in an age of globalisation.

A more obvious argument is that, with yields on cash and government bonds so low, investors are willing to pay a high price for equities because they represent their only hope for decent returns. But given the low level of dividend yields and the sluggish rate of economic growth, profits will have to keep rising as a proportion of GDP to allow high equity returns to continue.
 
That seems unlikely.
 
Either there will be a political reaction—governments will clamp down on firms in response to public unrest—or, more prosaically, tighter labour markets mean that wage growth will start to erode profits.
 
Either way, it is understandable that GMO does not want to give up on the idea of mean reversion just yet. Its latest forecasts are pretty downbeat (see bottom chart). The real returns from most asset classes are expected to be negative; only emerging-market equities offer a decent return. Investors who disbelieve those forecasts are in essence betting that things will be “different this time”. That is certainly possible but it requires a lot of faith.


Barbarians at the Monetary Gate

Andrew Sheng, Xiao Geng
.
Bitcoin

HONG KONG – Financial markets today are thriving. The Dow Jones industrial average, the S&P 500, and the Nasdaq composite index have all reached record highs lately, with emerging-economy financial markets also performing strongly, as investors search for stability amid widespread uncertainty. But, because this performance is not based on market fundamentals, it is unsustainable – and very risky.
 
According to Mohamed El-Erian, the lost lesson of the 2007 financial crisis is that current economic-growth models are “overly reliant on liquidity and leverage – from private financial institutions, and then from central banks.” And, indeed, a key driver of financial markets’ performance today is the expectation of continued central-bank liquidity.
 
After the US Federal Reserved revealed its decision last month to leave interest rates unchanged, the Dow Jones industrial average set intraday and closing records; the Nasdaq, too, reached all-time highs. Now, financial markets are waiting for signals from this year’s meeting of the world’s major central bankers in Jackson Hole, Wyoming.
 
But there is another factor that could further destabilize an already-tenuous leverage- and liquidity-based system: digital currencies. And, on this front, policymakers and regulators have far less control.
 
The concept of private cryptocurrencies was born of mistrust of official money. In 2008, Satoshi Nakamoto – the mysterious creator of bitcoin, the first decentralized digital currency – described it as a “purely peer-to-peer version of electronic cash,” which “would allow online payments to be sent directly from one party to another without going through a financial institution.”
 
A 2016 working paper by the International Monetary Fund distinguished digital currency (legal tender that could be digitized) from virtual currency (non-legal tender). Bitcoin is a cryptocurrency, or a kind of virtual currency that uses cryptography and distributed ledgers (the blockchain) to keep transactions both public and fully anonymous.
 
However you slice it, the fact is that, nine years after Nakamoto introduced bitcoin, the concept of private electronic money is poised to transform the financial-market landscape. This month, the value of bitcoin reached $4,483, with a market cap of $74.5 billion, more than five times larger than at the beginning of 2017. Whether this is a bubble, destined to collapse, or a sign of a more radical shift in the concept of money, the implications for central banking and financial stability will be profound.
 
At first, central bankers and regulators were rather supportive of the innovation represented by bitcoin and the blockchain that underpins it. It is difficult to argue that people should not be allowed to use a privately created asset to settle transactions without the involvement of the state.
 
But national authorities were wary of potential illegal uses of such assets, reflected in the bitcoin-enabled, dark-web marketplace called Silk Road, a clearinghouse for, among other things, illicit drugs. Silk Road was shut down in 2013, but more such marketplaces have sprung up. When the bitcoin exchange Mt. Gox failed in 2014, some central banks, such as the People’s Bank of China, started discouraging the use of bitcoin. By November 2015, the Bank for International Settlements’ Committee on Payments and Market Infrastructures, made up of ten major central banks, launched an in-depth examination of digital currencies.
 
But the danger of cryptocurrencies extends beyond facilitation of illegal activities. Like conventional currencies, cryptocurrencies have no intrinsic value. But, unlike official money, they also have no corresponding liability, meaning that there is no institution like a central bank with a vested interest in sustaining their value.
 
Instead, cryptocurrencies function based on the willingness of people engaged in transactions to treat them as valuable. With the value of the proposition depending on attracting more and more users, cryptocurrencies take on the quality of a Ponzi scheme.
 
As the scale of cryptocurrency usage expands, so do the potential consequences of a collapse.
 
Already, the market capitalization of cryptocurrencies amounts to nearly one tenth the value of the physical stock of official gold, with the capability to handle significantly larger payment operations, owing to low transaction costs. That means that cryptocurrencies are already systemic in scale.
 
There is no telling how far this trend will go. Technically, the supply of cryptocurrencies is infinite: bitcoin is capped at 21 million units, but this can be increased if a majority of “miners” (who add transaction records to the public ledger) agree. Demand is related to mistrust of conventional stores of value. If people fear that excessive taxation, regulation, or social or financial instability places their assets at risk, they will increasingly turn to cryptocurrencies.
 
Last year’s IMF report indicated that cryptocurrencies have already been used to circumvent exchange and capital controls in China, Cyprus, Greece, and Venezuela. For countries subject to political uncertainty or social unrest, cryptocurrencies offer an attractive mechanism of capital flight, exacerbating the difficulties of maintaining domestic financial stability.
 
Moreover, while the state has no role in managing cryptocurrencies, it will be responsible for cleaning up any mess left by a burst bubble. And, depending on where and when a bubble bursts, the mess could be substantial. In advanced economies with reserve currencies, central banks may be able to mitigate the damage. The same may not be true for emerging economies.
 
An invasive new species does not pose an immediate threat to the largest trees in the forest. But it doesn’t take long for less-developed systems – the saplings on the forest floor – to feel the effects.
 
Cryptocurrencies are not merely new species to watch with interest; central banks must act now to rein in the very real threats they pose.
 
 


Sell the Swiss Franc if You Think the World Is a Better Place

Swiss franc proved slow to react to the brighter picture for the eurozone economy

By Richard Barley


SAFETY TRADE
How many euros one Swiss franc buys



For all of the controversy around aggressive monetary policy, there is little dispute that central bankers have succeeded in moving the values of stocks, bonds and currencies. The exception that proves the rule is the Swiss franc.

The Swiss National Bank has tried hard to battle the strength of its currency but where other central banks had big impacts, the Swiss franc has refused to fall. The central bank has gone deep into negative-interest-rate territory, taking its target rate to minus 0.75%. For four years it put an outright cap on appreciation against the euro, printing francs and buying foreign assets in a campaign that has taken its balance sheet to more than 100% of Switzerland’s gross domestic product.

The SNB’s cap did temporarily turn the Swiss franc around, but the chaos sparked by its January 2015 decision to abandon that policy still hasn’t fully reversed. On a trade-weighted basis and adjusted for inflation, the Swiss franc is still some 12% higher than its precrisis average, SNB data show. Against the euro, the franc has fallen 6% this year but is still stronger than the level the SNB targeted before January 2015.

The SNB’s efforts to weaken the franc have been overwhelmed by the actions of its much bigger neighbor, the European Central Bank. But now the ECB is gradually moving away from quantitative easing as the eurozone economy picks up.

On the Swiss side, extremely low inflation means the central bank has absolutely no reason to shift its policy. Annual inflation has only been above zero in 12 of the 67 months since the start of 2012 and has often been below that of Japan. The SNB forecasts inflation at 0.3% in 2018 and 1% in 2019.

The combination of weak inflation and loose monetary policy in Switzerland and stronger growth and less quantitative easing in Europe argues for the franc to weaken versus the euro.

The other factor pushing for a weaker franc is the improving prospects for the eurozone. Fear of the currency bloc breaking up benefits the franc. Swiss outward investment flows, much of which traditionally landed in the eurozone, have collapsed since the crisis. As those fears fade, so should the franc. The first time the Swiss franc showed signs of weakening this year was in the wake of the French elections, won by the staunchly pro-Europe Emmanuel Macron. A resumption of Swiss investment flows—which means investors sell francs and buy euros—could be a key factor in the franc’s path.

INTERRUPTED
Swiss residents net investments in foreign securities


EVEN LOWER, EVEN LONGER
Change in consumer prices from a year earlier


The Swiss franc won’t stop being a haven. When risk aversion rises, investors seem hard-wired to embrace it. Italian elections next year could be a flashpoint. But unless there is a specific threat to eurozone cohesion, such reversals shouldn’t prove too disruptive.

Put together, that makes the Swiss franc a sell against the euro. Even if the franc falls from its current €0.875 to €0.83, a big move in currencies, it would only be at the highest level that the Swiss central bank allowed it to go in 2015. A further decline would make those bankers happier. Investors should go along for the ride.


Economic Forecast: Theories Behind The Numbers

by: Dr. Bill Conerly

 
 
What's the theory behind my economic forecast? In simple language, it's complicated. My forecast is judgmental rather than coming from an econometric model. I begin with a "bottoms-up" prediction of major sectors, followed by a top-down reality-check. This article will explain my basic economic thought process.
 
The classical economists are in the back of my mind. They viewed the economy as self-regulating. The Pigou effect is one part of the process, but not the only one. I certainly believe we would have business cycles even in the absence of bad government policy, but I think the classicals were right that if the government took their hands off the levers of policy, the economy would come back to full employment. My judgment is that the speed of adjustment would be fairly rapid, but the slow-adjustment argument is worth considering.
 
 
Dr. Bill Conerly with data from Bureau of Economic Analysis
Economic Growth and Contraction
 
 
I read John Maynard Keynes' General Theory as a skeptical undergraduate, but I really took to it after reading Axel Leijonhufvud's splendid On Keynesian Economics and the Economics of Keynes. He said that textbook Keynesian economics had become mechanical, losing some key points. I took away two lessons. The first is that the basis for many spending decisions is soft.
 
We can teach MBA students how to find the optimum capital expenditure, but the calculations are based on a host of unknowns: future prices and future costs and future interest rates. The second lesson is that in an environment of unknowns, decision-makers often take on a herd mentality, leading to swings of optimism and pessimism. When forecasting business decisions, I look at the fundamental factors that should be driving capital spending, but I also recognize the possibility of these mood swings.

The monetarism of Milton Friedman and others heavily influenced me early in my career. I'm less a monetarist now, partly because it's so hard to find a measure of money supply for which demand is fairly stable. Nonetheless, I take monetary policy to be powerful, but not completely determinative for the economy.
 
"Real business cycle" theory shows that swings in new technology development can trigger booms and busts. For their work on this, Finn Kydland and Edward Prescott were awarded the Nobel prize in economics. Read the prize description for more about their work at the layman's level. When the tech sector develops new business models, there can certainly be a boost to capital spending - so long as the technology does not reduce the need for capital in total. I keep this in mind, but most of my effort focuses on other areas.
 
The dominant macroeconomic theory today is "new Keynesian," which emphasizes the business cycle consequences of market imperfections, such as wages and prices that adjust to new circumstances only gradually. I take this seriously, though with the proviso that when it is profitable to change wages and prices more quickly, that will happen.
 
That idea brings us to rational expectations, the notion that people make decisions using all of the information available to them. The idea is frequently criticized, even to the point of being laughed at, but let's state it a different way: You can't fool all the people all the time. Robert Lucas argues that economic policy which depended on tricking people would not long work.
 
Think of government spending to stimulate the economy. The stimulus comes only if people do not boost their savings so that they can pay a future tax bill. As more and more people worry about the federal debt burden, I think that policy is less effective.
 
I'm often asked about Austrian business cycle theory, which I studied both as an undergraduate and in my Ph.D. program at Duke. The simplistic version of this theory is that easy money policy from the Federal Reserve (or other central bank) causes more capital spending and more roundabout production processes than is warranted by the underlying productivity of capital and consumer time preference. Eventually, the misallocation of resources is corrected, resulting in a recession or depression. The downturn is necessary to correct the errors of the past. Although there are many insights from the Austrian school that I use regularly, I find the specifics of the business cycle theory less useful.

I also find a good bit of overlap between the economics of Keynes, with its emphasis on decision-making under uncertainty, and the Austrian view. This seems odd to those who see Keynesians as proponents of activist government and Austrians as opponents. The two schools are united in their emphasis on decision-making under uncertainty. (Although Hayek and Keynes are sometimes portrayed as antagonists, they were cordial colleagues. During World War II they walked the streets of Cambridge together as air wardens, checking that blackout curtains were in place.)
 
My economic theory is a mongrel, using a variety of insights developed by different theorists.
 
The most important basis is old-fashioned supply and demand, applied to different sectors of the economy. For instance, when I look at consumer spending on durables goods such as cars, I examine incomes and whether there might be pent-up demand. When business spending is surging, I'm concerned about supply-chain limitations.
 
In practice, forecasting is heavily judgmental. Some folks have computer models that they let run on autopilot. But each model is based on judgements about what factors to include and what to ignore.
 
The world is too complicated - and data too limited - to utilize all possible explanatory factors, so economists pick and choose. Whether with a computer model or a purely judgmental process, the economist makes his best guess in an atmosphere of uncertainty.


Pension Storm Warning

John Mauldin


This time is different are the four most dangerous words any economist or money manager can utter. We learn new things and invent new technologies. Players come and go. But in the big picture, this time is usually not fundamentally different, because fallible humans are still in charge. (Ken Rogoff and Carmen Reinhart wrote an important book called This Time Is Different on the 260-odd times that governments have defaulted on their debts; and on each occasion, up until the moment of collapse, investors kept telling themselves “This time is different.” It never was.)

Nevertheless, I uttered those four words in last week’s letter. I stand by them, too. In the next 20 years, we’re going to see changes that humanity has never seen before, and in some cases never even imagined, and we’re going to have to change. I truly believe this. We have unleashed economic and technological forces we can observe but not entirely control.

I will defend this bold claim at greater length in my forthcoming book, The Age of Transformation.

Today we will zero in on one of those forces, which last week I called “the bubble in government promises,” which I think is arguably the biggest bubble in human history. Elected officials at all levels have promised workers they will receive pension benefits without taking the hard steps necessary to deliver on those promises. This situation will end badly and hurt many people. Unfortunately, massive snafus like this rarely hurt the politicians who made those overly optimistic promises, often years ago.

Earlier this year I called the pension mess “The Crisis We Can’t Muddle Through.” Reflecting since then, I think I was too optimistic. Simply waiting for the floodwaters to drop down to muddle-through depth won’t be enough. We face an entire new ocean, deeper and wider than we can ever cross unaided.


Storms from Nowhere?

This year marks the first time on record that two Category 4 hurricanes have struck the US mainland in the same year. Worse, Harvey and Irma landed directly on some of our most valuable and vulnerable coastal areas. So now, in addition to all the problems that existed a month ago, the US economy has to absorb cleanup and rebuilding costs for large parts of Texas and Florida, as well as our Puerto Rico and US Virgin Islands territories.

Now then, people who live in coastal areas know full well that hurricanes happen – they know the risk, just not which hurricane season might launch a devastating storm in their direction. In a note to me about Harvey, fellow Rice University graduate Gary Haubold (1980) noted just how flawed the city’s assumptions actually were regarding what constitutes adequate preparedness. He cited this excerpt from a recent Los Angeles Times article:

The storm was unprecedented, but the city has been deceiving itself for decades about its vulnerability to flooding, said Robert Bea, a member of the National Academy of Engineering and UC Berkeley emeritus civil engineering professor who has studied hurricane risks along the Gulf Coast.

The city’s flood system is supposed to protect the public from a 100-year storm, but Bea calls that “a 100-year lie” because it is based on a rainfall total of 13 inches in 24 hours.

“That has happened more than eight times in the last 27 years,” Bea said. “It is wrong on two counts. It isn’t accurate about the past risk and it doesn’t reflect what will happen in the next 100 years.” (Source)

Anybody who lives in Houston can tell you that 13 inches in 24 hours is not all that unusual. But how do Robert Bea’s points apply to today’s topic, public pensions? Both pension plan shortfalls and hurricanes are known risks for which state and local governments must prepare. And in both instances, too much optimism and too little preparation ultimately have devastating results.

Admittedly, public pension liabilities don’t come out of nowhere the way hurricanes seem to – we know exactly where they will strike. In many cases, we know approximately when they’ll strike, too. Yet we still let our elected officials make impossible-to-fulfill promises on our behalf. The rest of us are not so different from those who built beach homes and didn’t buy hurricane or storm surge insurance. We just face a different kind of storm.

Worse, we let our government officials use predictions about future returns that are every bit as unrealistic as calling a 13-inch rain in Houston a 100-year event. And while some of us have called pension officials out, they just keep telling lies – and probably will until we reach the breaking point.

Puerto Rico is a good example. The Commonwealth was already in deep debt before Irma blew in – $123 billion worth of it. There’s simply no way the island can repay such a massive debt. Creditors can fight in the courts, but in the end you can’t squeeze money out of plantains or pineapples. Not enough money, anyway. Now add Irma damages, and the creditors have even less hope of recovering their principal, let alone interest.

Puerto Rico is presently in a new form of bankruptcy that Congress authorized last year. Court proceedings will probably drag on for years, but the final outcome isn’t in doubt. Creditors will get some scraps – at best perhaps $0.30 on the dollar, my sources say – and then move on. We’re going to find out how strong those credit insurance guarantees really are.

“That’s just Puerto Rico,” you may say if you’re a US citizen in one of the 50 states. Be very careful. Your state is probably not so much better off. In 10 years, your state may well be in the same place where Puerto Rico is now. I’d say the odds are better than even.

Are your elected leaders doing anything about this huge issue, or even talking about it? Probably not.

As it stands now, states can’t declare bankruptcy in federal courts. Letting them do so would raises thorny constitutional issues. So maybe we’ll have to call it something else, but it’s going to end the same way. Your state’s public-sector retirees will not get what they were promised, and they won’t take the outcome kindly.

Blood from Turnips

Public sector bankruptcy, up to and including state-level bankruptcy, is fundamentally different from corporate bankruptcy in ways that many people haven’t considered. The pension crisis will likely expose those differences as deadly to creditors and retirees.

Say a corporation goes bankrupt. A court will take all its assets and decide how to divvy them up. The assets are easy to identify: buildings, land, intellectual property, cash, etc. The parties may argue over their value, but everyone knows what the assets are. They won’t walk away.

Not so in a public bankruptcy. The primary asset of a city, county, or state is future tax revenue from households and businesses within its boundaries. The taxpayers can walk away. Even without moving, they can bypass sales taxes by shopping elsewhere. If property taxes are too high, they can sell and move. When they take a loss on the sale, the new owner will have established a property value that yields the city far less revenue than it used to receive.

Cities and states don’t have the ability to shed their pension liabilities. They are stuck with them, even as population and property values change.

We may soon see an example of this in Houston. Here in Texas, our property taxes are very high because we have no income tax. Your tax is a percentage of your home’s taxable value. So people argue to appraisal boards that their homes are falling apart and not worth anything like the appraised value. (Then they argue the opposite when it’s time to sell the home.)

About 200 entities in Harris County can charge taxes. That includes governments from Houston to Baytown to Hedwig Village, plus 20 independent school districts.

There’s a hospital district, port authority, several college districts, the flood control district, a multitude of utility districts, and the Harris County Department of Education. Some homes may fall within 10 or more jurisdictions.

What about those thousands of flooded homes in and around Houston; how much are they worth? Right now, I’d say their value is zero in many cases. Maybe they will have some value if it’s possible to rebuild, but at the very least they ought to receive a sharp discount from the tax collector this year.

Considering how many destroyed or unlivable properties there are all over South Texas, I suspect cities and counties will lose billions in revenue even as their expenses rise. That’s a small version of what I expect as city and state pension systems all over the US finally face reality.

Here in Dallas I pay about 2.7% in property taxes. When I bought my home over four years ago, I checked our local pension and was told we were 100% funded. I even mentioned in my letter that I was rather surprised. Turns out they lied. Now, realistic assessments suggest they will have to double the municipal tax rate (yes, I said double) to be able to fund fire and police pension funds. Not a terribly popular thing to do. At some point, look for taxpayers to desert the most-indebted cities and states. Then what? I don’t know. Every solution I can imagine is ugly.
 
Promises from Air

Most public pension plans are not fully funded. Earlier this year in “Disappearing Pensions” I shared this chart from my good friend Danielle DiMartino Booth:


 
Total unfunded liabilities in state and local pensions have roughly quintupled in the last decade. You read that right – not doubled, tripled or quadrupled: quintupled.
 
That’s nice when it happens on a slot machine, not so nice when it’s money you owe.

You will also notice in the chart that much of that change happened in 2008. Why was that? That’s when the Fed took interest rates down to nearly zero, meaning it suddenly took more cash to fund future payments. Also, some strapped localities conserved cash by promising public workers more generous pension benefits in lieu of pay raises.

According to a 2014 Pew study, only 15 states follow policies that have funded at least 100% of their pension needs. And that estimate is based on the aggressive assumptions of pension funds that they will get their predicted rate of returns (the “discount rate”).

Kentucky, for instance, has unfunded pension liabilities of $40 billion or more. This month the state budget director notified local governments that pension costs could jump 50-60% next year. That’s due to a proposed reduction in the system’s assumed rate of return from 7.5% to 6.25% – a step in the right direction but not nearly enough.

Think about this as an investor. Do you know a way to guarantee yourself even 6.25% average annual returns for the next 10–20 years? Of you don’t. Yes, some strategies have a good shot at doing it, but there’s no guarantee.

And if you believe Jeremy Grantham’s seven-year forecasts (I do: His 2009 growth forecast was spot on), then those pension funds have very little hope of getting their average 7% predicted rate of return, at least for the next seven years.


 
Now, here is the truth about pension liabilities. Let’s assume you have $1 billion in funding today. If you assume a 7% compound return – about the average for most pension funds – then that means in 30 years that $1 million will have grown to $8 billion (approximately). Now, what if it’s a 4% return? Using the Rule of 72, the $1 billion grows to around $3.5 billion, or less than half the future assets in 30 years if you assume 7%.

Remember that every dollar that is not funded today means that somewhere between four dollars and eight dollars will not be there in 30 years when somebody who is on a pension is expecting to get it. Worse, without proper funding, as the fund starts going negative, the funding ratio actually gets worse, sending it into a death spiral. The only way to bring it out of the spiral is with huge cuts to other needed services or with massive tax cuts to pension benefits.

The State of Kentucky’s unusually frank report regarding the state’s public pension liability sums up that state’s plight in one chart:


 
The news for Kentucky retirees is quite dire, especially considering what returns on investments are realistically likely to be. But there’s a make or break point somewhere. What if pension plans must either hit that 6% average annual return for 2018–2028 or declare bankruptcy and lose it all?

That’s a much greater problem, and it’s a rough equivalent of what state pension trustees have to do. Failing to generate the target returns doesn’t reduce the liability. It just means taxpayers must make up the difference.

But wait, it gets worse. The graph we showed earlier stated that unfunded pension liabilities for state and local governments was $2 trillion. But that assumes an average 7% compound return. What if we assume 4% compound returns? Now the admitted unfunded pension liability is $4 trillion. But what if we have a recession and the stock market goes down by the past average of more than 40%? Now you have an unfunded liability in the range of $7–8 trillion.


 
We throw the words a trillion dollars around, not realizing how much that actually is.
 
Combined state and local revenues for the US total around $2.6 trillion. Following the next recession (whenever that is), the unfunded pension liabilities for state and local governments will be roughly three times the revenue they are collecting today, and that’s before a recession reduces their revenues. Can you see the taxpayer stuck between a rock and a hard place? Two immovable objects meeting? The math just doesn’t work.

Pension trustees don’t face personal liability. They’re literally playing with someone else’s money. Some try very hard to be realistic and cautious. Others don’t. But even the most diligent can’t control when the next recession comes, or when the stock market will crash, leaving a gaping hole in their assets while liabilities keep right on rising.

I have had meetings with trustees of various government pensions. Many of them want to assume a more realistic discount rate, but the politicians in their state literally refuse to allow them to assume a reasonable discount rate, because owning up to reality would require them to increase their current pension funding dramatically. So they kick the can down the road.

Intentionally or not, state and local officials all over the US made pension promises that future officials can’t possibly keep. Many will be out of office when the bill comes due, protected from liability by sovereign immunity.

We are starting to see cities filing for bankruptcy. That small ripple will be a tsunami within 7–10 years.

But wait, it gets still worse. (Do you see a trend here?) Many state and local governments have actually 100% funded their pension plans. Some states and local governments have even overfunded them – assuming they get their projected returns. What that really means is that the unfunded liabilities are more concentrated, and they show up in unlikely places. You think Texas is doing well? Look at some of our cities and weep. Look, too, at other seemingly semi-prosperous cities all over the country. Do you think the suburbs of Dallas will want to see their taxes increased to help out the city? If you do, I may have a bridge to sell you – unless you would rather have oceanfront properties in Arizona.

This issue is going to set neighbor against neighbor and retirees against taxpayers. It will become one of the most heated battles of my lifetime. It will make the Trump-Clinton campaigns look like a school kids’ tiddlywinks smackdown.

I was heavily involved in politics at both the national and local levels in the 80s and 90s and much of the 2000s. Trust me, local politics is far nastier and more vicious. And there is nothing more local than police and firefighters and teachers seeing their pensions cut because the money isn’t there. Tax increases of up to 100% are going to become commonplace. But even these new revenues won’t be enough… because we will be acting with too little, too late.

This is the core problem. Our political system gives some people incentives to make unrealistic promises while also absolving them of liability for doing so. It also places the costs of those must-break promises on innocent parties, i.e. the retirees who did their jobs and rightly expect the compensation they were told they would receive.

So at its heart the pension crisis is really not a financial problem. It’s a moral and ethical problem of making and breaking promises that profoundly impact people’s lives. Our culture puts a high value on integrity: doing what you said you would do.

We take a job because the compensation package includes x, y and z. Then someone says no, we can’t give you z, so quit and go elsewhere.

The pension problem is going to get worse as more and more retirees get stuck with broken promises, and as taxpayers get handed higher and higher bills. These are irreconcilable demands in many cases. It’s not possible to keep contradictory promises.

What’s the endgame? I think much of the US will end up like Puerto Rico. But the hardship map will be more random than you can possibly imagine. Some sort of authority – whether bankruptcy courts or something else – will have to seize pension assets and figure out who gets hurt and how much. Some courts in some states will require taxes to go up. But courts don’t have taxing authority, so they can only require cities to pay, but with what money and from whom?

In many states we literally don’t have the laws and courts in place with authority to deal with this. And just try passing a law that allows for states or cities to file bankruptcy in order to get out of their pension obligations.

The struggle will get ugly, and innocent people on both sides will be hurt. We hear stories about retired police chiefs and teachers with lifetime six-digit pensions and so on. Those aberrations (if you look at the national salary picture) are a problem, but the more distressing cases are the firefighters, teachers, police officers, or humble civil servants who served the public for decades, never making much money but looking forward to a somewhat comfortable retirement. How do you tell these people that they can’t have a livable pension? We will see many human tragedies.

On the other side will be homeowners and small business owners, already struggling in a changing economy and then being told their taxes will double. This may actually happen in Dallas; and if it does, we won’t be alone for long.

The website Pension Tsunami posts scores of articles, written all across America, about pension problems. We find out today that in places like New York and Chicago and Cook County, pension funds have more retirees collecting than workers paying into the fund. There are more retired cops in New York and Chicago than there are working cops. And the numbers of retirees just keep growing. On an individual basis, it is smart for the Chicago police officer to retire as early possible, locking in benefits, go on to another job that offers more retirement benefits, and round out a career by working at least three years at a private job that qualifies the officer for Social Security. Many police and fire pensions are based on the last three years of income; so in the last three years before they retire, these diligent public servants work enormous amounts of overtime, increasing their annual pay and thus their final pension payouts.

As I’ve said, this is the crisis we can’t muddle through. While the federal government (and I realize this is economic heresy) can print money if it has to, state and local governments can’t print. They actually have to tax to pay their bills. It’s the law. It’s also an arrangement with real potential to cause political and social upheaval that Americans have not seen in decades. The storm is only beginning. Think Hurricane Harvey on steroids, but all over America. Of all the intractable economic problems I see in the future (and I have a vivid imagination), this is the most daunting.

Chicago, Lisbon, Denver, Lugano, and Hong Kong

I will be in Chicago the afternoon of August 26, meeting with clients and friends, and then I’ll speak at the Wisconsin Real Estate Alumni conference the morning of the 28th, before returning to Dallas that afternoon and flying with Shane to Lisbon the next day. My hosts are graciously giving me a few extra days to explore Lisbon, and Portugal is one of the last two Western European countries I have never been to. After this, only Luxembourg is left, so the next time I’m in Brussels or Amsterdam on a Sunday, I’m going to get on a train and go have lunch in Luxembourg.

On Wednesday morning the 27th I will be on CNBC with my friend Rick Santelli. As usual, we’ll talk about whatever’s on the top of Rick’s mind at the moment. It makes for a hellaciously fun discussion.

I return to Dallas to speak at the Dallas Money Show on October 5–6. You can click on the link for details. I will speak at an alternative investments conference in Denver on October 23–24 (details in future letters) and return to Denver on November 6 and 7, speaking for the CFA Society and holding meetings. After a lot of small back-and-forth flights in November, I’ll end up in Lugano, Switzerland, right before Thanksgiving. Busy month! Then there will be a (currently) lightly scheduled December, followed by an early trip to Hong Kong in January. It looks like Lacy Hunt and his wife, JK, will join Shane and me there. Lacy and I will come back home exhausted from trying to keep up with the bundles of indefatigable energy that JK and Shane are.

Boston was a very intriguing two full days of meetings. There is the potential to expand the services that my firms can offer readers and investors into areas that I never knew might be possible. It is truly exciting, and I hope we can pull it off.

I am off to meet with a close friend from out of town and compare notes on the world, one of my favorite things to do. I know we all have times when we wish we were being more productive, when we wondering why are we here and not moving the ball forward. But when I get to spend time with good friends, old or new, I somehow never feel that way. And while our pension systems may be going to hell in a handbasket, friendships will remain forever. You have a great week.

Your wishing I could see a better path forward analyst,