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    My Summer Break – Missing Out on the next financial crisis?!

    September 2019

    With the daily headlines about the US and China imposing tariffs on merchandise in each other’s markets, you might get the impression that all that matters in international commerce today is the exchange of goods between countries, such as raw or refined commodities, textiles and clothing, steel products, and other manufactured items. However, you would be dead wrong – as wrong as Trump.

    A large portion of cross – border transactions in the modern economy of the 21st century is in the services sectors, a swathe of diverse activities, including transport, banking, tourism, telecommunications, e-commerce, management consulting, education, accounting, and informatics. In fact, worldwide growth in services trade has significantly outpaced that of products.

    In 1975, total global merchandise trade (both exports and imports) accounted for 27% of the world’s GDP. At that time, the share of global GDP represented by total service trade was only 6%. But by 2018, services trade as a percentage of the world’s GDP had more than doubled, whereas trade in goods as a share global GDP increased by only 70%.

    To be sure, the current White House’s obsession with merchandise trade is most pronounced in the case of US-China economic relations. Washington’s current trade war with Beijing is predicated on the bilateral deficit in the two countries’ trade in goods. That deficit totaled 419.2 billion US-Dollar are in 2018. This is why US President Donald Trump’s trade weapon of choice with the Chinese is the imposition of tariffs on US imports of goods from China. If Trump could eliminate the bilateral deficit in merchandise trade with China by applying higher and higher tariffs – or perhaps more simply if Xi Jinping would just write him a check for 499.2 billion US-Dollar – Trump would declare victory.

    That objective is wrong-headed for two reasons.

    First, Trump ignores the fact that the Chinese in 2018 bought 41.5 billion US-Dollar more services from Americans than the US bought from China. That is, the US is actually running a surplus in services trade with China. This surplus means the overall US bilateral trade deficit with China is actually lower than what Trump thinks. It is 377.7 billion US-Dollar.

    Second, bilateral trade deficits in and of themselves are not economically meaningful. To this end, the problem with China’s trade practices are for more fundamental in my opinion: it is that they are not consistent with Beijing’s legal market reform commitments made in 2001 with China’s accession to the WTO (World Trade Organization), including ending subsidies to state-owned enterprises; protecting intellectual property; and transparently and consistently applying administrative procedures and laws, among other items.

    No matter how high the tariffs, they will not induce these structural reforms, which are in my opinion urgently needed for fair global trade. Many people, with Trump at the head of the pack, do not seem to understand that growth of international trade in services runs in parallel with the prosperity of nations, epitomized by the wealthiest countries – the members of the OECD. The two largest OECD participants in services trade with the rest of the world are the US, whose global trade in services totaled 1.3 trillion US-Dollar in 2016, and Germany, where the corresponding number was 607 billion US-Dollar, less than half the magnitude of the US.

    Trump in my opinion will no doubt be surprised to learn that while the US balance of global trade in services is in surplus by 247 billion US-Dollar, Germany’s global services trade balance is in deficit of 23 billion US-Dollar.

    While the importance of services trade to US competitiveness may have once been out of the mainstream of trade policy thinking, that was decades ago if Trump’s economic advisers are worth their salt, they should show better. If they do, then the question remains why can’t they get through to the boss?

    Perhaps Trump’s distorted view towards the importance of international trade and globalization in services stems from sheer ignorance. That for me is hard to believe. After all, he did attend the Wharton School of Business.

    So we have to ask ourselves one serious question: why are so many key global leaders like Trump pursuing so many stupid economic policies?

    As recently as January 2018, the International Monetary Fund (IMF) issued one of its most upbeat economic forecasts in recent years, extolling “broad based” growth, with “notable upside surprises”.

    By July 2019, 18 months later the fund had sliced its forecast for expansion this year to 3.2% – a significant fall-off from the 3.9% projection reiterated just 6 months earlier – and had pronounced the economic picture “sluggish”. American investors are more concerned: the bond market is sounding its loudest recessionary alarm since April 2007. The deterioration in the economic picture is not the consequence of irresponsible behavior by banks or a natural disaster or an unanticipated economic shock; it’s in my opinion completely self-inflicted by major world leaders who have delivered almost universally poor economic stewardship.

    The trade war initiated by President Trump sits firmly atop the list of bad policies. Brexit has tipped Britain into economic contraction. With European governments unwilling to pursue reforms, the continent is barely growing. President Xi Jinping of China has focused on solidifying his own power. After a promising start reforming the economy, India’s prime minister, Narendra Modi, has turned instead to oppressing his country’s Muslim minority.

    And on and on….

    None of this in my opinion was necessary. As the January 2018 IMF report indicated, the world economy was firing on all cylinders – “the broadest synchronized global growth up surge since 2010” – as jobs were being added and inflation remained subdued.

    Yes, Trump’s trade war and Brexit loomed, but amid hope that the former would prove empty and the latter would be softened. Not so today, often against the recommendations of his more sensible advisers, Trump has implemented the country’s most protectionist actions since the 1930s. As a result, World Trade has begun to fall for the first time in a decade, with noticeable economic impact. Last month, Goldman Sachs cut it’s already modest projections for fourth-quarter growth 1.8% from 2%. That’s a far cry from the “4,5,6 percent that trump talked about just before his tax cut passed.

    The trade war between the US and China has also started to affect Europe and its largest economy Germany. When the debt crisis slammed the Eurozone nearly a decade ago, Germany’s powerhouse economy helped lift troubled neighbors like Greece, Portugal, and Spain above the turmoil. The question that Europe faces now is whether those countries are strong enough to actually return the favor.

    Germany is currently on the brink of recession after its economy declined in the year’s second quarter. Spain by comparison, is experiencing brisk growth, and even the Portuguese an Greek economies are expanding. Buoyed by tourism, booming construction and steady job growth, the Southern European countries are helping to offset Germany’s weak performance. But will it be enough? As the US economy appears to slow, China loses momentum and Brexit looms, can Europe dodge a downturn? The question may be decisive for Europe and crucial for the United States. Most economists are not yet predicting a Europewide recession, but they are worried about the prospect. There is in my opinion little chance that the European Union can thrive when Germany is sickly. Should Europe sustain more economic body blows, like for example a no-deal Brexit, a debt meltdown in Italy or a further escalation of the trade war, the risk of a recession in my opinion is rather high.

    When Germany ‘s official statistics office reported that the economy shrank 0.1% in the second quarter, shockwaves rippled through stock markets around the world. The reaction reflected the degree to which Germany sets the tone for the continent.

    Germany has by far the Eurozone’s biggest economy, accounting for more than a quarter of the bloc’s output. It has the most people, 83 million, and the most workers, who help stoke nearly every other country’s economy. The number of European Union countries that count Germany as their number one trading partner is long. It includes France, Italy, the Netherlands, Belgium, Slovakia and Sweden. The relationships sometimes border on dependency.

    Germany accounts for 27% of Poland’s foreign trade.

    Suppliers throughout Europe earn much of their revenue by selling to big German manufacturers like Daimler, Siemens and Thyssen Krupp. But those companies are struggling now.

    As it strains against the German downdraft, Europe is battling a host of other woes. High on the list in my opinion is Italy, which has a stagnant economy, an unstable government and one of the highest debt burdens in the world, giving it the potential to touch off another financial crisis.

    But this is by far not the only reason when I realized that the next financial crisis is inevitable. It wasn’t August 23, when the US President wondered who was the “bigger enemy”, Jerome Powell, the chair of the Federal Reserve Board, or President Xi Jinping of China. It also wasn’t the week before those comments, when it looked as if the trade war would tip the world into recession.

    Rather the moment was several months ago, at the end of November 2018, when Powell was giving a speech at the Economic Club of New York. By that point, the Fed had already raised short-term interest rates three times in 2018, and the crowd of economists, policy wonks and business journalists were looking for any sign that he might do so again.

    Fed chairs rarely make their policy changes explicit, but it was clear from Powell’s comments that he was putting on the brakes. “Interest rates are still low by historical standards,” Powell said, “and they remain just below the broad range of estimates of the level that would be neutral for the economy – that is, neither speeding up nor slowing down growth.”

    His use of the word “neutral” at that moment was the key and opened my eyes. while he was talking, the Dow Jones industrial average rocketed up 618 points, its biggest one- day gain in months.

    Although a sense of euphoria spread through the room, as well as through debt and equity markets, I was overcome by a sense of dread. A decade of historically low interest rates has begun to warp the US economy. As we all learnt to our collective horror during the 2008 financial crisis, a period of sustained low interest rates forces investors on a desperate search for higher yield, inflating asset prices and the risks of owning loans and debt of all kinds

    Instead of continuing to try to write the skip and doing the right thing, by gradually raising interest rates further, Powell seemed to be carving to political pressure – from the president and from Wall Street bankers and greedy traders – to keep rates low. And indeed, that is what he has done.

    On July 31, for the first time in more than a decade, he lowered short term interest rates. That in my opinion was a big mistake. Powell and his colleagues at the Fed need to step up and stand up to Trump and do what’s right for the economy – something Trump doesn’t know. If they don’t, the only question that remains is, in my opinion, when will it all blow up?

    When it does – and that day in my opinion will be soon – we will be staring down yet another financial panic.

    And now I tell and explain you why!

    We’re now more than a decade into an era of super – low interest rates. The Fed’s decision to keep capital cheap and plentiful made of course sense after the financial crisis. It allowed companies and consumers to get the money they needed to rev up the economy after the recession choked the capital markets.

    But the years of low interest rates have also caused that investors – who couldn’t get good returns on low – yielding Treasury securities pegged do the Fed rate – to start chasing higher yields. As a result, they’ve been taking on far too much risk, for far too low return, for far too long.

    All that risk please understand is not hidden on the balance-sheets of the big Wall Street banks, as it was during the 2008/2009 financial crisis.

    But it doesn’t just disappear into thin air. It’s all around us, in hedge funds, private equity firms, and pension funds and university endowments that have been investing in risky debt, in the form of corporate bonds and other securities, to the tune of trillions – yes trillions – of dollars.

    What do those securities look like?

    There is, first of all, a proliferation of the dodgy bank loans, issued without the covenants that are designed to protect the lender in case of default.

    In typical Wall Street fashion, those loans are turned into securities and sold to investors like you and me around the world.

    It’s the current version of the mortgage-backed securities phenomenon that helped to sink the economy in 2008 – rememso?!

    There is also an eye-popping amount of risk propagated by some of the biggest names in American business. Bonds rated BBB -a notch above “junk’ bonds – issued by big companies such as AT&T, Verizon, G.E., G.M. and Ford, represent more than half of the investment – grade corporate bond market. That raises the ugly spectre of the “triple – B Cliff “, the losses bond holders will incur when the economy dips – as right now – and some of those companies can’t repay their debt. The troubling size of this debt is not news – not even to the Fed or to the Treasury. “Business debt has clearly reached a level that should give businesses and investors reason to pause and reflect,” Powell said on May 20. “If financial and economic conditions were to deteriorate, overly indebted firms could well face severe strains.”

    Powell was careful to note that “the parallels to the mortgage boom that led to the global financial crisis are not fully convincing.” But Without capital, layoffs and recession are inevitable, which in my opinion could bring to an abrupt end a decade of prosperity.

    No one of course knows exactly how much of the trillions of debt that’s out there is at risk of default. We do know that since 2008, the dollar amount of American corporate bonds outstanding has increased to more than 3 trillion US-Dollar, from around 5 trillion US-Dollar. Companies, universities, municipalities and governments globally have never been more indebted, with a record of 237 trillion US-Dollar reached at the end of 2017, 40% more debt than a decade ago.

    In large part, the explosion of debt issuance has been driven by central bank policies that have kept interest rates at historically low levels, in effect rewarding entities for issuing more in more debt. Interest payments on corporate debt are tax deductible, in most jurisdictions.

    But all of this is the risk we can see! There are in my opinion plenty of additional risks hiding in the undisclosed obligations of private companies and in the “shadow banking system”, nonbank financial institutions that have sprung up in the past decade to hold the risk that the Federal Reserve insisted, after the 2008 financial crisis, that Wall Street avoid.

    So what would happen if interest rates did increase slightly, or if the economy dipped into a recession, and some of those over leveraged companies could no longer meet their interest payments? Trust me, it wouldn’t be pretty. But while we look to the stock market as a barometer of our economic health, it’s increasingly less relevant. In the late 1990s, the number of publicly traded companies peaked at around 7,300; today there are around 3,600 – just half.

    With more companies in private hands, and the market for private finance growing, we know less and less about the hidden risks these companies pose to the economy. For calm to return to the capital markets, we must in my opinion pop the debt bubble, the sooner the better. For now, I just take a break and think about “what might happen next.”