Negative Interest Rate Neverland


For any good or commodity, if supply increases and there are too few takers, the price will fall.

If supply increases further and demand is still low, prices can fall all the way to zero.

If supply increases thereafter, and there are still too few takers, the supplier can offer a cash incentive to those willing to take the accumulated goods off their hands.

This is a negative price, so it turns out that zero is not a lower-bound price for anything.

The implication for the supplier is that the good generates negative revenues and earnings, so doing business at negative prices dissolves the supplier’s net worth. Offering products at negative prices is not a good business to be in, and if you are, you won’t be for long.

As absurd as it might seem, this has become the business model for banks in countries that are persevering under negative interest rates, primarily in Europe and Japan — and the US is not far off.

Banks and other financial institutions supply credit within the credit markets, and if there is great supply and soft demand, the interest rate (as the price of credit) can fall to zero, as in the example above.

The US and most developed countries have been at the borderline zero price of credit since the Great Recession. But it turns out that zero is not a lower bound in financial markets either.

In a sense of desperation, the European Central Bank (ECB) and the Bank of Japan are pushing the interest rate into negative territory because they are supplying credit at a negative rate to their governments and banks. That is, they are offering the borrower a zero interest rate and, in addition, paying the borrowers to borrow by requiring less repayment for the funds loaned.

So, given the need for financing ever-expanding government debt accumulation, and being scarcely able to afford its already existing interest carry, the interest meter for government borrowing goes into negative territory thanks to central bank generosity. This means governments receive more cash with each borrowing than they are required to pay back on the bonds originally purchased by the central bank.

And those terms are also being extended to private borrowers by their banks.

From the central bank’s point of view, negative rates are in vogue because they seemingly kill two birds with one stone: First, they are seen to revive a weak economy (if only the economy behaved as in Keynesian textbooks) and second, it reduces the government’s interest carry, which is great news for debt-strapped governments.

But think what that does to the lenders who are caught in the middle. Earning a negative interest rate on their assets is a net cost for lenders, so instead of receiving investment income, they are instead subsidizing borrowers.

Hence, negative interest rates are an unlegislated wealth transfer from lenders to borrowers, something, no doubt, The Bern would approve of.

In this upside down world of negative interest rates, you might ask why banks lend money with the certainty of getting less in return. This is compelled to some extent via bank asset regulation and central bank pressure to hold government bonds and deposit at the central bank at negative interest rates.

The net of it is that lenders are resisting as bank shrinkage is taking place and bank capital is being run off the books — and the equity market, understanding this, has marked down European bank stocks by 25% since the beginning of this year.

This is a financial extremum, and it doesn’t just undermine banks.

Banks are on the pathway to insolvency, and the same calculus affects all financial institutions that generally live on investment income. In addition to banks, this includes: savings banks, insurance companies, pension funds, endowment funds, and a variety of trusts (both government and private), all of which are being force-fed very low and even negative returning assets.

So you should now see the larger picture of what’s unfolding before our very eyes.

Low and negative interest rates have become the new means to subsidize broke governments and broke businesses with debt outstanding.

Now then, why have central bankers (Draghi of the European Central Bank and Kuroda of the Bank of Japan) recently renewed the pledge for yet a deeper plunge into negative interest rate Neverland?   And Yellen is studying it.

Negative Interest Rate NeverlandIs their loyalty to government subsidization above their responsibility to their own central banks’ balance sheets and the commercial banks they regulate? Or are they fools who have been seduced by Keynesian central bank ideology in which lower interest rates are seen as always better for the economy? And that includes Ben Bernanke.

There is a mindlessness going on ­— a failure to pay attention to the blatant damage to financial institutions that investors in bank stocks more clearly see. Where are the thinkers who can think beyond the dusty textbooks of the post-WWII era in which lower interest rates are applied but fail to result in the usual positive multipliers of bank credit, investment expenditures, and job creation?

Moreover, do the central banks — responsible for driving the negative market interest rates — warn the governments that all stripes of lenders will not be able to survive on such low rates on invested assets and, furthermore, expect they will come knocking on the door for major bailouts that cannot be afforded by already debt strapped governments?

This is the road we are on, and it’s a road that leads to promises made and never delivered by commercial banks, by insurance companies, by pension funds, by saving banks, and by trust funds.

When citizens come to realize that their bank deposits or pension fund payments or insurance annuities are worthless pieces of paper, will they not take to the streets in anger? From there, will not the military be called in to contain the destructive anger of its citizens and, in turn, suspend statutes and Constitutional law and place the country under a military dictatorship? It’s happened before — not in the US, but in many places in the Americas. The alternative would be to merely fire up the printing presses and satisfy those private obligations with more printed money.

So when the history book is written, who will be seen as the villain for devising negative interest rate Neverland? Will the mad genius be seen as a Treasury official of a broke government seeking an interest cost subsidy, or will it be the misguided central bankers for being enablers with their zeal for Keynesian orthodoxy?

Those are the issues and stakes involved. However, there is a positive way out, and that is for the government to change the economic environment (via regulation, taxation, or by winning the globalism competitive battle as a national goal). Sufficient economic incentives and the elimination of barriers can bring about an environment in which businesses are born and prosper and become viable borrowers and employers that can pay off loans at positive interest rates as in the good old days of yore.

These changes are within the domain of the government — not the central bank — so the upcoming elections are of extreme importance to the future of the economy, financial institutions, and the government as we know it.

Incenting and allowing businesses to be able to borrow and repay with positive rates needs to be the new operational objective of public policy. No more, “Let’s reduce the interest rate, even if already negative, as long as there are some remaining unemployed.”

Central bankers stuck in negative interest rate Neverland are naively undermining the very foundation of governments, retirement promises made, and even democracy in the process. This is darn profound stuff and well beyond being merely a Keynesian fix that has been overcooked so that it generates major adverse side effects.

The only constructive thing left for central bankers is to stand up in unison and in public and let the government know that they have done all they can and the ball is in their court. Only the legislative and executive branches can change economic incentives and remove impediments to business success so that business borrowers are once again willing and able to pay positive interest rates.

Sign up to receive the Spellman Report. Bracing financial and economic insight. Now with free delivery!

Click to Email Dr. Spellman

A Grand, Simultaneous Financial Bust: Asian Contagion II


Globalism changed the economic order of things. Most relate globalism to free trade. However, the greater effects of globalism can come via the opening of capital flows among countries — both when capital surges in and when it surges out. This is now the case for a large number of developing countries. You might ask why countries would be inclined to block foreign capital inflows given that they finance investment, pump up financial prices, and generates wealth. That was understood by most, except for a few socialist countries not wanting to be tainted by capitalism despite its benefits. However, the bigger pre-globalism propensity was to restrain capital outflows. And ironically, without the ability to exit, few foreign investors were willing to enter with their capital in the first place. Globalism changed that by causing countries to relax constraints on capital outflows. Predictably, foreign investors themselves relaxed and enjoyed the greater returns available in faster growing smaller economies. So the elimination of capital outflow barriers increased the tendency of foreign investors to partake in offshore speculation, with the biggest beneficiaries being the developing countries. Foreign capital freed these countries from dependence on local savings and local banks to finance investment. And when foreign capital flowed in, it financed investment in plant and equipment for manufacturing that was leveraging low-cost labor, especially China. Foreign capital also financed office developments, infrastructure and residential condos making the skylines of places like Panama City look like this. Foreign capital provides jobs and income, but it becomes problematic because it is seldom applied at a steady and measured pace in proportion to the opportunities. During the Great Recession, the Fed’s QE provided investors with a large liquidity pool disproportionate to the onshore investment opportunities, so a good deal of that liquidity gushed into off-shore investment. And much of that went to the commodity and energy industries, which, at the time, were supply-constrained and expensive. These include Brazil, Indonesia, Russia, South Africa, and Chile, Peru among others, as well as some developed country plays in Australia, West Texas, and Canada. In investment booms fed by outside (and not very discerning) capital, animal spirit-driven developers keep on borrowing and building to be absorbed by the market before their competitors, and the unrestrained booms that follow result in over-building, excess production, inventory build-ups and in turn soft prices, debt defaults, eventual bankruptcies, and penny stocks. That much is true for any domestic boom and bust, but now there is a foreign twist when the projects are debt-financed from offshore sources that typically require repayment in US dollars. Hence, foreign-financed investment has a built-in currency crisis in the making when settlement takes place because it drives the price of the US dollar upward and the local currency downward. Predictably, it comes at a time when the boom is over-built, leaving investors scrambling to generate revenue, and commodities continue to be sold at very low prices in order to cover the rising cost of dollar-debt repayment. There is a rush to extinguish dollar debt before a property is lost to foreclosure, which, in turn, leads to major multiple market reactions – all downward. The selling of commodities at ultra-low prices creates an adverse currency movement for the affected country. For example, see the correlation (below) of the declining price of copper relative to Peru’s Sol and Iron Ore relative to the Australian Dollar. This strong currency decline then causes unrelated companies, individuals, and even governments to sell most anything denominated in local currency and use the proceeds to purchase US dollar-denominated assets. The debt repayment wave deteriorates into a generalized capital flight and a currency collapse for the involved country. Basically, the bright shining buildings shown above are still standing and shinning, but in the economic and financial dimensions, all prices are falling down. This is the basic scenario that followed the early days of globalism in which there was an over-build of manufacturing capability in the cheap labor countries of Asia in the 1990s. The consequence was a bust phase known as the Asian financial crisis that unfolded in 1997. The return of capital to the lender that spilled over to most emerging nations was therefore known as the “Asian contagion.” What occurred were falling prices of everything: over-built goods, currencies, physical capital assets, as well as the financial claims to these assets. This scenario is being repeated today in the great commodity boom of the last few years. Not only are the commodity prices falling but so, too, are the foreign currencies and foreign and domestic stocks and bonds that have financed the commodity boom. This also affects those financial entities that hold claims to commodity related securities in their portfolios. As a result, oil, coal, copper, and iron ore all are selling in the area of 70% less than when the facilities were built only two years ago. The price bust, the currency bust, the financial price bust, and the capital goods bust are in a grand, coordinated bust. The bust phase includes China’s over-expanded manufacturing sector that gave rise to the commodity boom in the first place. Meanwhile, the question becomes: Can the US economy continue to grow in the face of this? There are adverse implications for US companies are attempting to export goods (in the face of a relatively expensive dollar) to a developing world in recession. The foreign sales and earnings of these companies are being hurt, and that hurt is being registered in the US equity market. But meanwhile, American companies and consumers are benefitting from the cheaper import and energy cost savings. Indeed, the service sector is holding up the US economy. When the dust settles, US companies will leverage the cheap prices of foreign-made goods and increase their profit margins. Indeed, Dell Computer back in the late 1990s became a break out company that benefitted enormously from the first Asian Contagion because it was outsourcing production to the countries whose currency was most affected. Distressed prices of foreign currencies and assets will become a high return opportunity for the US dollar investor willing to patiently wait it out. Subsequently, one must keep an eye on commodity inventories. When inventories start to work their way down, there is a bottoming-out of commodity prices, which, in this slow growth environment, could take some time. This will likely be measured in years, but no doubt its day will come. The reversal of cheap currency in the EMs will set a bottom and bring capital back to those countries with a rush. At that time, all the prices that have fallen together will all rise in unison. So it seems that two decades into globalism, we are finding that global capital flows — first gushing in and then gushing out of relatively smaller countries — add a new dimension of volatility to financial markets with a foreign currency twist. These are relatively long cycles, so investors must be patient. In the meantime, producers in developed countries will benefit from rising profit margins thanks to cheap foreign outsources.

Sign up to receive the Spellman Report. Bracing financial and economic insight. Now with free delivery!

Click to Email Dr. Spellman

Tell Spellman It’s an Art, Not a Science


Economies mutate. This occurs when responses among variables in the economy start to change. In the terminology of economics, the elasticities have changed and they, in turn, change the behavior of the entire economic system.

These can be due to changes in incentives (or the reactions to incentives), changes in the rules (either regulatory or legal), or changes in supply conditions. And then there is technology, which constantly morphs.

So relationships that one has become accustomed to may not hold up as they did for decades. Ultimately, they were not written in stone.

For the designated managers of the US economy, The Federal Reserve Open Market Committee who influence financial variables as a means to bring about desired changes to a national economy such as for employment and inflation, this is a perplexing task.   To manage it, economists have endeavored to model the economic system mathematically based on a history of economic reactions. They then seek to derive simple rules for adjusting the variables subject to their control to bring about the desired end results.

Therein lies the development of “rules of thumb” for how to manage the economy. One such example is the Taylor Rule for interest rates to smooth economic cycles. Another was Milton Friedman’s dictate to keep the money supply growing at a constant rate. And there are a lot more.

However, once these simple rules of thumb are developed, often mutations creep in and the rules no longer work as well (or at all), and policy becomes a perplexing endeavor — and that’s where we are today.

It’s in this context that we should view the work of the besieged members of the Federal Open Market Committee who make the call as to whether or not to attempt to raise interest rates. It’s clear they have been perplexed for some time as to whether or not to pull the trigger.

Rather than scorn these poor public servants, it would be more appropriate to pity these mere mortals who are tasked to keep the economy and financial markets running smoothly as per their instructions via the Full Employment Act of 1946.

The question of raising interest rates at the moment has become a much ballyhooed event for which every investor, financial writer, and taxi cab driver no doubt has his or her own opinion mostly held with near certainty.

After all, it’s a momentous event when, after seven years of buying securities and adding quantum leaps to its balance sheet, the Fed contemplates switching to selling securities in order to lower financial prices and raise interest rates as a means to glide to a new economic growth path.

To undertake the task of economic management that was thrust upon the government about 70 years ago, economists both inside and outside the Federal Reserve attempt to systematically estimate as exactly as possible the restraining and simulative effects of Fed actions.

That is, the financial variables that are life and death to investors are, to the Fed, a means to an end: economic stabilization. More broadly, the mandate is to adjust the financial variables in order to iron out the excesses of the spending cycles — both the highs and the lows relative to the available resources. The objective is to produce smooth spending growth that matches the level of and the growth of the supply capability.

The supply side target is called Potential GDP and it’s not static. That is, the supply side target moves through time when labor and capital resources grow and productivity advances and the matchup would result in no more than 5% unemployment and an inflation rate of about 2%. Undershoot it and the unemployment rate is higher and over shooting would result in higher inflation.

So this process of matching up spending with the growing supply capability is akin to trying to send a rocket to the moon and produce a soft landing. The policymakers are trying to produce a spending trajectory that neither misses the moving target to either the high or low side, least we have unacceptable unemployment or inflation.

Obviously, this requires a good deal of estimation of not just the path of the target but how the system will move and react to policy controls to reach the target.

To do so, the science (or, some would say, the art) of econometrics was developed to mathematically model the systems reactions to the financial variables that the Fed can control based on past data.

From the point of view of the econometric creators of the mathematical version of the economic-financial system…this was the linkage from the Fed’s controlled variable to the variables that Congressman tasked them to hit …some version of full employment and price level stability.

So for many years since at least the l960s, econometric models of the system of responses have been built and added to each year. Of course, it’s based on the precious little data. Because there are many variables to be estimated, accuracy requires that economists collect a lot of data.

More important, reducing estimation errors also requires collecting more relevant data. For example, in picking the voters’ choice for the Republican nomination, one would not to care to rely on a sample of fifteen voters which is not much greater than the number of candidates. More accurate estimates of many variables derive from a sample of many thousands.

So as to be able to obtain as much data as possible to make estimates of how the variables of the economy react to each other, the economists had to go back to the data bin of past experiences and recreate the data starting in 1929.

But herein lies the rub of the scientific approach: to enlarge the sample size, which is still at bare minimum levels relative to the number of variables that are involved, they looked backwards and relied on history — but history can be fickle. Mutations to the underlying elasticities create a misleading database.

So they have been in a quandary as to whether or not to raise interest rates because the system they had thought they understood suddenly stopped working in its usual way.

Stimulus was applied in some great multiple of any previous stimulus, but the reaction has been weak and late to materialize.

The source of the uncertainty is the new context of the economy as it labors to produce positive results within an open global system of not just foreign goods competing with domestic goods but also with the wild card of foreign capital flows that are capable of gushing in or out of a country and offsetting or magnifying Federal Reserve changes in available market funding.

Moreover, exchange rates have become flexible and no longer fixed by governments, and there is no insulation from foreign capital inflows or outflows. So when the US dollar strengthens, as it has, the products of US multi-nationals get priced out of foreign markets. Further, the changing exchange rates drive capital in and out of countries, which accounts for far more financial buying power than the Federal Reserve would dare employ.

To make matters more difficult, foreign central banks are motivated to protect their own end of the global bargain and offset Fed actions that are self-serving to the US. Furthermore, the US banking system has not responded to the availability of cash reserves remotely near past responses.

So one should understand the complications are not just determining the path of the “moon” that our rocket is chasing but also the responsiveness of the rocket to the Fed’s control tower.

So the question is, is policymaking today an art or a science given that the models they have to go on fail to capture the essence of today’s elasticities?

This idea causes me to harken back to an experience I had in the l960s when I was an economist at the Federal Reserve. At the time, economists (myself included) were agog over the science of being able to model the responses to policy.

To do so, I constructed a model of the economy on an analog computer, which was ideal for tracking the interactions of the financial and economic variables over time. There was a lot of experimentation to set the elasticities so that the resulting system reactions followed patterns that were similar to the then-current economy.

To give the experiment some life, I set about simulating what the Fed’s Chairman at the time described to be his method of stabilizing the economy. He called it “leaning against the wind.” While highly suggestive, it needed to be fleshed out. I came up with a few versions of practical implementations of what could arguably be a policy rule for “leaning against the wind.”

I presented the methodology and results to a staff economist colloquium that also included most of the Governors who sit on the Federal Open Market Committee.

The response was dramatic among those tasked with deriving a mathematical response to policy stimulus. Alas, the paper and news of the presentation reached the Chairman whose considered response was that someone should “tell Spellman that monetary policy is an art, not a science.”

Over the following decades, the scientific approach to modeling has attempted to be more precise, but during those same decades, the underlying system mutated and there is insufficient historical data that’s relevant to today’s mutated economy.

So now we have come full circle. The Fed, in making its historic interest rate decision, is left only with art and models built from less relevant data, which for them is an uncomfortable place to be as the policymakers these days are trained scientists, not artists.

Let’s hope they have the courage to move on even though they lack the scientific proof that, indeed, raising interest rates would push the economy toward absorbing the last of the unemployed while not trigging incipient inflation, nor which would send the economy back into the Great Recession.

At this point in life, decades later, I’ve come to agree with the Chairman of bygone days. Policymaking is an art, not a science. This is not to say they shouldn’t lean on what science would suggest.

This is not a comfortable place to be when having the responsibility for the outcomes ahead, so I do watch for nervous twitches as they testify before Congress and global financial opinion.

Sign up to receive the Spellman Report. Bracing financial and economic insight. Now with free delivery!

The Next Leg of Globalism


In 1993, there was a great debate carried live on national TV between then-Vice President Al Gore and Dallas entrepreneur Ross Perot. The issue was the pros and cons of going global — that is, whether the U.S. should allow foreign-made goods to be sold in the U.S. without tariffs or other barriers if, in turn, barriers were eliminated for U.S.-made goods. And if you can believe it, the decision that required landmark legislation was rendered thanks to a public opinion poll that provided guidance to the politicians.

Even more unusual by today’s political environment, the case for opening trade was presented by the Democrat, Al Gore. His argument was that the elimination of trade barriers would, on balance, be to the U.S.’s advantage because it would unshackle its producers so they could export and outcompete foreign producers (tires made in Tennessee and shipped to Mexico was his example).

Equally unusual in terms of today’s political alignment was the right-leaning Perot (as the Donald Trump of his time) arguing against globalism. His position was that the lower wages abroad would result in a “giant sucking sound” of jobs lost to lower-wage countries.

Well two decades later, there is no doubt who got it right.

Yes, globalism did open foreign markets to U.S.-made goods and created jobs, but on balance, the “giant sucking sound” was the demand being sucked out of U.S. labor markets.

If the Democrats look at this as a victory, it’s because it created a lot of future Democratic voters who wanted to respond to the sapping of jobs, wages, and income. Simply put, globalism has undercut the real median household income, which is today lower than it was in 1990s, and created the Bernie Sanders Democrats we hear from today.

So it’s been a rough adjustment, not just for the U.S. but also for the other countries that called themselves “developed.” This included Europe and Japan and a few others that had relatively higher wages at the time.

Now in 2015, two decades removed from the debate and probably three decades from the general loosening of trade barriers in one form or another, we find ourselves in a world in which the old dichotomy of developed countries vs. less-developed countries is no longer applicable. Those less- developed morphed into being emerging for a time and have now emerged, and they have undercut developed nations in the process.

This a watershed moment in time when a post-Communist country like China has virtually run the table on developed world manufacturing to shift to their economy.

It has been a process of meeting in the middle with most countries now, more or less, equally developed. China has risen from nowhere to be second to the U.S. in GDP and in number of millionaires. This is the logical conclusion of the opening of trade in a two-wage-rate world.

But in the race to economic development, China’s economy was driven by a roughly 50 percent share of GDP spending in the form of plant and equipment, which has now created an oversupply of manufacturing capacity.

And the same applies to commodity producers, whether from emerging markets, Canada, or Australia. During the last decades, their capacity to meet manufacturing and infrastructure demands grew dramatically, but now they find themselves in a state of oversupply while demand moderates.

Thus, we are in a Kondratieff world in which the long cycle of building generated excess supply — in this case, manufacturing and commodity capability. What follows are falling prices and slack future demand, causing plants to close and new ghost towns to pop up. And I’m not describing Muncie, Indiana, or the U.S. rustbelt but rather Chengdu, China when it recently closed its steel plant.

Globalism has reached its logical conclusion: Over-supply and cheaper goods, but at least it’s an end to the leakage of U.S. manufacturing abroad. It’s been a 30-year uphill battle for the developed world.

At this stage, it takes down the financing of the manufacturing and commodity expansion and all those who financed it. It takes down demand for new plant and equipment substantially, and it takes down the governments’ tax revenues and country credit ratings for those who formerly succeeded.

And there is a strong currency component to this as well: U.S. dollars borrowed during the expansion are being repaid while dollar revenues earned from the export of manufactured goods and commodities are slack.

All in all, this is the dynamic that played out in 1997, known then as the Asian contagion. However in this go-round, the U.S. is not in a tech boom as it was then, so keeping up growth in the developed world will be more difficult.

This leaves the old-time developed world still floundering with continued over-reliance on QEs that don’t do much to stimulate the economy, nor do they produce inflation (no matter how hard their central banks try). But all in all, from here on out at least, the China leakage is over, and there will be benefits from expending a lower proportion of income for the same imported products.

Sign up to receive the Spellman Report. Bracing financial and economic insight. Now with free delivery!

The Knockout Punch: Has America Turned to Socialism?

In the days following the election there was a numbing silence. It was as if the body politic was dazed by a heavyweight champion’s blow to the head. It staggered and sought clarity to understand what’s to become of our future.  Even the 24/7 financial market / economic blogosphere went silent in contemplation.

What began to emerge from the cobwebs was a trickle of semi-coherent commentary of what was learned in the 1930s. Was it again a New Deal tilt toward socialism? References to past classicists such as Von Mises, Hayek, and H.L. Mencken were everywhere. Ayn Rand’s Atlas Shrugged sold more than 1.5 million copies since the first Obama election — a startling comeback for a 55-year-old work of fiction — and sales are again soaring. It has also spawned a series of film adaptations.

A realization set in that Obama’s victory in 2008 was not a one-off reaction to the George W. Bush presidency. Rather, it validated the notion that the U.S. was now a left-leaning democracy in the European style.

If there were any doubts, as the first order of business by Friday of election week, the president asserted that the election was a referendum revealing that Americans want taxes to increase for the wealthiest citizens but not anyone below the $250,000 income level. In his words, “Nobody — not Republicans, not Democrats — wants taxes to go up for folks making under $250,000,” he proclaimed. The definition of the bad guys has hardened.

While a very good case can be made for all taxpayers to pay more, apparently the imperative to redistribute income was more important than the goal of growing jobs and the economy or containing the fiscal deficits.

The question is whether the goal to redistribute and regulate is a shift in fundamental American values or merely a reflection of the president’s own agenda.

While a morphing of the American willingness to redistribute is a socialistic ideal, it is also possible that the redistribution reaction to events that began to unfold in the early 1980s and could even be nearing its end.

At that time, the globe was bifurcated into the developed world (the U.S., Europe and Japan) and a large number of countries that fell into the category of Less Developed Countries (LDCs). There were extreme differences in wages and income per capita.

With wages differing between the developed nations and the LDCs — in some cases with a ratio of 100 to 1 — producers naturally would gravitate to the ultra-low-wage countries. But there was a catch: Tariffs deterring “cheap” goods from entering the high wage countries needed to be dismantled.

At first, exports to the developed world proceeded in a trickle as producers sought cracks in the tariff structure, but such vast cost differences would lead to creative means of dismantling trade barriers.

The major break in protectionism of goods to high-wage countries came in the form of multi-country treaties to systemically eliminate trade barriers among countries.

NAFTA broke the ice and the post-WWII efforts to lower tariff barriers — the General Agreement on Tariffs and Trade — was replaced by the more effective World Trade Organization (WTO) with membership leading to a phasing out of trade barriers. Even Russia, the latest of more than 150 WTO participating nations, pledged to open trade and the momentum continues with a proposed U.S.-EU free trade agreement making headway.

As trade opened and production and jobs gravitated to the low-cost producers, new terminology was invented. Off-shoring and globalization meant that LDCs were “emerging” and then “developing.” All in all, Ross Perrot was right in his great debate with Al Gore. There would be a “Giant Sucking Sound” of jobs (and income) gravitating to the low-wage countries.

Of course, as the process of globalization unfolded, wages in the formerly ultra-low-wage countries have subsequently risen while those in the U.S. have declined, leading to a convergence of labor costs across countries. We are not at absolute convergence, but enough movement has occurred so that the U.S. is not as relatively expensive a place to produce any longer. While the exportation of jobs is not over, we are beginning to see the end of the tide going out and a trickle of the tide coming in (see: Made in America Again).

This is a process economists call Factor Price Equalization. That is, wages (the price of labor in all countries free to trade) eventually meet in some middle ground given the incentives to shift production to the cheapest source.

How does all of this relate to the election and socialism? The distribution of income in the U.S. got fatter in the two tails: those made poorer by being forced to get in line with the ultra-low-wages competition, and those with capital or skills that could not easily be duplicated abroad, which were made richer. The two tails in the income distribution end up fighting it out through their respective presidential candidates.

But globalism has also significantly eroded the middle class and shaped the election result.

According to an August 2012 Pew Research Center report, “half of American households are middle-income, down from 61 percent in the 1970s. In addition, median middle-class (real) income decreased by 5 percent in the last decade, while (middle class) total wealth dropped 28 percent. According to the Economic Policy Institute, households in the wealthiest 1 percent of the U.S. population now have 288 times the amount of wealth of the average middle-class American family” — making that a less-than-ideal group from which to select a presidential candidate.

The trends of globalization, wage convergence and the declining numbers and income of the middle class have been in process for almost the last 40 years, which is largely attributable to declining wage income. Moreover, wage income as a percent of total income has declined by about 10 percentage points. This was an enormous reduction in the labor’s share of the income pie and accounts for the middle class decline.

However, to compensate for this loss of income over the same period, transfer payments by governments as a share of the income pie has increased by 10 percentage points, as shown in the accompanying graph.

Since there is no free lunch, the transfers known today as entitlements needed to be financed somehow. The two logical options for addressing this issue were to tax and redistribute corporate profits or to redistribute from the president’s targeted group. Given the political stand-off in our body politic, the expeditious means to sooth the labor income shortfall was to borrow on the credit of the U.S. and subsidize via transfers or entitlements. As a result, the Census Bureau reported that 49 percent of American families receive at least one government benefit.

So here we are in 2012, and the ability to continue compensating for the loss of wage income by borrowing and transferring has hit up against funding limits due to baby boomer entitlements coming due. The cookie is crumbling, but the election indicates the middle class still wants its cookie — and the ability to borrow someone else’s cookie and pass it around has reached an un-financeable end. We have three choices: take a cookie from “rich folks” and pass it around, grow the number of cookies, or realize there will be fewer cookies. The redistribution argument won at the ballot box.

Personally, I dont see Obamas reelection as an enthusiastic validation of a socialistic ideal but rather a vote to sustain labors income share but functionally it makes no difference.

As Forbes contributor Bill Frezza summarized it: “America has now hurtled past the dependency tipping point … and an electoral majority happily voted for itself unlimited benefits that will supposedly be paid for by a productive minority — until that productive minority starts eyeing the exits.”

Since blatant redistribution squashes incentives to produce and grow, the incentive to redistribute also grows. Once headed down that slippery slope, it takes dire circumstance, not a threat of dire circumstances, to cause a rethinking and a redirection back to free market capitalism.

China went all the way down the slippery slope.  With economic misery as a result, in the late 1970s Deng Xiaoping asked the question of how to provide more food as its state-owned farms didnt adequately feed the population (despite 82 percent of the population working in agriculture). The reform was to allow state farms to sell and retain the proceeds of its agriculture production in excess of its socialistic quota. Look what incentives did for China. She has never looked back and likely is now more capitalistic than the U.S.

In the election, Obama prevailed despite receiving 10 million fewer votes than he received in 2008. This was no apparent landslide for socialism. But the outcome was also a result of a Republican dialog that failed to demonstrate how making cookies includes a reward for the wage-earning middle class.

Both the message and the messenger were off key, and as a result we could be headed down that same slippery slope that might not be reversed until there are not enough cookies to go around. It could be generations before “reform,” such as in China, prompts us to reconsider entrepreneurs and the fruits of entrepreneurship.  At that time, they would once again be considered heroes rather than villains but that could be far down the road.

If you enjoy this blog, please forward it to others who may be interested. Sign up to receive the Spellman Report. Bracing financial and economic insight. Now with free delivery!

The Financial Multipliers of Globalism and Ross Perot’s Giant Sucking Sound

Fed Chairman Bernanke testified last week that “the situation in Europe poses significant risks to the U.S. financial system and economy”. This indicates the extent to which financial globalism has become a controlling factor in U.S. economic and financial prospects and policy.

While globalism wasn’t supposed to have that level of influence, there was a memorable warning in the great North Atlantic Free Trade Agreement (NAFTA) debate of 1992. As it was conceived of at the time, globalism meant trade rather than finance, and became a presidential campaign issue. It was at that time that Ross Perot famously associated globalism with a “giant sucking sound” of jobs being lost to low-wage countries.

Today, the issue is financial globalism, not trade,  and per Bernanke’s above statement, all efforts are being made to contain or “ring-fence” Euro sovereign and bank meltdown from also taking down the rest of the world’s financial asset valuations and the solvency of the institutions holding those assets.

This is not easy when Euro banks are highly leveraged, perhaps 30 times and funded by short-term financial claims such as deposits or Repo loans that can and do run without notice. This forces the sale of the banks’ troublesome assets, not just for liquidity to retire deposit but also to downsize the book of assets by the above leverage multiple for each dollar of declining net worth.

That all fits the description of a financial crisis (as previously explained in Dominos) but what makes it even more of a government crisis is when the bank’s questionable assets are government debt. The forced selling with few buyers and declining prices only makes it more transparent that the government is near insolvent and can’t backstop the bank’s insolvency as well.

This unstable equilibrium is destabilized one step further when other arm-twisted governments are coerced into providing bailout aid, because the costs of the spreading financial meltdown to them exceed their bailout costs. So the implication of financial globalism is indeed the giant sucking sound of sapping resources across the globe into a financial black hole which used to be called Greece, Ireland and Portugal but is now also called Spain.

This is done with a large multiple of the original bank asset write-downs as all banks are run, and in turn forces business firms to be cash-hoarding machines instead of expanding producers. The combined corporate stock market meltdown and bank asset sale meltdowns create financial multipliers of lost market value perhaps 10 to 20 times the bank’s actual defaulting assets. Such was the experience of 2008.

If the central banks are called in and they are indeed poised to spring into action, it would require a substantially larger asset purchasing infusion than the insolvency losses in the first place. This is because the multiplier of financial shrinkage due to a dollar loss of bank capital is far greater than the melt-up multiplier of a dollar of central bank liquidity. Banks are short of capital and don’t in turn expand with a money supply multiplier of textbook lore when central banks expand, which explains why central bank QEs are in the trillions when the bank losses causing the interventions are in the billions.

So here we are with governments and central banks poised to react with the old game plan of QEs to inject purchasing power into asset markets, but what we need is a new game plan with a reduced vulnerability to global financial interconnections unless fiscal sanity re-emerges. Hence, ring fencing or financial containment means the end of financial globalism as was developed over the last decade.

As the world moves away from financial globalism, expect one of the first and obvious disconnects to be Greece divorcing itself from the Euro currency — or, more rationally, for Germany to come to grips with the idea that they set themselves up to be the easy mark in the Euro game of wealth redistribution.

In response to prospective Euro breakup, both borrowers and lenders are re-aligning themselves to be borrowing and lending in the same country as cross border finance means one might end up holding assets in a declining country currency and owing in an appreciating currency. So private parties are de facto withdrawing from financial globalism even before governments constraints set in.

If and when Greece exits the Euro, financial markets will likely fade for a few hours until it collectively realizes it is better for Greece, Europe and global financial markets, and the flight to the U.S. Treasury and German Bund will recede.

Financial globalism has become a transmission mechanism to spread financial losses across the globe.  Hence, the pendulum of financial globalism is now swinging the other direction. Ironically, it will reinforce the reserve currency status of the U. S. dollar despite the U.S. fiscal problems.

If you enjoy this blog, please forward it to others who may be interested. Subscription to monthly blog is free.