WorldoutofWhack

In matters of trade and manufacturing, the United States has not been the naive victim of cunning Chinese masterminds. We asked for this.

BY

MICHAEL LIND

MAY 19, 2020

On May 25, 2000, President Bill Clinton hailed the passage of legislation by the House of Representatives establishing permanent normal trade relations with China: “Our administration has negotiated an agreement which will open China’s markets to American products made on American soil, everything from corn to chemicals to computers. Today the House has affirmed that agreement. … We will be exporting, however, more than our products. By this agreement, we will also export more of one of our most cherished values, economic freedom.”

Two decades later, the chickens—or rather, in the case of the novel coronavirus that spread to the world from China, the bats—have come home to roost. In a recent press conference about the pandemic, Gov. Andrew Cuomo of New York complained: “We need masks, they’re made in China; we need gowns, they’re made in China; we need face shields, they’re made in China; we need ventilators, they’re made in China. … And these are all like national security issues when you’re in this situation.”

We should not be shocked to discover that many essential items, including critical drugs and personal protective equipment (PPE), that used to be made in the United States and other countries are now virtually monopolized by Chinese producers. That was the plan all along.

Politicians pushing globalization like Clinton may have told the public that the purpose of NAFTA and of China’s admission to the World Trade Organization (WTO) was to open the closed markets of Mexico and China to “American products made on American soil, everything from corn to chemicals to computers.” But U.S. multinationals and their lobbyists 20 years ago knew that was not true. Their goal from the beginning was to transfer the production of many products from American soil to Mexican soil or Chinese soil, to take advantage of foreign low-wage, nonunion labor, and in some cases foreign government subsidies and other favors. Ross Perot was right about the motives of his fellow American corporate executives in supporting globalization.

The strategy of enacting trade treaties to make it easier for U.S. corporations to offshore industrial production to foreign cheap-labor pools was sold by Clinton and others to the American public on the basis of two implicit promises. First, it was assumed that the Western factory workers who would be replaced by poorly paid, unfree Chinese workers would find better-paying and more prestigious jobs in a new, postindustrial “knowledge economy.” Second, it was assumed that the Chinese regime would agree to the role assigned to it of low-value-added producer in a neocolonial global economic hierarchy led by the United States, European Union, and Japan. To put it another way, China had to consent to be a much bigger Mexico, rather than a much bigger Taiwan.

Neither of the promises made by those like Clinton who promoted deep economic integration between the United States and China two decades ago have been fulfilled.

The small number of well-paying tech jobs in the U.S. economy has not compensated for the number of manufacturing jobs that have been destroyed. A substantial percentage of those well-paying tech jobs have gone not to displaced former manufacturing workers who have been retrained to work in “the knowledge economy” but to foreign nationals and immigrants, a disproportionate number of whom have been nonimmigrant indentured servants from India working in the U.S. on H-1B visas.

The devastation of industrial regions by imports from China, often made by exploited Chinese workers for Western corporations, is correlated in the United States and Europe with electoral support for nationalist and populist politicians and parties. The Midwestern Rust Belt gave Donald Trump an electoral college advantage in 2016, and the British Labour Party’s Red Wall in the north of England cracked during the Brexit vote in 2016 and crumbled amid the resounding victory of Boris Johnson’s Conservatives in 2019.

The second implicit promise made by the cheerful advocates of deep Sino-American economic integration like Bill Clinton was that China would accept a neocolonial division of labor in which the United States and Europe and the advanced capitalist states of East Asia would specialize in high-end, high-wage “knowledge work,” while offshoring low-value-added manufacturing to unfree and poorly paid Chinese workers. China, it was hoped, would be to the West what Mexico with its maquiladoras in recent decades has been to the United States—a pool of poorly paid, docile labor for multinational corporations, assembling imported components in goods in export-processing zones for reexport to Western consumer markets.

But the leaders of China, not unreasonably, are not content for their country to be the low-wage sweatshop of the world, the unstated role assigned to it by Western policymakers in the 1990s. China’s rulers want China to compete in high-value-added industries and technological innovation as well. These are not inherently sinister ambitions. China is governed by an authoritarian state, but so were Taiwan and South Korea until late in the 20th century, while Japan was a de facto one-party state run for nearly half a century by the Liberal Democratic Party (LDP), which was neither liberal nor democratic.

Even a democratic, multiparty Chinese government that sponsored liberalizing social reforms would probably continue a version of the successful state sponsorship of industrial modernization in order to catch up with, if not surpass, the U.S. and other nations that developed earlier. That is what China’s neighbors, Japan, South Korea, Taiwan and Singapore, all did following WWII. Indeed, when the United States and Imperial Germany were striving to catch up with industrial Britain in the 19th century, they employed many of the same techniques of national developmentalism, including protective tariffs and, in America’s case, toleration of theft of foreign intellectual property. (British authors visiting the U.S. often discovered that pirated editions of their works were as easy to purchase then as pirated Hollywood movies and knockoffs of Western brands are to obtain in Asia today.)

The question, then, is not why China pursued its own variant of classic state-sponsored industrial development policies in its own interest. The question is why the U.S. establishment did not retaliate against China’s policies for so long, given the damage they have done to American manufacturing and its workforce.

The answer is simple. American politics and policy are disproportionately shaped by the rich, and many, perhaps most, rich Americans can do quite well for themselves and their families without the existence of any U.S. manufacturing base at all.

We are taught to speak about “capitalism” as though it is a single system But industrial capitalism is merely one kind of capitalism among others, including finance capitalism, commercial capitalism, real estate capitalism, and commodity capitalism. In different countries, different kinds of capitalism are favored by different regimes.

Recognizing that there are, in fact, different kinds of capitalism, not only among nations but within them, allows us to understand that the different variants of profit-seeking can interact in kaleidoscopic ways. National economies can compete with other national economies or they can complement them.

The United States could decline into a deindustrialized, English-speaking version of a Latin American republic, specializing in commodities, real estate, tourism, and perhaps transnational tax evasion.

America’s economic elite is made up mostly of individuals and institutions whose sectors complement state-sponsored Chinese industries instead of competing with them. It is pointless to try to persuade these influential Americans that they have a personal, financial stake in manufacturing on American soil. They know that they do not.

The business model of Silicon Valley is to invent something and let the dirty physical work of building it be done by serfs in other countries, while royalties flow to a small number of rentiers in the United States. Nor has partial U.S. deindustrialization been a problem for American financiers enjoying the low interest rates made possible in part by Chinese financial policies in the service of Chinese manufacturing exports. American pharma companies are content to allow China to dominate chemical and drug supply chains, American real estate developers lure Chinese investors with EB-5 visas to take part in downtown construction projects, American agribusinesses benefit from selling soybeans and pork to Chinese consumers, and American movie studios and sports leagues hope to pad their profits by breaking into the lucrative China market.

For their part, many once-great American manufacturing companies have become multinationals, setting up supply chains in China and other places with low-wage, unfree labor, while sheltering their profits from taxation by the United States in overseas tax havens like Ireland and the Cayman Islands and Panama. Many of these so-called “original equipment manufacturers” (OEMs)—companies that outsource and offshore most of their manufacturing—are engaged as much in trade, marketing, and consumer finance as they are in actually making things.

We should not be surprised that multinational firms, given the choice, typically prefer to maximize profits by a strategy of driving down labor costs, replacing well-paid workers with poorly paid workers in other countries, rather than by becoming more productive through replacing or augmenting expensive labor with innovative machinery and software in their home countries. Labor-saving technological innovation to keep production at home is hard. Finding cheaper labor in another country is easy.

In short, the United States has not been the naive victim of cunning Chinese masterminds. On the contrary, in the last generation many members of America’s elite have sought to get rich personally by selling or renting out America’s crown jewels—intellectual property, manufacturing capacity, high-end real estate, even university resources—to the elite of another country.

A century ago, many British investors did well from overseas investments in factories in the American Midwest and the German Ruhr, even as products from protectionist America and protectionist Germany displaced free-trading Britain’s own unprotected manufacturing industry in Britain’s own markets. By building up China’s economy at the expense of ours, America’s 21st-century overclass is merely following the example of the British elite, which, like a bankrupt aristocrat marrying a foreign plutocrat’s daughter, sells its steel plants to Indian tycoons and state-backed Chinese firms, sells London mansions to Russian gangsters and Arab aristocrats, and sells university diplomas to foreign students including Americans and Chinese.

When asked whether the rapid dismantling, in a few decades, of much of an industrial base built up painstakingly over two centuries has been bad for the United States, the typical reply by members of the U.S. establishment is an incoherent word salad of messianic liberal ideology and neoclassical economics. We are fighting global poverty by employing Chinese factory workers for a pittance! Don’t you understand Ricardo’s theory of comparative advantage?

Some of the profits made by rich Americans in the modern China trade are recycled as money flowing to universities, think tanks, and the news media. The denizens of these institutions tend to be smart and smart people know who butters their bread. Predictably, intellectuals and journalists who benefit from the largesse of American capitalists with interests in China are inclined to please their rich donors by characterizing critics of U.S. China policy as xenophobes who hate Asian people or else ignorant fools who do not understand that, according to this or that letter in The Wall Street Journal or The New York Times signed by 1,000 or 10,000 or 100,000 economics professors, free trade always magically benefits all sides everywhere all at once.

All of this idealistic verbiage about the wonders of free trade and the moral imperative of ending global poverty by replacing American workers with foreign workers cannot muffle the click of cash registers.

The dangerous dependence of the United States and other advanced industrial democracies on China for basic medical supplies has been exposed by the current pandemic. The U.S. and other industrial democracies now confront a stark choice. Western countries can continue to cede what remains of their manufacturing base and even control of their telecommunications and drone infrastructure to Beijing and specialize as suppliers of technological innovation, higher education, agriculture, minerals, real estate, and entertainment to industrial China. Or they can view Western economies as competitors of the Chinese economy, not complements to it, and act accordingly.

Rejection of the view that our economy should compete with, rather than complement, that of China in key sectors does not require us to endorse demagogic claims that the Chinese regime is a crusading ideological enemy hell-bent on world domination like Nazi Germany or the Soviet Union. On the contrary, a strategy of U.S. industrial independence informed by sober realism would entail recognition of the legitimate interest of China, under any regime, in building up its own advanced industries—on the condition that China in return recognize America’s legitimate interests in preserving its own domestic supply chains in the same key industrial sectors.

Econ 101 to the contrary, the purpose of international trade should not be to maximize the well-being of global consumers by means of a global division of labor among countries that specialize in different industries, but to allow sovereign states to pursue industrial policies in their own long-term interest, as they define it. Trade, investment, and immigration policies should be subservient to national industrial strategy. The purpose of trade negotiations should be the modest one of reconciling different, clashing, and equally legitimate national industrial policies in a mutually acceptable way.

National industrial policies are like national militaries—essential local public goods provided by a sovereign government to a particular people. The model for trade negotiations should be bilateral and multilateral arms control, which are based on the premise that all parties have a perpetual right to their own militaries, rather than global disarmament, which seeks the utopian goal of eliminating all militaries everywhere.

All modern economies are mixed economies, with public sectors and private sectors, and all modern trade should be mixed trade, with wholly protected sectors, partly protected sectors with managed trade, and sectors in which free trade is not dangerous and is therefore allowed. In a post-neoliberal world, it would be understood that the legitimate self-interest of sovereign nations and blocs inevitably imposes strict limits on the acceptable flow of goods, money, and labor across borders. Institutions which limit the right of sovereign states to promote their own national industries as they see fit, like the World Trade Organization (WTO), should be reformed or abolished.

All major countries like the United States, China, and India and all major trading blocs like the EU should insist on having their own permanent domestic supply chains in medicine, medical gear, machine tools, aircraft and drones, automobiles, consumer electronics, telecommunications equipment, and other key sectors. They should have the right to create or protect these essential industries by any means they choose, at the expense of free trade and free investment if necessary.

If China and India want to have their own national aerospace industries in addition to the United States and European Union, more power to them—as long as the United States and European Union can intervene to preserve their own national aerospace supply chains on their own soil employing their own workers. If this approach means accepting that Western-based aerospace firms like Boeing and Airbus cannot hope to enjoy a permanent shared monopoly in global markets for large jets, well, too bad. Boeing and Airbus cannot claim in good times to be post-national global corporations to justify offshoring policies and then claim in bad times to be national champions when they need bailouts.

The alternative—deepening the complementarity among China’s industrial and America’s postindustrial economies—would be much worse for the United States. The same American overclass whose members have profited the most from transferring national assets to China in the last generation has also been far more insulated from the effects of imports from China, both manufactured goods and viruses. The United States, which has always had features of a Third World country as well as a First World country, could decline into a deindustrialized, English-speaking version of a Latin American republic, specializing in commodities, real estate, tourism, and perhaps transnational tax evasion, with decayed factories scattered across the continent and a nepotistic rentier oligarchy clustered in a few big coastal cities.

It would be ironic as well as tragic if the strategy of Sino-American economic integration which American elites in the 1990s hoped would turn China into another Mexico for the United States ends up turning the United States into another Mexico for China.

The China Question – Tablet Magazine

via Project syndicate

May 25, 2021STEPHEN S. ROACH

The US Federal Reserve is insisting that recent increases in the price of food, construction materials, used cars, personal health products, gasoline, and appliances reflect transitory factors that will quickly fade with post-pandemic normalization. But what if they are a harbinger, not a “noisy” deviation?

NEW HAVEN – Memories can be tricky. I have long been haunted by the inflation of the 1970s. Fifty years ago, when I had just started my career as a professional economist at the Federal Reserve, I was witness to the birth of the Great Inflation as a Fed insider. That left me with the recurring nightmares of a financial post-traumatic stress disorder. The bad dreams are back.

They center on the Fed’s legendary chairman at the time, Arthur F. Burns, who brought a unique perspective to the US central bank as an expert on the business cycle. In 1946, he co-authored the definitive treatise on the seemingly rhythmic ups and downs of the US economy back to the mid-nineteenth century. Working for him was intimidating, especially for someone in my position. I had been tasked with formal weekly briefings on the very subjects Burns knew best. He used that knowledge to poke holes in staff presentations. I found quickly that you couldn’t tell him anything.

Yet Burns, who ruled the Fed with an iron fist, lacked an analytical framework to assess the interplay between the real economy and inflation, and how that relationship was connected to monetary policy. As a data junkie, he was prone to segment the problems he faced as a policymaker, especially the emergence of what would soon become the Great Inflation. Like business cycles, he believed price trends were heavily influenced by idiosyncratic, or exogenous, factors – “noise” that had nothing to do with monetary policy.

This was a blunder of epic proportions. When US oil prices quadrupled following the OPEC oil embargo in the aftermath of the 1973 Yom Kippur War, Burns argued that, since this had nothing to do with monetary policy, the Fed should exclude oil and energy-related products (such as home heating oil and electricity) from the consumer price index. The staff protested, arguing that it made no sense to ignore such important items, especially because they had a weight of over 11% in the CPI. Burns was adamant: If we on the staff wouldn’t perform the calculation, he would have it done by “someone in New York” – an allusion to his prior affiliations at Columbia University and the National Bureau of Economic Research.

Then came surging food prices, which Burns surmised in 1973 were traceable to unusual weather – specifically, an El Niño event that had decimated Peruvian anchovies in 1972. He insisted that this was the source of rising fertilizer and feedstock prices, in turn driving up beef, poultry, and pork prices. Like good soldiers, we gulped and followed his order to take food – which had a weight of 25% – out of the CPI.

We didn’t know it at the time, but we had just created the first version of what is now fondly known as the core inflation rate – that purified portion of the CPI that purportedly is free of the volatile “special factors” of food and energy, where gyrations were traceable to distant wars and weather. Burns was pleased. Monetary policy needed to focus on more stable underlying inflation trends, he argued, and we had provided him with the perfect tool to sharpen his focus.

It was a fair point – to a point; unfortunately, Burns didn’t stop there. Over the next few years, he periodically uncovered similar idiosyncratic developments affecting the prices of mobile homes, used cars, children’s toys, even women’s jewelry (gold mania, he dubbed it); he also raised questions about homeownership costs, which accounted for another 16% of the CPI. Take them all out, he insisted!

By the time Burns was done, only about 35% of the CPI was left – and it was rising at a double-digit rate! Only at that point, in 1975, did Burns concede – far too late – that the United States had an inflation problem. The painful lesson: ignore so-called transitory factors at great peril.

Fast-forward to today. Evoking an eerie sense of déjà vu, the Fed is insisting that recent increases in the prices of food, construction materials, used cars, personal health products, gasoline, car rentals, and appliances reflect transitory factors that will quickly fade with post-pandemic normalization. Scattered labor shortages and surging home prices are supposedly also transitory. Sound familiar?

There are many more lessons from the 1970s that shed light on today’s cavalier dismissal of inflation risk. When the Fed finally tried to tackle the Great Inflation, it fixated on unit labor costs – rising wages accompanied by sagging productivity. While there are always good reasons to worry about productivity, wages appear to be largely in check; unionized labor, which, in the 1970s had sparked a vicious wage-price spiral through cost-of-living indexation, has been neutralized by global competition. But that doesn’t rule out a very different form of global cost-push inflation – namely, the confluence of supply-chain congestion (think semiconductors) and protectionist clamoring to reshore production.

But the biggest parallel may be another policy blunder. The Fed poured fuel on the Great Inflation by allowing real interest rates to plunge into negative territory in the 1970s. Today, the federal funds rate is currently more than 2.5 percentage points below the inflation rate. Now, add open-ended quantitative easing – some $120 billion per month injected into frothy financial markets – and the largest fiscal stimulus in post-World War II history. All of this is occurring precisely when a post-pandemic boom is absorbing slack capacity at an unprecedented rate. This policy gambit is in a league of its own.

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Bottom of Form

For my money, today’s Fed waxes far too confidently about well-anchored inflation expectations. It also preaches the new gospel of “average inflation targeting,” convinced that it can condone above-target inflation for an unspecified period to compensate for years of coming in below target. My students would love to throw out their worst grade(s) as well!

No, this isn’t the 1970s, but there are haunting similarities that bear watching. Timothy Leary, one of the more memorable gurus of the Age of Aquarius, purportedly said, “If you remember the 1960s, you weren’t there.” That doesn’t apply to the 1970s. Sleepless nights and vivid flashbacks, complete with visions of a pipe-smoking Burns – it’s almost like being there again, but without the great music.

by John authors via Zerohedge

An Emerging Problem Commodity prices are much higher than they have been for a while. Inflation in the U.S. is much higher than it has been for a while. How much are these things related, and what do they portend for the future? There’s certainly some relationship between the commodity complex and companies’ input prices. Producer price inflation provided another unpleasant surprise on Thursday, coming in at its highest in four decades, bar a brief peak in the summer of 2008 ahead of the global financial crisis — which uncoincidentally is when Bloomberg’s broad commodities index hit an all-time high: The 2008 price spike was driven by oil. There is nothing like such pressure now, although the latest 12-month increase for the Bloomberg index, at 48.4%, is the highest in four decades. However, in developed markets at least, the contribution of core goods — excluding oil and agricultural products — to inflation isn’t very significant. The following chart, from London’s Capital Economics Ltd., shows that the contribution is much lower than it was about 10 years ago, when the level of commodity prices was higher:  The steadily changing nature of the economy also makes basic commodity prices less important, They still matter greatly for the metals industry (obviously), and food business and utilities, but their contribution to the services that now dominate the economy is negligible. This chart is also from Capital Economics: But while commodity inflation is no longer of such direct import to the developed world, it still has serious effects on emerging economies. When we look at commodities’ share of final consumption, we find that emerging Asia is far more exposed to commodity prices than Europe and North America. Sub-Saharan Africa, not shown here, is even more commodity-dependent: One further problem for the developing world is that rises in commodity prices tend to be sustained, and move in waves. BNP Paribas SA shows that input prices (as taken from the Markit ISM surveys) are rising sharply in emerging markets. The last time they reached these levels, in the wake of the GFC, prices stayed high for a couple of years before settling into the prolonged bear market that is now over: This raises the disquieting prospect of social unrest in the emerging world. The spark that lit the Arab Spring revolts of 2011 was a protest in Tunisia over high food prices. As Jason DeSenna Trennert of Strategas Research Partners puts it:  Only in a rich nation could one exclude nourishment and staying warm as anything other than “core.” Commodity price inflation can thus be very politically destabilizing, especially in countries without strong and flexible systems of governance. It should be remembered that in the last financial crisis, America experienced both a significant decline in home prices (an event that hadn’t happened since the 1930s) as well as $150 oil simultaneously. Sadly, riots for food in countries like India, Egypt, and Indonesia became commonplace. With America’s twin deficits approaching 20% of GDP, it is difficult to get bullish about the U.S. dollar, especially against commodities and hard assets. In this way, the dollar is, as Treasury Secretary John Connally once said, “our currency and your problem.” So while stronger commodity prices aren’t in themselves too dangerous for inflation in developed countries, they could be profoundly destabilizing in the emerging world. Problems affording food would only exacerbate the pain for the countries like Brazil and particularly India that are currently suffering grievously from the pandemic. Food makes up 29.8% of consumer expenditures in India (and as much as 59% in Nigeria), and only 6.4% in the U.S. Food inflation feeds much more directly into headline inflation in emerging markets, and this will push headline and core inflation upward, according to BNP’s estimates: This could in turn force a number of countries into interest rate hikes at a point when their economies wouldn’t otherwise be ready for them. Brazil in particular looks set for sharp tightening, as well as increased inflation. In much of the rest of the developing world, BNP Paribas shows, the expectation is that countries will endure a rise in inflation without adjusting monetary policy from their previously planned course. Rising interest rates can be almost as unpopular as food price inflation in the developing world, particularly in a time of pandemics, so central banks will naturally try to avoid them. But this is where the most difficult inflationary challenges lie at present. In the developed world, the uptick in inflation might still prove a transitory quirk caused by reopening. In the emerging world, food price inflation is already forming a serious social and economic challenge.

There is an overarching issue I haven’t been able to get off my mind: Are we at the beginning of something new or in the waning days of the previous multi-decade cycle?

May 5 – Wall Street Journal (James Mackintosh): “We could be at a generational turning point for finance. Politics, economics, international relations, demography and labor are all shifting to supporting inflation. After more than 40 years of policies that gave priority to the fight against rising prices, investor- and consumer-friendly solutions are becoming less fashionable, not only in the U.S. but in much of the world. Investors are woefully unprepared for such a shift, perhaps because such historic turning points have proven remarkably hard to spot. This may be another false alarm, and it will take many years to play out, but the evidence for a general shift is strong across five fronts.”

The “five fronts” underscored in Mr. Mackintosh’s insightful piece are as follows: 1) “Central banks, led by the Federal Reserve, are now less concerned about inflation.” 2) “Politics has shifted to spend even more now, pay even less later.” 3) “Globalization is out of fashion.” 4) “Demographics worsen the situation.” 5) “Empowered labor puts upward pressure on wages and prices.”

The analysis is well-founded, as is the article’s headline: “Everything Screams Inflation.” After surging another 3.7% this week (lumber up 12%, copper 6%, corn 9%), the Bloomberg Commodities Index has already gained 20% this year. Lumber enjoys a y-t-d gain of 93% – WTI Crude 34%, Gasoline 51%, Copper 35%, Aluminum 26%, Steel Rebar 32%, Corn 51%, Soybeans 22%, Wheat 19%, Coffee 18%, Sugar 13%, Cotton 15%, Lean Hogs 59%… The focus on inflation is clearly justified. Yet Mackintosh began his article suggesting a “Generational Turning Point for finance” – rather than inflation. Let’s explore…

I mark the mid-eighties as the beginning of the current super-cycle. A major collapse in market yields (following the reversal of Paul Volcker’s tightening cycle) promoted financial innovation and the expansion of non-bank Credit expansion. Markets were turning increasingly speculative, while the economic boom was spurring increasingly destabilizing trade and Current Account Deficits. These deficits were helping feed Japan’s Bubble, fueled both by international financial flows as well as the misguided Japanese policy response seeking to use monetary stimulus to boost U.S. goods imports and rectify its ballooning trade surpluses. In the U.S., increasingly acute Monetary Disorder led to the “Black Monday” – October 19th, 1987 stock market crash.

The Greenspan Fed’s crash response launched a regime of activist central bank measures specifically directed at supporting the securities markets. U.S. stocks swiftly recovered, while loose financial conditions stealthily promoted the evolution of non-bank finance. Post-crash Bubble reflation developments cemented the “decade of greed” moniker. Michael Milken and the proliferation of junk bonds and leveraged finance. Insider trading, Ivan Boesky, the LBO boom, Charles Keating, and the Savings & Loan (S&L) fiasco. And, importantly, post-crash reflationary measures pushed Japan’s Bubble to catastrophic “Terminal Phase Excess.” After ending 1987 at 21,564, the Nikkei Index traded to an all-time high 38,916 on the final trading session in 1989.

All kinds of things went wrong in 1990 – including war and recession. Late-eighties U.S. bubbles burst in unison, including coastal real estate, junk bonds, LBOs, and the S&Ls. Japan’s Bubble began to unravel. Collapsing Bubbles left the U.S. banking system badly impaired, with multiple major failures and even concerns for the solvency of Citicorp. Already huge fiscal deficits were at risk of exploding uncontrollably, due to ballooning costs of bank and S&L recapitalizations.

“The Maestro” pushed central bank activism to a whole new level, collapsing rates and manipulating the yield curve. Banks were encouraged to borrow short (cheap) and lend long (dear), pocketing easy spread profits while rebuilding capital. Finance, financial structure and policymaking were changed forever. Importantly, Greenspan’s policies were a godsend to the fledgling leveraged speculating community that prospered on hugely profitable “carry trades” and levered derivatives strategies – and never looked back.

When the bond/derivatives Bubble burst in 1994, the rapidly expanding GSEs were elevated to quasi-central banks. The GSEs began aggressively buying debt securities during periods of market instability, creating a liquidity backstop that fundamentally altered the risk vs. reward dynamics of leveraged speculation and derivatives strategies more generally. With their implicit government debt guarantees, the GSEs enjoyed unlimited access to cheap market-based borrowings. Meanwhile, the Mexican bailout and global policy responses (including from the IMF) to a series of devastating EM Bubble collapses (SE Asian “Tigers” to Russia) reinforced the market perception that central banks, governments and inter-governmental agencies were all now fully committed to backstopping the rise of market-based “Wall Street finance”.

The 1998 LTCM bailout – and post-crisis GSE/Fed reflation measures – pushed the U.S. “tech” Bubble in 1999 to dangerous “Terminal Phase Excess.” The Fed’s post-tech Bubble reflationary measures then stoked the more expansive and systemic “mortgage finance Bubble”. And yet another post-Bubble reflation stoked this super-cycle’s “Terminal Phase” “global government finance Bubble.”

The pandemic erupted at a critical Bubble juncture. Speculative excess had already turned problematic. Financial and economic fragilities were manifesting globally, particularly in Bubble heavyweights U.S. and Chinese financial systems. In the summer of 2019, China was facing instability at its Credit system’s “periphery”, notably within the giant “small banking” sector. In the U.S., the eruption of repo market (a key source of finance for leveraged speculation) instability provoked the latest iteration of activist/inflationist monetary management – the so-called “insurance” monetary stimulus.

The Fed redeployed QE in the face of highly speculative markets (stocks near records) and unemployment at multi-decade lows. Arguably, this stimulus and resulting Bubble excess contributed to latent fragilities that erupted in near market collapse in March 2020. The Fed’s balance sheet has more than doubled (108%) in 86 weeks to $7.81 TN. A full-fledged mania erupted – stocks, cryptocurrencies, corporate Credit, SPACs, derivatives, houses, etc. Washington ran a $4.8 TN, or almost 25% of GDP, deficit in only 18 months.

Considering the unprecedented nature of recent excess, there is today every reason to contemplate a secular shift in inflation dynamics. The Fed is locked into runaway monetary inflation, while its new inflation-targeting regime specifically seeks to promote above-target inflation. Moreover, Washington had grown comfortable with massive deficits even prior to covid. Now, the Biden administration is pushing gargantuan spending programs, in what is a predictable political response to flagrant inequality and derelict infrastructure. There is also the astronomical cost of adjusting to climate change. Mr. Mackintosh’s above article highlights the major factors supporting the secular inflation thesis.

But what about finance? Central bank policies now command market trading dynamics, while government-related debt dominates system Credit expansion. There is every reason to believe state-directed lending, after reaching new extremes during the pandemic, will become only more obtrusive going forward. A compelling case can be made this new age of government directed finance and spending is now driving a new inflationary cycle.

However, I certainly don’t want to dismiss end-of-cycle dynamics. “Blow-off” dynamics, after all, are proliferating. One can start with the trajectory of the Fed’s balance sheet, along with unbounded fiscal deficit spending. There are, as well, myriad indications of “Terminal Phase” speculative excess, including numerous manias, over-leverage, ETF flows, corporate bond issuance, the Ark funds, etc. The breadth and scope of such extreme behavior portend change is in the offing.

These days, markets and about everyone anticipates that historic monetary and fiscal stimulus will continue to fuel historic asset bull markets. The existing cycle is very much intact, it is believed, with New Age central banking continuing to underpin unrestrained fiscal spending. But could both monetary and fiscal authorities have pushed things too far? Could we be nearing a major adjustment, where the respective interests of an expansive government and the markets finally diverge? Might a bout of market discipline catch Washington, along with about everybody, by complete surprise? A crazy thought.

This history of monetary inflation informs us that once it begins in earnest, it becomes extremely difficult to rein in. After expanding assets by $4.0 TN in about 18 months – and stoking historic manias in the process – any Fed retreat in the direction of “normalization” will prove highly destabilizing (a dynamic clearly not lost on Fed officials). A similar dilemma holds true for the Federal government after it’s $4.8 TN deficit spending free-for-all. Meanwhile, “melt-up” speculative market dynamics are similarly problematic. There is no reason to expect the type of historic excess we’ve been witnessing to end with a whimper.

All the key dynamics shaping finance have been pushed to such egregious “Terminal Phase” extremes. Shouldn’t we today be contemplating how such end-of-cycle dynamics might play out? A harsh market reaction to reckless Washington policymaking would appear long overdue. The flow of magma to the surface has been restricted for far too long. Could an inflation scare prove the catalyst for a market eruption?

Credit has been expanding rapidly throughout this most-protracted cycle. There has been tremendous debasement, yet for various reasons consumer price inflation remained relatively contained. Liquidity flowed into the securities and asset markets, while bond yields collapsed despite a historic increase in supply/issuance. Markets have been more than happy to accommodate huge fiscal spending and the attendant supply of government bonds. Of course it’s easy to extrapolate this wondrous dynamic far into the future.

But the markets’ failure to impose discipline had predictable consequences. Governments succumbed to late-cycle massive over-issuance, pushing the limits of market accommodation while also stoking general inflationary pressures. To this point, however, the Fed’s ongoing massive QE buying has masked deepening fragility. This has only emboldened deficit spending proponents, while throwing more fuel on both speculative manias and mounting pricing pressures throughout the real economy.

It all points to a major shakeout. An inflation upside surprise could come with momentous ramifications. The bond market would face major instability. Beyond debasement, there would be fear of a destabilizing de-risking/deleveraging dynamic taking hold. And market instability and illiquidity become even greater issues at the point when inflationary pressures weaken the Fed’s propensity for quick QE liquidity injections. Suddenly, the marketplace would be forced to reassess the reliability of its coveted liquidity backstop.

There’s a scenario we need to contemplate: Mounting inflationary pressures spook the bond market concurrent with the Fed moving forward its plans to wind down QE and commence rate increases. Bond market instability unleashes a bout of de-risking/deleveraging, a particularly problematic development for a highly levered corporate bond complex, as well as quite speculative equities markets. In such a scenario, the Fed would be under intense pressure to employ large QE purchases to underpin marketplace liquidity. A failure to act would be highly destabilizing for the markets. At the same time, another huge bout of QE in a backdrop of heightened inflationary concerns might prove problematic for bond investors.

It is worth recalling the chaos that ensued early in the March 2020 pandemic policy response. Markets continued a panicky de-risking/deleverage even as the Fed announced major liquidity operations. It was not until the Fed ratcheted up the response to monumental liquidity injections that crash dynamics were reversed. But speculation and leverage have surely expanded significantly over the past year, raising the issue of the scope of the next QE bailout necessary to again hold Bubble collapse at bay.

I believe another massive QE bailout program is inevitable. And such a program in the face of rapidly building inflationary pressures would risk a bond market backlash. This could throw Fed monetary doctrine into disarray: does it inflate its balance sheet to provide liquidity support to the markets, or must it focus instead on reining in inflationary policy measures to stabilize unsettled bond markets? A crisis of confidence in Federal Reserve policymaking would be a distinct possibility. And such a scenario would risk ending the past three decades’ nexus between progressively activist monetary management and ever-expanding financial Bubbles.

Markets have enjoyed reliable liquidity backstops going back to the GSEs in the mid-nineties. When accounting irregularities eventually ended Fannie and Freddie’s open-ended growth, the Fed’s balance sheet took over liquidity backstop operations. There are much different financial and economic worlds without a reliable Fed/central bank market liquidity backstop.

And while the assertion the Fed will always be there to backstop the markets has some merit, there are major challenges developing. Previous QE programs essentially directed liquidity into the markets. U.S. investment booms were for the most part disinflationary, with spending on new technologies, services, and digitized output creating an endless supply of “output” devoid of traditional upward pricing pressures.

Going forward, the investment boom will shift to infrastructure, along with a domestic manufacturing push. Climate change will require enormous investment in physical capital stock and associated manufacturing capacity. A strong case can be made this changing investment dynamic will play a significant role in evolving inflation dynamics. There will be tremendous demand for various commodities as well as skilled labor. Moreover, this will be a global phenomenon.

There were inflation concerns when the Fed initially employed QE in 2008. But that was in a post-Bubble backdrop replete with powerful real economy disinflationary forces. The liquidity and resulting inflationary effects remained largely contained within the securities markets. The “QE2” near doubling of the Fed’s balance sheet between 2011 and 2014 injected liquidity into a system with ongoing real economy disinflationary pressures, but with increasingly powerful inflationary Bubble Dynamics in the securities markets – at home and abroad. Market Bubbles, furthermore, fueled an investment boom throughout the expansive technology sector with minimal inflationary impacts upon the broader economy. Actually, the massive increase in supply of myriad technology gadgets, services and digitalized downloads acted as a sponge absorbing what would have traditionally been inflationary spending power.

There is already evidence the latest round of QE is fueling divergent inflationary dynamics. For one, it’s at such greater scope. Secondly, it has unfolded concurrently with unprecedented fiscal spending. Thirdly, QE was employed in an environment of already heightened real economy inflationary pressures – i.e. labor, housing, commodities, physical investment beyond new technologies, etc. And, finally, massive monetary stimulus comes following decades of inflationary dynamics that profoundly benefited securities prices and the wealthy at the expense of the working class. The inevitable social and political backlash, further energized by covid-related inequities, has spurred a flurry of wealth redistribution policy initiatives.

There is indeed every reason to contemplate the possibility of a momentous secular shift in inflation dynamics. This doesn’t necessarily mean CPI begins rising dramatically, although the likelihood of such an outcome is rising. But the strongest inflationary biases are poised to shift from the securities markets back to more traditional real economy impacts. This implies the Fed going forward will face obstacles in its “whatever it takes” open-ended QE doctrine. Rising inflation and a fragile bond market will force it to contemplate the risk of additional QE, while QE liquidity will now gravitate more toward inflationary dynamics within the real economy. This dynamic is already observable in booming commodities markets.

But back to the original question: Are we witnessing the start of something new – or the previous cycle’s end-game? There’s an understandable focus on how central banks and governments have hijacked Credit systems. To this point, this “money” has created an extraordinarily stable dynamic relative to runaway monetary inflation and debt growth.

Though bastardized by government intrusion, Credit remains dominated by market-based finance. Is this cycle of market-based Credit underpinned by activist central bank management sustainable? Or has the massive expansion of non-productive Credit, egregious monetary inflation, manic market excess and associated inflationary pressures created fragilities that place the existing financial structure at risk?

The Fed is in no hurry to find out. QE to the tune of $120 billion a month masks fragilities, while holding market adjustment at bay. And the mania rages on, while Washington luxuriates in blank checkbook overindulgence. Inflationary pressures mount. It’s worth noting the Dollar Index dropped 1.1% this week and is now only a couple percent from 2018 lows.

The future could not be murkier. Everyone is prepared for unchecked monetary and fiscal stimulus as far as the eye can see. But is existing market structure sustainable in a backdrop of unrelenting non-productive debt growth, rising inflation, waning central bank flexibility and shifting political priorities? A Bloomberg headline from Friday evening: “Reflation, Inflation, Deflation: Stocks Can Live With Everything.” I’m not convinced the financial Bubble can live without QE. Is massive monetary inflation the only thing sustaining a multi-decade market cycle?

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