China Shows Worrying Signs of Slowdown as Investors Weigh Risks

The Global Recession of 2008 took decades to manifest. The recovery may take just as long.

More than four years ago, I suggested the Chinese economy was headed toward economic slowdown, which would have adverse consequences for the rest of the world. Today, that prognostication seems frighteningly real.

From 2001 to 2010, consumption as a share of GDP in China fell to 36 percent from 46 percent, while the near reverse occurred for investment, rising to 47 percent from 36 percent.

This high level of investment, which was financed with large quantities of debt, could not be supported by the current levels of income. In essence, the Chinese built homes, offices and manufacturing plants that they neither needed nor had the ability to support financially.

Since 2007, China embarked on a debt-driven plan to increase domestic investment, income and economic growth, expanding total debt from $7 trillion to $28 trillion.

As a share of GDP, its debt more than doubled from 130 percent in 2009 to 282 percent by mid-2014, making it larger than that of the United States or Germany.

Roughly half of the loans are associated directly or indirectly with China’s real estate market; unregulated shadow banking now accounts for approximately half of all new lending; and the debt of many local governments is likely unmanageable, according to a McKinsey & Co. study.

China maintains a large presence on the world’s economic stage. By 2011, it contributed 40 percent of the world’s economic growth. In 2014, China was the third-largest importer, closely behind the United States and the European Union, with $1.96 trillion of imports, and the largest exporter with $2.34 trillion in sales. Currently, it accounts for 16 percent of world economic activity, the equivalent of the U.S. in purchasing power parity terms.

China purchases about half the world’s aluminum, nickel and steel, and nearly a third of its cotton and rice, as well as iron ore, copper and coal, which created a boon in commodity prices.

It also expanded its foreign direct investment program, growing ten-fold from 2005 to 2013, and was the largest investor in five of the 10 riskiest countries.

Given China’s premier global economic standing, its difficulties are metastasizing worldwide. It has begun reducing capital investment, causing commodity prices to fall and hurting many of its trading partners, including South Korea, Japan, the U.S., Taiwan, Germany, Australia, and Brazil.

China now contributes 30 percent to world GDP growth, down from 40 percent four years ago.

Structural demographic trends portend poorly for China, since its working-age population is beginning to contract. Lower employment, income and economic growth may precipitate asset sales to service outstanding debt — leading to real estate price declines, lower loan collateral, and less lending.

Further complicating matters, in 2007, Li Keqiang, now China’s premier, told the U.S. ambassador that the Chinese GDP figures are “man-made” and therefore unreliable, according to a memo released by WikiLeaks.

Since then, macroeconomic research firms have attempted to measure these data more independently. The official Chinese estimate of economic growth stands at 7 percent. This is in stark contrast to that suggested by Capital Economics at 4.1 percent, Conference Board/Hitotsubashi at 3.8 percent and Lombard Street at 3.7 percent.

In a bit of monetary and financial schizophrenia, China has recently vacillated between a market and state-driven economy to manage its economic affairs.

In an attempt to have the renminbi included in the International Monetary Fund’s Special Drawing Rights, China sought a more flexible exchange rate, only to see it plunge in value. This led it to strengthen the currency with daily purchases totaling tens of billions of dollars.

Investors suspect the yuan will weaken an additional 4 percent to 6.75 percent relative to the dollar. This anticipated decline is in addition to the 4.4 percent drop since August 11.

Daily trading in yuan options skyrocketed to $12 billion following the currency intervention by the People’s Bank of China from an average of $4.2 billion. The cost to insure $100 million against a weaker yuan ballooned from $30,500 to $1.7 million during this time, suggesting further currency erosion.

In a reversal, after discouraging the use of borrowed funds to purchase stocks, the Chinese government sanctioned this activity by providing funds to state lenders. In addition, it limited IPOs to reduce competition with existing equities; permitted a pension fund to purchase stock; limited stock sales by large shareholders; forced company stock buyback programs; lowered interest rates and deposit reserve requirements; and spent more than $200 billion buying Chinese stocks since early July, with the likelihood that this rate of spending would need to be indefinite.

The Chinese concluded this stock-propping program was unsustainable and decided to discontinue its operation. The gains of 60 percent since December 2014 have evaporated completely.

In March 2007, nine months before the beginning of the Great Recession, the U.S. experienced a government security yield curve inversion, when short-term interest rates were higher than long term rates: the three-month Treasury bill at 5.1 percent and two-year Treasury note at 4.6 percent.

Typically, longer-term investments are more risky and warrant greater returns on investment. However, yield inversion signifies greater short-term risk associated with an anticipated economic downturn.

Since 1970, yield inversions predicted an economic contraction six of seven times. By March 2008, the yield inversion was reversed, and short-term rates were lower than long-term: 1.11 percent for the three-month Treasury bill and 1.33 percent for the two-year Treasury note.

In the case of China, the yield inversion has lasted more than four years. On August 25, the two-year Chinese government bond stood at 3.50 percent and the 10-year bond at 3.48 percent: a minor inversion still exists.

This long duration signals the economic slowdown may continue for many years and possibly approach zero growth with negative global implications.

© 2015 Newsmax Finance. All rights reserved.

China Economy May Drag World Down

This article was originally published on December 16, 2011.

As China goes, so goes the world.

My column of June 24, 2011 (“China Yield Inversion May Portend Economic Slowdown”) opened with the following sentence:

“The yield on Chinese bonds are inverting at an accelerating rate. This does not portend well for the Chinese economy, and this may have negative implications globally.”

China’s contribution to global economic growth this year is nearly 40%.

The reason: property construction in China boomed significantly during the previous decade.

The Chinese government controls all the allocation of land. Beginning in 1998, Chinese authorities permitted individuals to buy the “right” to use property for 70 years. Domestic capital controls, which limited investment outside China, increased demand for this asset.

As a result, property construction boomed. The increased supply resulted in high levels of employment, income, and demand for residential and commercial properties.

The problem: insufficient demand to absorb the excess investment in property development.

According to the National Bureau of Statistics in China, real estate development for 2011 will total nearly $1 trillion, a 32% increase over last year. This investment represents approximately 15% of GDP, as calculated by the World Bank.

According to Jonathan Anderson of UBS, this is “the single most important sector in the entire global economy, in terms of its impact on the rest of the world.”

The reason: significant, productive economic activity is dependent on this sector.

Forty percent of Chinese steel use is related to property construction. China produces more steel than the next 10 steel producing countries combined, deeming it the most important procurer of iron ore, a key input for steel manufacturing.

Other essential steel manufacturing inputs are copper, cement, coal, and power generation. These activities generate a significant amount of income that is used to purchase global products and services.

Today, the average home price in China equals 9 times average annual income. The price for luxury apartments in Versailles Residentiel de Luxe La Grand Maison, located in the city of Wenzhou, are 350 times average annual income.

The perspective: at the peak of the U.S. real estate bubble, this ratio was 5.1. It is currently near 3, the historic average.

Using the current income level in China, real estate prices would need to fall by two thirds to be sustainably priced. Should income rise 50% in the coming decade (4% per annum), prices could fall 50% to achieve a stable equilibrium.

In the past year, real estate transactions (sales) and prices have fallen dramatically. At the current rate, prices may drop 50% within over the coming decade.

This decline has been due to low income demand at the current price level and the tremendous supply of inventory (approximately 20 years based on current vacancies, pending projects, and future population projections).

Demand for property development is decreasing. Less construction translates into lower income, personal, corporate, and governmental (local government derives 40% of its income from property sales). Smaller incomes suggest lower demand for global products and services.

In addition, lower property values imply less collateral for future credit, thereby limiting growth prospects.

This portends poorly for the global economy.

China’s annual trade surplus has been halved since 2008 to roughly $150 billion. This reflects a decrease in export and import growth, with exports declining at a greater rate. This decline is partially a manifestation of decreased demand by the eurozone and China’s domestic market.

In recent years, China increased the required reserve ratio for bank deposits to limit monetary growth, reduce aggregate demand, and minimize inflationary pressures.

However, due to the impending global economic slowdown, China recently reduced the reserve requirement to foster economic growth.

Deleveraging of the massive global debt, which is 3 times global income, will reduce monetary velocity (transactions) and income over the next decade.

Increases in monetary aggregates, credit, and liquidity may provide meager assistance in the immediate term.
In fact, it will delay, and possibly exacerbate, the underlying economic dysfunction, thereby extending anemic global growth for years to come.

Moreover, the increased money supply, without much increase in value added product supply, will increase transaction demand for existing products, thereby placing upward price pressures.

Lower government revenues may require additional debt issuance at higher interest rates to attract scarce capital. Existing economies of scale may not be sufficient to offset a possible increase in borrowing costs. Upward pressure on retail prices may result, creating an inflationary spiral.

Global stagflation may be the new paradigm over the coming decade.

© 2015 Newsmax Finance. All rights reserved.

China Yield Inversion May Portend Economic Slowdown

This article was originally published on June 24, 2011.

The yield on Chinese bonds are inverting at an accelerating rate. This does not portend well for the Chinese economy, and this may have negative implications globally.

An inversion of the yield curve occurs when short-term interest rates are higher than long-term interest rates.

Typically, the opposite occurs, since long-term investments are associated with more risk. Additional risk, such as price inflation, currency depreciation, default, and lost opportunities, cause investors to demand higher rates of return for longer-term investments.

An inversion of the yield curve is usually the result of an anticipated slowing of future economic activity over the coming year or two. This anticipation is reflected in lower demand for short-term corporate debt, which simultaneously depresses prices and increases rates for this debt.

In addition, this prognostication is followed by decreased demand for corporate equities based on unfavorable business conditions and lower profit potential in the near term (one to two years).

The China yield curve, which has been inverted for nearly six months, continues to move in this direction with greater velocity.

The Shanghai Interbank Offer Rate (SHIBOR) is the short-term rate of interest that Chinese banks are willing to lend other Chinese banks. The current rates for one week, one month, three months, one year, and 10 years are: 9 percent, 8 percent, 6 percent, 5 percent, and 4 percent, respectively.

Note: The longer the term, the lower the rate.

In the past 50 years, this indicator correctly predicted all but one economic slowdown.

The identical scenario occurred in the U.S. in February 2007 prior to the financial crisis. At that time, the yield for the two-year Treasury note was 4.93 percent, while that for the 10-year Treasury bond was 4.81 percent.

The National Bureau of Economic Research (NBER) determined the economic recession began in December 2007, 10 months later.

The reason for the Chinese yield inversion: the currency exchange rate mechanism

Since 1980, China has purposely devalued its currency (yuan) to increase the demand for its export products. When the Chinese yuan devalues, the yuan is equivalent to less foreign currency. Therefore, an export product priced in yuan requires less foreign currency, which translates into more demand for Chinese exports.

In 1980, the U.S. dollar purchased 1.50 yuan. By 1994, it purchased 8.46 yuan. Today, the rate is 6.50.

The Chinese do not allow the market to adjust the currency exchange rate: it is determined by government policy. The low relative value of the yuan has increased demand for Chinese products tremendously. This has created a huge demand for yuan and an inflow of foreign currency reserves (approximately $3 trillion).

The increase in demand would typically increase the value of the yuan, bringing supply and demand into equilibrium. Since, the currency exchange rate remains fixed, demand for yuan exceeds supply. Therefore, the Chinese create yuan to satisfy the demand.

Wu Xiaoling, vice chairman of the Financial and Economic Affairs Committee of China’s National People’s Congress, recently said, “In the past 30 years, we have used excessive money supply to rapidly advance our economy.”

China has the highest ratio of broad money (M)-to-income (GDP) in the world. This suggests there is an excess of money and a lack of transaction velocity (V), since GDP = M times V.

During the past decade, the broad money stock in China increased nearly 20 percent per annum, while real GDP grew at 10 percent per annum. In the U.S., money and income growth per annum were only 5 percent and 3 percent, respectively.

The large quantity of money has created an increase in demand for many asset classes, including land, housing, and commodities. The result has been an increase in asset prices. urrently, annual inflation is approaching 5 percent.

Inflation and inflationary expectations portend future uncertainties and risk. This unfavorable climate reduces demand for foreign and domestic investment as well as domestic exports.

To combat inflation, China is attempting to reduce the quantity of money available by increasing interest rates and required bank reserves (20 percent of deposits). The former restricts demand for loans, while the latter restricts supply of loans.

Ironically, further threatening growth and income are the downward price pressures on commercial and residential real estate. The former has excess supply and the latter has deficient demand

Price depreciation of these assets will likely dampen collateral values and reduce the supply and demand for loan and credit activity. This suggests a reduction in economic activity and income.

These dynamics indicate an economic slowing in the near term (one to two years) as money is removed from the system. The business environment may be less profitable, which may depress equity prices in the near term as well (one to two years).

This may have negative implications globally as well.

As excess money is removed from the Chinese system, velocity will increase, permitting more stable, long-term income growth.

© 2015 Newsmax Finance. All rights reserved.

Middle-Class Jobs Still Remain Elusive

The middle class continues to suffer during this economic recovery.

The U.S. Labor Department typically releases employment figures for the overall economy and particular industries.

However, these data exclude the income levels associated with these opportunities – a highly critical parameter.

Since the inception of our Great Recession, middle class jobs have yet to recover – far from it – while those at the upper and lower ends are ahead of the pre-crisis period, according to Georgetown University’s Center on Education and the Workforce in a recent study that focused on 485 occupation groups.

The middle third of workers shed 2.8 million jobs from 2008 through 2010, while those in the top third lost 1.9 million positions and the bottom third suffered a loss of 1 million opportunities. Since 2010, the middle class gained 1.9 million jobs; the upper class gained 2.9 million positions; and lower class opportunities grew by 1.8 million.

Nearly all of the 2.9 million high wage positions – or about 2.8 million – went to individuals with at least a bachelor’s degree. The net employment result since the beginning of the recession was a loss of 900,000 middle income jobs; a gain of 1 million high wage positions; and an increase of 800,000 low wage opportunities.

This Georgetown analysis defines high wage earners as full-time employees with salaries of at least $53,000 on average. More than two-thirds of these workers receive employer-provided health insurance and slightly less than two-thirds have employer-provided retirement plans. Occupations in this sector include financial analysts, physicians, registered nurses and software developers.

Those in the bottom third earn less than $32,000 on average. Only one-third in this group have employer-provided health insurance and only one-quarter receive employer-provided retirement benefits. Middle-wage occupations have average earnings between $32,000 and $53,000, and include occupations such as automobile mechanics, truck drivers and welders.

Growing the middle class is essential for robust, long-term economic growth. Unleashing our potential in the energy sector can move us in that direction, as I described in a previous article here.

Developing molten salt reactors will enable energy independence for a virtual eternity that is safe, efficient, affordable, and carbon-free while generating a great number of middle and upper-level jobs over long periods of time.

Coupled with my tax plan, strong economic growth can become a way of life.

© 2015 Newsmax Finance. All rights reserved.

Bureaucracy Is Stifling Innovation and Productivity

Hourly productivity rose a slender 0.4 percent on average each year over the past five years — perhaps the weakest advance in the past 30 years.

Total labor productivity, which includes a 12.9 percent rise in the number of hours worked for production and non-supervisory employees, limped along at an annual growth rate of 1.1 percent, according to the St. Louis Federal Reserve Bank.

For perspective, after World War II, total labor productivity increased 2.2 percent each year. However, the demarcation is stark: from 1948 through 1973 it grew on average at a robust 3.5 percent annual pace, but has throttled down since then to only1.8 percent, according to the U.S. Labor Department and the St. Louis Federal Reserve Bank.

The deceleration continues. Following two consecutive quarterly declines, non-farm business productivity — or the output of goods and services per hour worked — grew at a 1.3 percent seasonally adjusted annualized rate in the second quarter over the first, yet only advanced 0.3 percent from a year earlier, even lower than the most recent five year average, according to the U.S. Labor Department.

While these productivity figures are low, the Heritage Foundation estimates they may have been overstated by approximately 21 percent over the past 40 years — 16 percent due to depreciation and 5 percent due to understated import quantities.

Further compounding this issue, recent downward revisions for productivity by the Labor Department have been significant. From 2013 to 2014, these reductions ranged from 20 percent to 300 percent, according to the U.S. labor Department and the St. Louis Federal Reserve Bank, adding less credence to these data.

More employment has generated more hours worked, but low productivity has stifled wage gains and economic growth, which has stagnated recently and hovers near or below 2 percent, after adjusting for inflation, according to the Bureau of Economic Analysis.

Federal Reserve Chairwoman Janet Yellen recognizes productivity is essential to ensure robust household earnings. Yet, these weak productivity numbers suggest greater employment at modest wages may continue — a possible inflationary threat that could precipitate a hike in interest rates — the first in about 9 years. This places the Fed in a conundrum, since higher rates may squelch long-term business investment necessary for long-term economic stability.

The silver lining in all this has been the increase in productivity of the manufacturing sector. In the second quarter, durable manufacturing labor productivity rose at an annualized 3.4 percent rate over the previous quarter, and that for non-durable manufacturing grew at a 1.2 percent pace.

Michael Mandel of the Progressive Policy Institute observes that innovation has spanned many disciplines in the past, such as energy, information processing, materials, medicine, and transportation. He notes there has been a recent uptick in mining, geological and petroleum engineers due to the shale oil and gas surge, but also highlights a downturn since 2006 in biological, chemical, materials and medical scientists.

He claims, since 2000, the Food and Drug Administration has increased its oversight staff by 50 percent, from 12 employees for every 1000 in each industry it oversees to 18 now. He suggests the FDA stifles innovation by emphasizing efficacy of therapy relative to the established market participants rather than the efficiency of the new product, which can provide similar benefits at lower cost.

Productivity will be empowered when we lift the bureaucratic stranglehold on industry to innovate, create and compete. One fertile area to tap is the energy sector.

There are many well-intentioned projects underway that are developing new technologies to harness domestic energy resources. Molten Salt Reactor technology has been demonstrated to be safe, efficient and affordable. This technology can transform coal and solid waste into ultra clean diesel, gasoline and natural gas. The byproducts can be used as raw materials to produce high strength light weight steel, aluminum, and plastics. MSRs can also process radioactive material, such as uranium and thorium, in a safe and cost-effective manner, enabling the mining of rare earth elements that are essential to our aerospace industry for defense and consumer electronics.

The principle reason for slow progress heretofore has been the relative inertia on the part of the Environmental Protection Agency and the Nuclear Regulatory Commission.

America, if we want more jobs and better pay, we need our government to effect prudent regulatory oversight of the energy sector. Empower the energy sector and we empower our economy and national security.

© 2015 Newsmax Finance. All rights reserved.

Finance Returns to Its Roots – A Utility

Over the past few decades, the financial industry grew at the expense of its clients. Technology is beginning to change this – fast.

Technological finance, such as virtual currencies, is paving the way for the financial community to return to its original mission: helping consumers and business grow, which provide employment opportunities, stimulate economic activity, and promote prosperity.

A friend, who left a hedge fund to work at a major U.S. bank, recently informed me of his disillusionment when the bank wanted him to keep the good products for the bank and give the bad products to the client: He elected to resign.

As a share of the economy, finance grew 60 percent from 4.9 percent in 1980 to 7.9 percent in 2007 prior to the financial crisis, according to Harvard Business School professors Robin Greenwood and David Scharfstein, in a recent study.

Further, more than 20 percent of all corporate profit sits with the financial industry, according to The Federal Reserve. These data exclude the high levels of compensation received by financial employees in the form of salary, stock options, healthcare, and other benefits.

Intense political lobbying and rampant insider trading have distorted the competitiveness of the financial marketplace. Algorithmic trading is based on a model of receiving proprietary information ahead of others and manipulating the market accordingly to maximize profit at the expense of economic growth for the many. Similar sentiments were echoed this week to me by a friend, who is one of the chief economists for a global financial institution.

We are now witnessing the movement of Wall Street elites into this digital space at a quickening pace.

In the mid-1980s, Daniel Masters entered the oil trading market when it was volatile, relatively illiquid and lightly regulated. He had a successful career in this sector with Shell, Philbro and JP Morgan Chase – until 2013 when slow Chinese economic growth precipitated price declines in commodities and investor outflows. (I presaged the slowdown in this piece more than four years ago.)

Daniel Masters now sees the same opportunities in the virtual currency space that he saw with oil 30 years ago. New Jersey recently approved his Global Advisors fund, which trades bitcoin using an arbitrage strategy to leverage price volatility.

Initially driven by the libertarian-tech community, which favored anonymous, cross-border transactions that eliminated much unnecessary financial intermediation, high profile financial folks are now entering this market segment, despite the recent market turmoil: the collapse of Mt. Gox, the largest trading platform of bitcoin at the time; extreme price volatility; and a large price reduction, from nearly $1,200 at its peak in November 2013 to roughly $300 today.

Lawrence Summers, former treasury secretary, and John Reed, former Citibank chief executive, are now advisory board members of Xapo, a bitcoin startup. Barry Silbert, a former investment banker and founder of SecondMarket – a provider of liquidity for restricted securities – and a prolific angel investor in the bitcoin space, recently launched the Bitcoin Investment Trust that enables investors to trade its shares on an over-the-counter marketplace, though not registered with the Securities and Exchange Commission.

Blythe Masters, former wife of Daniel Masters and former chief financial officer and head of Global Commodities at JP Morgan Chase, is now the chief executive officer at Digital Asset Holdings, a virtual currency start-up that plans on settling digital and financial assets using the bitcoin blockchain ledger technology.

She was instrumental in creating credit derivative products in the 1990s, including credit default swaps that ignited the global financial and economic collapse of the Great Recession.

Separately, Cameron and Tyler Winklevoss, who both had early involvement with Facebook, are now venture capitalists and await approval for their bitcoin exchange-traded fund.

The total market capitalization of bitcoin is slightly more than $4 billion, a pittance relative to the $5.3 trillion of daily turnover in the global foreign currency market, according to the Bank for International Settlements in 2013.

Daniel Masters suspects demand for bitcoin will continue to grow due to its convenient, low cost transaction model for small purchases that integrate more effectively and efficiently with our digital economy: a utility and opportunity unparalleled by today’s payment systems.

The key here: unlike many bitcoin aficionados, Daniel Masters believes the digital currency movement offers significant synergies to the legacy financial institutions, such as banks, and can prosper with proper transparency and regulation: views sympathetic to the financial community and government, which I, too, support.

Where I differ with Daniel Masters is the future pricing of the virtual currency market. Masters expects strong price appreciation for bitcoin. In my view, the purpose of this currency is to ensure more stable purchasing power over time. This suggests the price of bitcoin will rise commensurate with the general price level of goods and services, and offer little in terms of unearned capital appreciation.

Either way, the future is bright for bitcoin.

© 2015 Newsmax Finance. All rights reserved.

Hillary Clinton’s Tax Reform Proposal Falls Short

Hillary Clinton is promoting a tax reform plan that will not achieve her objectives.

Clinton would like to increase long term business investment, since it would stimulate innovation, productivity and economic growth for the masses. A laudable goal, indeed; however, the remedy she prescribes will not cure this patient.

Clinton correctly states that corporate stock repurchases and dividend payments have benefited the corporate boardrooms, C-suite executives and shareholder class at the expense of the working class, since it lowered the level of retained earnings for investment in labor, plant and equipment for many years.

Stock repurchases and dividend payments have equaled, on average, 85 percent of earnings since 1998, excluding two years of recession in 2001 and 2008. In 2014, this figure was about $914 billion, or roughly 95 percent of earnings, with about $565 billion in buybacks and $349 billion in dividends, according to Bloomberg and S&P Dow Jones Indices.

Since March 2009, repurchases total nearly $2 trillion, a prime catalyst for the 191 percent increase in the S&P 500 Index in 5½ years, while stocks with the most repurchases saw a 300 percent return, according to Forbes. During the past two years, sales growth rose 2.6 percent each quarter for these firms, while per-share-earnings more than doubled to a whopping 6.1 percent, according to Bloomberg.

The share of cash flow allocated to buybacks rose to more than 30 percent, nearly double what it was in 2002, while the share for capital spending declined, from more than 50 percent to roughly 40 percent during the same time period, according to Barclays. Low levels of investment have resulted in the highest average age of fixed assets since 1956, reaching 22 years in 2013, according to the U.S. Commerce Department.

Carl Icahn believes the major proponents of quarterly-capitalism are the corporate board members and the chief executive officers, who promote the stock to enhance the value of their equity option plans.

Clinton proposes an increase in the capital gains rate on the wealthiest 0.5 percent to solve the problem.

She envisions doubling the rate to 40 percent for the first two years, and scaling it back gradually to 20 percent over the next four. Currently, the top 40 percent rate applies to assets held less than a year and reverts to 20 percent afterward. These figures exclude the 3.8 percent healthcare surcharge on net investment income.

Recently, BlackRock CEO Larry Fink proposed something similar: a 40 percent rate that applies to the first 3 years, then gradually falls to zero over the next seven.

In an interview several years ago, Larry Fink, whose firm manages $4.7 trillion, suggested he let the country down, since the financial industry became much too large over the previous three decades and the return on capital relative to labor was excessive. Bill Gross, the former founder of Pacific Investment Management Company and a current portfolio manager at Janus Capital, has expressed a similar view and expects these yields to plummet 50 percent.

The problem with Clinton’s proposal is four-fold:

* Approximately two-thirds of stock trading is conducted on behalf of tax-exempt organizations, such as pension funds and 401(k) plans, which are completely immune from any tax implications and already trade with a long-term view.

* Her proposal does not encourage 99.5 percent of the population to engage in a long-term investment perspective.

* Modifying the capital gains rate will not incentivize the corporate board and C-suite executives to focus on the long-term instead of seeking short-term profits to promote the stock price of their firm.

* Financial trading is based primarily on short-term arbitrage opportunities and speculation that do not promote long-term direct investment in labor and capital.

The key to increasing long-term capital investment is to make it more attractive for businesses to do so.

My tax proposal would achieve this objective by permitting an income tax deduction for all capital expenditures in the year they are made. Currently, these expenses are deducted over the entire life of an asset, which can range between two and fifty years.

In addition, my tax plan will replace all federal taxes with a low tax rate on consumption and savings that would balance the budget at current spending levels; save scores of billions of dollars each year in tax compliance expenditures; increase investment, employment and income; and maintain strong purchasing power.

Clinton’s capital gains scheme will not achieve these objectives.

© 2015 Newsmax Finance. All rights reserved.

Nobel Laureate Tirole Says Financial Regulation Is Inadequate

My article below, first published on October 17, 2014, is further validated by Paul Krugman’s op-ed piece in the New York Times on July 24, 2015.

Krugman, an MIT-trained Nobel Laureate in Economics, suggests as I did: the MIT-inspired model is more empirically accurate than the one promoted by scholars at the University of Chicago.

MIT economists recommended pragmatic and tailored financial regulations.  Chicago on the other hand – Nobel Laureate Milton Friedman in particular – subscribed to a more laissez-faire, less regulated construct.

Krugman writes:

“The coming of stagflation was a big win for Milton Friedman, who had predicted exactly that outcome if the government tried to keep unemployment too low for too long; it was widely seen, rightly or (mostly) wrongly, as proof that markets get it right and the government should just stay out of the way.

Or to put it another way, many economists responded to stagflation by turning their backs on Keynesian economics and its call for government action to fight recessions.

At M.I.T., however, Keynes never went away. To be sure, stagflation showed that there were limits to what policy can do. But students continued to learn about the imperfections of markets and the role that monetary and fiscal policy can play in boosting a depressed economy.”


Nobel Laureate Tirole Says Financial Regulation Is Inadequate
By Barry Elias
Friday, October 17, 2014

Jean Tirole, the 2014 recipient of the Nobel Prize in Economic Sciences, believes the financial industry is not properly regulated.

The selection of Tirole, a professor at the Toulouse School of Economics in France, comes on the heels of the 2008 financial crisis that unveiled the serious shortcomings in the regulation of banks and other financial firms, and the extraordinary market power of technology companies, such as Google and Apple.

Tirole, an MIT-trained economist, was mentored by Eric Maskin, another MIT economist and Nobel Laureate. His area of expertise is industrial organization, regulation and competition. The underlying premise of his work, which has been substantially validated empirically, suggests markets are inefficient, reflect choices based on behavioral psychology and require some level of regulation. This is in strong contrast to the long-held view by theorists from the University of Chicago that markets are efficient and require little, if any, regulation.

George Stigler, the 1982 Nobel Laureate in Economic Sciences from the University of Chicago for his work on regulation, acknowledged in his memoirs that he was very surprised by the confidence he had when he recommended the breakup of the U.S. Steel monopoly in the 1950s, despite having little knowledge of how the industry operated. He said this belief was driven by consensus more than evidence.

Tirole demonstrated that game theory and contract theory can be applied to regulatory paradigm, especially between strong market participants under oligopolistic and monopolistic conditions, where the quality, quantity and prices of goods and services are controlled by very few actors. In essence, he says firms factor into their strategic decision making how rivals will react when they vary prices or product offerings. The University of Chicago school recognized this, but did not follow the implications.

In addition, information asymmetries exist, since the regulated tend to have much more knowledge than the regulators regarding the successful operation of their business, specifically in terms of costs and strategic options. Additionally, there is incentive for firms to be opaque and hide knowledge, thereby “playing games” with other firms and those who regulate them.

A clever regulator can offset these asymmetries by permitting the firm to select from a series of contracts. The firms choice will hint at their cost structure and how much flexibility they have to lower prices.

Tirole believes each industry is unique in how the regulations need to be applied, and it is crucial that they not stymie long-term investment in innovation and productivity. He also suggests that regulation needs to apply to vertical industries that control many aspects of the production process, from simple raw materials to multiple end uses.

His research has been applied successfully in many industries, such as communications, technology and banking. In the 1980s, he helped European governments divest state monopolies. His recommended paradigm encouraged investment and innovation, curbed excess windfall profits and enabled consumers to experience lower prices and better service. In many industries, the United States has not adopted these regulatory measures.

In the late 1990s, Tirole stressed the importance of liquidity in the banking system, where assets can be readily converted to cash to meet financial obligations. He now recognizes the importance of systemic risk where regulated banks interact with unregulated financial entities. This was not addressed prior to the crisis, said Tirole.

Recently, he has been focusing more on banking and finance. He has teamed up with Emmanuel Farhi, another MIT-trained economist and now a Harvard professor of economics, to study the optimal bank bailout policy by the federal government in times of crisis. Tirole is also examining how central banks can enhance liquidity to commercial banks when the demand and supply of their assets are low.

Finally, regulators across the globe are requiring banks to hold more liquid assets.
Tirole also stresses, once you devise and implement an effective regulation strategy, it must be enforced efficiently by the state. To her credit, Federal Reserve Chair Janet Yellen is committed to reigning in the excessive risks taken by the financial community in recent decades.

The financial industry needs strong minds to tackle this issue before another cataclysm rears its ugly head.

© 2015 Newsmax Finance. All rights reserved.

First published on October 17, 2014.

Economic Growth Will Be Restored With Reforms to Protect Dollar

Fifty years ago, the United States began actively debasing the dollar, and the results are now readily apparent: low price-adjusted productivity and total compensation growth, extraordinary wealth and income disparities, and a more treacherous employment environment.

From the beginning of our republic, in 1792, the U.S. dollar was able to purchase 0.77 ounces of silver on a relatively consistent basis, until 1965. That year, President Lyndon Johnson signed the Coinage Act, which permitted the circulation of coins made from less valuable metal alloys instead of the original silver composition.

Since 1965, the dollar’s purchasing power has been in free fall – reaching a nadir of 0.02 ounces of silver in 1980, and recovering minimally to 0.06 ounces of silver today.

Further insult occurred when the dollar lost its backing by gold in 1973 under President Richard Nixon. As the value of the dollar slid, so did productivity. From 1947 through 1973, productivity expanded at an average annual rate of 2.8 percent. However, since 1973, this figure plummeted to a paltry 1.8 percent, according to the Bureau of Labor Statistics.

As productivity declined, many households required more than one earner to maintain comparable living standards.

The civilian labor participation rate for prime-age workers, from 25 to 54 years, was 64 percent in 1948, and by 1965, it reached 70 percent, according to the Federal Reserve. However, following the dollar debasement that year, this figure reached a zenith of 84.6 percent in January 1999 — a staggering rise given the relatively small improvement in living standards for many.

The labor participation rate has since retreated to 81 percent, not because we are experiencing an economic renaissance, rather because many workers in this age group are unable to get absorbed into the labor market due to poor business conditions or less than adequate skill levels.

How can we improve productivity?

Private currency creation is a critical way. Money creation predicated on a creative and innovative use of resources will provide the foundation for stable productivity and income growth.

Effective currency creation will stimulate more prudent long term investment in real goods and services, generating strong economic growth and a more consistent relationship between the money supply and the quantity of goods and services produced. In this scenario, labor productivity will rise, business cycle volatility will fall, and income and purchasing power will increase.

This is the premise behind the virtual currency movement.

Recently, Representative Paul Brown, R-Georgia, reintroduced the Free Competition in Currency Act, an idea originally promoted by Ron Paul, the former Texas Congressman, and based on the work of Friedrick Hayek, a Nobel laureate in economics.

This bill would end legal tender laws, permit private coinage and eliminate capital gains taxation on gold and silver. Also reintroduced recently was the proposal for the Centennial Monetary Commission by Representative Kevin Brady, R- Texas, chairman of the House-Senate Joint Economic Committee, to examine United States monetary policy, evaluate alternative monetary regimes and recommend a course of monetary policy going forward.

In addition to monetary reform, fiscal changes are essential to resuscitate labor productivity and economic growth. Principal among the possible initiatives is the simplification of the tax code.

My proposal, in collaboration with my wife Billie, can balance the budget at current spending levels with lower rates, fewer deductions and smaller compliance costs. We have work to do America – let’s get started!

© 2015 Newsmax Finance. All rights reserved.

The End of Government Bailouts As We Know It

We may be witnessing the end of government bailouts as we know it.

The American International Group became a metaphor for the excesses of Wall Street. The global insurance giant found itself in this dire predicament by producing and marketing ill-conceived financial derivative products that were not properly regulated by federal authorities. The intricate and systemically fragile nature of these complex and opaque financial products metastasized throughout the global economic landscape.

The ensuing financial crisis devastated the world, severing more than $34.4 trillion of wealth off global equity markets valuations from the end of the third quarter of 2007 through the end of the first quarter of 2009 — a 54.6 percent decline to $28.6 trillion from $63 trillion, according to the Roosevelt Institute, a non-profit organization.

During this period, U.S. household wealth plummeted $13 trillion, or 19 percent — from $68 trillion to $55 trillion, according to the Federal Reserve Bank. In addition, nominal GDP contacted $500 billion, or 3 percent — from $14.8 trillion in the third quarter of 2008 to $14.3 trillion in the second quarter of 2009.

The Federal Reserve essentially took control of AIG by providing $182 billion in rescue funds, acquiring a 79.9 percent stake in the company, and replacing the chief executive officer. Despite this taxpayer support, the company issued executive bonuses of approximately $165 million and a bonus package for the entire firm of as much as $1 billion.

By the end of 2012, the U.S. government divested itself from AIG, receiving approximately $205 billion, generating a profit of nearly $22 billion.

In a recent class action lawsuit, plaintiff shareholders claimed the federal government intervention was illegal and sought $40 billion in damages. A recent ruling validated the unlawful nature of the governmental action, but the court awarded no damages. This plaintiffs plan an appeal.

Judge Thomas C. Wheeler of the United States Court of Federal Claims said the Federal Reserve did not have the legal authority to take executive control of the firm, since the Fed does not have jurisdiction over insurance firms. The repeal of Glass-Steagall in 1999 — which permitted insurance companies to engage the creation and marketing of financial products — created a regulatory vacuum for the financial business at AIG.

However, Judge Wheeler suggested this illegal activity actually added value to the firm, since the firm would have declared bankruptcy without any intervention. He therefore stipulated that the plaintiffs are not entitled to any monetary damages.

Supporting this notion, Wheeler cited John Studzinski, vice chairman of the Blackstone Group and an advisor to AIG, who advised the board of directors to accept the government’s offer of 20 percent equity in the company, since “20 percent of something [is] better than 100 percent of nothing.”

It seems the real victims of the AIG debacle are not the AIG shareholders: they are the world that suffered tens of trillions of dollars in lost wealth.

Judge Wheeler believes the banks were treated more favorably than AIG In fact, the Fed may have had more legal authority to intervene more forcefully with them.

While the Dodd-Frank financial overhaul legislation prohibits the Fed from assisting a single institution with capital injections, the new laws are ambiguous regarding equity stakes.

Notwithstanding this ambiguity, the future climate now favors less governmental intervention, since specific terms associated with tax payer subsidies may generate litigation.

As a result, untethered tax payer assistance of financial and non-financial corporations may be on the wane.

The real test is forthcoming, as hedge funds Pershing Square, Fairholme Funds and Perry Capital along with other investors await their day in court regarding government treatment of the Fannie Mae and Freddie Mac — mortgage companies that are now operated under the conservatorship of the Federal Housing Financial Agency.

These government sponsored entities received a federal cash infusion of over $200 billion after the financial crisis erupted, with a stipulation of a 10 percent dividend. In 2012, the terms of the agreement were amended: in lieu of dividend payments, the government would receive all the profits indefinitely. By the end of June, this figure may approach $230 billion.

These investors are staking a similar claim as that sought by the AIG shareholders.

We may be witnessing the failing of too big to fail.

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