Maggiore Risk Political Risk Analysis

Italy Becomes More Anti-Immigrant and Anti-EU

Thu, 10 Sep 2020 00:00:57 GMT

Domestic and international events are increasing the appeal of nationalistic parties.

Unemployment, population decline, changes in immigration, and world events like the COVID-19 pandemic and the wars in Syria and Libya strengthen Italian anti-immigrant and anti-EU parties and their chances for national power.

Significance:
Domestic Italian issues (unemployment, rural emptying, population decline) and world events (COVID-19 pandemic, wars in Syria and Libya) will increase the power of anti-immigrant and anti-EU political parties in Italy. This trend heightens the chance of anti-immigrant and anti-EU parties winning elections and gaining ruling power in Italy to the detriment of European integration and open Italian markets.

Forecast:
Immigration and anti-EU rhetoric will play an increasingly important role in upcoming regional and national elections in Italy, helping Matteo Salvini and his anti-immigrant League party and Giorgia Meloni and her Brothers of Italy party win elections in regions that historically supported left-of-centre parties. The combination of domestic concerns and international events surrounding immigration issues will further allow the League, the Brothers of Italy, and the 5-Star Movement to gain national power in Italy, move Italian politics to the right, and harm Italy’s relations with the EU.

Subsidiary impacts:

• Increased anti-immigrant sentiment will cause more attacks against immigrant populations in Italy and create harsher anti-immigrant policies at all levels of government

• Italy will further pursue an “Italy first” foreign policy lead by Salvini, Meloni, and conservative elements of the 5-Star Movement

• Italy will take steps to tighten its borders including against other EU member states

• International companies in Italy will find it more difficult to find qualified workers even as Italian unemployment remains very high

• More fighting in Syria’s Idlib province and Libya will push an increasing number of immigrants to Italy and other EU nations causing infighting between EU member states on how to deal with the crisis

Immigration in Italy by the numbers:
Total immigration to Italy was 515,000 in 2007 compared with 300,000 in 2017. Illegal immigration has also dropped in recent years. 181,000 migrants arrived in Italy by boat in 2016 compared to 11,500 in 2019. Salvini claims this drop is due to his tough policies. Despite the drop, Italy’s anti-immigrant parties continue to call for stronger border enforcement, more deportations of migrants already in Italy, and changes to asylum rules. Even though Salvini failed in his attempt in August to bring his League party to power, their anti-immigrant platform continues to make advances in regional elections. The election in Umbria in October 2019 of Donatella Tesei, backed by the League, is one example. More recently in Emilia-Romana, the League came close to unseating the center-left regional government which has been in power for seven decades. Although the center-left won a majority, when you look at the distribution of votes across parties the League is only 2 percentage points behind the center-left. The League candidate lost by about 100,000 votes, of more than 2.2 million votes cast. Anti-immigrant policies were a main plank of their candidate’s platform.

Domestic concerns:
Italy’s domestic population is in decline. In 2019, Italy’s overall population fell by 116,000 to 60.3 million. There was a steady rise in immigrant births helping to offset the declining domestic birth rate, but the decline remained. The loss of population can be seen most clearly in rural Italy, especially in the South, a phenomenon referred to as rural emptying. Between 2000 and 2018 rural Italy lost almost 800,000 residents. Young Italians move to larger cities or other countries leaving only older people in the villages. Some rural villages even resort to selling properties for one euro if the buyer promises to live in the town and maintain the property. The decline of Italians living in these areas, combined with immigrant arrivals cause some Italians to claim Italy is becoming less Italian. These trends cause anxiety among ordinary Italians who feel their way of life is threatened and must be protected from outside influence.

Anti-immigrant sentiment is felt among the youth as well older Italians, even in prosperous regions. One cause for this sentiment is high youth unemployment. At 29% even before the COVID-19 pandemic, Italy’s youth unemployment rate is one of the highest in the Eurozone. Many Italians leave Italy to find work in other countries. In 2018 over 150,000 Italians left the country. Many of the unemployed blame immigrants and EU policies for the situation. They feel the centre-left parties have failed them so the League, the Brothers of Italy, and 5-Star Movement draw some of the youth vote. In recent pre-polling election data, the 5-Star Movement won the support of 31 percent of those aged 18 to 22 and 35 percent of those aged 23 to 28. With the 5-Star Movement dropping in recent polls, some of the youth support will go to the League and possibly to the Brothers of Italy. Even in the wealthy university town of Bologna you hear middle class Italians speak negatively of immigrants.

Where immigrants to Italy come from has also changed. In the years after Bulgaria and Romania joined the EU, many migrants to Italy came from those countries. In 2019, the largest number of official migrants came from Tunisia (2,654) followed by Pakistan and Ivory Coast with more than 1,100 each. Many Pakistanis and Tunisians in Italy own, run, and maintain vegetable stands and other small shops. The newly arrived immigrants find it more difficult to integrate than did previous waves because they are culturally, racially, and religiously more distinct from Italians. Bulgarians and Romanians tend to be Orthodox, more similar to Roman Catholic Italians, while Pakistanis and Tunisians tend to be Muslim.

According to one survey most Italians describe their country in negative terms. More than half of Italians believed that “weak” was an accurate description of Italy, followed by “angry” and “divided.” Population decline, globalization, high unemployment, and the changing demographics of immigrants will create more voters sympathetic to anti-immigrant views and policies.

International events:
In addition to domestic issues, international events help anti-immigrant parties. The COVID-19 outbreak means 60 million Italians only recently exited government-imposed lockdown, isolation, and travel bans.    Italy has had more deaths than any country in Europe. Italy has more cases than any other country in Europe, and the outbreak was centered around the northern economic hubs of Lombardy, Veneto, and Emilia-Romagna. The effects on the Italian economy have been extreme and are not yet fully felt. Additionally, Salvini, Meloni and other anti-immigrant anti-EU politicians have used the crisis to call for tighter borders and to blame immigrants and foreign tourists for bringing the virus to Italy. They also blame the EU for acting too slowly and ignoring Italy. Meloni quipped “When the coronavirus was just an Italian problem it didn’t interest anyone in the European Union. They only did things when the virus arrived in Germany.” Salvini for his part has called for a tough approach, such as closing borders and shuttering all businesses, and the ruling coalition followed through with similarly tough actions, which Salvini claims he precipitated. As the true scale of the damage to the Italian economy becomes clearer and unemployment increases, anti-immigrant parties will find more support for the view that Italy must protect itself from the outside world. The latest Politico poll shows the League polling at 26%, with the 5-Star Movement at 16%, and the Brothers of Italy at 14%. Other world crises also have an effect.

Continued fighting in Idlib province in Syria created 1 million new refugees, with many of them heading to Europe, as evidenced by recent migrant clashes on the Greco-Turkish border. Turkey now allows Syrian refugees to pass through its territory unimpeded. As cracks in Syria’s ruling elite begin to increase, it is likely there will be more unrest. Additionally, the conflict in Libya hardens as both sides procure arms and prepare for a long fight. Foreign powers (Turkey, Russia, Egypt) send arms, mercenaries, and troops into the country, and UN flights with humanitarian assistance have recently been blocked from entry. Any large uptick in fighting is sure to cause refugees and increase the number of migrants seeking to reach Italy by boat. Additionally, Libya is a transit point for migrants from other sub-Saharan African countries so more chaos there will impede any efforts by Libyan authorities to stop the migrant flow across the Mediterranean. Both Italy and the EU need to form coherent policies on these matters quickly and have so far failed to do so.

Italy is a unique bellwether for anti-immigrant and anti-EU feeling across Europe. Anti-immigrant and anti-EU politicians in Italy are adept at exploiting the local issues and world events currently driving “Italy First” feelings. Salvini and Meloni are the Italian politicians to watch in the coming months as domestic concerns and international events further allow their parties to gain national power, move Italian politics to the right, and severely harm Italy’s relations with the EU .

Michael Guterbock worked for a decade in disaster preparedness and global health for the US Government. Michael currently works as a country risk manager for Booz Allen Hamilton and is pursuing his Doctorate in International Affairs from Johns Hopkin University's School for Advanced International Studies.

Farewell for Now, and Thank You!

183:773151858 (Kevin Rejent) — Tue, 09 Jun 2020 14:58:32 GMT

Thank you for supporting my work

This will be my last article for a while, and potentially ever. I have enjoyed writing them, and loved discussing the issues they raise even more. However, an incredible opportunity has arisen that requires me to step away from Maggiore Risk. While I am excited to deal with the challenges this new position will present (which I will discuss at another time), I will greatly miss working on the broad range of global risk issues Maggiore Risk has allowed me to ponder.

After some time of adjustment, if it is permitted by my new employer and appropriate, I may return to share my thoughts again. In the meantime, my colleagues at Maggiore Risk will continue to provide the same excellent service to their clients, and may even post articles here occasionally. While I will be unable to provide risk services, I can get you to the right person or organization, either with Maggiore Risk or elsewhere, to address your issues.

In closing, please allow me to say farewell, and thank you. Thank you for allowing me to assist you with your organization’s most pressing concerns. Thank you for reading my thoughts. Thank you for challenging my views. Thank you for sending me a short “hey I loved the article” message, which usually hit my inbox at the time I needed it most. I am forever grateful for my time here, and hope to remain close to everyone I have had the privilege of interacting with through this company. Farewell, and thank you.

The Future of the Euro (or Lack Thereof)

183:773151858 (Kevin Rejent) — Wed, 20 May 2020 12:50:12 GMT

Covid-19 is exposing deep cracks within the Eurozone. Can the divide be bridged?

This article is best viewed in its PDF format, which is available here.

Executive Summary

The COVID-19 crisis has laid bare disagreements in the Eurozone regarding nations’ obligations to each other as the continent contemplates the enormous task of economic recovery. Old prejudices in the north developed when southern nations were more fiscally reckless than they are at present have tied the hands of politicians on both sides of the divide. The hardest-hit nations, Italy and Spain, are seeking a joint recovery effort while fiscally prudent nations such as the Netherlands and Germany believe loans to impacted areas are sufficient. Despite token gestures and speeches praising European unity, the great divide remains.

In this article, we look at the issue through the eyes of two nations that best represent the views of their respective “side” of the discussion: The Netherlands and Italy. Divergent economic and cultural priorities have resulted in prejudices and resentment between the populations which must be manifested in the actions of politicians if the politicians wish to remain in power. Without the political ability to overcome these positions, the Euro could be in trouble.

The most likely course for the Euro is to continue some version of the status quo. The members would patch over their differences and hope resentment would die down in the post-COVID era. However, this “easiest” path poses plenty of issues for the fiscally prudent northern nations since the trajectory of European institutions is almost always towards further integration, and potential new Eurozone members much more closely resemble the zone’s southern members. A less likely, but still possible, scenario sees politics in Italy causing it to go down an unfortunate path of reintroducing the Lira as a parallel currency and eventually redenominating its debt. In this scenario, Greece might also leave the Eurozone, but with the assistance of the remaining Eurozone members. A final scenario sees the Euro broken into three regional Euros under the auspices of the ECB. While this is also unlikely, it would solve some political issues and leave little doubt that the regional Euros meet the requirements of an Optimum Currency Area.

The Promise of Europe

As they met on Capitoline Hill to sign the Treaty of Rome in 1957, the leaders of Italy, France, the Netherlands, Belgium, Luxembourg, and West Germany dreamed of a cooperative Europe where continental advancement triumphed over petty national gain. These nations were joined thirty-five years later by six others in Maastricht, Netherlands to bind monetary policy through the Euro. Since then, sixteen more European nations have joined the EU (with the UK subsequently leaving), and nineteen nations now belong to the Eurozone. But now, the nations that hosted the signing of the treaties upon which the great European experiment is based, Italy and the Netherlands, embody the continental disagreements on the EU and the Euro that the current COVID-19 crisis has laid bare…disagreements that just may lead to the end of the Euro.

It is hard to imagine a world without the Euro, since most level-headed analyst would agree it has been a rousing success. However, it has only been in use for eighteen years, and several of those were spent handling crises in specific nations or Eurozone-wide. But handle them it has, and history will judge the actions of the European Central Bank kindly, or at least neutrally. Of course, it will never satisfy everyone, and hindsight provides plenty of hiccups, but overall, the ECB has been a force for good in Europe. It should continue to play a central role in the European economy, regardless of the paths taken by member states in the post-COVID future.

Recent European History
(like…past few months recent)

With the spread of COVID-19 and subsequent economic crash, European nations have been forced to consider both national and continental responses to achieve the most effective recovery. While there have been some incredible shows of pan-European unity, the crisis has also accelerated and deepened intra-continental divides and tested the strength of institutions. The fact that Italy and Spain, two frequent targets of fiscally prudent northern Europeans’ derision, were the first and hardest hit on the continent only complicated matters.

When the virus first hit northern Italy, there was some confidence that it could be contained quickly and not cause much disruption outside of the initially impacted regions Lombardy and Veneto. But it crept out of those areas and, within a few weeks, forced Italy to lock its citizens into their homes and basically shut down the economy. Other nations, initially Spain and then France, followed, and the pandemic was now continent-wide and spreading fast.

The ECB wobbled in its first COVID-19 test, with President Christine Lagarde first stating that the role of the ECB was not to minimize the bond spread between nations. This caused Italian borrowing costs to shoot up as investors feared the ECB would not come to Italy’s aid. Lagarde quickly realized the errors of her statement and leapt into action to defend Italy and other nations whose bonds were under pressure. Eventually, the ECB implemented a bond-purchasing program of over $750B, and even started buying non-sovereign bonds, which is similar to the US Federal Reserve’s actions (although on a smaller scale). So thus far, the EBC has done its best to stabilize the Eurozone and provide the monetary foundation for recovery.

In the US, there has also been a multi-trillion-dollar fiscal response to avoid the worst-case scenarios and position the nation for recovery. Europe obviously needs something similar, as the individual nations are not, with a few exceptions, capable of raising the amount of money that will be needed to keep their people fed and working while digging out of the crater left by COVID-19. The first suggestion was the oft-discussed Eurobonds, which would create an attractive new vehicle to mutualize some portion of European debt. The northern nations could not be more opposed to this, and that idea was quickly replaced by a proposal to issue limited-time bonds specifically to aid in recovery: Coronabonds. Once again, however, northern nations shot down this idea as edging too close to the mutualization line. Then Spain devised a popular compromise solution that paid for recovery out of future EU budgets instead of debt obligations. This has also stalled, as northern nations would rather promote a package, including loans with strings attached, that is completely unacceptable to the countries in need. Therefore, the EU response has been nothing but solemn talk and unfulfilled potential.

What Does This Have to do With the Euro?

When evaluating the overlapping European structures, mischievous situations that were certainly not contemplated by their architects come into focus. And while exploiting these cracks in the system would be dangerous, a desperate nation that perceives that it has been abandoned by its fellow Europeans just may take that chance.

As this Venn diagram from the European Council on Foreign Relations demonstrates, Europe is a jumble of institutions and agreements.

A nation can be a member of several European institutions without being required to join others. There are currently nine members of the European Union that are not members of the Eurozone, and four members of the EU Customs Union that are not even members of the EU. While sliding between these groups is challenging and has generally been in the direction of more integration, theoretically one could go the other way.

These institutions craft policy to varying degrees of integration, but none are more impactful than the ECB crafting of monetary policy for the nineteen Eurozone members. The system is based upon the work of Nobel Prize winner Robert Mundell on Optimum Currency Areas, or geographic areas that would most benefit from sharing a currency, regardless of national borders. According to Dr. Mundell, there are four criteria for an optimum currency area:

1.    A large, available, and integrated labor market which allows workers to move freely throughout the area and smooth out unemployment in any single zone.
2.    The flexibility of pricing and wages, along with the mobility of capital, to eliminate regional trade imbalances.
3.    A centralized budget or control to redistribute wealth to parts of the area which suffer due to labor and capital mobility.
4.    Similar business cycles in the participating regions and timing for economic data to avoid a shock in any one area.

Criteria 1 and 2 are mostly satisfied by the wider European Union’s mandate of free movement of people, capital, and goods between member states. Criterion 3 is somewhat satisfied by the EU, with supplements to member state budgets to promote economic harmony, but is also often a primary issue of concern in the Eurozone. Criterion 4 is more theoretical, and thus the easiest upon which to craft arguments for or against the Euro as an Optimum Currency Area. But it is important to note that the Euro is managed by the ECB, which only controls monetary policy. Fiscal policy is left to the individual nations. Thus, the monetary policy of one Eurozone nation is directly impacted by the fiscal policy of another. Herein lies the crux of virtually every Eurozone disagreement this century.

Further fiscal integration is often discussed as the next step in European integration, with Mario Draghi campaigning for it in his final speech as ECB President.   Despite the appearance of momentum for this idea pre-COVID, a deeper look indicates further integration was unlikely then and even more unlikely now. While the UK was never in the Eurozone, its issues with deeper European political integration and loss of sovereignty made Brexit inevitable. This concern for sovereignty is not contained to the west side of the English Channel. Eurosceptics are sizable blocks in most nations and their ranks would swell if citizens saw their countries run more and more by European entities. For example, the Gilets Jaune protests are an example of citizens opposing the actions of their own government. How much more intense would the protests be if they were protesting actions imposed upon them by European central bankers? For these and many more reasons, deeper fiscal integration of the Eurozone economies is unlikely, and Europe is stuck navigating the COVID-19 crisis under current institutional constraints.

The Rift

While the current institutions have done some things well, rifts have existed from the beginning, and the long process of fracturing has accelerated in the current crisis. Historically, northern European nations such as the Netherlands, Luxembourg, Germany, Austria, and Finland have taken southern European nations such as Italy, Greece, and Spain to task for irresponsible spending, and they’ve often had good reason. However, since the financial crisis of 2008-10, these nations have been pretty responsible, and their budget deficits have been consistently improving. Most of these nations are actually running surpluses when debt service is removed.

But Europe’s current financial malaise has nothing to do with reckless spending in southern Europe, nor can it be solved by northern European frugality. It is the result of a calamity that knows no borders and is not any European nation’s “fault.” So why the hesitation to fight the economic impact together, which would absolutely benefit everyone? Politically, the Dutch and Luxembourgian and, to some extent German, electorate are deeply suspicious of southern Europe, and being seen as “giving in” to their requests for money can be politically costly. At the same time, voters in southern nations question the value of a union with “partners” who constantly lecture them about prudence while stacking the deck against their growth through either aggressive tax competition (Netherlands or Luxembourg) or trade practices (Germany). Viewing the political, economic, and social issues through Dutch and Italian eyes clarifies the conflict and provides insight regarding why the Euro is in a precarious position.

The Dutch Position

Former Eurogroup President and Dutch Finance Minister Jeroen Dijsselbloem made headlines (negative abroad but wildly positive at home) when he said about southern countries’ indebtedness, “you can’t first spend all your money on drinks and women, and subsequently ask for financial support.” This view was long held but rarely spoken, and is the view of a large share of the Dutch electorate.

Since this is the popular view in the Netherlands, politicians are constrained to act in accordance with this belief. To be seen as acceding to southern needs would be viewed as selling out Dutch pensioners for undisciplined spendthrifts. And this opinion is not without some basis in truth. The Netherlands, along with Germany, Luxembourg, and Austria, have much higher net national savings rates than Italy, Greece, and Spain. The Dutch value financial constraint over immediate quality of life experiences, and do not believe the citizens of southern nations work hard enough or appropriately value saving for the future.

Politicians that may disagree with this sentiment cannot express that disagreement if they want to remain in office. Great policy ideas do not benefit anyone if their champions are not in office to implement them. And historically, Dutch domestic financial concerns take precedent over European harmony, so placing European well-being ahead of Dutch priorities is a politically dangerous path.

With a general election scheduled for March 2021, and potentially earlier if snap elections are called, Prime Minister Mark Rutte cannot afford to be seen as giving away Dutch financial stability in the middle of a global crisis. The far-right PVV and FvD are threats to his VVD-led coalition, and would pounce on any action that could be twisted into a pro-southern Europe giveaway by Dutch leaders. So while it is easy to suggest he stand up for the nation’s European brethren and convince his people to deepen integration, Mr. Rutte and his government must walk the tightrope between doing what they believe is best and what will allow them to remain in power (and thus allow them to continue to do what they view as good for several more years.)

The Dutch want to be a key player in European institutions. They do not want European institutions to cost them any more than the Dutch view them as currently costing. Thus, the Dutch will not take steps to leave the Euro, but their mindset, as demonstrated in their policy positions, may just drive other nations out.

The Italian Position

The Italian perspective is shaped by a prevailing view that its Eurozone partners treat it as a problem to be managed instead of with the level of respect that the third-largest economy in the group deserves. Italians resent the view that they are shirking work and partying the piazzas all night. They are well-aware of the nation’s economic history and also keenly aware of how challenging it is to dig out, especially when “partners” engage in actions some view as economic sabotage. Most Italians understand the value of EU and Eurozone membership, but feel underappreciated and frustrated by paternalistic treatment from northerners.

Italy is currently the third-largest economy in the European Union and the Eurozone. Thus, it contributes more to the ECB than all nations but Germany and France, and is far and away a net contributor to the European Union. Additionally, Italy and other southern nations bear the brunt of Europe’s biggest crisis pre-COVID: migration. In 2017, Italy spent €3.2B on increased naval activity and care of refugees that landed on its shores. Despite EU promises to share the burden financially and disperse refugees throughout the Union, Italy has received less that €1B in support from the EU for the care of migrants since 2015, and other nations (except Germany) have been slow to accept new refugees from the southern countries.

Despite being one of the largest contributors to the EU and ECB and shouldering more than its share of the refugee burden for the EU, Mr. Dijsselbloem’s attitude that Italians are spending their money on vices is hard to shake. Sure, bad decisions such as the “Baby Pensioni” arrangement that allowed government workers to retire with full lifetime pensions in their 30s and 40s needed to be corrected and have left a costly legacy. But Italian governments since the financial crisis have reigned in spending and attempted to reform labor laws to permit more employer flexibility. And Italian workers are not idle. In fact, they work quite a bit: fourth most hours in the Eurozone at 1,723 per year. This is behind leader Greece’s 1956, but well ahead of the 1,433 hours worker by the average Dutch worker per year and 1,363 worked by an average German.

Hours worked is not necessarily the best gauge of productivity, however, as the efficiency of workers in the different nations and type of work they are performing are vital components. German manufacturing is among the most technologically advanced and efficient in the world, and the well-educated German workforce creates incredible products for sale throughout Europe and beyond. These sales create a large trade surplus, meaning the Germans are causing their trading partners to go into debt. Many Europeans believe their unwillingness to adjust the trade strategy violates the spirit, if not the letter, of EU and ECB agreements.

Similarly, Italians and other Europeans refuse to listen to northern European lectures on public debt when those nations’ tax structures greatly contribute to the southern nations’ need to take on debt. The Netherlands, Luxembourg, and Ireland, with a combined 4.4% of the EU’s population, house more than 50% of global foreign direct investment. This is often in the form of holding companies to exploit the favorable tax regimes and corporate law in these three nations. Italian companies will domicile in the Netherlands and pay corporate taxes there while performing almost all operations in Italy. Even former Prime Minister Silvio Berlusconi has moved the “headquarters” of his Mediaset empire from Milan to Amsterdam. Thus, the tax haven nations receive the lower corporate taxes but need to provide virtually no services to the taxpayer, while the nations that must provide services to the employees of those taxpayers are left without the tax revenue they should have to provide them.

It is often challenging to measure the strength of these opinions, and even harder to determine how citizens would like to act upon the opinions if given the opportunity. Fortunately, Davide Angelucci and Vincenzo Emanuele recently conducted a detailed survey of Italian attitudes towards to EU for Centro Italiano Studi Electtorali. According to the survey, a shocking 85% believe the EU is not helping Italy in its fight against COVID-19. 42% of Italians have a negative opinion of the EU, 23% are neutral, and only 35% hold positive opinion of the EU. Additionally, 35% would like to leave the EU, 18% prefer to leave the Euro but not the EU, and 47% would choose to stay in the EU. Anti-EU sentiment in Italy is growing, and failure of the EU and ECB to support Italy in near future could push it out of the Euro.

Possible Outcomes

When considering how these divides might impact the Euro, it is important to begin any analysis with an understanding that *nobody* who would experience real consequences, financial or electoral, wants even a partial failure of the Euro. Of course, populist politicians like Matteo Salvini rattle sabers because 65% of the voters for his Lega party would like to leave the EU; but the financial and industrial giants in Lega’s northern Italian strongholds would certainly do all they could to kill any Italeave movement. So there is a strong desire to patch over any differences and retain the status quo. But disagreements occur, intentions are misread, ill-advised ultimatums are made, offenses are taken, and history happens. It is therefore no certainty that the current structure of the Eurozone will survive the next decade. The COVID-19 crisis has shown that some cracks were deeper than previous believed and accelerated the impact of long-term structural issues. It is no longer crazy to believe that the Euro might fail.

Central to any contemplation of the future of the Euro is the concept of Optimum Currency Areas discussed above. Whether the Euro or any successor currency can succeed is dependent upon 1) integration and mobility of labor, 2) price, wage and capital flexibility, 3) centralized budgeting to redistribute wealth to parts of the area which suffer due to labor and capital mobility, and 4) similar business cycles throughout the zone. The first two are basically satisfied through the EU and Customs Union. The third is somewhat satisfied by the EU. But the fourth requirement leads to much debate regarding how much the members’ national economies must move in harmony with each other.

With this in mind, and considering current and future economic, political, and social conditions in the various European nations, some potential paths are worthy of discussion. Of course, there are variations and complications with all potential paths, including these; but discussing multiple options before they evolve will allow smoother resolution of the complications.

Status Quo

When imaging how things might be in the future, it is easiest to revert to a future version of the current. This, however, rarely occurs, as evolution and events pull the course away from the narrow range of “likely” towards somewhere on the very wide range of “possible.” But let’s assume that this time is different, and the Euro continues in its current form without any substantial change in mandate or course alterations since that is close to what most stakeholders would prefer. Specifically, the frugal nations are likely operating under the assumption that southern nations will accept the best relief package they can get and, after a period of hard feelings, eventually return to business as usual. And that assumption might be correct.

However, as all European institutions have since the European Coal and Steel Commission in 1952, the ECB is likely to expand and integrate further. All EU members except Denmark are technically obligated to adopt the Euro at some point, with Bulgaria and Croatia already taking the necessary step of joining the Exchange Rate Mechanism (“ERM”). The other nations that “must” at some point join the Euro are Bulgaria, Croatia, Czech Republic, Hungary, Poland, Romania, and Sweden.

Viewed through the Optimum Currency Area lens, the expansion of the Eurozone will stretch the requirements of budgeting/redistribution and common business cycles. Since the Euro’s introduction, experts including monetary theorists, political scientists, and econometricians have weighed in on whether the Eurozone is an Optimum Currency Area. The idea of breaking it up, however, has never been seriously discussed because all members are relatively affluent and have integrated financial systems. It may, however, be challenging to sell the notion that the business cycles and financial systems in Sofia, Strasburg, Lodz, and Lisbon operate in harmony. And if the nineteen current Eurozone economies are finding it challenging to redistribute capital to nations that are lagging now, adding seven new members that are net recipients from the EU compared to only one net EU contributor may prove impossible.

Unfortunately for the frugal members that currently exert great sway in the ECB, the potential new members are much more like the southern Euro members, with Sweden an exception. Thus, the frugal nations would be wise to ensure any long-term division in the ECB falls along the lines of original vs. new member instead of frugal vs. everyone else. This will require them to give a little to their current ECB partners, with the Spanish proposal of spending through the EU budget currently the most palatable plan on the table. Otherwise the status quo, which is a state of perpetual expansion of European institutions, will cause the frugal nations much more heartburn in the future by causing the same issues to arise during the next global financial crisis, only with more partners seeking financial support.

Italy and Greece Leave Euro

Matteo Salvini will likely be the next Prime Minister of Italy as the head of the Lega party, supported by coalition partners Fratelli d’Italia (Brothers of Italy) and former Prime Minister Silvio Berlusconi’s Forza Italia. Lega and Fratelli d’Italia have been vocal in their Euroscepticism, and while Forza Italia is very pro-EU and Euro, Berlusconi tries to stay relevant any way he can, so he would join with these parties in the hope that issues with other European nations would blow over.

The coalition would know that it could not just leave the Euro, but would feel immense pressure to both stand up to what Italians view as northern European callousness and inject some life into the economy hardest hit by COVID-19. Living up to its political promises could cause it to take drastic action: reintroducing the Lira as a parallel currency for domestic transaction. To give those who spend money in Italy (specifically Italian businesses) an advantage, it would likely peg the value of the Lira (or a certain number of lira) at something like .95 Euro per Lira. Employers would seek to pay wages in the cheaper currency, but debts would still be owed in Euros. The ECB would almost certainly refuse to recognize the Lira and prohibit banks in the Eurozone from accepting it as payment even though its value would be pegged to the Euro. Italian leaders could argue that, unless it is expelled from the Eurozone after being declared a member state in derogation, its membership and full participation cannot be hindered; but the rest of the Eurozone members would be in no mood for legalities and do what they could to punish Italian behavior. Eventually, tensions would escalate with Italy halting payments to the ECB, and the ECB suspending Italy from its bond-purchasing program.

Such a move would be bad for the Eurozone, but catastrophic for Italy. The COVID-19 crisis has shown its leaders that fellow Europeans do not believe the nation to be so systemic as to require significant financial support in an emergency. With no support coming, Italian banks would face a double mismatch problem of liabilities short-term in Euros and assets long-term in Lira. The economy would need a lot of Euros cycling through it, but Italy’s trade to GDP ratio is only around 60%, which places it dead last in the EU, meaning banks would burn through their Euros quickly. Banka D’Italia would do everything it could to keep Euros in the system, defend the Lira to Euro peg, and keep the spread on Italian bonds manageable, but it would eventually burn through what reserves it possesses outside of those dedicated to the ECB (including nearly €90B in gold) and need to allow the currency to float. With this action, Italians would lose a significant portion of savings not held in Euros, and the economy would deteriorate even further.

There could be a silver lining in this scenario, however. Italy could decide to try to take advantage of the crisis to shed its debt and become more competitive. It could agree to expulsion from the Eurozone and fully transition to the Lira. Its populist government might then seek to redenominate its debt at the new depreciated exchange rate. Much like Argentina in 2005, Italy would likely offer to swap outstanding bonds for either a bond with a discount rate of around 60% of face value to mature at its original maturity date, or a longer-term bond at 100% value with smaller coupon payments.

Since it would be burning investors and would pay a large premium to access capital markets, Italy would need to be aggressive in creating growth. To do so, it could rely on a key membership it would not shed: the European Customs Union. With its cheaper yet well-educated workforce, complete access to the European market, and a willingness to provide special incentives to boost employment, Italy would be primed to attract employers looking to operate in the EU at lower costs than those in Eurozone countries. The economic warfare between Italy and the Eurozone would be vicious, but at least Italy could provide its citizens some hope.

The battle between Italy and the rest of the Eurozone would not go unnoticed in the nations that “must” join the Euro, and they would probably be hesitant to enter into a monetary union that cannot be undone without economic warfare. Simultaneously, Greece would feel like even more of an outlier in the Eurozone and realize that it is a populist government away from enduring the same fate as Italy. Eurozone leaders could use this as an opportunity to show how a nation can leave the Euro on friendly terms. The parties would both be happy to negotiate a Grexit through which the ECB supports Greece’s transition back to the Drachma and keeps its debts payable in Euros. The Drachma is tied to the Euro, and the ECB would agree to provide a certain level of capital to defend that peg for several years.

Regional Euros, With or Without Italy and Greec e

Regardless of whether Italy and Greece leave the Euro, COVID-19 is exposing existential deep divides between Eurozone nations that will not be easily overcome. Two camps of nations led by Germany and France fundamentally disagree on the role of the ECB and integration. Additionally, if Italy leaves and redenominates its debt, the redenomination risk priced into the bonds of nations like Spain and Portugal would skyrocket. The spread between bonds in the Eurozone could become much too expensive for the ECB to manage. Risk would need to be localized instead of socialized, and the only way to effectively do this would be to break the Eurozone into Euro regions under the auspices of the ECB: essentially live in the same neighborhood but not the same house.

Breaking the Eurozone into three smaller but closely regulated monetary regions under the auspices of the ECB would both stabilize the nations’ monetary policy through more regionally-appropriate methods and contain any events that arise within those areas. They would be designed to take advantage of the attributes that make them Optimum Currency Areas, and cultural ties would facilitate easier resolution of issues.

Baltic Euro

The first region, the Baltic Euro, is by far the smallest. It would consist of Finland, Estonia, Lithuania, and Latvia and would be relatively stable as fiscal policy has always been conservative in these nations. Further, if any unforeseen issues arise in this region, assistance from the other regions will be very effective given the small size of aid that would be needed to resolve a crisis.

Coastal Euro

The next region is the most diverse and potentially most volatile; but share a vision of European unity and fiscal cooperation. France, Spain, Portugal, Malta, Cyprus, and Ireland work incredibly well together, and have made the political commitments necessary to defend each-others’ ability to borrow. They would likely even issue joint bonds to obtain the benefits of pooled risk. They are happy to work with the Germans through the ECB, but are also happy to determine the region’s monetary policy in a more democratic manner.

If Italy and Greece were to remain in the Euro, this is the region they would join, which would skew all of the chart’s numbers towards more debt and higher bond spreads. These nations have worked well together in the EU and ECB, so it is fair to assume they would continue to cooperate through this regional Euro.

Central Euro

The final region is the Central Euro, consisting of Germany, Austria, the Slovak Republic, the Netherlands, Belgium, Luxembourg, and Slovenia. Belgium’s fiscal policy fits more comfortably with the previous region, but the investments in and deep connections to the Benelux ideal draws it into this one. Germany and the Netherlands make most decisions in this region; but unlike the entire Eurozone before the breakup, their partners are happy to defer since they greatly benefit from their monetary association with Germany. Sovereign bond spreads between the nations would decline significantly, and the members would be more likely to assist each other in an emergency since they share values and a history of fiscal prudence.

Coordination

The Euro and non-Euro EU nations would coordinate their exchange rates through an enhanced European Exchange Rate Mechanism (the ERM). Hard feelings would likely exist on all sides; but like divorced couples with common debts, it would be best to work together on a limited basis instead of refighting old battles that do not benefit anyone. Additionally, all nations would remain members of the EU and Customs Union, so there are ample opportunities to work together on continent-wide issues and engage in initiatives between the Euro regions.

Hard Choices Ahead

The COVID-19 crisis has forced Europeans to reevaluate what it means to be both their nationalities and European, and exposed their fellow Europeans’ beliefs on that issue. As a result, they have learned that old prejudices linger and, in many cases, national well-being trumps continental recovery. Such revelations make the fractures in the Eurozone difficult to mend, and make the unthinkable – the end of the Euro – slightly more possible. The issues exposed by the COVID-19 crisis will not disappear, and will almost certainly arise again at a most unfortunate time if not properly addressed now. Thus, it would behoove leaders on all sides of the debate to honestly confront the Eurozone’s structural problems before the promise of Europe fades away.

Frequent COVID-19 Global Risk Questions Answered (As Well As They Can Be Right Now) Part 3 – Changes to Global Structures and Economies

Thu, 09 Apr 2020 01:25:39 GMT

We've discussed the US and European responses, so now what are some of the structural changes that COVID-19 might bring?

So far, we’ve looked at the US fiscal and monetary response to COVID-19 and the European response , of which we have vastly diverging opinions. Now we’d like to take a step back from the technical and look at some bigger picture changes COVID-19 is forcing upon the world, for good or for ill.

Will this alter the established global order?

A bit ambitious of a question to ask us in this format, eh? Oh well, let’s take a shot at answering.

Yes, but not in the way some are expecting. As we previously discussed, the EU is in tatters, and the US monetary policy (if not fiscal policy) has been a lifeline to struggling nations. China will be throwing around money like confetti to buy friends after the crash of trust caused by its lack of transparency regarding COVID-19. Politically, we will truly be what the father of political risk, Ian Bremmer, calls a “G-Zero world,” with no clear leadership or unity. But financially, there was, is, and will be a dominant economy for a while: the United States.

In the midst of financial collapse, the first thing every investor sought were US dollars. Foreign central banks have needed one thing to keep their economies afloat and pay for the COVID-19 fight: US dollars. And when the US needed to pay for its measures, it went over $2 trillion (that’s $2,ooo,ooo,ooo,ooo.00) deeper into debt. If most nations were to issue debt equal to 10% of its GDP overnight, the interest rate investors would demand to hold that nation’s bonds would skyrocket, the currency would likely weaken, and inflation would be a real concern. What has happened to US debt? The interest rate has gone down, the dollar has gotten stronger versus all other currencies, and the overall economic picture removes the threat of inflation. Regardless of whether political leaders are playing nice with their foreign counterparts, the US will emerge from this crisis with even greater dominance in the world economy that when it began.

What about China? As mentioned above, it has lost significant credibility given its early suppression of information regarding the virus and reporting of cases and deaths that is widely viewed as deceptive, which allowed the virus to spread more widely than it may have otherwise spread. Additionally, its economy, possibly more than others, has been impacted, and its currency has “cracked 7,” which means it has passed a mythical ceiling in exchange rate with the US dollar, and the regime probably could not case less given everything else it must deal with. We identified cracks in the Chinese authoritarian system as our #3 risk to watch in 2020 before anyone knew about COVID-19, and that risk has only increased in the past few months.

With the US dollar dominant, China floundering, and Europe trying to figure out what it is, there are some natural realities Americans need to prepare for. First, Americans will be able to buy anything from anyone cheaper than we could before and travel like kings. Unfortunately, that means nobody can afford to buy as much of America’s stuff as they could before or visit the USA. Thus, to the great chagrin of President Trump and others obsessed with trade deficits, they are going to get *YUGE* in the next few years. But fortunately for those concerned about US relations with the rest of the world, even a lack of moral authority won’t overcome the ability to guide global decisions due to the dominant financial power. So while many are opining that COVID-19 will decrease US geopolitical power, we believe it will actually increase it. The rest of the world may think US leaders are a bunch of jerks, but it’s the only nation that can buy their goods and fund large international projects, so they’ll swallow their pride and smile for the pictures. (Now if we could have dominant financial power AND some moral authority…)

What industries will be the most changed?

Virtually no industry will be untouched by this crisis; but thinking through societal changes that COVID-19 will cause shows what areas of the economy will be most impacted. Of course, current stay at home orders have really hurt restaurants, bars, and brick and mortar retail. But people have gathered to eat together in public establishments since before Greek and Roman times and people will always need to buy stuff, so these will recover to some extent.

Looking to history for a guide, anyone who has spoken to an elder about the Great Depression is struck by how their illusion of financial strength were shattered, resulting in their incredible efforts to avoid taking unnecessary risks with their money. Similarly, modern society has had its complacency that we can treat all potential illnesses stripped away. All of us who experience this pandemic will be focused on protecting our health in the same way those who lived through the Depression protected their money. How?

First, we will clean more and invest in our health like never before. No, we probably won’t work out more or eat healthier, but sanitize everything and reward businesses that promote excessive cleanliness in their operations. For example, look for hotels to provide videos of room cleanings and airlines to make a show of new filtration systems. Like security after 9/11, we will engage in excessive public sanitation theater to make people comfortable coming out of their homes.

Second, we will avoid unnecessary events. Sporting events will return in full force (with maybe some negligible downturn), and let’s be honest, casinos would still be full if they could stay open. But with more people learning how to exercise at home with online assistance (such as Peloton and apps), along with concerns of sweaty people leaving bugs everywhere, gyms might find fewer members when they reopen the doors. And concerts and festivals do not lend themselves to the social distancing people will want to practice for the next few years, driving away casual participants and leaving only serious fans and festival devotees in attendance.

Third, with people learning they can be productive at home, companies might see work from home as both an enhanced benefit and cost-cutting move. If employees only come to the office a few days per week for meetings, there would be no need to dedicate office space for everyone, allowing smaller workspaces (and lower rent). Employees seeking human interaction but hoping to avoid the bugs transmitted in crowds would be relieved on both counts to have an office to visit, but without mandatory attendance.

Finally, if more people are both working outside of a daily office and hoping to have room to avoid pathogens, real estate in city centers will be less in demand. Since the commute into an office will only be a few days per week, people will be more willing to sit in traffic on those days as a trade off for a more controllable health environment.

When can I leave my house?

That one is a little outside of our (and everyone’s) wheelhouse. Just check this page often and watch this to pass the time, and we’ll be back on the streets before you know it. Stay strong, stay healthy, and stay home!

Do you agree or disagree with our assessments here? What important topics did we miss? What else would you like to discuss?

Frequent COVID-19 Global Risk Questions Answered (As Well As They Can Be Right Now) - Part 2: European Response

183:773151858 (Kevin Rejent) — Tue, 07 Apr 2020 01:56:00 GMT

Have the responses of the ECB and EU been sufficient? What are the consequences if it has not?

In the month since Italy closed its borders, Europe has faced economic calamity unlike anything it has seen since World War 2. The continent’s economy has been shut down, and nations have faced incredible costs to both fight the virus and keep society from descending into chaos as life has grinding to a halt. Digging out of this mess will take time, patience, and lots and lots of money. But Europe’s willingness to commit that money has been lacking, and failure to present a common approach could end up undoing the European Union.

Has Europe’s response been effective?

Has the monetary response been appropriate and sufficient? After a rocky start (like saying the European Central Bank was not interested in lowering Italy’s bond spread), Christine Lagarde and the ECB got it right, injecting liquidity into the financial system and implementing creative solutions similar to the United States Federal Reserve’s. So while there might be room for improvement, they are a part of the solution, not the problem.

The political/fiscal response, however…

In a few years, we may be able to direct you to one of the numerous articles we will write on the subject, or a large collection the Ph.D. theses or books on the topic with titles such as “The Death of the Euro”, “Modern Dutch Disease”, or “Divided We Fall.” Until then, however, we’ll just touch on some of the issues and leave so, so many hanging out there because there is no adequate way to summarize the historical, political, social, and economic roots of the disunion of the European Union in a Q and A article.

Historically, northern European nations such as the Netherlands, Luxembourg, Germany, Austria, and Finland have taken southern European nations such as Italy, Greece, and Spain to task for irresponsible spending, and they’ve usually had a good reason. If your nation’s monetary policy is dependent upon another nation’s fiscal policy over which you have no control, you’d get salty watching loads of irresponsible spending, too. However, since the financial crisis of 2008-10, these nations have been pretty dang responsible, and their budget deficits have been consistently improving.

Most of these nations are actually running surpluses when debt service is removed. However, giving credit for that is like saying the guy who bought an expensive car he couldn’t afford and ran up his credit card is “responsible” because he isn’t buying as much new stuff. Yes, that’s great. But the previous debt is still his problem, and it will take a while for his friends and neighbors to view him as “responsible.” Viewed in that context, the north’s skepticism to entering into a fiscal union with the south makes sense, and we have written about why that will likely never happen here.

But Europe’s current financial malaise has nothing to do with reckless spending in southern Europe, nor can it be solved by northern European frugality . It is the result of an uncontrollable natural calamity that knows no borders. So why the hesitation to fight the economic impact together, which would absolutely benefit everyone? Politically, the Dutch and Luxembourgish and, to some extent German, electorate are deeply suspicious of southern Europe, and being seen as “giving in” to their requests for money can be politically costly. Fair enough point in normal times. But now? Northern leaders are concerned that the mutualization of Eurozone debt now will open a Pandora’s Box that will see the industrious nations working hard so southerners can go on vacations and retire early. OK, that perception, as wrong as it might be, could at least be a valid political reason not to create permanent Eurobonds that are the joint responsibility of each nation. But what is the objection to limited purpose joint debt instruments that have a definite sunset? What could the Dutch and Luxembourgish have against that? No answer they can say out loud, but in addition to the absolute aversion to sharing obligations with the south, they also understand any joint obligations will likely require them to alter their tax systems that have been incredibly successful in attracting foreign investment (which the south believes is at its expense.)

What happens if “European coronabonds” never materialize? In the minds of northern European voters, their economies will recover quickly, and they can go back to chiding the south for its spending. However, we fear it will cause southern nations to eventually re-denominate their debt into parallel local currencies, which will be the end of the Euro and crush the lender banks of northern Europe. These nations, still in the European Customs Union and the Schengen Region, will suck businesses from the north with their lower costs and well-educated workforces. We’ll write more about this soon; but just know that nobody wins in this scenario. So European fiscal response must be EU-wide, and it must be significant, or the great European experiment will fail.

Frequent COVID-19 Global Risk Questions Answered (As Well As They Can Be Right Now) - Part 1: The US Response

183:773151858 (Kevin Rejent) — Mon, 06 Apr 2020 02:03:03 GMT

Have American Monetary and Fiscal Efforts Been Effective? Are They Enough?

Although it seems like ages ago, Italy issued its “stay at home” order less than one month ago , and the world has caught up, shutting down shops, events, and well…life. While obviously societies are going through collective disruption during the shutdown, what are the short-term ramifications on societies and economies as restrictions are loosened? More importantly, what long-term changes and risks should we prepare for as a weary world settles into post-pandemic life? We have spoken about these issues with clients and colleagues over the past month, and have put together a Q & A to stimulate thought and discussion by a wider group. We originally planned one article addressing several issues, it just kept growing, so we have broken it up into three shorter pieces on the US response, European response, and other important issues and will share them throughout the week.

Has the US response been sufficient?

That depends on your definition of sufficient. Has it saved the economy from any pain resulting from Covid-19? No, of course not. But has it removed worst case societal possibilities and reassured both the real economy and financial system that it will do whatever it takes to keep the world functioning? Yes, it has.

The Federal Reserve’s response has been an A+. By lowering rates to 0, entering new bond markets, and opening up lines for other central banks to convert their treasuries to much needed liquid dollars (more on the significance of this later), the Fed has been creative and effective at keeping the financial world running while everyone in the real economy stays home and watches Tiger King. There are limits to what monetary policy can accomplish, and the Fed has used every tool at its disposal very well to get the most out of its resources within its limits.

The political/fiscal policymakers’ response has also, surprisingly, been solid. While there was plenty of drama and give and take, the three rescue packages passed thus far have addressed the biggest potential problems posed by COVID-19. By providing cash payments to Americans, leaders are keeping money flowing through the economy. By adding $600 per week to any state unemployment payment, they are making sure people do not worry about starving (and thus have no reason to cause unrest). And by providing loans to businesses that are forgivable if they pay their employees, they are keeping people away from those unemployment rolls and keeping the number of those $600 per week payments as low as possible. And the packages have committed hundreds of billions to health care organizations to prevent and fight COVID-19. Plenty more will need to be done; but if the initial goal was to provide peace of mind that there would be no mass starvation and financial ruin, the initial packages have succeeded.

What more does the US need to do?

Governments’ responses will be used for decades to come in game theory textbooks to explain Bayesian games, where leaders make their best choices based upon incomplete information and modify their actions to match new knowledge. As we are living through this, asking “what else needs to be done” is like asking “what will the weather be like next November?” Sure, we can make an educated guess, but precision is nearly impossible. There are some steps we can reasonably anticipate the government will need to take to maintain order and protect small businesses (and their employees) after the pandemic is “over.”

First, it will need to address immediate shortages in medical supplies and equipment. Stories of COVID-19 patients dying because basic supplies are lacking, or medical professionals contracting the disease because of a lack of PPE can only add to the general feeling of unrest. Even if people are confident their jobs will be there when this is “over,” they need to be confident that they will be here when it’s “over.” While too much is unknown to write this risk off as manageable, we are cautiously optimistic that American health professionals, manufacturers, and ingenuity will at least mitigate it to stop any large-scale social issues.

Second, and more important, it will need to ensure that our food supply chains remain strong. The first few weeks of this pandemic have been marked by runs on toilet paper, hand sanitizer, and flour, which the government has attributed to people purchasing everything at once instead of spreading those purchases. However, if shortages continue, people will grow more and more tense, and unrest could flare up at first in isolated locations, then spread. However, just like with medical equipment, we believe that while some chains may be disrupted, enough will be maintained to keep general order. Additionally, conversations with supply chain experts and have eased our concerns. We are also heartened by the example of Italy, which has much more fragile supply chains and more personal restrictions. The only items suffering from any type of shortage in their supermarkets are wine and liquor.

Finally, more will likely need to be done to protect small businesses. Offering forgivable loans to allow businesses to pay employees was a very good idea and will keep millions of people off out of the unemployment system. However, businesses have expenses other than wages that do not necessarily go away, so plenty of businesses will do whatever they need to do to stay alive, including using the loan money to pay other bills. We identified the popping of a business debt bubble as our fourth most impactful global risk of 2020 , and adding even more debt to this mountain is unlikely to solve much. Unless more is done to help businesses that are bringing in no revenue because of mandated stay at home orders, a curve of business closings may be flattened, but the number will not be decreased.

Irish Elections: “When I Have It, I Spend It.”

183:773151858 (Kevin Rejent) — Mon, 09 Mar 2020 03:29:48 GMT

The Result of Recent Elections Indicate Ireland is Likely to Continue Its Boom-Bust Cycle

In January 2018, I was asked to write about the confluence if Irish history, politics, and economy. The nation was on top of the world as one of the leading and most educated economies in Europe and running circles around the UK on Brexit issues. It was running budget surpluses and had fantastic leadership, specifically Finance Minister Pascal Donohoe, that understood the nation’s historic boom-bust cycle and the need to break it.

Examining history and modern politics, I had no choice but to rain on the parade, concluding:

“Today’s Irish have a unique opportunity to break the boom-bust cycle, and in the process, bury the ghosts of their past that perpetually haunt them. Unfortunately, political expediency and jolts of happiness almost always win the battle for the hearts and minds of people everywhere over difficult, paradigm shifting change. Thus, the likelihood of the Irish government refraining from excessive spending in the next few years is slim. They are likely, therefore, to perpetuate the boom-bust cycle that has dominated their economy since independence.”

I hoped against hope that I was wrong, and held onto that hope as Taoiseach (Prime Minister) Leo Varadkar and Mr. Donohoe continued their prudent governing while standing firm (and bringing EU partner along) during Brexit discussions. The economy continued to grow at a healthy but sustainable rate, and the government was preparing for both Brexit and the eventual slowdown of the global economy. Unfortunately, the government did not effectively address the housing shortage and prices, and in fact promoted policies that deepened the crisis. As Brexit became less novel and the economy appeared normal, it became evident the type of policies that Irish voters were looking for, and neither of the two primary parties, Fine Gael or Fianna Fail, were advancing them. This created an opening for nationalist/socialist Sinn Fein to fill the void.

Issues Facing Ireland, Near and Far

The Irish people know sacrifice. The Viking arrival in the ninth century exacerbated the perpetual clan warfare already raging on the island. According to the Irish, this would be preferred over the injustices suffered in the 800 years of British domination. They have had their land taken, their leaders killed, their crops sold abroad during famine, their farmers essentially enslaved by absentee British landowners, their population halved by starvation and emigration, their culture suppressed, and their beloved religion declared illegal. They then fought a war to evict the British only to have them keep a chunk of the island, lived through a Civil War, and have experienced more economic turmoil than most of their European brethren.

The Irish people can endure suffering; but they endure it so they can enjoy the prosperity that suffering later allows. That, paradoxically, is the biggest threat currently facing Ireland. As succinctly stated by former Minister of Finance Charlie McCreevy: “when I have it, I spend it.” It is no coincidence that Ireland traditionally runs its biggest budget deficits in years immediately preceding elections, as the party in power seeks to buy their way into the electorate’s good graces. For a ruling party to retain power, it needs to do what governments in Ireland have done during every boom portion of the boom-bust cycle: deliver payment for the people’s suffering when the public purse is full.

Fine Gael, however, did not take that approach leading up to this election. Instead it worked on negotiating the best Brexit deal possible and providing tax cuts instead of increasing government spending. While arguably prudent, they avoided the biggest economic crisis facing Ireland today: housing. Since independence, owning land has been an obsession of the Irish. Of course, this is understandable given Oliver Cromwell’s confiscation of Irish land for his British soldiers and the ensuing centuries of landlord-tenant disputes. Thus, the Irish government’s programs to assist first-time homebuyers in achieving this dream are understandable, and even laudable. However, when there are not enough homes to buy, government incentives to increase home sales have the perverse effect of artificially inflating prices and making home ownership less accessible while potentially creating another housing bubble like the one generated by the Celtic Tiger in the early 2000s. Experts estimate that Ireland needs more than 50,000 new housing units each year to alleviate its shortage. 2019 saw the most units built in over ten years: 21,241 units, and Mr. Varadkar appeared to be in no hurry to promote building. This bit Fine Gael, as housing shortages have pushed the cost of rent to an unacceptable level of workers’ incomes, and ownership has slipped even further out of reach.

Election Results and Negotiations

This unwillingness to spend on social programs, combined with the housing shortage and Fianna Fail’s general agreement with Fine Gael on economic policies, gave Sinn Fein the chance to be the only party tapping into the Irish historical demand for more spending when the Treasury can afford it. This uniqueness of their position led to Sinn Fein obtaining the largest percentage of votes at 24.5% (compared to Fianna Fail’s 22.2% and Fine Gael’s 20.9%), and the second most seats in parliament with 37 (behind Fianna Fail’s 38, but ahead of Fine Gael’s 35).

Outsiders immediately tied the results to UK elections in which Republicans outnumbers Unionists and Sinn Fein’s fervent desire to unite Ireland, and opined that the combination of results were a demand for unification. While we have previously written about why that might make sense in the long term for other reasons , it was likely not the driving motivation of Sinn Fein voters. They were motivated by the usual promises of cheaper housing, better health care, and lower university tuition.

After the election, Fine Gael immediately said it would go into opposition instead of forming a government with Sinn Fein. Fianna Fail also stated its ideological and historical differences would not allow a coalition with Sinn Fein. With no path to a Sinn Fein government supported by a majority of the parliament, new elections appeared likely. However, Fianna Fail and Fine Gael have recently discussed a “stitch up” government to ensure Sinn Fein remains out of power (somewhat like the PD-5 Star coalition in Italy intended to keep Matteo Salvini and his Lega party on the outside looking in.) Whether this government will be formed will become clear in the coming days and weeks. However, as discussed below, it will not matter.

Outlook

Ireland is doing as well as any nation economically, and it is easy to understand the desire to demand the fruits of the national labor. And since the people have demanded it, the next government will need to deliver it, especially if it is led by the party the led the government that was expelled from power because it did not deliver enough. But a longer-term view shows dark clouds building on the horizon.

Everyone is tired of Brexit, and its estimated impacts have been discussed so much it would be very easy to tune out any discussion of the topic. But it’s real, and it will have a significant detrimental impact on the Irish economy from 2021 onward. While there are some tremendous long-term opportunities for Ireland in the UK’s departure , short-term estimates range from bad to really bad for the Irish economy. Keeping some money in reserve to ensure current social programs are fully funded so future debt is not required would be prudent.

Housing is not getting cheaper, and the bubble will burst. When it does, a great amount of wealth linked to property holdings will disappear, exacerbating the downturn.

Finally, the EU will demand loyalty from Ireland as payback for its loyalty to Ireland during the Brexit negotiations. That payback will likely come in the form of Ireland’s assent to tax agreements that end some of the policies that currently make Ireland so attractive to foreign investors. While Ireland still has much to offer, losing its tax advantages will impact its attraction of foreign direct investment.

The recently defeated Fine Gael-led government saw the storm clouds gathering and wanted to buy umbrellas. Irish voters want to enjoy the sunshine just a little bit longer. Regardless of the parties involved in the next government, they will need to cede to the voters’ demands for more spending. Ireland has been presented with another opportunity to break its historic boom-bust cycle, and has unfortunately chosen to spend it because they have it.

What's an Autocrat to Do? The Selectorate Theory and Azerbaijani Elections

183:773151858 (Kevin Rejent) — Mon, 17 Feb 2020 02:04:33 GMT

President Aliyev's failed attempt to send powerful members of Parliament into retirement shows that even autocrats have limits to their power.

On a recent trip to Azerbaijan, we landed at Baku’s Heydar Aliyev Airport, took Airport Road to Heydar Aliyev Avenue, drove past the Heydar Aliyev Cultural Center to Heyday Aliyev Boulevard, and then past the Heydar Aliyev Sports Hall to our hotel, the lobby of which was decorated with pictures of Heydar Aliyev and his son and current Azerbaijani President, Ilham.

Suffice it to say, the mythology of Heydar Aliyev (and by extension his son) is reinforced nearly everywhere in this Caucasus nation of nearly ten million people, and he certainly did many things to endear himself of the Azerbaijani people. The senior Aliyev settled the nation down after a turbulent few years following the collapse of the Soviet Union. He also defended Azerbaijani interests in the battle with Armenia over Nagorno-Karabakh, and embarked upon a massive infrastructure renovation using revenue from oil and natural gas extracted from the Caspian Sea. With his son Ilham married to a member of the Pashayev family (described by the US Embassy as the most powerful family in Azerbaijan), there were no constraints on Heydar Aliyev’s power, and no real challengers to his position.

Ilham inherited the role of President and most of its power; but some power stayed with those close to his father. So while Ilham Aliyev has enjoyed power and control that wannabe autocrats in the West could only dream of, there are individuals with their own power bases that can flex their muscles to oppose his plans.

This situation is a textbook example of the Selectorate Theory, which was best explained by Prof. Bruce Bueno de Mesquita and Alistair Smith, both of NYU, in their entertaining book, The Dictator’s Handbook: Why Bad Behavior is Almost Always Good Politics . There are layers of groups that matter to varying degrees: the nominal selectorate, the real selectorate, and the winning coalition. In American politics, the nominal selectorate is the pool of eligible voters, the real selectorate is the group that actually votes, and the winning coalition is the patchwork of voters in various areas that combine to deliver a victory. In autocracies, the nominal selectorate might be large (such as the pool of voters), but the real selectorate is a much smaller group usually consisting of the wealthy and military leaders, and the winning coalition is an even smaller subset of these groups.

Since the goal of all leaders is to remain in power, they must provide goods to members of their winning coalition to retain their support. In Western democracies where the winning coalitions are very large, those goods are public goods, such as roads, healthcare, schools, a cleaner environment, etc., paid for with public money. In nations with much smaller winning coalitions, those goods are generally private goods, such as planes, payoffs, luxury items, etc., also paid for with public money (often through dodgy contracts to family members or proxies.)

Which brings us to Azerbaijan. The Senior Aliyev had an extremely small real selectorate, and a winning coalition that consisted of himself and a few other key officials. When his son took over, the real selectorate remained small, but he did not have the same power as his father, so the winning coalition expanded to include those powerful members of Parliament mentioned above. Thus, he must provide private goods to a larger group than he would prefer, and wants to replace these people with younger and more loyal members of Parliament keen on modernizing.

Old and New Baku

President Aliyev has undertaken some economic reforms, but has more he would like to pursue. He realizes that oil and natural gas deposits run out, and the economy needs to diversify now before that happens. He also would like to invest more in infrastructure to prepare the country for this inevitability. Some of the older members of Parliament with their own power bases and lucrative contracts in the oil and gas sector and do not want to spread the wealth any further than necessary. Additionally, some of his recent reforms, coupled with volatility in the oil and natural gas sector, have led to three devaluations of the Azerbaijani Manat in the past five years, so hard liners are not sold on his economic liberalization program.

Manat/USD Rate

President Aliyev’s power is not enough to force these people into compliance, so he needs to force them out of the positions from which they derive their power. Thus, he called for early elections.

Azerbaijani elections are strange in that there are not party primaries to narrow the field before elections. Thus, you could have several members of the ruling YAP running for the same seat. Additionally, there are several other parties that work in coalition with YAP, so candidates from those parties often syphon votes away from YAP candidates disfavored by the government. For example, if a disfavored YAP member makes hard-lined security his primary issue, a candidate from a coalition party will run on an even stronger hard-lined security platform to steal votes from voters interested in that topic and allow the preferred YAP candidate to remain moderate. In America, these candidates would be referred to as “stalking horse” candidates; candidates not running to win, but to divert votes from another candidate for the benefit of a 3rd candidate.

The election occurred February 9, 2020, often with a dozen or so people running for each seat. Our views regarding the conduct and fairness of the election are contained in the OSCE/ODIHR’s Initial Statement , and will be expanded upon in a forthcoming final report. Notwithstanding the mechanics and fairness of the election, the results were not what President Aliyev had sought, with the hard-liners holding onto their seats and retaining their power. Thus, President Aliyev will continue to have to keep them satisfied inside his winning coalition, potentially stalling much needed economic reforms.

Which goes to show you that, even when every major road and building bears your name, you are not immune from power politics and having to make the sacrifices necessary to keep your power.

Capitol Flight: Does Moving a Nation’s Capital Make Sense?

183:773151858 (Kevin Rejent) — Tue, 28 Jan 2020 04:23:34 GMT

Many nations have successfully relocated their government. Maybe it's time for the United States to consider moving out of Washington, D.C.

As every fan of Hamilton can tell you, a few people met in “the room where it happens” and voila, a useless patch of swamp between Virginia and Maryland became the capital of the United States. Now Washington D.C. is the sixth largest metropolitan area in the U.S. with the highest per capita income of any city in the country. Clearly, holding the seat of power has served D.C. well, as it has capitals of other nations. But what if that seat weren’t permanent? What if a nation’s capital moved to better accommodate the business of government and spur economic development? Crazy, right? Well, it has been done before and a plan to move the capital is currently underway in Indonesia.

Moving a capital city seems radical, but several nations have done just that with varying levels of success. Some of these projects were driven by necessity, others by vanity, but all were obviously massive undertakings that changed the face of the nations. The most recent capitol relocation occurred in Myanmar in 2005. The government (OK, military…same difference) built a fresh city, Naypyidaw, away from the former capital of Yangon to give the government (military) distance from the cosmopolitan atmosphere of Yangon and be closer to “rebels” in the northern portion of the country. The cost to build Naypyidaw is rumored to be between $4-$5 billion, which sounds like a steal; but when you consider that amount is approximately the current total annual tax revenue for the nation, the cost is staggering.

A few years earlier, in 1998, Nursultan Nazarbayev moved the capital of his newly independent Kazakhstan from Almaty, in the far southern portion of the country, to a more central location and named it “Astana,” which simply means “Capital” in Kazakh. Only he didn’t spend $4B on this grand endeavor. No, he spent an estimated $40B. However, since Kazakhstan has considerable oil and gas revenue to tax, the hit was not as pronounced as in Myanmar. President Nazarbayev has retired, and to honor his contributions to the nation upon his retirement, Astana was renamed Nur-Sultan.

Two other large nations that have purpose-built capitals are Nigeria and Brazil. Moves to Abuja and Brasilia were necessitated by overcrowding in the previous capitals (Lagos and Rio de Janeiro), a desire to place a capital in a neutral area, and security from attacks by sea. While both have been described as somewhat stale and isolated, they now boast populations of over 3 million and generate healthy portions of their nations’ GDPs.

Which brings us to Indonesia and its plans to move the capital from the incredibly overpopulated Jakarta to a purpose-build city on the island of Borneo beginning in 2024. The costs have been announced at $33B, of which the state will directly fund approximately 20% with the rest coming from public-private partnerships and private development. The new city’s central location, along with increasing concern surrounding Jakarta’s pollution, overpopulation, lack of adequate water, and sinking of 25 cm per year make the move appear reasonable.

All of this movement raises the fun questions: what if the US moved its capital? Why would it do that? Would that eventually result in the same conditions that led to the movement out of Washington, D.C.? Where would it go?

“Drain the swamp!” supporters of President Donald Trump say, referring to the entrenched government class they not so affectionately refer to as the “Deep State.” “Get money out of government!” say liberal activists disgusted by the appearance that wealth drives government decisions. Moving the seat of government away from the location where power and money has concentrated for the purpose of influencing and profiting from that government would be a grand experiment in good governance, just as the US was once a grand experiment in democracy.

But if the capital were to relocate, wouldn’t the new capital attract the same wealth and power that has taken root in D.C.? Perhaps, but this is where a potential moderating force comes into play: what if the move was not permanent? What if the capital was purpose build and moved every 100 years? The new city could be designed for modern transportation and societal needs (hyperlink hub and fully wired?) instead of shoehorning modernism into older cities. The price tag on this experiment would undoubtedly be large; but building this city from scratch is probably worth the expenses if we know that it will serve such an important function for a century and would spur economic development. An entrenched class of government elites would inevitably develop. However, it could not firmly establish itself because as soon as it fully evolved, the capital would move again and start over elsewhere.

As for where this new capital could be built, that is a political decision that would rely upon good old-fashioned politics and compromise. Ideally, the nation would divide into five regions, Northeast, Southeast, Midwest, Mountain, and West Coast, and rotate the capital between the regions. Since the city would need to be a new build, it should be located between other cities to create a strong regional grouping that could both help in the building of the new city and foster economic integration. For example, it could be built in northeastern Iowa, close to Chicago, Milwaukee, Minneapolis, and Des Moines. Or it could be placed in southern Oregon, making a continuous link of cities between Seattle and San Diego. These are mere suggestions; but the idea is to create something new that could remain viable after the capital moves.

Ah, there’s the problem! What happens to D.C. after the move, and what happens to the other capital cities? In short, D.C. would take a large hit. However, vibrant non-governmental industries have developed that could continue to thrive after the move due to the concentration of talent and advantageous location. The new cities would also face challenges after the government left; but since it would be known that the government was leaving and the cities would be in strategic locations, they would be better prepared to deal with the changes.

Of course, this is a crazy idea that would need to be developed more fully, and the political wrangling would be epic. But if America wants to keep its edge as an innovator of democracy and good governance, the most effective location of the capital should be discussed to refresh our democracy, just as it was when the three men met in “the room where it happens” two hundred years ago and saved our fledgling democracy.

Macro Monday: Iran, Russia, and Beyond – What Are Sanctions and Do They Work?

183:773151858 (Kevin Rejent) — Mon, 06 Jan 2020 01:32:52 GMT

Primary and Secondary Sanctions Can Impact Targets (and Non-Targets) in Different Ways

Sanctions have been hitting headlines quite a bit lately, but the explanation of who/what is being sanctioned, how sanctions work, and whether they can be an effective method of getting the sanctioned person, company, or even country to bend to the sanctioning country’s demands has been absent. This is understandable, because the complex web of laws, regulations, entities, and consequences are nearly impossible to summarize in a pithy article. However, considering their increased use and potentially severe consequences (as we are currently seeing in Iran), informed citizens should at least attempt to understand these important tools of foreign policy.

Let’s begin by pointing out that tariffs are not sanctions. Tariffs are an economic tool intended to benefit the economy of the issuing nation while sanctions are a political tool intended to punish the sanctioned party for bad behavior. If you are reading this article hoping for a discussion of US-China trade, you will be disappointed, but can raise your spirits by reading our previous article on that topic here.

Once we are firmly in the realm of sanctions, the first question is “who can sanction?” Technically, any nation can impose sanctions and try to enforce them; but only three entities have the practical ability to impose meaningful sanctions: United States, European Union, and United Nations. Often the sanctions overlap, as the excellent model from the Council on Foreign Relations below indicates.

CFR’s thorough sanctions explanation can be found here.

These sanctions are of varying significance. For example, the EU’s sanctions of the US are just harshly worded rebukes of America’s enforcement of its sanctions beyond its borders while those imposed on North Korea can cripple an economy. And the sanctions are of varying clarity, from very clear prohibitions, such as those regarding business with the Taliban, to amorphous topical sanctions like US sanctions on transnational crime organizations.

Primary Sanctions

The type of sanctions that most make the news, the “big ones,” are the primary sanctions. These directly target a bad actor and attempt to correct their behavior. In the case of Crimea, the United States prohibited new investment in Crimea by any US person or company after Russia’s annexation. Hard stop. No new American money could enter the Crimean economy. Other forms of primary sanctions can be embargoes, asset freezes, travel prohibitions, and other actions that are clearly punishment.

Secondary Sanctions

While primary sanctions are relatively straightforward, US secondary sanctions can be confusing, overbroad, and lead global businesses into minefields they had no intention of entering. Secondary sanctions are sanctions that the United States applies to wholly non-US actors in wholly non-US transactions of which the US disapproves. They can be imposed if a non-US company engages in a “significant transaction” or provides “material support” to a sanctioned person or entity. However, “significant transaction” and “material support” are vaguely defined, and a non-US entity cannot obtain a license or opinion from the agency that polices sanctions, the Office of Foreign Assets Controls (“OFAC”).

Problems most arise in the field of banking, where OFAC requires that any bank accessing the US banking system honor US sanctions. If such a bank is found to have violated US sanctions by handling Iranian oil transactions, for example, that bank can be fined and/or prohibited from accessing the US banking system (which would be death for any large bank). This policy gives US sanctions teeth, as nearly every multinational bank has at least tangential connections to the US banking system and cannot afford to lose access. European banks have been fined *billions* of dollars in single prosecutions for facilitating transactions with sanctioned entities. The EU has vociferously protected this position and, as mentioned above, “sanctioned” the US by stating that any member nation may respond to the US in a manner they see fit. This has not deterred the United States from prosecuting violations, however, as OFAC collected nearly $1.3B in settlements in 2019, largely from banks and insurance companies.

Do Sanctions Work?

This seems like a lot of work for third parties to punish allegedly bad actors, so the obviously question is: do sanctions work? And the answer is a clear, absolute, irrefutable…it depends. A Russian oligarch sanctioned for assisting with the annexation of Crimea will find life and business more difficult, and vacations will be rather boring, but overall life will continue mostly as before. And OFAC cannot keep up with all worldwide transactions, so networks of shell companies and straw-men can sometimes allow them to evade sanctions.

Primary sanctions against a nation, however, can be crippling, leading to economic calamity and belligerent and violent behavior. Recent news from Iran illustrates this more clearly than any hypothetical a textbook author could dream up. Of course, Iran was cut off from the world banking network until 2015, when it reached an agreement with the US and several European nations to curb its nuclear ambitions in exchange for the lifting of sanctions. It was allowed to sell its oil to almost any buyer, and its isolation from the global banking system ended.

Iran immediately experienced an economic shot in the arm, with its economy growing 12.5% in 2016. It slowed to a more stable 3.7% in 2017 and appeared to be normalizing. But then President Trump withdrew the US from the agreement entered into by President Obama and re-imposed sanctions. The US also gave foreign entities, such as banks, a set amount of time to wind down their relationships with Iran or face secondary sanctions. European business and political leaders protested loudly, but it was to no avail.

As a result of its freezing out of the global economy, Iran’s economy shrunk by 4.8% in 2018 and 9.5% in 2019. The economic turmoil caused the ruling mullahs to tighten social controls, engage in black market transactions, and attempt to project power through proxies (rarely directly) in the Middle East and the world. As its bad behavior met with success, it continually pushed a little further to show it could be a power, even while sanctioned. Masterminding the Iraqi storming of the US Embassy was the final straw for the US, however, as it escalated the conflict by killing Quds Force leader Qasem Soleimani. The world is waiting for Iran’s response (and it may have occurred b the time this article is read), but it is likely that either assets will be damaged, more lives will be lost, or both.

So, do sanctions work? Sometimes yes, as in the cases of the Former Yugoslavia and Liberia; sometimes no, as with most Russian sanctions. But do sanctions matter? As Iran indicates, absolutely yes.

From the United Kingdom to a Celtic Union

183:773151858 (Kevin Rejent) — Wed, 18 Dec 2019 03:56:31 GMT

Does the British Election Make a Celtic Union of Northern Ireland, Scotland, and the Republic of Ireland More Likely?

When King George V surveyed his empire before World War I , he saw approximately one-quarter of the Earth’s land mass and people under his crown. The sun truly never set on the British Empire, and Pax Britannica had stabilized the world for several decades. But then history happened as nations sought to rule themselves and far-flung territories became more of a burden to rule than benefit to the empire. Over the next century, the United Kingdom shrunk from 13,700,000 square miles to 93,628 square miles, or .68% of its summit, and rules over .88% of the world’s population. Hong Kong was the most recent defection in 1997, leaving the United Kingdom with essentially its population base in the British Isles, a few strategic ports, and some nice Caribbean vacation spots.

This is not an effort to denigrate Great Britain as a has-been power clinging to relevance. It is still one of the world’s foremost military, economic, and cultural powers. This history is provided to demonstrate that time has a way of changing things, and “permanent” truths are subject to unforeseen events and forces even the most visionary leaders cannot control. And when perceived community interests diverge from those of the larger nation, division is sought and, sometimes, obtained. The United Kingdom may be approaching another such point after last week’s Parliament vote.

Last week’s vote leaves no doubt: Brexit will happen. And Boris Johnson, a man about whom we have written in the past, will be the person to pilot that ship out of the European Union. The certainty of the exit ends a period of volatility that has hampered British politics and business for several years, and certainty is good . However, the certainty of Brexit has unleashed related uncertainties that will plague the United Kingdom for the next decade or longer, potentially leading to a further contraction of Great Britain and, eventually, the forming of a rival firmly planted within the European Union.

Scotland

Scottish independence is not a new passion. The two neighbors have centuries of conflict and cooperation, and since the Treaty of Union merged the nations in 1707, Scottish nationalists have been clamoring for a reversal. Most recently in 2014, a referendum on independence resulted in a 55-45 vote to remain within the United Kingdom. But that was before the Brexit referendum. In that election, Scottish voters voices a strong desire to remain within the EU, only to be overruled by their British and Welsh countrymen.

In last week’s Parliamentary elections, the Scottish Nationalist Party, formed to promote an independent Scotland, won 48 of Scotland’s 59 seats in Parliament, 13 more seats than the previous election. Its percentage of the vote increased 8% to 45%. Leader Nicola Sturgeon has already asked Prime Minister Boris Johnson for a second referendum, which he has refused.

While there would seem to be movement towards independence, it should not be forgotten that, just five years ago, Scottish voters rejected leaving the UK by 10 percent. And the SNP’s 45 percent of the 2019 vote, while impressive, is the same percentage of those who voted for independence; thus it is unclear how much public opinion has shifted. Further, the electorate is likely exhausted with no appetite for another bruising campaign after the 2014 independence vote, 2016 Brexit vote, and 2017 and 2019 Parliamentary elections.

However, if Scottish nationalists are patient, Brexit may advance their cause far more effectively than any campaign. 62% of the voters in Scotland voted Remain. Further, Boris Johnson’s breed of Conservatism is often interpreted as English nationalist and paternalistic towards Scotland, Northern Ireland, and Wales. He was forced to work with everyone prior to the election since he was leading a minority government; but now that he has a large Parliamentary majority composed almost exclusively of English members, he may pay less attention to the other nations within the Kingdom. Further, Brexit will harm the British economy, and leaving the UK to join the EU will become more appealing in time. If Scottish nationalists spend the next several years linking independence with EU membership (and a reversal of the difficulties Brexit will bring) and give the electorate time to get over the recent wave of monumental elections, another vote on an independent Scotland could occur within the next five to ten years.

Northern Ireland

More surprising than the SNP’s success in Scotland were the victories of Nationalist parties in Northern Ireland. For the first time in Northern Irish history, they won more seats than Loyalist parties, 10 to 8 (with one additional seat going to a compromise party). Additionally, Northern Ireland voted 56-44 to remain within the EU in the 2017 referendum. Northern Irish voters understand that, regardless of the extremely tumultuous religious conflicts within its nation and with the Republic of Ireland, its economy is intimately linked to that of the Republic, which requires it to be a member of the EU to continue unfettered trade.

The Brexit process has exposed deep cracks in the English-Northern Irish relationship, but the Conservatives’ need of the Democratic Unionist Party’s support to remain in power prior to the recent election meant that any plans needed to meet with the approval of at least some Northern Irish leaders. Mr. Johnson, like his predecessor Theresa May, was consistently flabbergasted that the EU did not disregard the interests of Ireland during Brexit negotiations, but were unable to disregard their own Irish’s considerations since they were needed to govern. With his large England-based majority, Mr. Johnson is free from those shackles. On the most perplexing issues of the negotiations, such as customs complications and a backstop to EU regulations, Mr. Johnson has already shown himself to be more concerned with getting a deal than finding solutions that benefit Northern Ireland. As the EU exercises tougher negotiation tactics (since it will be negotiating with a third party instead of a member state), the UK will find itself with less and less leverage, and Northern Irish interests are politically the easiest for Mr. Johnson to disregard. With it already being the nation absorbing the largest blow from Brexit, the lack of concern from Westminster might be enough to soften some Unionist positions.

Of course, *might* is the operative word here. Centuries of conflict followed by several decades of violence are not swept away simply because one side wants access to markets for their widgets. The Good Friday Accords have greatly improved relations between Northern Ireland and the Republic of Ireland, and common EU membership has provided a neutral setting for the nations to jointly prosper. But removing EU membership does not mean that the parties will be drawn together in common cause and Northern Ireland will abandon the United Kingdom.

What About Wales?

Recent polling puts support for Welsh independence at around 30%. Additionally, Wales voted in favor of Brexit. Wales is comfortable within the UK, and the nations of the potential future Celtic Union should not waste energy attempting to extract it from the Kingdom.

Toward a Celtic Union

On paper, a Celtic Union of Scotland, Ireland, and Northern Ireland makes perfect sense. The three nations are much more culturally similar to each other than England, economically invested in the EU, and Northern Ireland and Scotland would be able to exert more control over their national affairs. It would form the world’s 21st largest economy, and its GDP per capita would fit between Sweden and the Netherlands.

However, if the stars were to ever align for this Union, it would be because all parties exhibited patience and perfect statecraft. Scotland would likely be the first domino to fall. With an already active independence movement, a strong desire to remain within the EU, and North Sea oil revenue to ease the transition, the Scottish could conceivably vote for independence in five to ten years. It would then face the problems Northern Ireland is dealing with now related to borders and customs checks. Further, the EU might not be willing to discuss membership until Scotland is independent, thus making the Scotleave transition potentially as calamitous as Brexit.

If Scotland were to leave, Northern Ireland would then look around and recognize that it is even more of a cultural and geographic mismatch with the United Kingdom than before. However, it is likely too small and not economically prosperous enough to consider independence. Despite the temptation of pushing for the union of Northern Ireland and the Republic, the Republic would be wise to let Northern Ireland find its proper place without pressure. It is quite conceivable that Northern Ireland will feel most comfortable sticking with Scotland. And if Scotland has been granted EU membership, the problems of controls between the Republic and Northern Ireland would be solved.

But what if Scotland is not immediately granted EU membership and access to the Common Market? Would it be worth seeking independence? Would Northern Ireland follow? If Ireland is savvy (and its current leadership is very talented), it will work with the EU to steer Scotland towards a loose union with Ireland. The nations would have a limited “national” government, but essentially remain separate nations, as the Scots would prefer it status within the UK to be. As noted above, Northern Ireland might be reluctant to join the Republic of Ireland; but if it could also maintain autonomy within this Union, and Scotland and the Republic could entice it with investment at or above the UK’s current investments, Northern Ireland might also jump.

What Would the Celtic Union Look Like?

Scotland and Northern Ireland would likely only leave the UK for more autonomy and EU market access. Thus, the Celtic Union would have to operate through a weak central government that handles mostly EU affairs with remaining powers reverting to the member states. The head of the central government could be rotated between the states (yes, even though Northern Ireland is much weaker – Scotland and the Republic would essentially be overpaying for its membership), and each state could be in charge of certain ministries, which would also be rotated. The Union would only have one vote in the European Council, but with the EU’s ninth largest population and sixth largest economy, it could have a great impact on European debates. The cultural issues within Northern Ireland and between the North and the Republic of Ireland would not disappear; but having protestant Scotland as a friend to both sides could provide current protestant Unionists some comfort.

Is the Celtic Union Inevitable?

Immediately after last week’s election, commentators rushed in front of cameras to pronounce that Scottish independence is now inevitable. They are wrong. It is more likely now; but the political, cultural, and economic foundations keeping Scotland within the United Kingdom run deeper than Brexit, as do those tying Belfast to London.

However, if the Johnson government promotes English nationalism and ignores the needs of the other nations within the Kingdom, independence looks a slightly more attractive. And if Scotland and Northern Ireland can fast-track their reentry into the EU through a loose union with the Republic of Ireland, it looks more attractive still. Slowly, over the course of several years, there are many opportunities for Scotland and Northern Ireland the drift away from the United Kingdom as so many other nations have done before them. Unless the Great Britain recognizes this possibility and actively demonstrates that it is not taking their relationships for granted, the contraction of the United Kingdom might continue, and the rise of a Celtic Union may begin.

Holiday Gift Guide for Naughty and Nice World Leaders

183:773151858 (Kevin Rejent) — Thu, 12 Dec 2019 03:32:17 GMT

What to Get The Hard to Shop For Head of State on Your List

What do you get the man or woman who has everything? When they are provided free housing, food, private jets, security, and staffs to cater to their every whim, selecting a gift for the world leader on your list gets more complicated each year! Luckily, we here at Maggiore Risk have thought through your problem and come up with a list for 15 leaders to help you give them the present they need, not necessarily the one they want.

Donald Trump – This one is easy. He wants nothing. He wants nothing. This is the final word from the President of the U.S. Do the right thing and honor his request.

Jair Bolsonaro – A DVD copy of Titanic, so the Brazilian leader can see that Leonardo DiCaprio is much better working with water than fire .

Xi Jinping – All he wants is your absolute and unquestioned obedience. Is that too much to ask?

Justin Trudeau – A little humility. His biggest problems (blackface, talking about Trump behind his back, etc.) stem from a compulsion to be the coolest kid in the room. We’re not sure how you put that in a box under the tree; but it would be a gift he definitely needs.

Abiy Ahmed – Plane tickets to New York. The 43-year-old Ethiopian Prime Minister and Nobel Peace Prize winner will almost certainly be Secretary General of the United Nations someday if he wants it. A nice trip to the Big Apple would give him a chance to scout out some real estate.

Sebastian Pinera – Aspirin. Chile has the most advanced economy in South America, strong political and legal institutions, solid public finances, good monetary policy, and a well-educated population…and they riot. Working class Chileans who have seen the country prosper while they seem stuck have legitimate gripes; but burning Santiago? That is a vast and totally unexpected overreaction. So this man just needs some aspirin, and maybe a stiff drink.

Mohammed bin Salman – Etiquette lessons. When you have absolute power, you can rule absolutely. However, when you want to foster investment in your one-dimensional economy, you need to project a pleasant face. Holding family members captive in a hotel is counter to this goal, and murdering dissidents abroad is strictly out of the question. Some classes on courtesy and manners could do him a world of good.

Angela Merkel – While she still probably has another year as German Chancellor before stepping aside, Ms. Merkel could use a nice beach vacation and massage. Carrying the entire western alliance on your back for several years can’t be easy. She would probably also enjoy a framed collection of the time she spent with her good friend Donald Trump.

Vladimir Putin – Don’t worry about getting him anything. He usually picks up something for himself. A few years ago, he saw a nice peninsula that he just *had* to have, and when nobody got it for him, he just took it.

Emmanuel Macron – A crown. As Angela Merkel exits the scene and the UK Brexits stage left out of the EU, Mr. Macron has done all he can to position himself as the next leader of Europe. By aggressively taking on President Trump and putting himself in the forefront of Brexit negotiations, President Macron is attempting to pull off the modern-day equivalent of Napoleon’s self-coronation. Thus, a nice crown would be thoughtful.

Anwar Ibrahim – The Prime Minister position. The Malaysian Prime Minister in waiting was in line to become Prime Minister in the 1990s, but a falling out with then-Prime Minister Mahathir Mohamad led to several years of imprisonment on trumped-up sodomy charges. Released from jail in 2018, he joined forces with Mohamad (yes, the man who sent him to jail to get him out of the way) to win the Malaysian elections. The agreement was that Mohamad, already in his late 80s, would serve for a short time before turning over the reins to Ibrahim. Now Mohamad has stated that while he will step aside, it might not be for a while. So if you have the power to give Mr. Ibrahim the PM spot, he would be incredibly grateful.

Boris Johnson – A rearview mirror that he can’t wait to see Brexit in. Or his own phone so he doesn’t need to steal journalists’ .

Jacinda Ardern – Nothing, she received her present early. With Finland’s selection of 34-year-old Sanna Marin as Prime Minister, Ms. Ardern has been freed from the annoyance of having to serve as the only standard bearer for young female leaders. Now she can focus on the difficult enough task of leading New Zealand without the added pressures of showing that young women can dominate in politics while raising a family.

Giuseppe Conte – Dale Carnegie’s How to Win Friends and Influence People. The left-wing populist Five-Star Movement (5S) and right-wing populist Lega, united by their hatred of the Democratic Party (PD), joined forces to form a coalition government after the 2018 elections. When the parties could not agree on whether 5S leader Luigi Di Maio or Lega’s Matteo Salvini should serve as Prime Minister, they plucked law professor Giuseppe Conte from obscurity to serve as a compromise Prime Minister. Then Salvini tried to force a general election by pulling out of the coalition, leaving 5S without the votes needed to rule. He miscalculated, however, as it turns out 5S and PD agree on one thing: intense hatred of Matteo Salvini. So the ideologically mismatched parties united to form a government without Lega but with Conte as PM. Oh, by the way, former PD Prime Minister Matteo Renzi has left the PD and formed his own party. Conte now needs to keep everyone happy because any slight disturbance could lead to the government crashing and early elections being called, which will likely bring Salvini to power. A little advice from the master of interpersonal relationships would come in handy.

Volodymyr Zelensky – Noise-cancelling headphones. For everything.

Of course, these are only suggestions. When in doubt, a Chili’s gift card is always appreciated.

Top 20 Global Risks of 2020

183:773151858 (Kevin Rejent) — Sun, 01 Dec 2019 18:24:22 GMT

U.S. political volatility, deepfake technology, and developing cracks in the Chinese system headline Maggiore Risk’s Top 20 Global Risks of 2020.

With a potentially slowing global economy, governments behaving badly, and cooperation between traditional trading partners and allies at an all-time low, the risks confronting the world’s political and economic systems are diverse and growing. Frayed relationships will make these challenges more difficult to manage, and domestic political concerns further complicate efforts to collectively solve global problems. These are the major risks we see challenging business and political leaders in 2020.

20. Chinese/South Korean Cooperation – Soon after the US demanded that it triple its contribution to US forces on the Korean peninsula, South Korea struck an agreement to deepen military and intelligence ties with China. How will this be received in Pyongyang, Tokyo, and D.C.?

19. Turkish Instability – Turkey is attempting to serve as a stabilizing force in a volatile region. However, the economy and currency are stumbling while President Recep Tayyip Erdoğan tightens his grip on power by placing party lackeys and relatives in important roles. Can he hold it together long enough for the economy to turn around and lessen social pressures?

18. Canadian Real Estate Crash – In 2016 and 2017, the Canadian real estate market experienced unprecedented growth, with annual real price gains of 8.6% and 9.8%. The Canadian government feared a bubble was forming, so it tightened lending standard while the Bank of Canada raised interest rates. If this isn’t enough for an orderly deflation of the bubble, a pop could reverberate through the Canadian, American, and some Asian economies.

17.   Stalled Saudi Reform – A disappointing IPO of its state oil company would be the next in a line of disappointing results in Crown Price Mohammed Bin Salman’s (above) efforts to transform the Saudi economy, society, and neighborhood. With arrest and/or murder probably no longer options for dissidents, can discord be effectively contained in such a chaotic region?

16.   Argentina Default – Incoming left-wing populist president Alberto Fernandez is much less concerned about paying the nation’s bondholders than previous conservative President Mauricio Macri. Any default would cut off Argentina’s access to international capital markets and harm the overall South American economy.

15.   Sub-Prime Securitization…Again – Banks are bundling subprime loans and selling them in bulk as securitized products. Sound familiar? Only this time it’s auto loans instead of mortgages. Banks claim they learned their lesson and have made these products less volatile; but with loan defaults on the rise, can these products hold together or will we see another explosion of bad debt dragging down the economy?

14. Putin Meddling – There is absolutely no question that Vladimir Putin will try to influence the US elections and stir chaos around the globe. Will the rest of the world effectively fight it off and punish Russia in a manner that makes Putin think twice about continuing his interference?

13. German Stagnation – The economic engine of the Eurozone has been hit hard by global trade tensions. Will is alter its trade and fiscal policies to deal with an economic slowdown or try to weather any storm using the same policies? The consequences of its decision will reverberate throughout Europe and the world.

12. Sahel Terrorism – Sub-Saharan Africa, particularly the central and western portions of the Sahel region (Mali, Niger, Chad) has seen a marked increase in terrorism the past few years as Boko Haram, al Qaeda, and others have flourished in the area. In addition to ending the tragedies suffered by residents of the area, western nations have concentrated efforts on the region to prevent the spread of extremism and flow of terrorists into Europe.

11. Indian Backsliding – Prime Minister Modi’s BJP Party took power with promises of economic transformation, but has recently been focused on Hindu nationalism as the economy has cooled. Can Modi return to a focus on economic development, or will he continue to be distracted by religious issues that harm economic and social progress?
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10.   Venezuelan Death Throes – It’s not really a question of “if”, but rather “when” and “how” Venezuela’s corrupt regime will finally collapse. President Nicolas Maduro is widely viewed as a buffoon who retains power by lavishing the political and military elite with luxury while the Venezuelan people go without basic necessities such as food and medicine. There is a chance that Maduro would accept asylum in a friendly nation (Cuba? Russia?) and leave voluntarily since even his allies are not interested in providing Venezuela with any more economic lifelines; but more than likely he will need to removed by a military that turns on him or a popular revolt that is yet to materialize. There is real concern that he will lash out at anyone he feels is responsible or any nation that will rally his supporters. Attacks on American, Colombia, and Brazilian interests could produce significant damage.

9.   Brexit – This has been near to top of every political risk list for the past several years. However, the markets appear to have mostly priced in the risks by now, so its significance has decreased. Additionally, the exit scenarios have been batted around for so long that affected businesses and nations have (hopefully) had enough time to plan for each contingency. Volatility resulting from any dramatic deviations from the currently understood scenarios is the primary Brexit risk heading into 2020.

8.   North Korean Temper Tantrum – Kim Jong Un did not get the diplomatic breakthrough that he wanted with the United States, so he has returned to the traditional North Korean strategy of spewing extreme rhetoric and stepping up missile tests and military preparations. Quite frankly, he is running out of options. His Hail Mary attempt to charm President Trump into removing sanctions without demanding denuclearization failed, and he now sees his greatest enemy on one border (South Korea) strengthen ties with his patron state on another border (China)(see Risk #20). If he feels pinned in and losing control, he may lash out, either at Japan to garner support from the South Korean population or the US to inflict the largest symbolic damage before his inevitable fall. Keeping pressure on North Korea to reform without triggering a military incident will take tremendous skill on the part of regional actors and the United States.

7.   Massive Data Hack – Of course everyone is concerned about cybersecurity; but while annoying and time consuming, most data breaches are intended to steal information for profit. What would happen if a powerful actor (maybe a state like North Korea or Iran) pulls off a data breach on a scale never before seen and with a goal of disrupting life as much as possible? In addition to economic pandemonium, such an attack could result in a war since most nations view cyber-attacks as a similar level of hostility as a physical attack. In our connected world with the technology of both the good guys and bad guys improving every minute, the risk of this type of conflict is constantly rising.

6.   Crumbling Trade System – President Trump’s trade war with China and dust up with virtually all other trading partners are slowing global growth, and with only minor agreements in sight, are likely to continue to impact economies. In an election year, President Trump will either want to finalize several agreements quickly to show that he is the dealmaker he claimed to be in 2016 or stir up more discord to demonstrate concern for American manufacturers. Combine this with Brexit uncertainty and slowdowns of the Chinese and German economies and you have a recipe for global economic trouble.

5.   Iranian Activism – The reinstatement of sanctions after the United States’ withdrawal from the JCPOA has hit Iran’s economy hard. The nation is cut off from most normal banking arrangements and has difficulty selling its oil. Recent protests, ostensibly caused by an increase in fuel costs but more related to the overall state of the Iranian economy, resulted in over 140 deaths and a brief shut down of Iranian internet. With no relief from sanctions in sight, Iran is likely to take a more active role in black market activities such as cybercrime and illegal oil sales. Additionally, as its recent attack on Saudi oil facilities and proxy wars in Yemen and Syria demonstrate, Iran is willing to use its strong military to project its power and express its frustrations. And let us not forget their nuclear ambitions, with most experts believing Iran could possibly enrich uranium to the necessary purity within one year since it is no longer constrained by the JCPOA.

4.   Corporate Debt Bomb – Low interest rates are vital to stimulate investment in challenging economic times. However, they also allow inefficient companies access to what is close to free money to remain in operation when the best thing for the economy would be for them to shut down and release their capital and talent back into the market. An additional $60 trillion in debt has come into existence in the post-financial crisis low interest rate world, much of it in the private corporate sector. Economists have been worried about this potential bubble for years, and the risk will grow larger if the global economy slows in 2020 and over-extended companies are unable to satisfy their obligations.

3.   Chinese System Cracks – The Chinese system has been built on an agreement between the people and government that the government would deliver wealth and, in exchange, the people would not challenge its authority. However, the history of all nations is that, as the people obtain wealth and a middle class develops, they demand more political and social rights. With the Chinese economy slowing down, middle class wealth accumulation has stalled, and Chinese citizens are starting to question their government more. Further, the protests in Hong Kong challenge the “One Nation, Two Systems” principle that has been accepted since the transfer of Hong Kong to Chinese control. While the Communist regime is not on the edge of collapse, how it addresses the rising angst will indicate whether it will attempt to evolve or dig in.

2.   Deepfake Tomfoolery – Deepfake technology, or technology used to produce or alter video content so that it shows something that didn't actually occur, is evolving quickly and, in the wrong hands, has the potential to stir up trouble. Imagine, if you will, video of a presidential candidate disparaging a large group of voters on a “hidden camera” video that is actually the creation of a partisan from the other side. Or imagine an incredibly believable video of a western leader blaspheming the Prophet Mohammed and stating that mosques should be burned making rounds through the Islamic world. As the technology advances, so must the ability to credibly identify deepfakes and quickly demonstrate their false nature to the viewing public.

1. U.S. Elections/Impeachment – Putting the United States at the top of this list is certainly unusual, and every effort was made to move it down; but the volatility that the Trump administration unleashes even on a normal day (usually on Twitter), combined with the potential Constitutional crises (yes, more than one potential crisis) make this placement unavoidable. Add to that the uncertainty of who will be leading the nation in 2021, and investors could not be blamed for keeping their money on the sidelines until there is more clarity. The philosophical reason it rises to the top of the list is simple: if the institutions of the most stable democracy the world has ever known can be shaken so quickly by so few people in power, what does this say about the stability of less-established nations?

Of course, the world is increasingly connected, so these events would not occur in a vacuum, and the occurrence of one could lead to the occurrence of another. Similarly, solving one problem may prevent another from occurring. This is not a list of doomsday prophecies or ways in which the world ends. The world isn’t going crazy…it was born that way , and we have, for millennia, done the best we can to address challenges, manage risk, and move forward. The entirety of human history indicates that we will continue to do so only, hopefully, a little better each time.

Expertise, General Knowledge, and the Wisdom to Know the Difference

183:773151858 (Kevin Rejent) — Tue, 26 Nov 2019 03:53:47 GMT

"I said to him 'This is all going to blow up.' And here we are."

“Having been a dental supply salesman for four years and a Merchant Marine for four and a half months, I think it’s safe to say I know a little about the music industry,” says Kids in the Hall’s Scott Thompson during a hilarious sketch about naming a band while the rest of the Kids nod in agreement. The absurdity of the wholly irrelevant expertise forming the foundation of accepted wisdom was obvious twenty-five years ago; but would not be instantly rejected today. Mistrust of “experts” is at an all-time high as our egalitarian society transitions from one in which specific expertise is given great deference to one that praises general knowledge and a belief that intelligence is transferable to fields in which the person has no experience. But while little deference should be given in some areas and fluid interdisciplinary knowledge often results in creative problem solving, time and time again we need to remember that expertise is necessary, as we are seeing play out on our television screens daily via the impeachment hearings.

“Beware the tyranny of the expert,” late Supreme Court Justice Antonin Scalia would tell rooms of lawyers (who, it must be said, often view themselves as “experts” in most discussions.) His starting point was Federal Rule of Evidence 702, which allowed for expert testimony in instances where specific “scientific, technical, or other specialized knowledge will help the trier of fact to understand the evidence or to determine a fact in issue.” His argument was that courts had rapidly diminished laymen’s ability to understand evidence on their own, and thus demanded that more and more types of experts spoon-feed otherwise competent people the “truth.” He further warned against even more erosion of individual and societal decision making in deference to “experts” of one type or another who want to craft the perfect society. On matters of policy, he warned of unelected regulators usurping the responsibilities of elected representatives. On moral issues, he lamented courts trading in moral issues since, according to Justice Scalia, certain issues are no more known to the “nine Justices of this Court any better than they are known to nine people picked at random from the Kansas City telephone directory.” Blind deference on certain issues to supposedly smart people simply because they are smart and therefore must know better is not only a foolish abdication of responsibility; but also downright un-American.

While blind deference is dangerous, reasoned reliance on experts in matters that require specific knowledge is not only wise, but necessary. For example, while an accountant might be brilliant, have fantastic general knowledge, and even study brain surgery as a hobby; their opinion on a particular surgical method is NOT as valid as say…an actual brain surgeon’s. Similarly, while it is perfectly reasonable (and civic-minded) for laypeople have an understanding of facts and opinions regarding nuclear weapons, this is certainly an area where responsible practitioners, trained by competent institutions and experienced through a progression of professional roles, are required. Nuclear security expert Professor Tom Nichols of the Naval War College and Harvard University has fought this battle so much that he decided to write a book about it. In “ The Death of Expertise: The Campaign Against Established Knowledge and Why it Matters ,” Prof. Nichols observes that “[w]e are supposed to ‘agree to disagree,’ a phrase now used indiscriminately as little more than a conversational fire extinguisher. And if we insist that not everything is a matter of opinion, that some things are right and others are wrong…well, then we’re just being jerks, apparently.” Nichols argues that Americans have decided that feeling good about something trumps whether or not those feelings are backed up by facts. Unless we return to reliance on experts to grasp the ramifications of societal decisions, Nichols states, we are headed to national decline “because a stable democracy in any culture relies on the public actually understanding the implications of its own choices.”

With professional experience in law and political risk, I am sympathetic to both views. It is humorous when legal jobs will only consider candidates who started their career in trade credit finance law in middle school, or political risk jobs seeking four languages and vast international institutional/intelligence experience (but only two-four years professional experience because the employer doesn’t want to pay for more expertise). On the flip side, most attorneys would be challenged by trade credit insurance issues without additional education, and simply living abroad and “totally getting” how a different society operates does not prepare you for a career in political risk analysis. The skill, it seems, is understanding when expertise is required and when outsiders’ skills will be beneficial and are transferable.

Which, like every other discussion these days, leads us to the current impeachment proceedings against President Donald Trump. This article isn’t interested in breaking down the merits of the charges (I have definite views, but expressing them here has no benefit); but rather attempts to understand the varying beliefs on the value of experts in American foreign policy. On one side are those who believe that success in one field (real estate, mayoralty, hotel operations) will lead to better results than relying upon subject matter experts in another field. On the other side are those who believe elected officials and their appointed administrators should stick to photo ops and leave all real policy to those that have dedicated their professional lives to the topic.

I am not opposed to the practice of nominating outsiders to serve as ambassadors and advisors to Presidents. This tradition seems outdated, but can inject new ideas into professional diplomatic corps that can grow insular. Additionally, these outsiders often have private sector contacts that can help advance US interests when government channels run dry. However, they need to understand when they have reached the limits of their abilities, discuss the situation with the on-staff experts, and defer to their guidance. They also need to avoid doing what they *think* the experts do and try to live out some Tinker Tailor Soldier Spy book or star in their own personal Tom Clancy movie. At best, the laymen here appear to have not sought (or followed) expert advice, which itself would demonstrate bad judgment. At worst, they play-pretended to be masters of global intrigue with the expected awful results and are now trying to burn everything down (including the experts) to justify their bungled misadventures.

Government employees are certainly not all selfless heroes acting with only the nation’s best interests at heart at all times. However, for anyone to state that the conclusions Dr. Fiona Hill has reached applying her years of education and experience to the facts surrounding Russian and Ukrainian affairs are “opinions” to which their own are equal is the embodiment of the anti-intellectual culture Dr. Nichols warns is currently growing in American public life. Criticism of a decorated military officer chosen by the administration itself to advise on Ukrainian issues because his testimony did not align perfectly with the wishes of the administration is equivalent to the accountant criticizing the brain surgeon. And tweeting that a distinguished foreign service officer has been the cause of dysfunction in prior diplomatic postings is the political equivalent of Ogre chanting “nerds!” on the roof of the Alpha Beta house. Nobody wanted to listen to the experts, and as Dr. Hill warned Ambassador Sondland, “’This is all going to blow up.’ And here we are.”

But I am ever the optimist! Hopefully this situation forms the outer bound of disregarding and attacking experts, and future political operators keen to avoid the morass in which the President now finds himself will defer to those who have dedicated their careers to studying the specific issue. This will not happen overnight, but as more Americans understand that, just as America is incredibly complex (try explaining the difference between typical Louisianans and New Yorkers to a foreigner), most other countries are also very complex, and effective relations require specialists with experience operating in those nations’ institutions and according to its norms. The dollar diplomacy that appointed officials often rely upon only gets you so far. We need the experts to pull American strategies across the proverbal finish line. And if we don’t realize this, we need to prepare for the inevitable consequences of the diplomatic version of accountants practicing brain surgery.

Macro Monday: Sovereign Wealth Funds Are Seeing Green

183:773151858 (Kevin Rejent) — Mon, 04 Nov 2019 18:50:38 GMT

Massive national investors are prioritizing sustainable and ethical investments.

In a recent speech to investment bankers, the head of Kuwait’s nearly $600 billion sovereign wealth fund, the Kuwait Investment Authority, discussed the need for the oil-rich kingdom to reduce its carbon footprint by investing in sustainable energy and companies that prioritize fighting global warming. This follows the over $1 trillion Norwegian sovereign wealth fund’s decision to sell its interests in oil and gas exploration companies. What is the motivation of these sovereign wealth funds, fueled by fossil fuel sales, to get out of the fossil fuel market? And what impact can the sovereign wealth funds really have on the global investment landscape?

First let’s take a step back and examine the sovereign wealth funds world to get a sense of their motivations. A sovereign wealth fund is simply a pot of public money that a nation invests. Usually, the country’s wealth derives from a resource, and the fund diversifies investments and spreads risk against a decline in the market for the nation’s main commodity. Oil-rich nations such as Norway and Middle Eastern counties have large and active funds with the goal of creating sustainable wealth for the time when the oil runs out or is no longer a major source of revenue. Other nations, such as China and Singapore, have sovereign wealth funds to prepare for aging populations and/or a time when their economic comparative advantages are lessened. The US federal government does not operate a sovereign wealth fund; but several states do, and Texas has two.

While the primary purpose of the funds is to produce healthy returns, nations can also use them to export their values. The head of Kuwait’s fund stressed the importance of incorporating climate change risks into investment portfolios. To that end, it has joined with seven other sovereign wealth funds to form the “One Planet” working group in an effort to direct investment towards companies that further the working group’s goals. Norway’s fund goes much further, using fund investments as a tool of social policy. It has divested itself of companies that produce weapons, mine or process coal, or sell tobacco. It has also established strict ethical and sustainability requirements for investments, incentivizing good behavior. It seeks to influence the companies in which it invests through voting at company meetings. And with respectable ownership interests (over 2%) in companies such as Nestle and Bayer, it has the power to influence corporate decisions to meet ethical demands.

Some energy industry watchers have ascribed a more cynical motive to the sovereign wealth funds’ green conversion. If there is less investment in oil and gas exploration, the incumbent producers will have less fear of new producers diluting their market shares. And the drive to divest themselves of coal stocks is more about competition than ethics. However, if this were the motivation, why would the funds invest heavily in alternative fuels? And why would they invest in the expansion of current producers, such as Kuwait and Bahrain’s consideration of investment in the Saudi Aramco IPO? The funds are not attempting to selectively knock out the competition; they are seeking to diversify their risks and/or provide a healthy return.

Sovereign wealth funds are often beholden to political actors and thus, their actions sometimes appear more policy than investment oriented; but what impact can they really have in the total global investment market? When a few numbers are considered, it turns out they can have a huge effect. According to the Sovereign Wealth Fund Institute, the top 84 sovereign wealth funds hold combined assets of approximately $8.1 trillion. This is more than twice the assets under management of all of the alternative investment funds (hedge funds) in the world. The market cap of all stocks in the world, according to the World Bank, is $68.2 trillion. Thus, if sovereign wealth funds were to invest solely in public equities, they could own 12% of all global equities. More realistically, if funds invest a percentage in public equities similar to Norway’s 65%, they own 7.7% of all stocks. Norway’s fund alone owns approximately 1.3% of all equities in the world. Finally, the EU estimates that the total stock of foreign direct investment in the world is $27.6 trillion. Many sovereign bond funds are prohibited from investing in their own countries to avoid the appearance of corruption, so it is fair to assume that a large percentage of global FDI is through sovereign wealth funds.

This level of investment capability provides sovereign wealth funds with a great power to shape investment markets and lead trends. Recently, they have been exerting this influence to lead global investment away from fossil fuels and towards more sustainable investments that meet stringent ethical guidelines. Regardless of whether this is dictated by home governments, a cynical ploy to under-fund competition, or a real commitment to these investments as growth opportunities, the shift in investment strategies is happening. Smaller investors (which is to say all other investors) would be wise to follow the money and reap the rewards of the massive investments sovereign wealth funds can provide.

Eurozone Fiscal Union – An Idea Whose Time Will Never Come

183:773151858 (Kevin Rejent) — Mon, 28 Oct 2019 02:20:43 GMT

Mario Draghi's proposed deeper fiscal and political integration of Eurozone members could lead to the end of the Euro.

In his farewell tour as President of the European Central Bank, Mario Draghi has again discussed the elephant in the Eurozone’s room: fiscal integration. With the German and French economies showing signs of slowing and Euro-friendly leaders in Italy and Greece, taking steps in this direction makes sense, and on paper the goal seems logical…almost inevitable. But people don’t live on paper, and the political winds are likely blowing away from fiscal integration instead of towards it. There may be ways to strengthen the Euro; but if Frankfort and Brussels insist on further fiscal (and thus political) integration, the more likely result will be the Euro’s demise.

The Euro was a bold response to the concern that economic unrest in one nation could spread throughout the region, and an optimistic belief that a common currency could promote economic develop as envisioned by Robert Mundell in his Nobel-prize winning work on Optimal Currency Areas. By almost all measures, it has benefited the nations that adopted it. Borrowing rates have plummeted, economic expansion has been facilitated by easier cross-border transactions, and the emergency mechanisms were essential to avoiding complete disaster after some Eurozone countries, most notably Greece, faced economic meltdowns. But Greece also exposed limitations to the monetary union’s effectiveness.

The limitations on the Eurozone’s effectiveness are primarily the lack of fiscal (and thus political) control over member nations’ taxes and spending . The ECB couldn’t force Greece to make political decisions, it could only premise financial support on the implementation of certain policies. If Greece did not comply, it would not receive funds and would remain a significant drag on the other members of the Eurozone. By only having control over monetary policy, such as interest rates and money supply, the European Central Bank has few arrows in its quiver when crises strike. Mr. Draghi is concerned that the negative interest rates and quantitative easing used by the Bank during the last crisis was the extent of its options. Thus, the Bank needs control over the larger set of options: member nations’ tax policy, spending, and budgetary decisions. Taking control of these issues would, according to the European Council on Foreign Relations, require nations to make difficult decisions on three dimensions:

     1.) Limited versus full economic federalism – Are only really important national decisions subject to oversight, or are any decisions with potential external effects within the purview of the pan-Eurozone entity’s review?
     2.) Rules versus discretion – Must the central authority live within rules granted by the national governments, or would this entity have discretion to implement Eurozone-wide actions if it deemed them necessary?
     3.) Direct versus indirect legitimacy – Are the actions of the central authority immediately and directly legitimate, or do they need to be legitimated by the national governments?

Currently, the European system has limited economic federalism, a central authority constrained by rules, and indirect legitimacy through member-state ratification. At the very minimum, the stronger Eurozone governance structure as envisioned by Mr. Draghi would require a more directly legitimate central authority with discretion to respond to events.

Is such a structure viable in Europe today? France is promoting it, and with the German economy slowing, now might be the best chance to get it on board. Additionally, the wealthier nations who might fear that a central European government would be a vehicle to transfer wealth from north to south might instead relish the chance to control southern European spending. The current southern governments of Italy, Greece, and Portugal are pro-European and pro-Euro, and such a structure would benefit them. Thus, they might be willing to sign onto this plan.

Despite the appearance of momentum for this idea, a deeper look indicates further integration could very well lead to the death of the Euro . While the UK was never in the Eurozone, its issues with deeper European political integration and loss of sovereignty made Brexit inevitable. This concern for sovereignty is not contained to the west side of the English Channel. Eurosceptics, such as the Lega in Italy, are sizable contingents in most nations and their ranks would swell if citizens saw their countries run more and more by European entities. For example, the Gilets Jaune protests are the latest example of citizens opposing the actions of their own government, elected by the protestors and their neighbors. How much more intense would the protests be if the actions they were protesting were imposed upon them by European central bankers? Italy blows a gasket when the EU even mentions the most basic of budgetary rules; so it is hard to believe it would cede more sovereignty to its northern European partners.

While the fiscal and political integration envisioned by Mr. Draghi is unlikely, there are alternatives. A less ambitious plan that could pay large dividends, proposed by Harvard Professor Dani Rodrick, would be integration of private banking systems, but no integration of public banking systems. This would allow the financial system to reap the rewards of cross-border activity but keep public banking under the nations’ control. Public bailouts of private banks would not be necessary because private bank failures would not expose public banks to massive risk. A more radical alternative arrived at in a recent Maggiore Risk strategic foresight exercise is the breakup of the Euro into a few smaller affiliated currencies operating under the loose management of the ECB. Regionalized mini-Euros connecting like-minded neighbors would put to rest the fiction that conditions in Helsinki are equivalent to those in Lisbon and allow for the level of integration desired by the member states. These regional Euros could more effectively respond to crises as smaller issues would only be socialized to that sub-Euro zone while larger issues could be dealt with on a Euro-wide manner with more Draconian consequences if ECB or European Stabilization Mechanism resources needed to be tapped.

The next three to five years are critical for the survival of the Euro. The global economy is likely to slow down and this decline will be exacerbated by Brexit and trade wars. If powerful Eurozone nations attempt to use the predicament to deepen fiscal ties, it may be the beginning of the end for the Euro. However, if member states and the ECB think creatively, they might be able to reach the same desired result of a more stable Eurozone while evolving the currency to better respond to both regional and Eurozone-wide challenges.

Chile’s Wake Up Call

183:773151858 (Kevin Rejent) — Fri, 25 Oct 2019 02:38:59 GMT

High inequality has been ignored for too long.

Tanks push through the capital clearing out protestors defying the government’s curfew. Buildings burn and trains are rolling balls of fire. The protestors demand a new constitution and a greater share of the economic pie. If this scenario had been presented a month ago as a coming storm in a South American country, Chile would likely have been the last guess of experts attempting to divine where this calamity would occur. But here we are…

A proposed increase in public transportation fares unleashed the wrath of the working class upon the government of Conservative Sebastian Piñera. Of course, the riots are only tangentially about a 3% hike in Metro fares. This unrest, like the Gilets Jaunes protests, Hong Kong riots, and the Ferguson riots in the United States has a catalyst; but are about deeper structural issues than that catalyst would indicate. In Chile, those deeper issues relate to the amount of the nation’s prosperity that is reaching the working class, and what the government can do to help its citizens feel like they are living in a wealthy country with the most successful economy in South America.

Chile’s political and economic development since the peaceful ousting of the Augusto Pinochet dictatorship in 1990 has been nothing short of miraculous. Considering its geographic and resource restraints, Chile has masterfully crafted stable economic and political systems that are the envy of similarly situated nations. It has led free trade agreements, such as the CPTPP (the successor to the now-defunct TPP), Mercosur (associated member), and the Pacific Alliance, and has effectively walked a fine line in the US-China trade dispute. And while copper and cobalt are 40% of Chile’s exports and 10% of GDP, the financial sector is very open to investment and services are rapidly becoming a larger portion to GDP. Most importantly, average wages are growing faster than inflation.

BUT, that is “average” wage, and the standard deviation from “average” is very high in Chile. The Gini Index is a simple measure of income distributions, with a higher Gini index being an indication of higher income inequality. While a low Gini Index is not necessarily an indication of a good economy (unless Ukraine and Moldova, with two of the lowest Gini Indexes, are “good”), a high Gini Index is generally a sign of a challenged society. Alas, Chile’s Gini Index of 46.6 is the worst among OECD nations and places it in a class with the likes of Cameroon and Guatemala. This inequality seems less pronounced during periods of rapid growth when the poor are happy to be increasing their income at, for example, 4% per year even if the wealthy are increasing theirs’ at 6%. Everyone is benefiting. But often in nations with high inequality, inflation equals or exceeds wage growth at the low end, so the lower- and middle-class workers hear and read about great economy and wonder when it will benefit them. Great days are always near, but never arrive. In Chile, the underlying problem was not a 30-cent fare increase; but 30 years of being promised that everything was about to be much better for people like them without ever being rewarded for their patience.

In a way, Chile is a Bizarro World version of its neighbor Argentina. Argentina is a poor nation with high taxes and extensive social services. The current government’s efforts to rein in costs has caused political unrest. Chile is a rich nation with low taxes and subpar social services. The current administration’s failure to improve them has led to unrest. The sweet spot is somewhere in the middle; although getting there will be painful for both.

The initial reaction of the Chilean government was both correct and incredibly tone deaf. President Piñera was correct that radical group used the discord as a springboard to sew discontent and perpetrate violence, just as they have done in Gilet Jaunes, Hong Kong, and Ferguson. However, to blame the protests completely on these groups dismissed the fact that average Chileans have legitimate complaints that the government has often attempted to address, but never successfully has because of its pursuit of macroeconomic objectives.

Chile is now in an economic position that it can both address these issues and continue its economic ascent, and in a political position that is cannot afford not to. President Piñera has realized his mistake, changed his tone, and invited the UN Human Rights Commission (led by former Chilean President Michelle Bachelet) to investigate the military’s response. He has also proposed a $1.2B reform package that repeals the fare increase and unpopular electricity increases and raises the minimum pension (Chilean Social Security) by 20%. Sure, these new measures might knock a few tenths of a percent off of future GDP growth, and certainly the middle of a trade war when future exports are uncertain is not the ideal time to commit to new social spending; but Chile has the money, and forcing it to spend some of it on social services is likely a long term net positive. The question that remains is: will it be enough?

Macro Monday: Highlights of the OECD Proposal to Solve Global Tax Distortion

183:773151858 (Kevin Rejent) — Mon, 14 Oct 2019 01:38:08 GMT

The 134-Nation Effort Could Transform Multinational Tax Structures

Recently, we have discussed Phantom FDI , Ireland’s Brexit opportunities , shifts in Asian export countries of origin to avoid tariffs (taxes), and the origins of Brexit . Little did we know that the Organization for Economic Cooperation and Development (“OECD”) was on the verge of issuing a proposal that would impact all of these and potentially fundamentally alter the global economic landscape. In response to several nations’ efforts to unilaterally tax multinational activity within their borders, the OECD brought together 134 nations, which have set forth a framework for voluntary reform to solve some of the tax base eroding practices or large multinational corporations. Thorough analyses of the implications of these changes on nations and businesses have begun and will continue long after the December 2020 proposed date to reach an agreement on the proposal. Before you dive into these detailed discussions, here is an early cheat sheet to get you up to speed.

The Problem . Ten economies around the world, none with a population larger than the Netherlands’s 17 million, hold 85% of the world’s stock of FDI, and the three largest EU FDI destinations (Netherlands, Luxembourg, and Ireland) house more than 50% of global FDI due to their business-friendly tax systems. In some instances, a company’s “office” is a mailbox with no employees, such as Apple’s employee-less Ireland office. The most prominent examples of establishing offices to reap tax benefits are the tech giants, also known as the FAANGs (Facebook, Amazon, Apple, Netflix, and Google.) Under the current tax regime, established in the 1920s, a French Google sales rep can sell an advertising program to a French company, advertising to French consumers, on google.fr; but since it is headquartered in Dublin, it will pay no tax in France, instead paying Ireland’s much lower tax even though Ireland had very little to do with the transaction. France and other nations tired of seeing tax revenue shifted out of their country by legal and accounting semantics have threatened to impose additional taxes on these companies, potentially resulting in a completely unworkable global tax system.

The Proposed Solution . In an effort to avoid the chaos that would result from this “every nation for itself” approach, the OECD has gathered 134 nations to create a new framework for multinational corporations. The proposal is primarily geared towards technological companies (the FAANGs); but would cover any consumer-facing company with over €750m in global revenue, which could theoretically include banks, hedge funds, and large service providers. The first of the two pillars is most directed at tech companies because it focuses on redefining the nexus of economic activity for tax purposes. It attempts to establish a “usual profit” for an industry, segregate revenue between companies’ activities, and then allocate tax obligations based upon the location of the activities.

The second pillar potentially has a much larger impact as it seeks to establish minimum levels of corporate taxes and proposes agreements on minimum national levels of taxation. Much like the American Alternative Minimum Tax and EU’s Anti-Tax Avoidance Initiative, this would require a parent corporation to “top up” tax payments on the global profits of its subsidiaries if the taxes paid fall below the minimum. It would then allow nations to deny any deductions for base-eroding payments to foreign related entities (such as transfer of profits to an entity with more favorable tax treatment), and only extend treaty benefits to nations with a tax rate at or above the agreed-to global minimum rate.

Potential Winners . The obvious winners are large economies with higher taxes that currently see profits shifted to low tax nations and economic activity reported on these low tax nations, despite the obvious connection to other nations. The United States, France, Japan, Germany, and Italy would benefit from economic activity occurring within their borders, targeting their citizens, and using the economic structures and institutions they maintain.

The UK also loses in the current scheme, and these losses were likely to grow with British companies playing both sides of the English Channel to save from the uncertainty caused by Brexit and profit from different rules. If some version of this OECD proposal can be implemented, it will provide the UK with some certainty and the ability to target companies playing it against the EU, even though it will no longer be a member.

Potential Losers . Obviously, multinational companies seeking the most efficient tax structures will pay more. One could argue that certainty of minimum taxation would allow them to focus resources on other initiatives; but it’s highly likely they do not see it this way.

Countries with favorable corporate tax regimes will be required to alter them in a manner that could make the countries less attractive. Smaller economies such as Ireland and the Netherlands have much at stake, and need to play an outsized role in the upcoming OECD discussions to ensure they limit the impact on their economies. Ireland especially has much at stake as Brexit will already be causing havoc and it will have little leverage with its fellow EU members after they have expended considerable political energy in support of Ireland throughout the Brexit process; but OECD, US, and European officials want to make certain there are no significant losers in this process, and Ireland must hold them to that promise.

Finally, since the treaty would carve out resource extraction, poorer economies reliant on extraction would not see the same benefits as countries housing tech giants.

Much is made about current conflicts in the global system, and it is correct to view cooperation at a post-Cold War low. However, it is in almost every nations’ economic interest to construct a reasonable tax structure for the emerging multinational companies that simply do not fit into the 1920’s-era system. Adoption of the OECD proposal would be an absolute game-changer and provide hope that maybe, just maybe, nations can still work together to creatively solve the biggest issues of the day.

Macro Monday: A Little Love for Little Ghana

183:773151858 (Kevin Rejent) — Mon, 07 Oct 2019 12:38:01 GMT

Taking a moment to appreciate a country on the rise.

With the political risk world consumed with hour-by-hour Brexit and impeachment developments, we wanted to take a break and talk about a nation that just does not get enough credit. Some nations, like the Philippines, are challenged by complex colonial and post-colonial histories. Other, like Chile, are hindered by less than ideal neighbors. And still others, like Ghana, have both. However, Ghana has fought off adversity to become a relatively politically and economically stable nation in a complex neighborhood. So please join us as we consider how Ghana arrived at its current status, where it may be headed, and how its neighbors can use its example to improve stability and growth.

The forests of northern Ghana have been settled around 4000 B.C., and the coastal areas since approximately 2000 B.C. It has seen mighty empires and small kingdoms. Ninth Century Arab histories fawned over its abundant gold and were impressed by its organization. The Ashanti kingdom arose in the region, and the copious resources (as well as slaves from rival kingdoms) led to deep connections with Europeans. These connections resulted in increasing control by the British by the middle of the 19th Century. However, in 1956, Ghana requested its independence from Great Britain, and the request was granted. From this time until 1993, Ghana experienced various levels of political and economic turmoil that could be expected after independence. However, since its new constitution took effect in 1993, it has been remarkably stable, with free and fair election and peaceful transfers of power between opposing parties.

For over a millennium, natural resources formed the basis of Ghana’s economy, as stories of its gold spread far and wide. As agriculture developed, Ghana proved perfectly suited to grow cocoa, which has developed into a primary export. More recently, Ghana began producing crude oil and natural gas in commercial quantities in 2011, providing fresh revenue for the government’s push to reduce poverty and improve social conditions.

That push began in earnest in the early 1990s and has shown great progress. Ghana reduced poverty from 52.7% in 1991 to 24.2% by 2012, achieving its Millennium Challenge goal ahead of schedule. The primary driver in this rapid poverty reduction was increased agricultural productivity. And with primary school attendance increased from 66% in 1990 to 89% in 2016 and secondary school increased from 36% to 62%, its workforce has been obtaining the training it needs to shift away from agriculture, allowing services to overtake agriculture as the largest segment of the economy in 2015. At the same time, the dependency ratio has fallen from 89 in 1990 to 68 today, meaning a higher proportion of the population is working. Finally, it is hoped that since oil was not a component of Ghana’s economic development until recently, it can avoid the resources curse that has plagued so many of its neighbors.

There have certainly been some hiccups along the way. Fiscal and current account deficits were substantial as recently as 2013, and the country has used IMF lifelines three times since 2000. Inflation has fluctuated, and debt to GDP has continued its rise since a great reduction a decade ago. It has also struggled to improve in “Ease of Doing Business” rankings, as the bureaucracy has not yet figured out how to efficiently deal with the growing economy. So essentially, Ghana has experienced the highs and lows of a nation trying to break into the sphere of middle-income countries.

While the desire to write off Ghana as a typical B-rated country that is only interesting to frontier-economy investors is strong; Ghana’s success when viewed in light of similarly-situated nations shows why it should be taken seriously. It has been growing at a rapid pace, and since 2010, it has created significant distance between it and its neighbors with respect to GDP per capita.

How has Ghana managed to outpace its neighbors and grow faster than almost any other nation on the planet? Quite simply, it has governed itself more effectively and has lower levels of political and economic risk. Sure, some markets are still developing and nobody will claim the government has achieved Scandinavian-level efficiency, but investors know that whoever is running the country has been appropriately elected and, as a result, is very unlikely to be overthrown. This type of stability matters, and Ghana is reaping the benefits of committing to democracy and the development of its people.

Ghana still as a long way to go. This is both depressing, since they have worked so hard to develop, and exciting, as there is still much growth to be achieved. With a commitment to democracy, economic development, and workforce improvement, it is likely to remain on course to be the first country in its neighborhood to achieve middle-income status. And in these times of instant over-analysis of breaking Brexit and impeachment news, its refreshing to take a moment to recognize countries that are working hard to move in the right direction.

Macro Monday: Trade War Causing More Products to be Made in the U.S.A. (Ulterior States of Asia)

183:773151858 (Kevin Rejent) — Mon, 30 Sep 2019 04:11:51 GMT

Asian Manufacturers Are Shifting Export Locations of Products to Avoid U.S. Tariffs.

President Donald Trump struck a chord in his campaign for President in 2016 by promising to “Make America Great Again” by reviving the American factory and the towns they once supported. His condemnation of outsourcing and pleas (and in some cases “orders”) for American companies to stop making products abroad has earned him the support of voters in America’s Rust Belt, where manufacturing was once the best path to a middle-class lifestyle and a staple of communities but is now a shell of its former self. Since taking office, President Trump has taken on the country he and his voters label the primary villain in the outsourcing process, China, and slapped numerous tariffs on its products to encourage more American manufacturing. Has it worked? Maybe with respect to China; but the globalized world Trump and his supporters are fighting against allows manufacturers to shift production to nations not experiencing tariffs, especially other Asian nations that are already integrated into regional supply chains.

The starting point for most economists that do not work in the White House is that tariffs are not an effective tool of trade relations. This soil has been effectively tilled by others, so this article won’t go into detail other than to say that there are no winners in a trade war, only one side hoping the losses hurt the other side more. And more controversial, but almost as accepted, is the idea that the United States should not manufacture low-tech products. The work can be done more efficiently elsewhere, allowing the United States to engage its well-educated workforce in more complicated (and profitable) manufacturing processes.

Regardless of the benefits or propriety, it makes sense to check in with trade data to see if the tariffs are having their intended effect. First, the tariffs have slowed American trade, with overall trade for the United States decreasing .06% in the first seven months of this year compared to the first seven months of last year. Exports are down .71% while imports are up .38%. Second, with respect to China, the trade deficit is falling, with a $199.8B deficit year to date (through July), compared to $220B in the first seven months of 2018. However, the amount exported to China has decreased more significantly, with China selling the United States 329% more goods than it buys through July, up from 211% more in the first seven months of 2018. If the objective is simply to inject less US money into the Chinese economy by buying less, it is working; however, US companies that sell products to China are the collateral damage suffered in furtherance of this objective.

So where are we getting the stuff we used to buy from China? Mostly still from China, but some companies have shifted their manufacturing processes to complete products in countries other than China to avoid the tariffs. While some companies have improperly mislabeled products to avoid tariffs, there has also been a significant uptick in legitimate imports from other Asian nations. The US is importing 73% more products and services from Asian nations other than China than it is exporting to these nations, which is within the normal range for the past few years. However, in a period where US leadership is seeking to close trade deficits, the deficits with Asia continue to rise. In fact, as the chart below demonstrates, total US trade deficits with the rest of Asia have increased in the first seven months of 2019 more than deficit with China has decreased ($45B vs. $20B). This means it is likely that either a) the US has found alternative suppliers of the products that previously were sold by China, b) multi-national companies that previously finished their products in China are finishing them elsewhere to avoid tariffs, or c) both.

At first glance, it would be easy to write this off as a victory: American consumers still get their goods and it does not benefit the Chinese economy. However, if the increase in trade deficits actually is diversion of the same sales to different suppliers, then US consumers are paying billions more for the same things. If this is what is happening, it is because the more efficient Chinese suppliers are priced out of the market by tariffs and less efficient (higher priced) producers from other nations are taking their place, or the products are priced higher to make up for the costs associated with the change in the ultimate exporting nation.

This increase of imports from Asian nations other than China is positive if it demonstrates a diversification of good and suppliers. However, if it merely represents a diversion of purchases to less efficient manufacturers or multinational companies shifting the final manufacturing location of products that were previously finished in China, American consumers are bearing the cost of this trade war and US manufacturers hoping to sell products to an increasingly affluent Chinese population are searching for replacement markets. For those that believe buying less from China with the goal of harming its economy and impacting its ability to keep its citizens employed is the objective, an argument can be made that the trade war has met its objective. However, even viewing the tariff spat through strongly hued rose-colored glasses, American consumers and manufacturers are incurring billions of dollars in damages, and likely cannot wait much longer for the leaders of the US and China to decide that the political gains achieved through “getting tough” on the other party are not worth the losses suffered by both sides in the process.

Going Dutch: The Rise of Phantom Foreign Direct Investment

183:773151858 (Kevin Rejent) — Mon, 23 Sep 2019 03:35:49 GMT

Tax avoidance is increasingly the primary motivation for FDI decisions.

Earlier this month, the International Monetary Fund published an article in its Finance & Development magazine analyzing the amount of Foreign Direct Investment (“FDI”) that is simply “pass through” investment intended to minimize taxes instead of foster growth. Not surprisingly it found that, as economies have recovered from the shock of 2008-09, nations with favorable tax laws have received a greater share of FDI. However, the amount of “Phantom FDI,” or that which appears solely intended to avoid taxes, has risen steadily over the past decade, leading to large FDI stocks in small counties that keep tax revenue out of actual home counties that need to supply services to the companies and their real employees.

Cultural, economic, and political ties between the United States and its European friends are undoubtedly strong. As a result, it could be expected that US-based companies would have significant integration with European entities. However, the current distribution of the United States’s FDI stock strongly hints at other reasons for the heavy “investment” in certain nations. The nations with the largest stock of US FDI are the Netherlands, with $883B in American investments, Luxemburg with $714B, and Ireland with $442B. The stock of US FDI in these nations constitutes a third of all US foreign direct investment. These amounts translate to US companies having investments equivalent to $51,700 per Dutch citizen, $92,400 per Irish citizen, and an amazing $1.2M per citizen of Luxembourg. By way of comparison, Canada and Mexico, with whom the US has its most comprehensive trade deal and integrated supply chains (and thus *real* investment), hold $401B and $115B of FDI stock respectively, or the equivalent of $10,850 per Canadian and $889 per citizen of Mexico.

So why these random nations that only comprise 4.4% of the EU’s total population? Sure, they have well-respected business and legal cultures that ensure property rights will be honored and global integration can continue virtually unfettered; but Germany, Australia, and dozens of other nations have equal systems. Yes, these nations’ populations are well-educated, thus ensuring a constant stream of capable employees; but so are the populations of France, Japan, and several other countries. There is one thing that sets these countries apart from their competitors in the global arena: taxes. The Netherlands, Luxembourg, and Ireland established hyper-competitive tax regimes intended to lure in companies, and it has worked. While their actual corporate tax rates are nothing special (except for Ireland’s 12.5%), the carve outs and exemptions for corporate revenue, depending upon its source and ultimate destination, make it almost mandatory for corporations to operate through entities in these nations. The most famous arrangement is called a “Double Irish with a Dutch Sandwich,” sending profits between affiliated entities in Ireland, the Netherlands, and Caribbean jurisdictions to achieve tax rate below Ireland’s 12.5% and sometimes as low as 0%.

The three largest European FDI destinations house more than 50% of global FDI, and ten economies around the world, none with a population larger than the Netherlands’s 17 million, hold 85% of the world’s stock of FDI. In some instances, a company’s “office” is a mailbox with no employees, such as Apple’ employee-less Ireland office. But in several instances, US FDI generates real economic activity. According to the American Chamber of the Netherlands, US companies employ 4.6% of the Dutch workforce and add 8.8% of the added value in the Dutch economy. Additionally, even if the companies themselves do not hire local employees, they engage service providers such as accountants, lawyers, and asset managers to ensure compliance with local laws. Nearly 87% of the GDP of Luxembourg is created by service providers (compared to 69% of German GDP and 80% of US GDP).

Taking advantage of beneficial tax treatment is nothing new, and companies in competitive industries often need every tenth of a percent of retained revenue to remain competitive. Additionally, high-tax jurisdictions need to wise up and realize that they are not entitled to growing levels of tax revenue in perpetuity. However, a disconnect occurs when governments need to provide services to the companies and their real employees, but the tax revenue required to do so is being routed through a tax haven across the ocean. For all of the benefits of globalization, this is one issue that has yet to be solved. G20 governments need to coordinate to close the most egregious loopholes and avoid a race to the bottom. This is not to suggest a “global minimum tax” or anything limiting any nation’s sovereignty; but reasonable agreements (aided by good old-fashioned political pressure) can likely be achieved that retain corporate flexibility while injecting common sense into the global tax regime. It is a logical next step in the globalization process, with the ultimate benefits being greater political, social, and economic stability worldwide since the companies and workers will receive the services to which they are entitled based upon their economic contributions.

Macro Monday: Canada's Household Spending Addiction

Mon, 16 Sep 2019 05:00:00 GMT

Canada's high household debt to income ratio fueled by a red-hot real estate market could cause major headaches if the economy slows down.

Canada’s reputation for stability and prudence is well-earned. Its ability to provide social services (such as universal healthcare) while keeping the top tax rate 33% and debt to GDP steady under 90% makes it the envy of western governments. But there is a time bomb waiting to explode during the next financial downturn, and it has nothing to do with government spending. Canada faces a financial meltdown due to its spending habits, namely its households’ addiction to cheap credit, which has the potential to grind the economy to a halt and harm it more intensely than would be expected in less indebted nations.

By all measures, Canada’s economy is strong. It is growing slowly, but steadily, fueled in large part to a red-hot housing market caused by low interest rates. In 2016 and 2017, the Canadian real estate market experienced unprecedented growth, registering annual price gains of 10.6% and 11.6%. In real terms (growth minus inflation), this amounted to annual growth of 8.6% and 9.8%. The government feared a bubble was forming and made borrowing more difficult while also implementing other policies to discourage real estate speculation in cities experiencing housing shortages. The policies appear to have worked, and the real rate of growth for Canadian housing turned negative in 2018.

This type of correction occurs often in developed economies, as consumers and investors slow down purchases as prices rise. However, low mortgage rates have allowed Canadians to purchase more home that they otherwise could, high rates of growth have encouraged them to view homes as high yield investments, and an optimism that the real estate sector will help the economy to continue to grow has caused Canadians to continue to consume, fueling even more growth. However, much of this consumption is on credit, and the levels of debt are starting to set off alarm bells among economists and government officials.

For every $1.00 of income, the average Canadian owes $1.74. This is up from $1.48 in 2009, with the sharpest rise occurring during the 2016 housing boom. This ratio compares unfavorably to the United States’s 87%, the Euro Zone’s 93%, and the UK’s 133%. Each month, Canadians spend 14.93% of their disposable income making payments on debt, while the average American only spends 9.91% and the average German only 6.0%.

Of course, all of this could be of little to no importance. Canadians could maintain or decrease this debt level through economic growth and real estate appreciation. However, if the economy were to slow down, unemployment rise, and homeowners become underwater on their mortgages, the high amounts of household debt would likely amplify the effects of a slowdown. This would cause a feedback loop as more real estate would go onto the market (either by buyers with too much debt or through foreclosures) which would lower prices even more, causing more debtors to slide underwater. The result would be a quicker and deeper recession than would otherwise occur in an economy with healthier levels of household debt.

The Canadian government has been a reliable economic steward that usually implements rational policies to maintain economic peace and relative prosperity, and it very well may do so here. However, household debt levels are historically high, and it may be too late to control them without harming the consumption that is driving growth in the Canadian economy. When the next economic downturn arrives (and it is always “when,” not “if”), Canadian real estate prices and debtors’ consumption patterns should demonstrate relatively quickly whether Canada will be harder hit than similar less indebted nations. If they are worse that anticipated earlier than anticipated, Canada’s well-earned reputation may be lost in an instant.

Little Lion Man: Why Boris?

183:773151858 (Kevin Rejent) — Fri, 13 Sep 2019 03:17:00 GMT

Prime Minister Boris Johnson. Think about that for a minute, then read how we reached this absurd point.

I promised myself I wouldn’t do it. I swore that I wouldn’t kill any digital trees or waste electricity to add to the cacophony of chatter. While I’ve danced around the issue by writing about Ireland, I have remained strong until now. But I am weak. Please forgive me. I am writing about Brexit. But not exactly about Brexit. If you want to read about the crazy politics, negotiating positions, impact, etc., this isn’t the place. Visit the BBC, the Financial Times, or literally any other website to read hot takes from the smartest commentators on the latest developments. No, I am going to take a longer view and ask why the UK has reached the absurd point of a Boris Johnson Premiership, and why Boris Johnson is doing the things he is doing.

“We are with Europe, but not of it.” – Winston Churchill

Originally written in 1930, Sir Churchill’s warm but self-excluding statement could have been written by numerous British leaders at any point since then. The UK probably should not have joined the EU, and certainly should not have joined when it did. And doubts about whether it belonged haunted the nation until it finally, and inevitably, voted to leave in 2016. While there are specific disagreements that highlight the conflict, the ethos driving the UK out of the EU existed long before the EEC passed its first law. Even as it begged for entry, the UK was never comfortable being an equal member and believed it had the right to retain the “Britishness” that stood up to Hitler and saved Europe from the menace of fascism. This strain of this self-confidence (or arrogance, depending upon your perspective) has run through British leaders since World War II, mutating with each generation and leading to Prime Minister Boris Johnson.

But where did the come from? And how has it mutated? The first fundamental truth that must be grasped when discussing Brexit is that the United Kingdom has been ruled for a thousand years by a Parliament in London. Parliament is sacred, and its actions are the nation’s constitution. The UK was eager to integrate economically with continental Europe; but had absolutely no interest in political integration that would limit the powers of Parliament. This reverence for the sovereignty of Parliament made the British weary and kept the UK from initially join the precursor to the EU. Instead, it looked inward to develop its own industry and markets. However, when the UK saw European Economic Community nations greatly outperforming it (including Italy…Italy!), it was concerned it was missing an opportunity.

Years of debates ensued, with prominent intellectuals arguing for and against further integration with the continent. The most prominent voice in opposition to the UK joining the EEC was Enoch Powell (of “River of Blood” speech fame), who argued that the UK was different from its continental brethren, British institutions were more advanced and capable than EEC committees, and the British would be “unwilling subjects” loyal to their Parliament instead of some new institution on the continent. Powell and his cohorts won the debate at that time, and established a theory of UK-European relations that has evolved since this time.

In 1972, while in the midst of an economic downturn and only a few years removed from a devaluation of the pound, the UK negotiated a treaty with the EEC and Parliament passed the European Communities Act, permitting the UK to finally join in 1973. British citizens reacted to this victory by promptly throwing the government out of office in exchange for a promise to renegotiate the deal on more beneficial terms and put the new deal to a nationwide referendum. The EEC renegotiated, and the vote passed by a healthy margin; but the UK’s tentativeness to accept a role as an equal member of the EEC was a harbinger of future events.

Under Margaret Thatcher, British weariness of further European integration deepened. By 1984, the UK was furious with what it perceived to be a lack of EEC investment in Britain, causing Lady Thatcher to demand a rebate. The EEC again capitulated and created special rules for the UK. The 1992 negotiation and ratification of the Maastricht Treaty further demonstrated that the UK had one foot on the continent while retaining the Parliamentary sovereignty that other EU nations had ceded. After all nations other than the UK and Denmark agreed to terms, the UK demanded special provisions, refusing the convert to the Euro and adopt EU-wide labor terms.

After Maastricht, European integration continued without UK buy-in, and the British population was fed a steady diet of perceived absurdities from Brussels, many written by Daily Telegraph Brussels correspondent Boris Johnson. By 2010, European integration was plowing ahead, and the British were understanding that their ability to demand special treatment had all but evaporated. Lashing out at the EU became a popular way to mask the decline of British self-confidence as it began to comprehend its diminished world standing.

The UKIP, led by the cartoonishly fiendish Nigel Farage, ran an entire campaign in 2014 telling half-truths about the EU and making outlandish promises about how great life would be outside of it. It won a startling number of elections, mainly stealing votes from the Conservatives. To solidify the right flank of his party and show that Brexit was lunacy when viewed in a rational light, David Cameron called for a referendum on the UK’s membership in the EU. The political elite populated the Remain camp, while the Leave camp was filled with populists and amateurs.

Boris Johnson wrote essays supporting both sides; but realized that if Remain won, he would be just another voice in the large crowd of politicians who supported the winning side. But if Leave were to somehow pull it out, he was a better politician and much more prominent than anyone on its side, so he would be on the fast track to No.10 Downing Street. Thus, Mr. Johnson filled the empty vessel of his political soul with the beliefs that gave him the best chance to gain the most power. In this case, these beliefs were modern, inelegant versions of Enoch Powell’s complaints about the British being “unwilling subjects” and boasts that the UK would be much more prosperous outside of the EU.

As was destined to happen eventually, the UK voted to leave the EU, and Boris Johnson was the de facto leader of the winning side. With the ability to lob bombs at Theresa May’s government, he savaged the exit deal she negotiated along jingoistic lines, arguing that the UK would be better with no deal than the one on the table. But then he became the dog that finally caught the car when Ms. May resigned and he was thrust into the Premiership. Certain that the EU would throw Ireland under the bus and completely caught off guard when it did not, he is now scrambling to get any concessions that he can sell as an improvement on the May agreement and move on from this catastrophe as quickly as possible.

"In a democracy people get the leaders they deserve." – Joseph de Maistre

So…why Boris? There is a very legitimate argument to be made that the UK should not be in the EU and never should have joined the EU. Parliament’s sovereignty is sacred, and the UK was never, and would never be, willing to trade its national identity for European harmony. That being said, the British recognize the tremendous economic benefits to membership. Lie upon lie needed to be told and appeals to “Britishness” needed to be amplified by ambitious politicians to squeak out a victory. Boris Johnson was the most prominent politician promoting the winning side, so by voting for Brexit, the British people were voting for him, or someone like him, to lead their nation.

“Your boldness stands alone among the wreck.” – Mumford and Sons, “Little Lion Man”

And…why, Boris? Boris Johnson is doing exactly what Boris Johnson could be expected to do. Rhetorically gifted, he can eloquently express his government’s objectives and lead people to believe all is going according to plan. But he has no friends in Europe. And the politicians left in the Tory party after his purge of “disloyal” MPs are second-rate, unable to effectively negotiate a “better” deal with Brussels. He is using his gift of gab to talk a big game, but is completely unable to back it up. And since he is a politician with the typical politician’s inclination towards self-preservation, he will use his abilities to either sell a deal with minor tweaks as an entirely new agreement or try to talk his way out of responsibility for a no deal Brexit. Regardless of whether Britain experiences the great pain of Brexit with an agreement or the catastrophe of no deal, the roots of the decision might reach back decades, but blame will lie solely on Mr. Johnson’s shoulders.

Macro Monday: Fitch Recognizes the Inevitability of Hong Kong Integration

183:773151858 (Kevin Rejent) — Tue, 10 Sep 2019 18:39:28 GMT

Protests have exposes cracks in "one nation/two systems."

The protests in Hong Kong are entering their fifth month, with escalating demands and more aggressive protestor tactics every week in a quest for political freedom, and the world is watching. It was only a matter of time before investors began questioning the impact of these protests on Hong Kong’s economy, both in the short term and regarding long-term structural problems exposed by the protests. With respect to short-term effects, Hong Kong’s stock market, the Hang Seng, has lagged behind other major markets. Then last week Fitch became the first ratings agency to question the “one nation, two systems” structure and argue that Hong Kong may not such deserve a large spread between its rating and that of mainland China, revealing uncertainty regarding the city’s long-term prospects. Many of the issues recently raised have always been present in the background; but the protests have forced economists and risk managers to examine Hong Kong’s future, and their finding raise doubts regarding the long-term competitiveness of the special administrative region.

When Great Britain and China agreed to the terms of the transition of Hong Kong in 1997, the nations agreed to the “one nation, two systems” structure that allowed Hong Kong to remain relatively free from Communist oversight. However, the agreement called for a complete integration of Hong Kong into China by 2047, thus implying that China would slowly alter Hong Kong’s institutions to allow for a smooth transition. Hong Kong also eschewed the yuan in favor of a stable peg between the Hong Kong dollar and the U.S. dollar to maintain investor confidence in the territory, using its incredible foreign reserves to defend the peg. It also maintained the structure of the Hong Kong Stock Exchange, the most trusted Asian exchange outside of the Tokyo Stock Exchange.

China had good reason to treat Hong Kong with kid gloves in 1997 since it represented 27% of all Chinese economic activity. However, as mainland China has risen in affluence, Hong Kong’s share of Chinese GDP has fallen to 2.9%. The Chinese Communist Party has thus seemingly accelerated the integration, with its control over Hong Kong government fueling the protests as residents are realizing that, even though they have universal suffrage, their leaders are essentially chosen by Beijing. Further, the Shanghai Exchange has moved past the Hong Kong exchange in participant market cap, and many of the best performing stocks in the Hong Kong exchange are mainland Chinese companies. Hong Kong’s leverage is fading.

In the past year and a half, the peg to the US dollar has come under pressure by currency traders who are not sure it is as strong as the territory would like investors to believe. Hong Kong was forced to spend approximately $20B of its foreign currency reserves to defend it in 2018, but steadily rebuilt its massive reserves in the first half of 2019. However, due to the uncertainly caused by protests and the Chinese response, Hong Kong had to expend almost $16B in August 2019 alone to keep the currency stable. Now this $16B came out of a pool of over $430B (enough to pay each of the 7.4 million residents of Hong Kong $58,486 cash if it wanted), and it has other monetary tools totaling over $1T, so there is no currency crisis coming anytime soon; but the fact that pressure caused the quick use of reserves is troubling.

More troubling, however, is the performance of the index measuring stocks on the Hong Kong Stock exchange, the Hang Seng. It is up only 3.27% on the year. In comparison, the S&P 500 is up 19%, the German DAX is 15.9% ahead, and the Hang Seng’s Asian counterpart, the Japanese Nikkei, has yielded a positive 6% year to date. While the trade war is having an impact throughout Asia, that does not explain the lackluster performance considering that the Nikkei has grown at twice the rate of the Hang Seng this year. Since the territory’s main sales pitch to the world is its free markets and competitive economic infrastructure, more dismal performance could drive money elsewhere and force more reliance on mainland China.

Fitch became the first ratings agency to signal concern, lowering Hong Kong’s Long-Term Foreign-Currency Issuer Default Rating (IDR) to 'AA' from 'AA+', with a negative outlook. Mainland China is A+ with a stable outlook. Given the political and economic integration already undertaken, Fitch simply could not justify keeping the issuers three ratings apart (now only the rating of AA- lies between the current ratings). Fitch also asserts that the protests and the government’s response have called into question the “quality and effectiveness of Hong Kong's governance system and rule of law, and have called into question the stability and dynamism of its business environment.” To be sure, Hong Kong will still have no problem borrowing money at low rates; but the analysis is damning.

The façade of “one nation, two systems” is cracking, and with a countdown to the date when it no longer even needs to exist, any rehabilitation is simply forestalling the inevitable. The protesters are valiantly challenging that inevitability and the free world is hoping they succeed; but Fitch’s downgrade is likely the first of many acknowledging the cold truth that integration is rolling downhill, and Hong Kong’s special status is fading fast.

Macro Monday: I Will Gladly Repay You Next Century for a Hamburger Today – The Appeal of the 100-Year Sovereign Bond

Tue, 03 Sep 2019 02:09:54 GMT

Century Bonds are delivering much needed yield to bond investors, but are they a long-term solution?

Growth and safety. Safety and growth. These are the two constants in investors’ lives. Chase the growth, give up the safety. Grab the safety, lose the growth. With returns in the equities markets providing plenty of growth but starting to show signs of trouble, investors are looking to hedge their bets with safe debt. However, they still want to get SOME growth from their safe investments, but with sovereign bonds trading near zero or at a negative rate, what’s a money manager to do? Enter the 100-year sovereign bond. This instrument provides the security of a sovereign bond with a positive interest rate. But how do these bonds work? Why would a country issue them? Why would anyone buy a bond that won’t mature for 100 years? And what happens if the nation issuing the bond doesn’t exist in 100 years?

Before discussing why any nation would issue and any investors would buy these particular bonds, let’s take a moment to discuss how bond investing works in general. An issuing entity (country, company, university, etc.) looking to raise revenue surveys the current landscape and tries to determine the lowest rate it can pay per year for a certain duration of time and still sell out of its bonds. For example, Indonesia might issue 10-year bonds at 7%, pay the bondholder 7% every year (called a coupon) as their return on the risk of tying up their money in the bonds, and then return the principal at the end of the 10 years. The goal is to outpace the interest rate (how much their money could get just sitting in a bank) by as much as possible within a certain risk threshold. Thus, as interest rates decrease, the value of bonds increases, and people are willing to pay more than their face value (par value). Conversely, interest rate increases causes bonds to lose value, since the bond pays what the bond pay. The amount the issuer pays on the coupons does not change once the bond is issued, only the amount a secondary buyer is willing to pay does.

Putting the puzzle together, 100-year bonds make some sense. As noted above, the purpose of bond investing is to provide security while also hopefully obtaining a return above the interest rate. With interest rates near or below zero, and the benchmark German bund issuing at a negative return, there isn’t much yield to be found. But if the country could hold the money longer, it could pay a higher rate in exchange for higher duration and political risk. That’s exactly what a handful of nations have done, issuing 100-year “Century Bonds” to take advantage of historically low interest rates and investors’ desire for any growth from bonds. Successful European issuances have been from Ireland (2.35% coupon in 2016), Belgium (2.3% in 2016), and recently, Austria, whose 2017 Century Bond paying 2.1% was so successful that it followed it up with a 98-year bond in 2019 that only pays 1.2%. Mexico has successfully issued Century Bonds in three currencies (dollars, pounds, and euros), most recently paying 4.5% on its euro-denominated bonds in 2015. What do countries do with the money raised through these bonds? Whatever they want; but most will replace shorter bond issuances or be used to pay down higher interest debt.

Of course, the higher rates reflect the duration and political risk investors incur through the bond. Argentina issued a Century Bond with a 7.125% coupon and, through technical quirks of bonds, a total annual yield of 7.9% in 2017. That one has reminded investors that there is a political risk downside to these bonds. The Argentine Century Bond is trading at around 54 cents on the dollar, indicating that investors are weary of coupons and the principal being repaid.

Right now, the pool of Century Bonds is limited for a few countries and private organizations. However, it is the dream of many national treasuries, including that of the United States, the push debt maturity as far into the future as possible. The time value of money will more than compensate for the slightly higher rates that must be paid. Inflation would cause $1000 invested in 1918 to balloon to $16,907, but payments on a 3% coupon would only be $3,000, resulting in a windfall to the government of over $13,000 in present value money. Alternatively, even if the 30-year treasury paid 3% (it is currently at 1.97%), inflation over the past 30 years would cause the value of the $1000 to increase to $2,142, but interest payments of $1,200 would mean the issuer would only profit $942. This is why these bonds are so attractive to governments.

Given the duration and political risk, even with the returns higher than shorter bonds, the pool of purchasers would appear limited. No grandmothers are buying these so their grandchildren can collect $1000 on their 100th birthday. Instead, large companies with long-term liabilities such as insurance companies and pension managers use these bonds to provide guaranteed returns to cover guaranteed obligations. In fact, the Irish Century Bond issuance was a private placement with an insurance company. Ireland received €100m from the company and now pays €2.35m to that company every year until 2116, when it will pay back the €100m principal.

So will we see more Century Bonds being offered, and are they worth the risk? Right now, the market craves these positive payments in low interest rate times; but are we in a new economic reality with interest rates remaining low enough for a large enough portion of the next century to justify them? Are we confident that we can pull the right economic levers to avoid crises? What happens if the nation issuing the bond ceases to exist? Austria was officially 101 years old when it issued its 2017 Century Bond, and you could say that the previous century had its up and downs. While the Ottoman Empire is not at their doorstep and Germany poses no threat, history has a way happening. If the UK issued 100-year bonds in 1915, nobody would have anticipated it losing approximately 95% of its landmass in the ensuing century. There is a bias towards viewing the way things are as the way they always will be, notwithstanding all evidence to the contrary. Regardless of their long-term merits, so long as buyers need to lock in guaranteed returns to offset guaranteed liabilities, these products offer a nice option. But if you’re looking for that perfect gift for a newborn, a onesie and blanket set is probably a better choice.

Ireland's Brexit Opportunities

183:773151858 (Kevin Rejent) — Thu, 29 Aug 2019 12:47:02 GMT

The United Kingdom's hard departure from the European Union will certainly bring challenges, but Ireland is well prepared to endure the initial shock and thrive.

When the United Kingdom voted to leave the European Union, no nation was put more on edge than Ireland, which shares a landmass, has a complicated history, and engages in extensive trade with the UK. However, almost everyone assumed sane policies would prevail and an orderly departure would allow trade and cross-border relations to continue. But with the UK now intent on going full-Boris and crashing out on October 31 without a deal, EU nations need to deal with the impossible: a UK government that just doesn’t seem to care about the negative ramifications of a hard Brexit. And while everyone is focused on these ramifications on the UK and EU nations, especially Ireland, we would like to take a moment to highlight the opportunities that await Ireland if it can weather the initial Brexit storm.

Let’s get this out of the way early: Brexit is going to sting. It will sting the UK the hardest, all EU nations in some way, and Ireland the most of any EU nation. 12% of all Irish exports are destined for the UK (including 40% of agriculture exports) and the supply chains of Ireland and Britain are intricately intertwined, especially along the border between the Republic of Ireland and Northern Ireland. Even with an orderly Brexit agreement, there would be some short to medium term pain for Ireland as it adjusts to the new reality of an EU without the UK, leading to an estimated 1.2% loss in Irish economic growth by 2021. And with the UK playing chicken with the EU regarding the border and customs backstop, Ireland will be hit harder than anyone was planning even three months ago.

However, a more long-term perspective provides the Irish with reasons for optimism. First, Brexit leaves Ireland as the largest remaining English-speaking EU member, which is enticing to European businesses that use English as the primary corporate language of communication. Second, UK businesses that rely upon single-market access will only need to move across the Irish Sea, or even more easily, a few kilometers south into the Republic from Northern Ireland, to retain that access. Finally, Ireland’s tax rates will remain the lowest in the EU, and UK businesses that were previously disincentivized to jump between EU nations will have no such constraints post-Brexit.

In addition to these advantages, Ireland’s response to the economic crash of 2008 has provided it with more arrows in its quiver to fight the hardships that are likely to come. The first is a strong banking system that can be mobilized to inject liquidity into the economy. The Irish government purchased most of the shares of the two largest banks, Allied Irish Bank and Bank of Ireland, after the 2008 crisis. While they changed management and imposed some restrictions, they have, for the most part, allowed the banks to operate independent of government control. The government is, in turn, strategically selling its shares of the banks to pay down its debt. Since banks have been very prudent while the economy has boomed and their liquidity has improved, they have money to invest. Some say there is more capital than there are good projects in which to invest. Since the government owns a majority of the shares in the banks, the banks are politically attuned enough not to let too much capital leave the country, and will likely know (or be told) when it is politically smart to finance more projects than they have thus far.

Additionally, through austerity and the prudent sale of bank shares, Ireland has lowered its debt to GDP ratio from 119% in 2010 to 64.8% in 2018 with a goal of lowering it to 45% by 2021. While this seems impressive, it must be noted that Ireland’s pre-financial crisis debt to GDP ratio was 23.9%. The current Finance Minister, Paschal Donohoe, has stated that paying down the debt is a priority of the Irish government, possibly higher than spending additional money on social programs. This disciplined management has lowered Ireland’s cost of borrowing (through a 10-year bond) from 1.73% in 2014 to -0.09% now. Thus, Ireland can take on additional debt (although it does not want to) at a reasonable rate to cope with the fallout of a hard Brexit.

Finally, the aftermath of the Celtic Tiger crash has once again reminded the Irish that they can fight and they can win. The Irish people know sacrifice. They have had their land taken, their leaders killed, their crops sold abroad during famine, their land essentially ruined by absentee landowners, their population halved by starvation and emigration, their culture suppressed, and their beloved religion declared illegal. They then fought a war of independence only to have the other nation keep a chunk of the island, lived through a Civil War, and have experienced more economic turmoil than most of their European brethren. Yet here they are, living in one of the most prosperous nations on Earth, watching as organizations from around the globe race to their island for the opportunity to employ the educated workforce they have willed themselves to become. And now the UK is negotiating Brexit under the assumption that the EU will sell out Ireland because it’s Ireland? This is a challenge the Irish will rise to.

There are great opportunities for Ireland in Brexit: to deepen ties with continental Europe, to diversify trade, and to compete and win against the British in business attraction and retention. Brexit will bite the Irish economy, but the Irish have shown that it would be fooling to predict that they will do anything other than endure the suffering and bite back.

Macro Monday: Go Ahead and Cry for Argentina...and Uruguay, and Paraguay. But Not Brazil.

183:773151858 (Kevin Rejent) — Mon, 26 Aug 2019 01:46:10 GMT

Brazil's response to the fires raging in its rainforests is putting the Mercosur-EU trade deal at risk, and potentially harming its innocent neighbors.

In late June, free traders everywhere were celebrating as the European Union and Mercosur, a collection of South American nations consisting of Brazil, Argentina, Uruguay, and Paraguay (and Venezuela; but they are suspended) agreed to a landmark trade deal. With the WTO’s 2001 Doha Round negotiations entering adulthood with no agreement in sight, multilateral deals scrapped by free trade skeptics, and unilateral agreements the norm, an agreement between large trading blocs was a breath of fresh air. Now that air is filled with smoke. Brazil’s rainforest fires are imperiling the deal, and innocent South American countries risk losing out because their neighbor doesn’t appear to care about the environmental disaster occurring within its borders.

Currently, the EU and Mercosur nations engage in approximately $120 billion in trade, with each importing about half that amount from the other. However, both sides impose challenging tariffs on most items and quality control restrictions on imports, especially Mercosur agriculture products going to the EU and EU machinery headed to South America. This deal reduces tariffs and allows for importation of the all members’ key exports. Under the current export makeup of trade between the blocs, this deal would save consumers and producers and estimated $8 billion in tariffs (and this does not include the increase in trade that results from such deals). While this number may seem modest in our world of cartoonishly large macroeconomic statistics, just imagine what an extra few hundred million could do in the $68 billion Paraguayan economy.

Then the Brazilian rainforests caught on fire. Forest fires have increased 87% over last year, with critics of Brazilian President Jair Bolsonaro blaming his policies for encouraging farmers to burn sections of forest to increase farmland. Mr. Bolsonaro has countered that environmentalists attempting to embarrass him have set fires and other nations should stay out of Brazil’s internal affairs. When the head of the Brazilian department charged with tracking Amazon deforestation presented satellite images revealing the alarming scope of the fires, Mr. Bolsonaro fired him.

European response to Brazil’s apparent disregard for its environmental disaster has placed implementation of the trade agreement in peril. Ireland Prime Minster Leo Varadkar has vowed to block the agreement unless Brazil takes action to protect the rainforest. France’s Emmanuel Macron stated Mr. Bolsonaro lied to him about Brazil’s environmental commitment, and he too will block the agreement until he is satisfied that Brazil is committed to protecting its forests.

Meanwhile, Argentina, Uruguay, and Paraguay are imagining billions of dollars’ worth of economic activity disappearing as they are caught in the crossfire between European leaders needing to “do something” about an environmental disaster to appeal to their political bases and a Brazilian president intent on promoting increased economic activity through less stringent environmental restrictions to satisfy his campaign promises. These nations have much to gain and little to lose in the trade deal, and watching their belligerent neighbor screw it up for them is excruciating. Brazilians have nobody to blame but themselves, and the neighbors hope that the business interests that helped elect Mr. Bolsonaro impress upon him the need complete this deal.

Argentina, poor Argentina, NEEDS any economic shot it can get. Cleaning up the mess left by the economic disaster that was twelve years of rule by Nestor and Christina Kirchner, President Mauricio Macri has been trying to walk the razor thin line between undertaking economic reforms necessary to stabilize the Argentine economy while also satisfying a populace that has grown accustomed to expensive political giveaways. Trade relations were heavily frayed by the protectionist Kirchners; but Macri has done an admirable job of growing international relationships, including developing a healthy $20 billion annual trade relationship with the EU. An agreement that allows Argentina to sell more agricultural products in the EU and lowers tariffs on the machinery it imports from the EU to improve agricultural efficiency is exactly what the country needs. But now Macri sees Ms. Kirchner as the VP candidate of his primary rival, a decline in the value of the Peso, and now the unraveling of this trade agreement, and he has to be wondering if he can ever catch a break. Hopefully Macri can convince his fellow pro-business President in Brazil to bite his tongue and see this agreement to fruition.

Conversely, Uruguay is doing relatively well. It has South America’s second highest GDP per capita (behind Chile) and healthy trade relationships. However, its economy is heavily dependent upon its neighbors Argentina and Brazil, and economic growth is forecasted to slow this year. Decreasing tariffs on the $3.5 billion of trade with the EU and creating opportunities to grow this amount would be a real boost for its industries, especially wood pulp and beef.

The smallest economy in Mercosur, Paraguay, has the most to gain from the EU agreement. With the third-lowest per capita income in South America and an economy heavily reliant on agriculture, reducing EU barriers to Mercosur agricultural imports could be a godsend. The agreement has some provisions that heavily favor Paraguay, such as duty-free importation of 7% of Paraguay’s sugar crop and an outsized share of duty-free meat to the EU. Increasing the $2 billion in EU trade has a real potential to transform the Paraguayan economy if Brazil can be convinced to take the necessary actions to push the agreement to completion.

Jair Bolsonaro is caught between domestic realities and international demands. Unless it is more economically beneficial to bow to international pressure than internal forces, domestic politics will always win. Prime Ministers Varadkar and Macron are attempting to apply that pressure. More impactful, however, will be the pressure from fellow Mercosur leaders pointing out to Mr. Bolsonaro that Brazil gains more in the long run from the EU agreement both through a direct increase in trade and the indirect benefit of increased trade with wealthier neighbors than it will from a few farms planted in the Amazon. Unless they can sell him on this vision of a more prosperous region, the world’s latest hope for free trade may just go up in smoke.

Salvini's Circus: The Latest Italian Political Mess

183:773151858 (Kevin Rejent) — Wed, 21 Aug 2019 03:27:53 GMT

The wannabe Prime Minister has pulled the plug on an awkward coalition and likely forced early elections.

Anyone who knows me knows that Italy holds a very special place in my heart. Heck, the company’s name is pays homage to the main piazza in Bologna, the first picture on the website is the statute of Neptune that adorns that piazza, and the logo hides the city’s Due Torre. My family’s time living there will always be remembered as among our happiest. We reminisce daily about the food, the history, the food, the arts, the food, the peaceful pace of life, and the food. That being said, its politics are insane.

The latest reminder that Italian politics are not normal comes courtesy of Matteo Salvini, leader of the Lega (League) party. The northern Italy-dominated conservative/populist Lega was the junior member of a coalition government it formed with the southern Italy-dominated liberal-ish/populist Cinque Stella (5 Star) after the March 2018 elections, but is now polling much higher than any other party, including Cinque Stella. Salvini no longer wanted be in a coalition with Cinque Stella, thus orchestrated a vote of no confidence in the current government, causing Prime Minister Giuseppe Conte to resign rather than face the vote.

Salvini had a choice of when to pull this stunt. Fall is Italian budget season, with ample opportunities to pick fights with Cinque Stella and then declare the coalition over after the budget passes, leading to a spring 2020 election. Or he could strike while his party is at its highest ever polling before it is sullied by the nasty budget process. Salvini has chosen the latter. Thus, there might be the first fall election in Italy since World War II. While the timing of the election would be unusual, the fact that an Italian government is collapsing would not be. Italy has had 67 governments since World War II, and while the trend is getting longer, the amount of turnover is head spinning.

So what’s next? I’ll spare you the machinations of Italian government except to say that President Sergio Matterella can either see if a new majority coalition can be formed without elections, appoint a caretaker government to create a budget, or call for immediate elections. In theory, elections could be held off until 2023; but will almost certainly occur before the middle of 2020.

Will fresh elections bring some stability to the peninsula? Probably not. Most likely, a combination of the Lega and the not so “borderline” fascist Fratelli d’Italia (Brothers of Italy) will combine for the 40% they need to form a government. If they are short, they may entice Silvio Berlusconi’s declining center-right Forza Italia party to join them, but will avoid that if possible. On the flip side, Cinque Stella could align with former Prime Minister Matteo Renzi’s Democratic Party. However, the Democratic Party is locked in a Pro-Renzi, Anti-Renzi squabble, and he was one of the main punching bags for Cinque Stella during the last election, so cobbling together a coalition without the Renzi faction of the Democratic Party would be challenging.

The deeper question is why Italy is experiencing this turmoil. Why have Italians abandoned the traditional center-right and center left parties in exchange for bands of charlatans with piecemeal agendas designed solely to pick at grievances? In the recent past, Italians had two primary choices: lower taxes and less regulation or higher taxes and more social services. Neither satisfied all; but like most political systems, compromise occurred and reasonable policies were implemented. Then along come fresh faces telling the people they can have it all without making any difficult decisions: lower taxes and no more expensive migrants (Lega), a guaranteed income (Cinque Stella), and escape from EU restraints (both). They promise conflicting supply-side and Keynesian remedies to jumpstart an Italian economy thwarted by meddlesome external constraints and internal villains (former governments.) And if it doesn’t work? Those forces fighting the Italian people must be stronger than imagined, and the nation needs to double-down on nationalism to fight the enemies of the people, in whatever form they may take. Italy is certainly not alone in this pattern, but is one of the clearest examples.

Can Italy break the pattern and return to responsible government? Sure. Will it? Probably not this time. Things aren’t great economically, but they’re not terrible. The current government is still fresh enough that Lega can still claim that any problems are everyone’s fault but theirs, and pin recent difficulties on Cinque Stella. They might then blow off European budget rules and disregard migrant agreements, leading to more conflict with Brussels, and give them a chance to again blame outsiders for Italy’s travails. Wash. Rinse. Repeat. But eventually the problems will lie clearly at Lega’s feet, and Italians will dig themselves out of the ditch they’re currently digging by making hard political choices again because there will be no other option. Until then, just try to ignore the politics and enjoy the food.

Macro Monday: No China Isn't Manipulating Its Currency (Anymore)

183:773151858 (Kevin Rejent) — Mon, 19 Aug 2019 02:02:12 GMT

The Trump Administration's labeling of China as a currency manipulator misses the mark.

China isn’t manipulating its currency anymore, and that’s the US’s complaint. Of course, President Trump and the Treasury Department won’t admit this is the problem; but Monetary Theory 101 belies the howls from Washington about the currency scheming of Beijing. Instead, the administration’s labeling of China as a currency manipulator is a transparent and toothless ploy attempting to advance American interests in the trade war which, like a five-year old threatening not to play with a classmate, is not taken seriously by anyone.

First, there is a major threshold to cross: what the heck is “currency manipulation” anyway? There are major currencies, “haven” currencies, that are trusted by investors to retain their value and fairly trade against other currencies. The U.S. dollar is far and away the most common haven currency, but the Euro, Japanese Yen, and Swiss Franc are also considered by most to be havens. Central banks of nations with currencies other than these will purchase large amounts of liabilities issued in these currencies (usually government bonds) for two reasons:

1. As a sort of insurance policy to ensure stability if some form of economic shock (inflation, stock market crash, etc.) befalls their economy. Even haven economies’ central banks will buy large amounts of other currency to diversify holdings (Japan holds $1.2 trillion in foreign reserves, Switzerland $800 billion, and the U.S. holds $42 billion).

2. To maintain a “peg” between their currency and a haven currency (usually the dollar.) Counties like their currency to have a fixed value against the dollar because it provides certainty to importers and exporters, and allows for easier domestic commerce.

But as witnessed regularly around the world, economic events can cause currency to fluctuate in value. Can a country just *say* that its currency has a certain value? Well, it can until it can’t. Nations use supply and demand of their currency to manage its value. If their currency is experiencing pressure to devalue and rise to an exchange rate above the peg (say from 15 pesos/$1 to 18 pesos/$1) thus making imports priced in dollars too expensive, the central bank will BUY its currency with dollars. This will decrease the amount of their currency in circulation, which will hopefully increase the demand. If its currency gets too strong (say 15 pesos/$1 to 10 pesos/$1) thus making exports in local currency too expensive, the central bank will SELL its currency and buy dollars. This will hopefully lessen demand for their currency and cause the exchange rate to fall to the level the government has targeted.

Of course, this requires the country to have foreign currency to sell if it is attempting to defend its own currency. Banks, investors, and other nations closely monitor foreign currency reserves to verify the stability of a nation’s economy and currency. If a country’s reported reserves are decreasing every month while its currency is also losing value, the country is in economic trouble and a candidate for currency devaluation, which will likely result in a series of unfortunate events for both the country and its leaders. Thus, if a country can buy haven currencies in good economic times to spend in tough times, it should.

Keeping this background in mind, let’s turn to China and the claim that it manipulates its currency. From 1994 through 2005, China pegged the value of its currency, the yuan, at ¥8.28/$1. To maintain this peg, it undertook an aggressive program of purchasing liabilities issued in U.S. dollars (usually Treasury bonds). This declared exchange rate was probably too weak because as soon as the peg was removed and the yuan was allowed to “float” (trade without strict government mandates of value), it began to strengthen to around ¥7/$1. You might be saying, “That’s great! Their economy must be pretty healthy for investors have such confidence in their currency.” And you would be correct, except that China, at the time, did not want their currency to be stronger because a stronger exchange rate would make Chinese exports more expensive, and China needed to export A LOT to keep growing. Thus, it embarks on an even more aggressive program of buying dollars and selling yuan in an effort to keep exports cheap as the chart at the bottom of this post demonstrates.

China argued that, as the world’s most populous country and a growing economy, it needed large foreign currency reserves as insurance; but it was clear that it was desperately buying dollars to keep its exports cheap. And it worked. The yuan stayed between ¥6/$1 and ¥6.5/$1, which was likely where the Chinese government saw the best trade off of export pricing and import purchasing power for well-off Chinese. Although it was never labeled a manipulator due to political and trade reasons, China’s action between approximately 2002 and 2014 will be featured in monetary policy textbooks discussing currency manipulation for the next century.

Then something strange happened in 2014. China began to *sell* its dollars. Why? Based upon various domestic and international forces, the yuan started to weaken, and that raised the cost of imports for the growing Chinese middle class. Thus, the central bank needed a buy yuan to create demand for the currency and keep the exchange rate in the desired range. Between June 2014 and January 2017, the People’s Bank of China spent 25% of its foreign currency reserves, $1 trillion, buying yuan to keep it strong. Since 2017, China’s foreign reserves have fluctuated by percentages that don’t raise eyebrows; but it has shown that it is willing to sell its reserves to keep the yuan stronger than market forces would dictate.

Funny thing is, though, when your main trading partner declares a trade war against you, you probably aren’t going to be apt to spend your money to increase the cost of your exports everywhere in the world while decreasing the cost of their imports into your country. So for a brief moment, China got out of the currency support game and allowed the yuan to trade freely (or at least more freely than normal) against other currencies. Since the Chinese economy is experiencing pain as a result of the trade war, and since it was beginning to cool off regardless of the trade war, investors are not bullish on the yuan, and its value slipped above ¥7 per $1. While this has implications for the Chinese market, more importantly, it effects the value of currencies of Asian countries on which the Trump Administration has not (yet) imposed tariffs, which means imports from these countries to the U.S. will be cheaper. As soon as the value of the yuan cracked ¥7 per $1, the U.S. government labeled China a currency manipulator. Thus, by failing to manipulate the market to keep its currency below an acceptable threshold and letting free market capitalism determine the value if its currency, China was awarded the label “currency manipulator.”

So what does this designation mean? Not a heck of a lot. Under U.S. law, the Department of the Treasury must now “consult” with China, and if that is unsuccessful, the International Monetary Fund. China will not be adjusting any policies to make the U.S. happy anytime soon, and the IMF has recently given China’s currency practices a bill of good health (as did Treasury itself in May 2019.) Thus, “currency manipulation” serves only to whip voters into a frenzy…a sort of monetary boogeyman (or strawman) to justify the continued trade war. The problem is, though, that there are *plenty* of legitimate complaints about Chinese practices (intellectual property theft, support for state-owned enterprises, and environmental concerns just to name a few), and trumped up currency manipulation charges distract from them, detract from the overall message the administration is trying to send, and provide the Chinese government with talking points calling into doubt the legitimacy of the U.S. position on this and every other issue. Trade wars are not easy to win, and dang near impossible when you water down your credibility with claims that nobody cares about or believes.

The National Association of REALTORS International Investment Report - The Sky is Not Falling

Mon, 19 Aug 2019 01:08:47 GMT

The large decline in inbound real estate investment is alarming, but there are global and country-specific reasons for the decline.

The National Association of REALTORS® has released their annual Profile of International Transactions in U.S. Residential Real Estate , and the numbers appear grim. Very grim. International investment in U.S. residential real estate is down 36% from 2017-2018, and a whopping 49% from the all-time record set in 2016-2017. Every single nation in the top 5 nations (China, Canada, India, UK, and Mexico) invested less than last year. It is clearly time to panic, right?

Probably not. While such a large decline is not great news, the health of the U.S. real estate market and global economic conditions are contributing to the decline, as are factors specific to each nation. Each of the issues leading to the decline provides some cause for concern and collectively form the perfect storm for foreign investment in U.S. real estate this past year; but there is no reason to panic, and every reason to believe that residential properties in the U.S. will continue to sell, either to domestic or foreign buyers.

The National Association of REALTORS® reports that foreign buyers purchased $77.9 billion worth of properties in the United States between April 2018 and March 2019. This is a 36% decline from the $121 billion in sales the previous year, and a 49% decline from April 2016-March 2017 figures. The top 5 nations account for 44% of purchases, continuing a gradual decline that saw them account for 49% last year after making up 79% of foreign purchasers in the first survey in 2010. The 183,000 total properties purchased by foreign buyers sound like quite a bit; but they only comprise 3% of all purchases (they also account for 5% of all sales since foreign buyers purchase slightly more expensive homes than the average domestic purchaser.) The upshot of the report is that there is a more geographically diverse batch of foreigners buying fewer homes than previous years for more per home than domestic buyers.

But WHY are there fewer foreign buyers? Aren’t we in a globalized economy where the best and brightest are attracted to the nation with the most lucrative opportunities? Yes; but we are still in an economy with all of its starts and stops. Economic growth has slowed globally, with China slowing from 6.9% to 6.4%, and Latin America, Canada, and Europe all growing at a rate below 2%. We also still live in a political world where leaders’ actions influence investment decisions. President Donald Trump’s trade wars have cooled foreign direct investment inflow into the United States from $420 billion in 2015 to $297 billion in 2018. Foreign companies are unwilling to expand in the uncertain environment, and thus they will not be sending their employees who would need homes to the United States. Additionally, the U.S. housing supply has remained tight at 4.2 months, which nudged prices upwards and, when combined with the strengthening of the dollar, makes homes a little less affordable for foreign buyers.

The country whose citizens invest the most in United States residential real estate is also the most interesting because it invested less than half what it did last year and still remained number one. Chinese purchases of $13.4 billion are 56% less than the $30.4 billion invested last year; but are still enough to remain the largest investor in U.S. real estate by over $5 billion. How could Chinese investment drop so precipitously in only one year? In addition to the cooling Chinese economy and strengthening dollar, a few other factors are decreasing Chinese participation. First and most obviously, as mentioned above, the trade war between the countries dampens expansion plans going both directions and lessens the need for Chinese workers to either establish their companies’ operations in the U.S. or come to the U.S. to learn their new American employers’ operations before taking the knowledge back to China. Second, to cope with a weakening economy and currency, China implemented more stringent capital controls that made moving money to buy a home extremely difficult. Third, China’s big foreign policy and business strategy is their Belt and Road Initiative which seeks to build a network of roads and ports between China and Europe and Africa to more efficiently transport goods. It makes sense that potential Chinese buyers of U.S. properties might now buy an apartment in Venice instead of a penthouse in San Francisco since future business is much more certain. Finally, China’s domestic real estate market is slowing down, lowering prices and providing better investment opportunities than the previous few years without the hassle of navigating capital controls.

Canada remained the second-largest aggregate investor in U.S. residential real estate, purchasing $8.0 billion worth of property, down 24% from the $10.5 billion purchased last year and $19.0 billion purchased in 2017. The biggest culprit here is probably Canada’s weak dollar. The NAR report indicates that a purchase cost a Canadian 6% more this year than last. Another factor keeping Canadians out of the U.S. market are better opportunities in their own market. Canadian real estate has been scorching hot the past decade with many foreign investors racing in to snatch up properties in the cities and resort towns. However, to avoid a popping bubble, several cities have imposed a tax on foreigners purchasing property to keep speculators out. This has had the desired impact thus far as prices are growing at a slower rate and foreign buyers are not buying in the same numbers. With less foreign competition, Canadian buyers can get better deals without the concern of the unfavorable exchange rate that comes with purchasing in the U.S. Finally, as with China, trade concerns have likely hampered cross-border moves until more certainty can be achieved.

The third largest country of investment, India, is unique in that the amount invested by Indian purchasers has remained relatively consistent since the survey began in 2010. There have been a few high and low outliers, but 2019’s $6.9 billion is only 4% lower than last year’s $7.2 billion with the number of homes purchased actually increasing despite a property costing 13% more for Indian buyers than last year as a result of the Rupee losing ground versus the dollar. This consistency indicates that the United States is still a destination of choice for Indian workers and investors.

Citizens of the United Kingdom invested the fourth most in the U.S. real estate market; but decreased the amount invested by 48% from $7.3 billion to $3.8 billion. Of course, Brexit dominates all discussion of UK economics, including here. It has driven the Pound down from a range of $1.49/₤1-$1.39/₤1 in the year before the Brexit vote to a range of $1.42/₤1-$1.24/₤1 in the past year. Additionally, foreign direct investment in the UK has plummeted. The most recent report of Parliament covers the years 2016 and 2017 and states that FDI going into the UK dropped from ₤192.0 billion in 2016 to ₤92.4 in 2017. As with a decrease in trade, this decrease in FDI means that fewer companies are sending employees to the UK and pulling employees from the UK. Finally, it is probable that those with the means to purchase property abroad in anticipation of Brexit have already done so. UK purchases in the U.S. rose from $5.5 billion in 2016 to $9.6 billion in 2017, the year after the Brexit vote. They remained historically high at $7.3 billion in 2018 before being cut almost in half this year. Thus, the evidence indicates that those who were considering a purchase around the time of the Brexit vote may have accelerated their timelines and purchased earlier than planned.

Finally, Mexican buyers decreased their U.S. purchases by 45% but remained the fifth largest aggregate investor in U.S. property. The $2.3 billion spent is less than a quarter of the $9.6 billion worth of purchases in 2017. The biggest cause is likely the weak peso, with a home in the U.S. costing Mexican purchasers 9% more than last year. Mexico also suffers from trade uncertainty, with companies waiting for finalization of a new NAFTA deal before committing to expansion. Regardless of the reason for the decrease, geography dictates that Mexican and American buyers will consistently purchase in each other’s nations when the markets are right, so it is safe to assume Mexican purchases will increase in due time.

The National Association of REALTORS® report does not indicate the death of U.S. property as a popular investment for foreigners, nor does it signal some gathering storm preparing to devastate the market. Properties are selling. Prices are increasing. The nationalities of the purchasers do not matter one bit. It is troubling that all of the factors discussed above aligned to create such a large decrease in purchases, and significant attention should be paid to determining which factors are structural and which are simply deviations from the norm. But the impact of a strong U.S. economy, real estate market, and dollar have magnified the effect of these foreign factors, and there is no reason to believe that foreign buyer won’t return in record numbers when market conditions are more favorable. So watch the skies but put away the umbrella. The sky is not falling on the U.S. residential real estate market.