The U.S. delegation consisted of Treasury secretary Steve Mnuchin, U.S. trade representative Robert E. Lighthizer, director of the National Economic Council Larry Kudlow, and White House trade director Peter Navarro. This delegation included every senior U.S. official with line responsibility for trade issues except Commerce secretary Wilbur Ross. The composition of the delegation was President Trump’s way of announcing the negotiations were of the utmost importance. Wits have compared this delegation to the bar scene in the original Star Wars film, where an eclectic group of characters speaking different languages mingle, and trouble is never far from the surface—an apt comparison.
Lighthizer is a trade war veteran with public service going back to the Reagan administration and over thirty years in the private practice of trade law, representing major corporate clients including U. S. Steel. Navarro is a trade hawk also, but from academia and without Lighthizer’s deal-making experience. Kudlow is well liked yet is seen as a free-trade cheerleader. Mnuchin has not shown any particular interest in trade issues, is more aligned with the globalist agenda, but does favor a cheap dollar, which is another way to improve the U.S. trade deficit. Officially, the delegation was led by Mnuchin because he has the highest Cabinet rank of those present. That said, there’s no doubt that Lighthizer was the most important official in the trade delegation.
In a closed-door meeting during an earlier visit to Beijing with high-level Chinese trade and political officials, Lighthizer leaned forward across the table, engaged with his counterpart, and unleashed a detailed chronology of Chinese cheating on trade issues.3 The trade deception litany recited by Lighthizer started in 1994, when China engaged in an overnight 33 percent maxi-devaluation of the yuan, taking it to 8.7 yuan to $1.00. That devaluation was a declaration of a currency war and trade war at the same time, since the cheap currency helped Chinese exports at the expense of its trading partners. Lighthizer went on to recite further instances of currency manipulation, theft of intellectual property, subsidies to state-owned enterprises, development of excess capacity in tradeable goods, dumping, ignoring environmental costs, forced labor, and willful violations of World Trade Organization, or WTO, rules over nearly a quarter century, from 1994 to 2017. When Lighthizer was done he paused, looked directly at the top Chinese delegate, and said, “You’ve been lying to us for twenty-five years. Why should we believe you now?”
The Chinese were shocked. They had never witnessed anything like Lighthizer’s bluntness, combined with his complete mastery of the facts. There was no more to say at the meeting, yet a message was delivered. The United States would no longer accept vague promises and delayed deadlines that never seemed to arrive. From now on, the United States would insist on substantial actions delivered in verifiable ways.
Upon learning of this trade tour de force, President Trump asked Lighthizer for the notes he used in describing the Chinese trade violations. Trump thought it would be useful in building his own stump speeches on the subject.
“Sir, I didn’t use notes,” replied Lighthizer.
“Okay,” said Trump, “I understand. Just give me your outline or bullet points, then.”
“Sir, I didn’t use bullet points,” Lighthizer informed the president.
Trump smiled and nodded. He realized that Lighthizer kept it all in his head, had lived through these trade issues for decades, and could repeat the litany of Chinese cheating anytime and without preparation. Trump liked that because he too is an intuitive presenter who uses notes or teleprompters infrequently. Trump knew he had made the right choice for trade representative.
Lighthizer enjoys Trump’s full support in his trade confrontation with China and in pending rounds of negotiation with Canada, the EU, Japan, Brazil, and other trading partners. For his part, Lighthizer rarely does interviews, is not in the limelight, and does not leak to the press. He is fine with Peter Navarro doing rounds of high-profile interviews and being the public face of the trade wars. In the Trump White House, there’s more downside than upside when you upstage the boss or contradict some real-time tweet you haven’t even seen. Lighthizer avoids these dangers with his low-profile demeanor. Trump likes that too.
Lighthizer lives in Palm Beach, Florida, not far from President Trump’s getaway estate at Mar-a-Lago. This makes it convenient for Trump to invite Lighthizer aboard Air Force One when he leaves Washington, D.C., for a weekend visit to Palm Beach. Lighthizer takes Trump up on his offer as frequently as possible. This gives him valuable one-on-one time with the president outside the White House glare that most Cabinet officers and West Wing advisers can only dream about.
Lighthizer developed the Trump trade approach to China using a hardline playbook he developed in confrontations with Japan during the Reagan years. In the early 1980s, the U.S. automobile industry was reeling from cheap Japanese imported cars. Lighthizer realized the Japanese manipulated their currency to lower their unit labor costs when converted to dollars. He worked with Reagan to impose steep tariffs on imports of Japanese and European cars. This forced the Japanese and Germans to jump the tariff wall by locating auto plants in the United States. Today most “German” BMWs and “Japanese” Hondas are built in Alabama, South Carolina, Tennessee, and elsewhere in the South and Midwest. The result was thousands of high-paying manufacturing jobs in the United States. Lighthizer and Trump are ready to run this playbook again on the Chinese.
In early 2018, Trump announced tariffs on Chinese solar panels, washing machines, steel, and aluminum under Section 272 of the Trade Act of 1974. Trump also announced tariffs on $50 billion of Chinese imports under Section 301 of the act as punitive action for Chinese theft of U.S. intellectual property.
The Chinese promptly announced tariffs on $50 billion of U.S. imports, including agricultural goods such as soybeans and sorghum, in retaliation for the U.S. Section 301 tariffs. Like a shrewd poker player with a large stack of chips, Trump announced tariffs on another $50 billion of Chinese imports on top of the original $50 billion, as retaliation for the retaliation. It was as if China said, “I’ll see your fifty billion dollars,” and Trump said, “I’ll raise you fifty.”
Initially, the stock market took these announcements in stride, betting that Trump’s announcements were a negotiating bluff and China’s response was simply to avoid loss of face. Wall Street had high confidence that after the initial threats were hurled the two sides would negotiate their differences, lower tariffs, and reduce the trade deficit pragmatically, with larger purchases of U.S. soybeans by China.
As usual, the Wall Street forecast was an unrealistic, rosy scenario. In fact, the initial tariffs went into effect by September 2018 and additional rounds of tariffs were then imposed by Trump. China did not back down, and announced its own additional rounds of tariffs on U.S. exports to China. However, China was fighting a losing battle. U.S. imports from China are almost $300 billion greater than Chinese imports from the United States. China was simply running out of space to match the U.S. tariffs dollar for dollar because it did not buy enough from the United States. By late 2018, China’s only recourse was to cheapen its currency so that lower production costs measured in dollars might offset some of the higher costs imposed by tariffs. As in the 1930s, currency wars and trade wars were working side by side.
China feels that its economy is sufficiently strong and resilient enough to weather a trade war with the United States. China can always buy soybeans from Canada and aircraft from Airbus. It is betting that the United States has more to lose than China if the trade war escalates. China is wrong in its estimate. Both sides may lose in a trade war, but China has far more to lose. Trade is a materially larger component of Chinese GDP than it is for the United States. Trump weaponized CFIUS to prevent Chinese acquisitions of U.S. technology firms. China is living atop a mountain of debt. Any forced decline in China’s trade surplus with the United States will slow the Chinese economy, increase unemployment, jeopardize debt service, and possibly lead to the kind of social unrest the Communist Chinese m
ost fear. While Mnuchin is not a trade hawk, he is a currency hawk and can unleash a cheaper dollar to complement Trump’s tariffs and make American purchases of Chinese goods more expensive. In short, Trump has more trade war weapons than China, and Lighthizer is as skilled as a four-star general when it comes to using them.
The U.S.-China trade war has far to run. The United States will win, but there will be collateral damage in markets. The dollar will head lower both in order to mitigate trade damage and to maintain maximum pressure on China.
Fed Fantasia
Is the Fed ready for the next recession?
The answer is no.
Economic research shows that it takes 300 to 500 basis points of interest-rate cuts by the Fed to pull the U.S. economy out of a recession. One basis point is 1/100 of 1 percentage point. Five hundred basis points of rate reduction means the Fed would have to cut rates 5 percentage points. As of January 2019, the Fed’s target rate for Fed funds, the so-called policy rate, is 2.5 percent. How do you cut rates 3 percent to 5 percent when you’re starting at 2.5 percent? You can’t.
What about more quantitative easing? The Fed ended QE in late 2014 after QE1, QE2, and QE3, from 2008 to 2014. What about QE4 in a new recession? The problem is that the Fed never normalized its balance sheet from QE1, QE2, and QE3, so their capacity to implement QE4 is in doubt. During that period, the Fed expanded its balance sheet from $800 billion to $4.4 trillion. The Fed used the $3.6 trillion of newly printed money to purchase long-term Treasury securities to suppress interest rates across the yield curve. Resulting higher valuations for stocks and real estate would create a wealth effect that would encourage more spending. The higher valuations would also provide collateral for more borrowing. This expected spending and lending was intended to put the U.S. economy on a sustainable path to higher growth.
This theory was another failure by the academics. The wealth effect never emerged and the return of high leverage by consumers never returned in the United States. The only part of the Bernanke plan that worked was higher asset values, but those values now look dangerously like bubbles waiting to burst. The result is that almost all of the leverage from QE is still on the Fed’s balance sheet. The $3.6 trillion of new money was never mopped up by the Fed; it’s on the Fed’s books in the form of bank reserves. The Fed began a program of balance-sheet normalization in 2017, yet that program is not far along. The Fed’s balance sheet today is still almost $4 trillion. That makes it highly problematic for the Fed to start QE4. When the Fed started QE1 in 2008, the balance sheet was $800 billion; if the Fed started a new QE program today, it would be starting from a much higher base. The policy question is whether the Fed could take their balance sheet to $5 trillion or $6 trillion in the course of QE4 or QE5. In answering that question, bear in mind the Fed has only $40 billion in capital. With current assets of $4 trillion, the Fed is leveraged 100:1, a ratio that is problematic for banks and brokers and unheard of among hedge funds.
Modern monetary theory (MMT), led by left-wing academics like Stephanie Kelton, see no problem with the Fed printing as much money as it wants to monetize Treasury debt. MMT is almost certainly incorrect about this. There’s an invisible confidence boundary beyond which everyday Americans suddenly lose confidence in Fed liabilities (aka dollars) in a hypersynchronous phase transition. No one knows exactly where the boundary is, but no one wants to find out the hard way. The confidence boundary certainly exists, possibly at the $5 trillion level. The Fed seems to agree, although they won’t say so. The Fed is trying to reduce its balance sheet today so that it can expand again in future without destroying confidence. If a recession hit tomorrow, the Fed would not be able to save the day with rate cuts because they’d hit the zero bound before they could cut enough to make a difference. They would not be able to save the day with QE4 because they’re already overleveraged.
What can the Fed do?
All the Fed can do is raise rates (slowly), reduce the balance sheet (slowly), and hope that a recession does not hit before they get policy rates and leverage back to normal, probably around 2021. The odds of the Fed being able to pull this off before the next recession are low. The current expansion started in June 2009 and continues until today. It is the second longest expansion since 1945, currently over 117 months. It is longer than the Reagan-Bush expansion of 1982–1990. It is longer than the Kennedy-Johnson expansion of 1961–1969. It’s longer than any expansion except the Clinton-Gingrich expansion of 1991–2001. Probabilistically, the odds of this current expansion turning to recession before the end of 2020 are extremely high.
In short, there’s a very high probability that the U.S. economy will go into recession before the Fed is prepared to pull the economy out of it. Once the recession starts, the United States, like Japan starting in the 1990s, may stay near recession levels for decades. Japan has had three lost decades. The United States is just finishing its first and may have more to go.
The situation is even worse than this dire forecast suggests. The reason is that by preparing to fight the next recession, the Fed may cause the recession they’re preparing to cure. It’s like trying to run a marathon while being chased by a hungry bear. The Fed needs to raise rates and reduce their balance sheet in order to have enough policy leeway to fight a recession. If they move too quickly, they’ll cause a recession. If they move too slowly, they’ll run out of time and be eaten by the bear.
This conundrum is at the root of the Fed’s monetary finesse. This trap was caused by Bernanke’s failure to raise rates in 2010 and 2011 when the economy was in a better position to absorb rate hikes in the early stages of an expansion. It was also caused by Bernanke’s insistence on QE2 and QE3 despite zero evidence then or now that quantitative easing helps the economy. (QE1 was needed to deal with a liquidity crisis, but that was over in 2009. There’s no rationale for QE2 and QE3.)
A recession is coming, the Fed is unprepared, and it’s extremely unlikely the Fed will be prepared in time. Investors fear inflation, but if the recession scenario unfolds, deflation will emerge as a greater concern.
Emerging Markets Submerge
Emerging-markets debt crises are as predictable as spring rain. They happen every ten to fifteen years with few variations or exceptions. In recent decades, the first crisis in this series was the 1982–1985 Latin American debt crisis. The combination of inflation and a commodity price boom in the late 1970s had given a huge boost to economies such as Brazil, Argentina, Mexico, Zaire (now the Congo), and many other nations. This commodity boom enabled these emerging-markets economies to earn U.S. dollar reserves in exchange for their exports. These dollar reserves were supplemented with dollar loans from U.S. banks looking to recycle petrodollars that the OPEC countries were putting on deposit after the 1970s oil price explosion.
I discussed the petrodollar recycling process personally with Walter Wriston, Citibank’s iconic leader during the energy crisis. In the 1960s, Wriston invented the negotiable eurodollar CD, which was later critical for funding those emerging-market loans. Wriston is considered the father of petrodollar recycling after the petrodollar was created by Henry Kissinger and William Simon in 1974. Citibank made billions of dollars recycling petrodollars and its stock price soared. It was a euphoric phase and a great time to be an international banker.
Then the market boom crashed and burned. Beginning in 1982, the debtors defaulted. They squandered their reserves on vanity projects such as skyscrapers in the jungle, which I saw firsthand on the Congo River in Central Africa. Whatever wasn’t wasted was stolen and stashed away in Swiss bank accounts by kleptocrats. Citibank was technically insolvent after these defaults, but was bailed out by the absence of mark-to-market accounting. We were able to pretend the loans were still good as long as we could refinance them or roll them over in some way. Citibank has a long and glorious history of being bailed out, stretching from the 1930s to the 2010s.
After the defaults of the 1980s, reaction set in. Emerging markets had to adopt austerity, devalue
their currencies, cut spending, cut imports, and gradually rebuild their credit. There was a major emerging-markets debt crisis in Mexico in 1994, the Tequila crisis, but that was contained by another U.S. bailout led by Treasury secretary Bob Rubin. On the whole, the emerging markets used the 1990s to rebuild reserves and restore their creditworthiness. Gradually, the banks looked favorably on this emerging-markets progress and new loans started to flow. Now the target of bank lending was not Latin America but the Asian Tigers (Singapore, Taiwan, South Korea, and Hong Kong), and the South Asian minitigers.
The next big emerging-markets debt crisis arrived right on time in 1997, fifteen years after the 1982 Latin American debt crisis. This new crisis began in Thailand in June 1997. Money had been flooding into Thailand for several years, mostly to build real estate projects, resorts, golf courses, and commercial office buildings. Thailand’s currency, the baht, was pegged to the dollar, so dollar-based investors could get high yields without currency risk. Suddenly a run on the baht emerged. Investors flocked to cash out their investments and get their dollars back. The Thai central bank was forced to close the capital account and devalue their currency, forcing large losses on foreign investors. This sparked fear that other Asian countries would do the same. Panic spread to Malaysia, Indonesia, South Korea, and finally to Russia, before coming to rest at Long-Term Capital Management, a hedge fund in Greenwich, Connecticut. As chief counsel to LTCM, I negotiated the fund’s rescue by fourteen Wall Street banks. Wall Street put up $4 billion in cash to prop up the LTCM balance sheet so it could be unwound gradually. At the time of the rescue on September 28, 1998, global capital markets were just hours away from complete collapse.
Emerging markets learned valuable lessons in the 1997–1998 crisis. In the decade that followed, the emerging markets built up their reserve positions to enormous size so they were not disadvantaged in another global liquidity crisis. These excess national savings were called “precautionary reserves” because they were over and above what central banks normally need to conduct foreign exchange operations. The emerging markets also avoided unrealistic fixed exchange rates, which was an open invitation to foreign speculators like George Soros to short their currencies and drain their reserves.
Aftermath Page 29