New Economic Plans of President Trump

How are you? Finally Trump becomes the 45th U.S. president. During his campaign, Trump has made so many promises on introducing new changes and making America strong. I hope he will deliver his promises and make America prosperous. Now let’s analyze his economic plans and see if they will work.

I think his economic plans are quite simple. As regard to the fiscal policy, President Trump wants to generate economic growth through tax cuts and government spending at the same time. He promised to generate 3.5 percent growth a year, which is much higher than many economists think it can be sustainable for a long period of time. He believes that a high economic growth will give Americans more disposable income to spend. To stimulate the economy, President Trump also promised to have more deregulations and cut taxes by $6.2 trillion over the next decade while spending more on the military and an extra $500 billion to repair and build the nation’s roads, bridges, airports, transit systems and other infrastructure. President Trump said that the increased government spending would not be a problem because faster growth will increase tax revenue even at lower tax rates.

The economic stimulus (i.e. the $500 billion spending on infrastructure) has helped send stocks higher in anticipation of higher corporate profits in addition to less regulation. Soon after President Trump made his first speech (which was very humble and quite acceptable by the public) pledging to unify a deeply divided nation, the global financial markets calmed down and then stock prices rebounded. The Dow was up 263 points, or 1.4 percent to 18,595. The S+P 500 rose 24 points or 1.2 percent to 2,163. Financial stocks took the lead, surging 4.2 percent based on the anticipation that interest rate will go higher (which benefit banks to earn more profits).

As regard to the monetary policy, President Trump favors an increase in interest rates. During his campaign, he said he was very unsatisfied with the performance of Janet Yellen, head of the Federal Reserve Bank, and would not re-appoint her when her term will expire in February 2018 because Yellen has kept interest rates ultra-low, creating asset bubbles and widening wealth disparity in America. He once said that persons like him can borrow money at low interest rates, giving him the advantage to acquire assets for future appreciation. This would only benefit the rich people and widen the wealth disparity in America.

During his campaign, he also promised to bring manufacturing jobs back to America. I think it would be difficult because the cost of manufacturing overseas is generally lower than that of the United States. In addition, now some U.S. manufacturing jobs are being performed by robots. In fact, it is the use of automation and robots that replace the U.S. workers in the factories.

As regard to job creation, his goal is to create 25 million of jobs over 10 years, which would be 2.5 million per year. In fact, U.S. employers have created 2.4 million jobs during the last 12 months. However, most of these are low-paying service jobs. I think the United States can continue to create about 2.5 million jobs per year if there are no recessions in the next ten years. Therefore, I think his goal of creating 25 million of jobs over 10 years is hard to achieve.

To attract the return of overseas assets being held by the U.S. multinational companies like Apple, President Trump will propose a drastic tax cut from 35 percent to 10 percent on overseas assets. It is estimated that the overseas assets being held by the U.S. companies amount to $2.5 to $5 trillion USD. The return of overseas assets will increase investment spending in America, creating more jobs and growth. However, I doubt that even a drastic tax cut would make it attractive enough for U.S. companies to bring overseas assets back home for investment. I think the U.S. companies have concerns other than a high tax rate.

As regard to trade policy, President Trump wants to renegotiate the NAFTA with Canada and Mexico because he thinks it is not a fair deal. In addition, he would not support TPP (President Trump called it “a rape of our country”). In fact, some of the terms in the NAFTA are not fair to the United States. For example, the Mexican government would levy custom duties on cars that are made in America, while there are no U.S. custom duties on cars that are made in Mexico.

During his campaign, President Trump said he would consider China a currency manipulator on his first day in office and impose a punitive tariff of 45 percent on Chinese imports into the United States. This could be a big blow to China’s economic growth as the country is struggling with mounting debt, excess capacity and declining exports. In the first presidential debate on September 26, President Trump said, “You look at what China’s doing to our country … they are devaluing their currency and there’s nobody in our government to fight them … They are using our country as a piggy bank to rebuild China.”

However, I don’t think it is easy for President Trump to pursue his trade protection policy against China. It is because the Republican Party, which regained control on both U.S. Senate and House of Representatives, are much more in favor of a free trade. Mainstream economists generally believe that free trade is good for an economy in the long run. I am pretty sure that President Trump will act tough on China to open her key industries to U.S. companies including finance and telecom, as it was promised by China to allow foreign companies to enter into these key industries when she was admitted to the WTO in 2001.

If President Trump were to aggressively implement the trade protection policy against China, it would spark a trade war, not only depressing the economies of both the U.S. and China but also possibly triggering a global recession. The trade war with China will cause backfire and reduce the U.S. GDP growth. Increasing tariffs could make Chinese goods more expensive to buy. U.S. companies will eventually increase prices in order to protect profits at the expense of consumers. In addition, China will certainly take retaliatory action against the United States.

A concern about a new trade relationship with the United States and a possible rate hike by the Fed in December, the Chinese currency slipped to 6.7907 per dollar in Shanghai when Trump won the presidential election on November 9, 2016. Yesterday the Chinese dollar further slipped to 6.84 per dollar, its lowest level in seven years. A rate hike makes U.S. dollar strong, causing the Chinese dollar to fall.

In fact, China has been relying on a prosperous United States to allow her economy to grow since the United States is her second largest trading partner and also the world’s economic locomotive. Free trade is important to China that needs foreign markets for her products to keep pushing its population into the middle class and achieve the dream of being a “moderately prosperous” country by 2020. To achieve this goal, China must have a growth rate of 6.5 percent a year.

If there is a trade war between the United States and China, Hong Kong will be vulnerable not only in trades and logistics (since Hong Kong is highly dependent on China’s imports and exports), but it will also affect the city’s financial service sector and property markets. Meanwhile, trade and logistics accounted for 23.4 percent of Hong Kong’s GDP in 2014 according to the Trade Development Council. It will be a serious blow to Hong Kong’s economy.

During his campaign, President Trump said he would repeal the Obamacare. I think this would be difficult. Although there are some defects in the Obamacare, repealing it can cause chaos because millions of Americans have already signed up the Obamacare. But I am sure that President Trump will make changes on some parts of the Obamacare. Hopefully, making changes to Obamacare can reduce the costs of health care, which account for a significant portion of the U.S. federal budget.

Now what worries me most is the rapid rise in bond yields. There was a selloff in bonds, driving the yield-to-maturity (or bond yield) on the 10-year U.S. Treasury bond to 2.08 percent after Trump was elected as the U.S. president. Today the 10-year bond yield further rose to 2.22 percent (after the Brexit, it was 1.31 percent, the lowest ever since WWII). I think it is because traders are selling bonds to hedge against the possible rate hikes (which have been super-low for many years since the financial crisis in 2009) and the expectation of a rising inflation (remember that bond investors hate inflation because it erodes the purchasing power of their fixed payments). Investors are worried that the fiscal policy of tax cuts combined with the increased government spending will cause inflation and increase the national debt sharply by $5 trillion to $7 trillion over a decade. Therefore, they expect higher debt, higher inflation and higher interest rates. All of these are negatives for bonds. This may end the bond bull market that has lasted for almost three decades.

In conclusion, I think President Trump has laid out economic plans that are very ambitious. If they are successful, it will bring economic prosperity back to our country and make America strong. However, they are risky too. In fact, I think electing him as our president is a gambling. He is lack of political experience and public administration. I still think he is unpredictable. Anyway, we need to give him a chance to try. Now the only thing we can do is to keep our fingers cross and hope for the best for America under God.

Note: This article is just my personal opinions and it does not offer any investment advice to readers.

Two Factors Affecting the U.S. Long-Term Economic Growth

The Commerce Department reported on Friday that the U.S. economy expanded 2.9 percent in the third quarter of 2016, which was twice more than the 1.4 percent growth in the second quarter. I think it is an encouraging report to confirm that the U.S. economy is regaining some the momentum that was lost in the last three quarters.

In fact, the U.S. economy suffered a slowdown in the final quarter of 2015 with a 0.9 percent growth, followed by an anemic growth of 0.8 percent and 1.4 percent in the first and second quarter of 2016, as exports declined due to a strong dollar, making American products more expensive on overseas markets, and companies cut back on their inventories in anticipation of a weaker retail sales.

The GDP growth of 2.9 percent in the third quarter of 2016 was attributed to a 10 percent rebound in exports (which added 0.8 percent to the GDP growth) and companies increased 1.2 percent in inventory buildup (which added 0.6 percent to the GDP growth). The strong rebound in export was in part due to a surge in soybean shipments to South America, where the local crop had been devastated by bad weather. Federal spending also rose 2.5 percent after declining for two consecutive quarters.

In fact, the U.S. economy in the third quarter this year hit the fastest pace in two years since it grew at a 5 percent rate in the third quarter of 2014. Consumer spending, which accounts for two-thirds of economic activity, also gained a solid growth of 2.1 percent. Economists believe that consumer spending will continue to remain strong to support growth in the current quarter and into 2017, as the job market is still very strong and wage growth is picking up.

Although the U.S. economy gained traction in the third quarter, economists project that the GDP growth will be around a lackluster 1.6 percent for the whole year in 2016. In 2015 the U.S. economy grew at a 2.6 percent. The economic recovery from the last recession in 2009 has been the weakest in the post-World War II period, with growth averaging just 2.1 percent over the past seven years. Why?

I think it is due to a decline in productivity and a change in demographics (the change of age structure). First of all, the declining productivity, which would restrain wage growth, has been a problem for the long-term U.S. economic growth. Productivity can affect economic expansion, labor costs, wage growth, inflation and profitability. A weak growth in productivity can lower the economy’s ability to grow fast and generate higher incomes without triggering too much inflation. It would also reduce corporate profits due to the rising labor costs. Productivity is an economic measure of output per unit of input. In the second quarter of 2016, the nonfarm business productivity, which measures the goods and services produced each hour by American workers, fell 0.5 percent. In fact, the productivity has been declining since the late 1970s. The growth in annual labor productivity in the last 30 years is 2 percent on average. In the 1950s and 1960s, it was about 4 percent on average.

Generally speaking, economic growth depends on the growth of labor force, the increase in capital and the gain in productivity. The growth of labor force (or the increase in supply of labors) is important because more workers can generate more goods and services, leading to a rise in GDP. Increase in capital (and loanable funds in the banking system) can provides more ammunition for investment. The gain in productivity through new technological innovations and increase in capital investments (i.e. buying new equipment that makes workers more productive) can boost production at reduced costs.

There are some reasons to cause the decline in U.S. productivity since the late 1970s. Firstly, low interest rates are eroding productivity. Low interest rates make it more appealing for corporations to buy back their stocks as a quick way to boost stock prices instead of making capital investments to improve the long-term productivity. Secondly, when the wage growth is slow (especially during a period of economic slowdown), it is cheaper for businesses to hire a new person instead of making big capital investments to reduce costs. In addition, a sluggish economy would make people more willing to accept lower wages. Therefore, the cost of labor becomes comparatively cheaper than that of a big capital investment that requires a number of years to fully depreciate the asset.

Other factors such as the lack of competition, slowdown in technological breakthroughs, tax codes that discourage investments by reducing investment tax credits, overregulation and cronyism can also reduce productivity. For example, intellectual-property protection can help companies keep out newcomers and maintain high profit margins within the protection period. Regulations, which are designed by the politicians to protect the profits of old companies, would also hurt productivity growth.

The change in demographics also has a strong impact on U.S. economic growth. According to a recent report from the Federal Reserve Bank, change in demographics accounts for a significant portion of the downward trend in economic growth for advanced economies. After the World War II, there were 77 million baby boomers who were born between 1946 and 1964. The baby boomers, which accounted for 25 percent of the U.S. population, brought prosperity to the U.S. economy. They increased the supply of labors to boost productivity and have also created big demand from cars, houses, computers, electronic products, Internet to financial services, thus driving the U.S. economy to grow rapidly and stock prices to rise. According to the U.S. Department of Labor, the baby boomers at the age of 47 are the most highest-spending people, so they buy new cars and big houses, creating a spending spree. After the age of 47, they tend to consume less and save more for retirement. Now the baby boomers are either in their retirement or will retire in the next ten years.

In fact, the peak of the baby boomers’ spending cycle ended in 2009, which was also the year of global recession. In 2010 the U.S. consumer spending began to fall. In the next ten years, as more baby boomers enter into retirement, the U.S. government will increase spending on retirement payments and health care expenses, which will increase the federal budget deficit and the total debt. Therefore, the decline in productivity and the change in age structure have made it very difficult for our economy to have a V-shape recovery. Now the U.S. economy has entered into a “new norm” with slow economic growth, low inflation and low interest rates.

In conclusion, unless we have new technological breakthroughs like the invention of Internet in late 1990s that could drive up our economy and created high-paying jobs, I think the U.S. economy will continue to grow slowly. I also think the better-than-expected GDP growth number in the third quarter will give the Fed a good reason to raise interest rates in December (unless there are surprises in the job numbers in the next few weeks). In fact, the Fed should raise interest rates as earlier as possible to reduce the asset bubble that was created by its super-low interest rate policy since 2009. The rate hike will also give the Fed more room to lower interest rates in the next recession.

If you have any comments or insights on the outlook of the U.S. economy, please kindly share with me. Thank you.

Note: This article is just my personal opinions and it does not offer any investment advice to readers.

 

The Biggest Bubble in History

How are you? Last week I had some discussions with my friends regarding the housing bubble in China. They are not sure what is going on there and wonder why the property prices in China are climbing so high recently, and when this housing bubble will implode.

I think we may get some hints from Wang Jianlin, the richest man in China. Wang Jianlin, chairman of the Dalian Wanda Group, commented in an interview recently that it (the housing market) is the “biggest bubble” in the history. “I don’t see a good solution to the problem,” he said. “The government has come up with all sorts of measures – limiting purchase or credit – but none of them worked.” According to Wang, the big problem is that prices keep on rising in major cities such as Shanghai and Beijing, Guangzhou and Shenzhen, but are falling in thousands of smaller cities where huge numbers of properties are empty (they are so-called the “ghost cities”). The housing market is really out of control.

I totally agree with his comments. Now the housing markets in China are of two extremes. In one extreme, the housing markets in the major cities are in a bubble with surging prices while the housing markets in the other extreme (i.e. the 3 and 4 tiered cities and smaller cities) are in depression. I think the housing markets in the major cities of China are really overheated and the overbuilding of the empty (or unoccupied) properties in the ghost cities is sinking China into a mountain of debt, which is a time bomb for a financial crisis if the Chinese government fails to correct the debt problem in a timely manner.

In fact, China’s housing market began to rise sharply in 2008. The $4 trillion RMB economic rescue plan introduced in 2009 by the Chinese government, which was intended to counteract the global recession, actually added fuel to the sizzling hot housing market. In 2010 Premier Wen wanted to cool it off in fear of generating a housing bubble. Therefore, the Chinese government implemented a series of measures to contain property prices. As a result, the Chinese housing markets were cooled off for a while. However, after the Chinese stock market crashed last year, investors lost their confidence in the stock investment (and a lot of them got burned in the Chinese stock markets), so China’s housing market was active again with Shenzhen leading the price surge for 50% on a year-to-year basis due to a high-tech boom in Shenzhen. Just in the month of August, the property prices of Beijing and Shanghai rose 3.8% and 5.2%, respectively. This time the housing market recovery was supported by a series of stimulating measures by the Chinese government, including interest rate cuts, lowering down payment, tax rebates for home buyers and liberalizing household registration policies, etc.  Meanwhile, the Chinese stock markets are still sluggish, so the Chinese investors moved their money into the housing market as a safe haven.

However, rapid price surge in the major cities induced fears of a bubble, so it prompted the local governments to tighten some home and land purchase requirements to cool off the housing markets. These tightening requirements also apply to the second and third-tiered cities such as Hangzhou, Xiamen and Nanjiang, which gained sharp increase in house prices recently (properties prices in some of these cities have risen by 30 to 40% year-to-date). Over the weekend, the authorities in both tier 1 and tier 2 cities just announced to impose new restrictions (including  restrictions on mortgages and down payment policies) to curb surging price on home buying, hoping to cool off the housing markets.

So, why do home prices rise so sharply of all suddenly in August and September? I think one of the reasons is that there are rumors that the Chinese government is going to implement further restrictions on home purchase soon. Therefore, the Chinese people rushed to buy homes before the restrictions will be imposed, thus driving the home prices even much higher within a short period of time. In addition, the Chinese government wants to boost the housing market to keep the GDP from falling below 6.5% a year when exports continue to decline due to a global economic slowdown.

Moreover, the limited choice for investments in China is also driving force for the housing bubble. Meanwhile, the Chinese financial markets are still in the developing stage without effective control and supervision. The market is flooded with risky financial products from shadow banks that are not regulated. The Chinese banks have also used the so called “wealth management products” to accelerate loan growth and get around restrictions on lending. According to International Monetary Fund (IMF), there are $2.9 trillion USD of credit products from the Chinese shadow banks that are high-risk and their defaults could lead to liquidity shocks. Since the capital account is still close, the Chinese investors cannot invest overseas directly even though they realize the investment opportunities with higher returns in the other countries. Since the second half of last year due to massive capital outflows, the Chinese government has tightened the capital control, making it even more difficult for Chinese investors to move money out of the country to invest overseas. The limited choice for investments and the sluggish stock markets together have made China’s housing market become overheated.

Meanwhile, the local government relies on land sales to fund their budgets and also the development of new homes to generate economic growth. A collapse in the housing market will become a serious economic problem in China. Since 75% of China’s household wealth is tied to the housing market, the collapse will wipe out the wealth of the Chinese households, thus affecting personal consumption and business investments. Therefore, Chinese people generally believe that the central government will do whatever it takes to support the housing market. In other words, the housing market is too big to fail. A sure-win mentality in home property investment makes Chinese people consider home property as an extremely safe asset to own and invest, especially when there are limited choices of investments in China. In fact, now home properties in China become a commodity and an investment tool for short-term speculation.

I think the real problem for the sharp rise in home prices in China is the rapid increase of money supply since 2009. Meanwhile, the M-2 is $151 trillion RMB (while the foreign currency reserves were $3.17 trillion USD at the end of September 2016.). In 2009, the M-2 was about $53 trillion RMB. The money supply has tripled three times since 2009. Now it grows at 11% a year (against 6.5% annual growth in GDP). In a couple of years, the total money supply will exceed $200 trillion RMB at the current growth rate, and almost three times more than the supply of U.S. dollar. No wonder the RMB is under devaluation pressure. The ample liquidity has inflated the home property prices in China.

In conclusion, a strong housing market is always supported by a strong economic fundamental. However, this is not the case in China. Instead, China’s housing market is driven by strong liquidity (i.e. the rapid rise in money supply) and short-term speculation. The implosion of the housing bubble or a downward price adjustment seems inevitable. I think it is just a matter of time. But I hope this is not a sharp U-turn, and the housing bubble can deflate gradually to ward off a full-blown crisis.

Note: The article is just my personal opinions and it does not offer any investment advice to readers.

The Economic Outlook of Japan in the next 5 to 10 Years

I received the following questions from my friend this week.

Thanks for the email about the helicopter money. I have learned a lot and enjoyed reading it. Japan was about to raise the sales tax, instead it started to drop helicopter money; effectively, it decreases revenues and increases expenses. Fiscally and monetarily, are there any more tools Japan can implement? What do you think the Japanese economy will be in 5 to 10 years? Will it have any effect on our economy?

I responded to the above questions as below:

Yes, I agree that raising sales tax may end up reducing the total revenues of the Japanese government because it would discourage consumer spending since products become more expensive. In July Bank of Japan (BOJ) Governor Haruhiko Kuroda ruled out the possibility of helicopter money. However, if the negative interest rate policy and the expansion of QE programs fail to combat deflation, which has been a chronic economic problem of Japan for the last two decades, and stimulate the economy, I think BOJ may have no choice but to implement the helicopter money as the last resort to prevent the economy from slipping into another recession, thus further deepening the deflation. Let’s wait and see what will happen.

I don’t believe that BOJ’s unconventional monetary policies (such as quantitative easing and negative interest rate policy) can effectively combat deflation and reboot the Japanese economy because Japan’s economic problems are structural, including the aging demographics, the traditional top-down management style that inhibits creativity and the close relationship between big corporations and the government. If the economic recession is due to cyclical reason, I am sure that the massive bond purchase program through QE can boost the economy, as interest rate declines sharply and economic activities will pick up.

I think BOJ’s unconventional monetary policy is a failure. It fails to combat the chronic deflation and boost the Japanese economy. In fact, the implementation of QEs and negative interest-rate policy only induces speculation, penalizes savers and retirees. The only benefactor seems to be the institutional investors and speculators who benefit from the rise in stock prices due to the massive QEs. Nowadays, the rise in stock prices is not equivalent to a strong economy. The stock prices are not supported by strong earnings and economic fundamentals, but it is rather driven by strong liquidity. This is definitely a market distortion as a result of the ultra-low interest rates and the increase in money supply by central banks.

Another way for Japan to boost her economy is to increase government spending through deficits and cut taxes under the fiscal policy. However, the Japanese government is heavily indebted. Her national debt to GDP ratio is about 250%, the highest among the world’s major advanced economies. Therefore, increasing budget deficit to finance public works (which can increase immediate employment) would be difficult.

Besides using fiscal stimulus and unconventional monetary policy, I don’t think Japan has other effective tools to implement now. The Japanese government is actually running out of ammunitions.

I think now Japan falls into a liquidity trap. The Japanese people hoard the money instead of spending it because the economic outlook is not good. Banks are reluctant to make new loans to companies and consumers to prevent from generating more bad debts. Although the economy is flooded with a lot of liquidity, business activities are still stagnant simply because companies are hesitated to invest and consumers are hesitated to spend. The aging population is also a major factor causing a constant decline in consumer spending. Therefore, Japan is unable to achieve a 2% inflation target even after a series of efforts.

The Japanese population has continued to fall after it peaked in 2008 for about 130 million, and labor force began to decline in the mid-1990s. The decline in total population is attributed to a low fertility rate (which is 1.3%) in Japan. The low birth rate has decreased the population growth and the growth of labor force. The aging population has also caused other economic and social problems (besides a decline in consumer spending), including the increase in health care spending by the Japanese government and a decline in productivity.

Therefore, I think new immigration policy should be implemented to tackle the aging population problem in Japan and to increase the young labor force. Meanwhile, Japan is the only advanced economy with shrinking population and tight control on immigration. Foreign residents are less than 2% of the total population. However, there are obstacles to implement new immigration policy. First of all, Japanese are anti-immigration traditionally. Two-thirds of the Japanese people are against large-scale immigration. An open immigration policy may create friction between the Japanese and the new immigrants due to a culture gap and language problem. New immigrants may have hard time in adjusting their life in Japan and moving ahead in the Japanese society (I think Japan has a strong glass ceiling for those who are not real Japanese).

In conclusion, I am not bullish on the Japanese economy in the next five to ten years unless the structural problems as mentioned above can be corrected. To tackle the economic problems, they need to consider new immigration policy to attract talents and skillful workers. They also need new technological inventions to boost productivity (to compensate for the loss of labor force). New inventions lead to new products, creating new demand and job opportunities. In addition, improving diplomatic relationship with China and South Korea is also important. It is because China now becomes her major export market.

Japan is also one of the major trading partners of the United States. I think the economic sluggishness in Japan can affect our economy, but not to a great extent because we do not rely on her economy for exports and growth.

Although I am not bullish on the Japanese economy, I am quite bullish on her stock market in the short run because of the QEs and negative interest rate policy. The BOJ has instructed pension funds to buy stocks instead of bonds, thus creating a big demand for stocks. In fact, the BOJ has already bought more than 50% of all Japanese ETFs. I think BOJ will continue to buy financial assets in Japan by increasing money supply and liquidity, and interest rates would remain negative for a while, so it would encourage the search for high yields, leading to higher stock prices in Japan.

Note: The article is just my personal opinions and it does not offer any investment advice to readers.

 

The Helicopter Money

How are you? Recently my friends asked me if Japan and Europe will use helicopter money to stimulate their economies because the unconventional monetary policies (including the quantitative easing and negative interest rate) are not working well for them.

Although Bank of Japan Governor Haruhiko Kuroda has ruled out helicopter money as “forbidden” and ECB president Mario Draghi has also totally ruled out the possibility of helicopter money (and even Bank of England governor Mark Carney has said he believes it can lead to a “compounded Ponzi scheme.”), I think now Japan may be on the verge of using helicopter money if the negative rate policy fails to stimulate her economy and combat deflation.

So, what is helicopter money? The term helicopter money was first introduced by the famous American economist Milton Friedman in the 1969. Milton Friedman used the following parable to describe “helicopter money”.

“Let us suppose one day a helicopter files over this community and drops an additional $1,000 in bills from the sky, which is, of course, hastily collected by members of the community. Let us suppose further that everyone is convinced that this is a unique event which will never be repeated.”

The basic principle of helicopter money is that central banks create new cash (by printing money) and give the cash directly to the people, so that they can spend the cash for whatever they want to. However, Milton Friedman didn’t seriously consider it as an effective monetary tool. He just used it as an example to explain how oversupply of money can ignite inflation. In his book “Money Mischief,” he said that the helicopter money would only end up generating inflation but not creating wealth (since the increase in money supply is not matched by real production). In fact, inflation is always and everywhere a monetary phenomenon (i.e. inflation is caused by oversupply of money) according to Milton Friedman.

Helicopter money is quite different from quantitative easing (QE) under which the central banks purchase government securities from banks and bond dealers by expanding the money supply, thus driving down the bond yields and borrowing costs as well as lowering the value of their currencies to stimulate exports. The increased money supply by central banks gives banks more firepower to lend. However, if banks are unwilling to lend to businesses and consumers, the newly created money through QE would not flow into the real economy to increase investments and create jobs. Therefore, the economy is still stagnant if banks are not making new loans to the borrowers. Instead, the newly created money just floods the financial markets with excess liquidity, which encourages speculation and the search for higher yields (because interest rates are too low). In this case, QE would only generate financial bubbles and widen the gap for wealth disparity.

I think the helicopter money is the last resort of the unconventional monetary policies after all the other policies have failed to resuscitate the economy. As a matter of fact, central banks are now running out of ammunitions. Unlike the QE, by using helicopter money, central banks are just putting money directly into people’s pocket, so they can spend. One good thing about helicopter money is that it would not increase new debt.

I think the helicopter money will work in the short term and can give an immediate stimulus to the economy without generating runaway inflation if the economy is in depression, cyclical recession with production overcapacity and insufficient aggregate demand, suffering from deflation or it falls into in a liquidity trap. In order for it to work, people must spend the helicopter money instead of hoarding it. If people don’t spend the helicopter money and just save the cash, it would not stimulate the economy.

The problem of helicopter money is that when it should stop. If it is a one-time deal, it would only give a short-term economic stimulus and it cannot combat deflation. Once it stops, the economy would fall into recession again. If it is on a continuous basis, it creates bad behavior (such as less incentive for people to work, etc.), encourages reckless spending and reduces personal savings. This is just like a drug addict relying on drugs to survive. Therefore, the helicopter money will not work on a continuous basis because no structural changes are made to resuscitate the economy. Helicopter money will definitely generate inflation on a continuous basis (depending on the amount of new money created, it will generate hyperinflation for massive amount of money printing). If printing money can solve economic problems, then Zimbabwe should have the strongest economy in the world because it has printed multi-trillions of dollars for its currency.

In 2002 speech, the former Federal Reserve Chairman Ben Bernanke talked about the idea of helicopter money to combat deflation and offered this idea to Japan. Now Japan may be on the verge of helicopter money if the negative rate policy fails to stimulate her economy. I doubt the effectiveness of the helicopter money in Japan given that the Japanese have a high propensity to save in their culture.

In conclusion, helicopter money is in no way a panacea to resuscitate the economy and combat deflation. It can only give a short-term economic stimulus. Instead, we should make structural reforms on the economy, introduce tax reform to offer incentive for investment, encourage new technological innovations, increase productivity and reduce wealth disparity.

Anyway, in a world of helicopter money, I think the best investment will be gold. In the short term, the helicopter money can boost the stocks by generating economic growth and inflation (because of the increase in money supply and excess liquidity).

Note: The article is just my personal opinions and it does not offer any investment advice to readers.

 

More Discussions on Brexit

I got the following questions from my friend regarding the Brexit. I responded to his questions as below, and now I would like to share with you.

After Brexit, the stock market suffered a rapid and massive drop. But now all indexes are at their all time high. Is it because (1) the market expects the Brexit will eventually be reversed? (2) the Brexit should not have/will not have any significant effects on the world economy? I still can’t figure out who wins/who loses in both scenarios: stay vs leave? Does Brexit change the aggregate demand/consumption for goods and services in Britain? In the whole world? If not, why does it matter if Britain is in or out of EU?

After the Brexit, the global stock markets plunged, but some of them recovered very well, particularly the U.S. stock markets with the major indexes reaching all time high recently. The U.S. dollar was getting strong against the British pound and euro. The yield of a 10-year Treasury bond dropped to 1.31%, the lowest ever since the WWII. As I mentioned before that in time of uncertainty, the U.S. dollar is always the safe haven for investors. The Brexit has caused the inflow of capitals into the U.S. for safety purpose, hence driving up the U.S. stock prices and also the prices of U.S. treasury securities. When the yields of Treasury securities fall to the lowest historical level, investors would search for higher yields from other investments, and the U.S. stock markets are good places to invest since the U.S. economy is performing better (comparatively) than other major economies and U.S. employment remains strong (287,000 new jobs were created in June and unemployment rate stood at 4.7%).

In fact, I think the surge in U.S. stock markets is mainly driven by liquidity (as more foreign capitals pour into the U.S. for safety purpose). The Brexit would definitely have adverse impacts on the U.K.’s economy in the next five years. Her economy may slip into recession before the end of this year. Due to uncertainties in the future after the Brexit, some companies in U.K. will relocate to Europe (especially the U.S. financial institutions), causing unemployment to rise and consumption on goods and services to fall. When foreign investors pull their investments out of U.K., it would also bring an end to the booming U.K. real estate markets. The U.K. may also lose Scotland after the Brexit. This will be another fissure for the U.K. economy.

After the U.K. has left the EU, some EU member countries such as France and Spain may follow suit. Therefore, it will increase the risks of the EU breakup, and eventually bringing an end to the euro. The breakup of euro will be a disaster for the global financial markets. The disruptions in the global financial markets will cause the global economy to fall into a recession and enter into a long period of deflation (as asset prices go down). I think this is the worse effect of Brexit on the global economy; otherwise, its spillover effects on the global economy should be very little (since U.K. accounted for roughly 2.4% of global GDP in 2015, down from about 4% in the early 1980s).

One June 21, 2016 George Soros, the legendary investor, wrote in The Guardian that the Brexit would be more damaging to the U.K.’s currency than Black Wednesday was in 1992 because the Bank of England has little firepower left to prop up markets and the U.K. is more dependent on foreign capital than at any other point in its history. Investments in manufacturing to benefit from a devaluation of the pound are unlikely because of reluctant lenders. Soros even predicted that the pound could possibly fall more than 20% to below $1.15 a dollar.

To counteract the impacts of the Brexit, the Bank of England and the European Central Bank (ECB) will continue to expand their monetary policies, which will further drive down the yields of government bonds (meanwhile, the German bonds have negative yields). I don’t think the expansionary monetary policy can further stimulate an economy. Instead, it just encourages more speculation, makes the financial bubble grow even bigger and disrupts the norms of the financial markets. The main driving force to stimulate the economy is investment. But investment is based on confidence and confidence is based on the economic outlook.

It is unarguably that in the short run the U.S. is the benefactor of the Brexit (as foreign capitals continue to move into the U.S., driving up the U.S. stock prices to new high and driving down the borrowing costs for the U.S. business and consumers). Britain and Europe both are suffering from the Brexit in the short run. I think the Brexit will also affect China in two ways. First of all, the Brexit would affect China’s exports to Europe, which is the second largest market for Chinese products, if there are disruptions in the European economy. Secondly, China has invested billions of dollars in Britain in the last few years, especially in the real estate markets. These investments are now under fire.  China has also placed high hope on London as the second largest RMB offshore center (beside Hong Kong) to internationalize the Chinese currency and issue RMB-denominated securities in London, and use London as a jumping board to Europe. The Brexit may affect London’s status as the world’s top financial center, so it may turn China’s hope into ashes (at least in the short run). Therefore, China may need to rethink this strategy.

 

The Possibility of a Rate Hike in July

Yesterday my friend asked me if the Fed would raise interest rate in July since it kept the interest rate unchanged on June 15, 2016 after the meeting. My answer is probably not. I don’t think the Fed will increase interest rate in July unless we have a very strong economy for the second quarter of this year (which I think the chance is very little). I even rule out the chance of a rate hike in September because it is too close to the presidential election. Therefore, I think it is most likely that the Fed will raise interest rate in December (probably a quarter-point) before the end of 2016.

In fact, the Fed had kept interest rates close to zero for a long time since the financial crisis in 2009. It raised the federal fund rate in December last year for the first time in nine years and it projected four more rate hikes in 2016. So far there were no rate hikes in the first half of 2016 because of the market turmoil and the anemic economic growth in the first quarter of 2016.

In early June, Fed Chair Janet Yellen mentioned four main risks to the U.S. economy, including slower demand, low productivity, low inflation, and volatility in financial markets overseas. First of all, a possible rate hike in June was killed by the unemployment report showing that only 38,000 jobs were created in May. The job gain in May was well below April’s job gain of 123,000 and the average of 230,000 jobs created per month in 2015. Economists polled by Reuters had forecast job creation of 164,000 in May before the release of the unemployment report. The job creation of 38,000 fell short of the economists’ forecast. Although the Fed said it should not place too much emphasis on a single monthly report for unemployment (instead, the Fed should see at least two more employment reports to determine the trend for job growth), I think the unexpected slow growth of job creation in May was a major factor for the Fed to hold interest rates unchanged.

Although the unemployment rate fell to 4.7% in May (which is the lowest since 2009), the labor force participation rate was only 62.6 percent, which is near all-time historic lows. In addition, involuntary part-time workers (those who are unable to find a full-time job) increased by 468,000 to 6.4 million. If we add those who want to work but have given up searching and those who are working part-time because they are unable to find full-time jobs, the unemployment rate held steady at 9.7 percent in May. Therefore, the U.S. employment picture is not as strong as what we think.

Low productivity is also a concern for the Fed. Productivity fell at an annual rate of 0.6 percent in the first quarter of 2016 after a 1.7 percent decline in the fourth quarter last year. In fact, productivity growth has been weak in the last five years with an annual growth rate of just 0.5 percent, which is only one-third of the annual productivity gain from 1970 to 1990.

In early June Yellen gave a speech in Philadelphia and she said “there is some evidence that the deep recession had a long-lasting effect in depressing investment, research and development spending, and the start-up of new firms, and that these factors have, in turn, lowered productivity growth.” I think the decline of U.S. productivity attributes to insufficient business investment, which is also the main driver for economic growth and employment.

Although the consumer price index rose 0.2 percent in May (which is the same as in April) and the core consumer price index (which excludes volatile food and fuel costs) increased 2.2 percent from May 2015, the personal consumption expenditures (PCE), which is the Fed’s preferred inflation guideline, still hasn’t reached its 2 percent targeted inflation rate since April 2012. Due to decline in energy prices and strong dollar, U.S. inflation is expected to remain low in the near term, so there is no reason for the Fed to raise interest rate if inflation remains low.

Yellen also noted that the global economic slowdown (particularly in China) continues to pose risks to financial markets despite less volatility in the Chinese stock markets and her currency in the recent months. Yellen is also very much concerned about the British referendum to exit from European Union (EU) on next Thursday, June 23. She said a “Brexit” “could have significant economic repercussions”.  I think if Britain votes to leave the EU, I think it may pose an immediate economic risk to both Britain and EU. The Brexit would also trigger more speculation on which country might be the next one to leave the EU. Meanwhile, opinion polls are suggesting more votes on leaving the EU. I will give my comments on this topic in my next email before the referendum on June 23, 2016 since I have a lot of discussion of with my friends on this topic recently, and I would like to share our thoughts with you.

Based on some latest economic reports, I think the U.S. GDP may rise about 1.5 percent to 2 percent in the second quarter of 2016. The rise in GDP is spurred by the increased consumer spending (which accounts for 70 percent of the U.S. GDP). For example, in April consumer spending rose 1 percent after a flat reading in March, the biggest jump in six years. All major components showed solid gains, which was led by a 2.3 percent increase in spending on durable goods. U.S. shoppers also increased their spending in May. This is a good sign that consumers continue to spend despite the recent slowdown in hiring. In May retail sales rose a seasonally adjusted 0.5 percent, the second straight increase after a 1.3 percent gain in April. Total retail sales have risen 2.5 percent from a year ago. Although the GDP may increase about 1.5 percent to 2 percent in the second quarter of 2016, it is by no means a strong economy for the Fed to raise interest rate in July. Therefore,

The Fed will meet in July, September, November and December later this year, so there will be four chances of rate hikes. However, unless the economy suddenly booms, I think now December seems to be the only time for a rate hike before the end of 2016. In addition, I don’t think the Fed will raise interest rates in September because it is very close to the presidential election in November. A rate hike in September will cause U.S. stock prices to plummet before the presidential election, which is something that Hillary Clinton hates to see.

 

The Possibility of Brexit and Its Impacts

Recently I had a lot of discussion with my friends on U.K.’s referendum to exit from the European Union (EU) on Thursday, June 23, 2016. Meanwhile, it seems that opinion polls are suggesting more votes for Great Britain to leave the EU. I think the Brexit may have an immediate economic risk to Britain and the EU, which will intensify the volatility in global financial markets. Many people are afraid if the U.K. leaves the EU, it will trigger a U.K. political and economic crisis. Therefore, the British government is campaigning very hard to the voters to stay in EU.

A week ago the U.S. Treasury Secretary Jack Lew commented in an interview on CNN on the risks of Brexit and he said, “I see only negative economic outcomes” if the U.K. votes to exit and a Brexit would also put geopolitical stability at risk.” In addition, European Council President Donald Tusk said the long term consequences are difficult to see but that every nation in the EU would be hurt economically, particularly the U.K. In fact, no one knows exactly what will happen after the Brexit and its impacts on the global economy and financial markets.

I can understand why the British want to leave the EU although U.K. has enjoyed solid economic growth after joining the EU. However, the British may be better off in the long run after leaving the EU because they can stay away from the EU problems including refugee crisis, rising immigration to U.K., the time bomb of sovereignty debt in Europe, anemic economic growth, persistent unemployment and deflation as well as terrorism, etc. Now the hot button issue for British voters is the EU policy on immigration, touching off waves of refugees to enter Europe from the Middle East.

According to Pew Research, the biggest issue in every EU country was Brussels’s handling of the refugee issue. Based on a survey in Greece, 94 percent of Greek citizens disapproved of how the EU handled the situation, as did 77 percent of Italians. The EU’s handling of economic issues was another disappointment. About two-thirds of respondents in France, Spain and Italy disapproved EU’s handling of economic issues.

Now the EU immigration policy is a big issue for U.K. For example, there has been a sharp increase in the number of immigrants coming to U.K. from other EU countries, including new immigrants from Romania and Bulgaria since EU rules allow any citizen of EU country to live in any other EU country and to enjoy their social services.

Staying in EU also means that U.K. will continue to relinquish national sovereignty (which means when a state has the absolute power to govern itself, make, execute and apply laws and impose and collect taxes). The recent terrorist attacks in France and Belgium by the Middle Eastern descent have also made it an even bigger issue for U.K. to stay in EU.

U.K. is also very unhappy with the some of the EU’s economic policies. Since 2010, the EU has introduced more than 3,500 new laws affecting British business. For example, under a EU proposal, it will introduce a financial transactions tax (FTT) to place a 0.05% tax on trades involving stocks, bonds, foreign currency, and derivatives. This will affect the development of U.K.’s financial industry (which is a backbone of the British economy).  Meanwhile, U.K. has a much stronger economy than other EU countries (except Germany). Unemployment rate is just 5.1%, while other EU countries are still suffering from high unemployment, chronic deflation and weak economic growth. U.K’s Inflation is low and real wages are solid. In fact, U.K. is a free-market economy more similar to that of the United State, while Germany and France are of more socialist capitalism. This is a quite difference in the concept of managing an economy.

However, if U.K. leaves EU, it will increase the fears that the Brexit may lead to the breakup of the 28-nation economic bloc, thus bringing an end to the euro. As for the U.K., the Brexit would create a period of political and economic uncertainty because it will reduce U.K.’s access to the huge European market, weaken London’s status as the world’s top financial center, and increase the risks of capital outflow and losing Scotland which will join the EU (this will be another fissure for the U.K. economy). Leaving the EU will require U.K. to renegotiate trade agreements with each EU country and a host of other issues.

If U.K. leaves the EU, the U.S. big banks will also suffer income losses.  The Brexit will pose an immediate pressure on U.S. big banks which will have to move their operations out of U.K. to other countries that are more connected to the EU. The Brexit would definitely hurt the income of the five biggest U.S. banks. Meanwhile, they earn about a total of $27 billion USD per year in U.K. For example, JPMorgan’s annual income from U.K. is about $8 billion USD a year, which are much more than it can make in Germany ($92 million USD) and France ($42 million USD).

The relocations of these U.S. big banks would hurt U.K.’s finances directly and her status as the world’s top financial center. It is estimated that Britain could lose as many as 400,000 service-industry jobs in the next two years after leaving the EU. Now workers in the banking sector contribute more than 7 percent of the U.K.’s tax rate take from wages. The Brexit will definitely benefit other financial centers, particularly New York, which could gain a competitive edge if the international financial institutions leave London.

Although the recent poll indicates that the votes for leaving EU are more than that of staying in EU. However, the global financial markets give a strong signal to disapprove the Brexit. In the last two weeks, Sterling fell to $1.4108 per pound against the U.S. dollar, its lowest point since April. Gold, being a safe haven in time of crisis, rallied to $1,294 USD an ounce on last Friday.

ANZ even predicts the gold price will move towards $1,400 USD an ounce because the Brexit would create big demand for gold. Concern ahead of the Britain’s referendum on June 23, the yield of 10-year U.S. Treasury note gained for a third week to 1.618% on last Friday, the lowest since 2012.

Japanese yen rose 2.6 percent last week, reaching 103.55 per dollar, the strongest level since August 2014, as investors sought refuge before the referendum in U.K.

The yield of 10-year German government bonds (known as Bunds), which are considered a benchmark of financial security, turned to -0.028 for the first time on last Tuesday. Investors are willing to accept negative returns for the privilege of owning the rock-solid German government bonds to avoid unexpected risks.

Anxiety over the Brexit has also affected the U.S. stock markets. U.S. Stocks continued to falling recently. Last week the Dow and S&P 500 each lost 1 percent while the Nasdaq fell almost 2 percent. Now even the Bitcoin traded above $730 per bitcoin at the end of last week, the highest not since February 2014.

Now it is very obvious that the poor performance of the global financial markets since June does not support the Brexit. The fears of an immediate recession in U.K. leading to rise in unemployment after leaving EU has changed the mood for more British voters to stay in EU. In addition, a well-regarded politician Jo Cox, who supported U.K.’s staying in EU, was shot to dead on last Thursday in Birstall, a small town she represents. Therefore, I believe that more British voters will turn to stay in EU on June 23, 2016 (because people usually do not want uncertainties and prefer to maintain status quo).

What is the impact of a Brexit on the U.S. economy? Since an actual exit from the EU takes a minimum of two years, and the procedures of EU exit will work out slowly. Therefore, its impact on the U.S. economy should be minimal and short-term. However, the Brexit may increase the swings in the U.S. financial markets for a while because of market uncertainties. In time of uncertainty and crisis, U.S. dollar is always the safe haven for investors, hence attracting capitals to move from Europe to the United States to seek safety. Therefore, I think investors will step up buying U.S. treasury securities as a hedge against the increased volatility in the financial markets caused by the Brexit and this will strengthen U.S. dollar. In addition, I think Mainland Chinese investors will may pull their investments out of U.K. and move to the United States. This will help the U.S. financial and housing markets. I think the United States will benefit directly from the Brexit.

Note: The article is just my personal opinions and it does not offer any investment advice to readers.

Proactive Fiscal Policy and Supply-Side Management

In the opening of People’s National Congress on Saturday, March 5, 2016, Premier Li Keqiang addressed to nearly 3,000 delegates in this 12-day session that China must be prepared for a tough battle to keep its economy growing at 6.5 percent for the next five years while creating more jobs and restructuring old industries. Building a “moderate prosperous society” is a main goal of the 13th Five-Year Plan covering the years from 2016 to 2020. To achieve this goal, China must maintain a minimum 6.5 percent of economic growth over the next five years. Premier Li announced a growth target of 6.5 percent to 7 percent in 2016 and generated at least 10 million new jobs as part of plans to create 50 million in the five years through 2020.

China will also introduce reform on her inefficient state-owned enterprises through mergers, bankruptcies and debt restructuring hoping to create 10 million new jobs and keeping the registered urban unemployment rate below 4.5 percent in 2016. Meanwhile, China has about 150,000 state-owned enterprises, managing more than $100 trillion RMB ($15 trillion) in state assets and employing over 30 million people, according to the official Xinhua news agency. The structural reform plans includes reducing the dominance of state companies from banking and telecommunications to oil and steel, and also giving entrepreneurs a bigger role. Premier Li also promised to open electric power, telecommunications, transportation, oil, natural gas and municipal utilities to private companies. In addition, the private companies would receive the same treatment as state-owned enterprises in project approval, finance and tax policy.

The government also hopes retailing, e-commerce and other service industries can help stimulate consumption that grew to 44.5 percent of the economy last year from 2014’s 36.8 percent. These service industries are growing and may absorb some idled workers. In 2015 consumption accounted for 66.4 percent of China’s GDP. In addition, the premier pledged to boost consumption in other areas such as elder care and health services.

Meanwhile, China is still struggling with the decelerating economy and accelerating debts. For example, the official Purchasing Managers’ Index (PMI) fell to 49.0 in February from January’s reading of 49.4. It was the slowest reading since November 2011. Due to the sluggish global demand, exports fell 20.6 percent from a year earlier to $821.8 billion RMB ($126 billion USD) in February, a much deeper drop than the 6.6 percent of the previous month. Import also plunged 8 percent to $612.3 billion RMB ($94 billion USD) in February after a 14.4 percent drop in January. In addition, the rise in debts continues to accelerate. China’s total debt-to-GDP ratio surged to 247 percent last year from 166 percent in 2007. Furthermore, China’s foreign currency reserves continued to fall for the fourth consecutive month in February to $3.20 trillion USD from $3.23 trillion RMB in January. I think the recent slowdown in the decline of foreign currency reserves was a seasonal factor because businesses and banks were shut down in February for the Chinese New Year. I think the Chinese currency remains weak as long as China’s economy is decelerating and the capital outflow continues due to the reversal of “carry trade” as a result of the strong dollar.

On March 1, 2016, Moody’s Investors Service lowered China’s credit-rating outlook from stable to negative, which highlighted the country’s rising debt problem and questioned the government’s ability to implement structural reforms. Despite the fact that Moody’s cut its credit-rating outlook, it affirmed China’s long-term credit rating of Aa3 because the large size of China’s economy contributes to its credit strength, and economic growth is still higher there than most of other economies. In addition, China has a comparatively low level of central government debt, high domestic savings and huge foreign exchange reserves. Moody said it may downgrade China’s credit rating if the pace of reforms needed to support growth slows, but it would revise the outlook to stable if China reduces its debts by restructuring state-owned enterprises.

To combat the decelerating economy, China will increase a budget deficit to 3 percent of GDP (about $2.18 trillion RMB) in 2016, up $560 billion RMB from the 2.3 percent of GDP in 2015. This is what the Chinese government called the “proactive fiscal policy”, which means pumping money into the economy to boost demand by deficit spending. In the western world, we call it the Keynesian economics, which lost favor in the West after the 1970s (because budget deficits grew and government debts surged to high level). The Chinese government expects these “proactive fiscal policies” to be continued and strengthened in 2016. During an economic slowdown, it really makes sense that deficit spending can stimulate demand and absorb excess capacity to boost the economy. However, in a growing economy, deficit spending would drive up prices, causing inflation. If the Chinese economy is still growing at an annual rate of more than 6 percent, why does the government still want to stimulate the economy by deficit spending? Keynesian economic policies make no sense at all. Therefore, it is quite obvious that China’s real growth rate is much less than 6.5 percent a year.

To stimulate the economy, China will also increase about 13 percent for the money supply M-2 in 2016, thus increasing the total M-2 to $150 trillion RMB. Meanwhile, China’s M-2 (about $135 trillion RMB) is 200 percent of her GDP (about $67.7 trillion RMB). This ratio is 70 percent in the United States. The rate of growth of money supply over (i.e. 13 percent) the targeted economic growth rate (6.5 percent to 7 percent) will add inflationary pressure on China’s economy in 2016. In fact, there are renewed sign of rising inflation in China. For example, the consumer price index in February increased 2.3 percent from a year earlier, the biggest increase in the last 19 months.

In addition to the “proactive fiscal policies” to boost demand, President Xi Jinping is calling for the “supply-side structural reform”, his new economic initiative which was advocated by U.S. President Ronald Reagan and British Prime Minister Thatcher in the 1980s. President Xi said that China should work more on supply-side structural reform including cutting excess industrial capacity, tackling debt overhang, increasing production efficiency and streamlining bureaucracy.

The Supply-side economists believe that the best way to stimulate economic growth is to encourage investment and production through tax cuts and deregulation (i.e. to reduce regulation to lower barriers to production and to encourage competitions). Supply-side management is expected to generate sustainable and quality growth instead of creating short-lived demand. The tax cut encourages businesses to invest and give workers the incentive to work harder with low tax rates. The increase in investment expands the supply of goods and services, encourages entrepreneurship and new innovation, and creates job opportunities.

To cut excess capacity, the Chinese government said on February 29, 2016 that it would lay off 1.8 million steel and coal workers, around 15 percent of the work force in those industries. As you may remember that the downsizing of state-owned factories starting in 1997 was quite effective. More than 30 million jobs were eliminated, but the Chinese economy took off, especially after China entered into the WTO in 2001, creating jobs that absorbed many of the layoff workers. Will the downsizing work again this time?

If the proactive fiscal policy is implemented correctly, it will stimulate growth and create economic values. However, if the Chinese government just increases deficit spending on inefficient infrastructure projects by building excess manufacturing plants and high-speed railways etc. to boost GDP, it will defeat the purpose of generating real economic growth. In my opinion, China should stimulate domestic consumer spending (since China is shifting from an economic model driven by fixed investments and exports to services and consumer spending) instead of increasing excessive spending on those inefficient infrastructure projects. To create sufficient demand for consumer spending, I think it is important for the Chinese government to expand her safety net (such as health care services, unemployment insurance, affordable housing and education, etc.), so that consumers can feel free to spend, thus increasing the aggregate demand.

To carry out the supply-side structural reform, one key principle of the supply-side management advocated by President Reagan is “Government is not the solution to our problem; government is the problem.” In fact, the private sector, not the government, is the key to economic growth (through lowering corporate tax rates, reducing regulations and encouraging fair competitions under the supply-side management). Therefore, I think the Chinese government should give more freedom to private enterprises to develop their businesses and to encourage innovations. The major economic function of a government is to provide a stable environment for companies to do business, enforce laws and orders, maintain competition within the economy by restricting monopolies and unfair trades, and manage wealth equality. Micromanaging all facets of the economy is not the supply-side management.

In conclusion, I hope the “proactive fiscal policy” can go hand in hand with the “supply-side management” to create multiplier effects to save China’s decelerating economy, thus reducing capital outflow, stabilizing the exchange rate of RMB and restoring investors’ confidence.

 

The Outlook of the U.S. Stock Markets

My friends asked me if the U.S. stock markets will turn bearish and how far it will go up or down.

 

First of all, I said that I am not a prophet, so I am unable to confirm the direction of the stock markets accurately (as there are so many variable factors including the unpredictable psychological factor). However, I can offer my prediction based on my research and the history of the financial markets. Since the U.S. stock markets haven’t fallen for more than 20 percent from its peak, they are not in the bear market yet.

 

I think the U.S. stock markets are still under selling pressure, so further corrections will be extended to the third quarter. However, I don’t think the U.S. stock markets will crash like the one in China.   

According to Wall Street, it expects a 3.4 percent decline in earnings for the S&P 500 companies in the third quarter of 2015, led by steep declines in the energy and materials sectors. The decline in earnings is also affected by the strong dollar whose strength has hurt the competitiveness of U.S.-made products, lowering the export sales of the U.S. companies. Since about half of the earnings of these S&P 500 companies generates from overseas sales (because they are multinational corporations), the currency translation (i.e. from domestic currency such as euro and yen into U.S. dollar) would reduce their earnings, causing stock prices to fall. Meanwhile, the average P/E ratio of the S&P 500 stocks is about 15 times after the recent fall in the U.S. stock markets. The decline in earnings means a lower P/E ratio and stock price. Therefore, I feel the selling pressure for the U.S. stocks, and further corrections in the U.S. stock markets seem to be inevitable.

 

In addition, I expect the Chinese stock markets will go lower because of the sluggish economy. I think China’s economic slowdown will last for a period of time since there is no quick fix for their economic problems including the over-reliance on fixed investments, high levels of debt, declining exports, and insufficient domestic consumer spending, etc. A 2 to 3 percent devaluation of its currency is not enough to stimulate strong exports. Therefore, I think the Chinese government needs to devalue the RMB by a total 5% to 7% before the end of this year in order to spur export growth.

 

To support the Chinese stock markets and a falling currency, the Chinese government might have spent a total $400 billion USD, causing the foreign exchange reserves to drop from $4.1 trillion USD in 2014 to $3.6 trillion USD at the current level. Spending $200 billion USD to pop up the Chinese stock markets is very costly, so the Chinese government may stop doing it. If this is the case, I think there may be another crash, and then it would adversely affect the U.S. stock markets.  Now the major buyers are the “National Team”. If they stop intervene the stock markets, the demand for Chinese stocks will tumble. The retail investors, who make up 80% of the Chinese stock markets, have got seriously burned, so they would not return to the stock markets quickly. Instead, they are waiting for the chance to unload their stocks to recover or to minimize their losses. The stock market crash and currency devaluation have caused capital outflows, which would reduce the money supply of RMB (since the money supply of Chinese currency is based on the inflow of U.S. dollar), further depressing the Chinese economy. If the Chinese government stimulates the economy by increasing the money supply of RMB not based on the inflow of U.S. dollar, this will be inflationary.

 

I don’t think the U.S. stock markets will crash because the U.S. economy remains strong. The GDP rose at a 3.7 percent (annualized rate) in the second quarter of this year after a revision from a 2.3 percent growth. The GDP growth was mainly driven by strong business investment with an increase of 8.6% percent in spending on intellectual property, the largest since the last quarter of 2007. Consumer spending, which accounts for about 70% of the U.S. economy, grew at 3.1 percent (annualized rate). Government spending increased at a 2.6 percent annualized rate. The trade also contributed 0.3 percent to the GDP growth. The growth in spending on business, consumer and government is quite impressive. In addition, non-farm payrolls increased 173,000 in August, so unemployment rate fell to 5.1 percent, which is close to the natural unemployment rate of 5%. The U.S. trade deficit also shrank 7.4 percent in July to $41.9 billion USD, the lowest in five months. Last week the Labor Department announced that the initial claims for state unemployment benefits were 282,000 for the week ended August 29 (Note: it was about 550,000 in 2009 when the U.S. economy entered into recession, so a weekly figure of 282,000 is a substantial improvement). Furthermore, falling gas prices has increased the U.S. consumer’s purchasing power, which is a windfall for Americans. Moreover, the U.S. construction spending increased 0.7 percent to $1.08 trillion USD in July, the highest level in more than seven years. All of these indicate that the U.S. economy is getting traction, so I don’t think the U.S. stock markets will crash because it has a strong economic fundamental.

On average, bull markets end after 4.5 years. Now the bull markets in the United States have lasted for almost 6.5 years since 2009, and they haven’t declined 10% for more than 40 months, so I am not surprising that there were corrections in the markets recently. Now I think the interest rate hike by the Fed and the Chinese stock markets are the two major factors determining the direction of the U.S. stock markets in the short term. Therefore, we need to pay particular attention to these two factors.