Byron Wien on Trump, Trade, Deficits and Thucydides

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Posted by Laurence B. Siegel

on Wednesday, 11 July 2018 15:43

UnknownOn June 27, 2018, I spoke with Byron Wien of the Blackstone Group, a longtime friend of Advisor Perspectives and the author of the widely-followed Ten Surprises series of predictions, which Byron has produced for 33 years. For many years, Byron was chief U.S. investment strategist at Morgan Stanley. 

If you are in the camp of those who think Donald Trump is mostly a destructive force in the U.S. economy, how destructive will he be? Some investors, such as Seth Klarman, who have not historically been sympathetic to Democratic causes, are actively working to elect Democrats to weaken Trump’s power. How do you react to that strategy?

Well, I am in that camp, but people are not recognizing that the vast majority of the electorate is probably applauding what Trump is doing. Most people think our trading partners have taken advantage of us. Many people are benefiting from the tax cut and the deregulation that Trump was able to achieve. As a result of that, the Wall Street community may be somewhat skeptical of Trump, but I think he has more support than most people realize. As a result of that, all the polls show Democrats are going to take the house. I think that outcome is less certain.

The tax cut and deregulation, in my view, are generic Republican stuff that is not unique to Trump. A trade war and an immigration war are not generic Republican policies and they concern me. 

I agree with that. But Trump’s method of operation is to take an extreme position and be willing to back down on it. The separation of children from their families is an example. That was a clear mistake. It was a humanitarian error and a political misjudgment and he reversed it. I think he lost some political capital in the process, but he did change his mind. He is perfectly willing to change his mind.

Trump appears to want domestic approval. He doesn’t care how many people abroad he offends. He is an example of inward thinking. Inward thinking is the most powerful political force operating in the world today. It is an aspect of populism. You first saw it with the Brexit decision, and you are seeing it around the world with the re-election of Erdogan in Turkey and his increase in power. In China, Xi Jinping is now president for life. The idea of countries cooperating with each other has diminished greatly over the past two years.

Well, I hope it doesn’t diminish further. Let’s move to the European question. With Brexit proceeding, all eyes are now on Italy. A coalition of strange bedfellows, consisting of the right-wing League (formerly the Northern League) and the left-wing Five Star Movement, which has “degrowth” as one of its platforms, has won the Italian election. While Italy is not going to leave the EU at least in the short term, that is an unstable situation. What risks does it pose? Is the likelihood of an Italian debt default and a subsequent EU bailout significant?

The European Union was able to survive Greece. I don’t know whether it can survive Italy, which is much larger. Italy has the fourth largest economy in Europe after the UK, Germany, and France. And they are in terrible financial trouble. Moreover, the far-right party is very much opposed to the European Union, and to immigration. It’s just a further example of an alliance that was very effective economically – the EU – being called into question. So that is something to worry about.

All these things – the trade wars, the trade hostility with China, the problems in the European Union – are negative for world trade and for world profitability. As a result, companies that operate globally are going to have disappointing earnings, and that is likely to have a negative effect on their financial market performance.

Let me push back a little. I want to see everybody in the world get along with everybody else. But, if you look at European growth rates up to 1997 when the EU was established, and compare them with growth after 1997, it seems like they went down. The European Union is very effective for Germany, but not for too many other countries except Poland. The continent seems stuck in kind of a slow-motion recession that won’t go away. Does that concern you at all? Do you think that Europe progresses at about the same rate with or without the Union?

Europe was doing well in 2017. It is not doing as well in 2018. My opinion is that the European Union is good for Europe, having free flow of people across borders, having no tariffs among the members of the Union. Those things are favorable. I agree with you that Germany has been the major beneficiary. But France and Italy have benefited too. A disintegration of the Union would be a negative for commerce around the world, but that is not imminent. Right now, my belief is that the European Union will limp along for another few years. I agree it is in more jeopardy than it has been, but it is going to survive at least several more years.

That is a big disappointment considering the amount of effort that went into creating it, but let’s move to the United States. Trump’s tariffs in the escalating trade war are arguably destabilizing the US economy, although by many measures we’re doing okay. Not everyone is doing okay, but they weren’t before. Is there a case to be made that his moves are correcting a long-standing unfairness? China has grown spectacularly, some would say by taking advantage of us – of our technology, high labor costs and free-trade philosophy. In one of your commentaries you said that a tough position with China could be justified and that we have a legitimate grievance. What is it? Please expand on those ideas.

Well, I abide by that position. China, by forcing us to perform joint ventures every time we want to do a deal over there, has confiscated our technology. They want to do it more. But China is getting on its feet in terms of technology. My own projections are that by 2025, China will be the leader in the world in biotechnology, digital and agricultural technology. So their position on trade is to seize an advantage for the next several years, but they are going to be on their own by the middle of the next decade.

Nevertheless, we should be tough on China. We should not be as tough on Europe. Our arrangements in Europe were fairer to both sides. So it’s China where the imbalance was most severe. In taking a tough trade stance around the world, Trump will be forced to compromise, but he should remain pretty adamant about his position vis-à-vis China.

I don’t blame the Chinese for trying. Forty or 50 years ago they were living at a standard that was positively medieval, and famine was their biggest problem. If you don’t have enough to eat, you’re doing pretty badly. Now we’re trying to figure out whether China is the leading economy in the world or just number two. If I were Chinese, I would say whatever we did was right.

Moving back to Europe, the US has been spending about three times as much of its GDP on defense as does Europe, and that has in part allowed Europe to set up generous social welfare and pension benefits which benefit Europe and European companies. Has Europe, especially Germany, been piggybacking on American prosperity? Or is that a misunderstanding of the situation?

That may be a little extreme. Europe has a little more of a socialist orientation than we do. So they have a natural proclivity toward entitlements, and I don’t think they are being supported by us. That is too strong. There is no question that they have benefited from trade with us. But the trade imbalance with Europe is nothing like the trade imbalance with China.

Europe, going back to the end of World War II, has believed more in social benefits for its people than we do. We believe that people should take more personal responsibility for their economic well-being. Europe believes that the government should play a bigger role. So that is a philosophical difference across the ocean, more rooted in culture than it is in trade practice.

Do you think a lot of Americans wish we were more like Europe in that way? In my experience, it is not just a small number of vocal people in universities on the east and west coasts who feel that way; it is about half. Most of our national elections have been tie elections, or almost a tie, for the best part of 20 years with the Democrats representing a more European-type view. Do you think that we would gain from a more European system? Or do you think we would lose?

I think we would lose. I am a believer in personal responsibility. I don’t believe the government should do more for the people than they are now doing. I do believe in universal health care, but I don’t believe in a guaranteed minimum wage, which would be counterproductive. And I don’t believe in a guaranteed annual income either. That deprives people of personal responsibility and self-respect and I am not on board with it. But in Europe, those ideas are more prevalent.

One of my professors, Art Laffer, said that social democracy works in Europe because the separation of effort and reward is much less in European socialism than it is in whatever aspects of socialist policy Americans have adopted. In Europe you pay a high tax rate, and then the government provides for you, not for somebody else. So their system amounts to the forced purchase of certain goods such as education and health care that you would purchase any way, although maybe they don’t have as much free choice and competition in those areas as we do. The American idea of socialist policy is redistribution. You work, somebody else consumes. As George Bernard Shaw said, a government that robs Peter to pay Paul can count on the support of Paul, but creates a problem for Peter. Is that a valid description of the difference between Europe and America?

Well, my view is that there is as much inequality in Europe as in the U.S., maybe even more. But the safety net is set higher in Europe. So, if you don’t succeed, the government plays a bigger role. Our system has made us the economic leader of the world, and it is a good system, but it has some flaws. Europe provides universal health care. We don’t, and we should. On the education part of it, Americans are more charitable. And, while our taxes are lower, our charitable contributions are greater, and that offsets some of the difference.

That’s a good point. Returning to trade, given that tradable goods represent a relatively small portion of the US economy, how big a threat are the Trump tariffs? How worried should we be about the effect on bourbon and Harley-Davidson sales? Woody Brock had something interesting to say about this. 

He said that comparisons to the Smoot-Hawley period are overdone. Back then, manufacturing and farming drove the US economy. Now, service occupations do. Tariffs have little effects on these. A significant trade war in today’s economy would reduce gross national income by about 2% over three years, far less than the 8% drop that Smoot-Hawley caused in the 1930s. How do you react to those comments?

Smoot-Hawley was a disaster. The tariffs that we are talking about are relatively small in comparison to that. They are not going to derail the US economy. They will hurt certain parts of it. But what has been enacted so far is not very large. If we do $400 billion more in tariffs, that’s important. But remember, we have a $20 trillion economy and $400 billion is only 2% of it. So it is unlikely to have a severe impact if it is enacted as proposed. But we’ll see. I’m hopeful that, in the end, some more moderate compromise is reached.

On the other side of the trade equation, tariffs on goods that we import could increase consumer prices in the US. When combining this effect with wage pressures, higher oil prices, and the desire of a heavily indebted government to reduce the real value of its debt, we could get some inflation. Do you think there is any risk of rekindling the great inflation of the 1970s that effectively eliminated our World War II debt? And if not, how will the debt be repaid?

Now we are into complicated issues. I don’t think the 1970s are going to return. It was actually the 1960s.

The great inflation started in the 1950s, when inflation continued after the war instead of tipping into deflation as it had done after previous wars. But it didn’t really build up a full head of steam until 1967, 1968, 1969.

It took Paul Volcker, who was appointed Fed chairman in 1979, to change all that.

It did. God bless him.

We’re not going to have anything like that. There are two factors that ameliorate inflation: globalization and technology, and they are very much in place. We are going to have more inflation, but I would really doubt that it will get much above 3%, not to 4%. That’s as bad as I can see it. And it may not reach that point. So I’m not concerned.

As far as the debt is concerned, look at it this way, Larry. In the year 2000, our debt – our accumulated debt from 1792 to 2000 – was $6 trillion. The interest rate was 6%. So it took $360 billion to service the debt. Today the debt is $21 trillion, but interest rates have come down tremendously, so debt service is about $450 billion, a little over 2% of GDP. The debt has more than tripled, but debt service has only gone up 25%.

That is actually a decrease as a percentage of GDP, but it’s due to a historic decline in interest rates that is hard to imagine being repeated. I don’t see how we can increase the debt at that rate in the future.

But some economists, including those in the modern monetary theory (MMT) school, think we are underutilizing our potential to grow the economy through fiscal stimulus (government spending). A more traditional view – Ricardian equivalence, about which I have written extensively – is that the debt has to be paid back by somebody, through either higher taxes, lower government services, or inflation which amounts to a gradual erosion of the savings of old people. Where do you come out on this question?

Why does the debt have to be paid back? We have never paid it back. We paid back some of it in the late 1990s, but as long as people will loan us money at a reasonable interest rate the debt can continue to increase indefinitely. Where is it written that it has to be paid back?

The debt has to be serviced by somebody. The principal does not have to be retired; it can just be rolled over. 

But how can you keep borrowing more and more without eventually driving the interest rate up to a point where debt service does becomes a burden on the government?

My challenge to you on that point is the debt has tripled, and the interest rate has gone down by two thirds. That’s a fact. If I told you in the year 2000 that the debt wouldn’t be $6 trillion, but $21 trillion, and I asked you what the interest rate would be, you’d say the interest rate would be 15%.

So why is it 3%? The credit markets seem to be saying that we’re a better credit at $21 trillion in debt than we were at $6 trillion. 

We can do it because we and other central banks have flooded the world with liquidity. And much of that liquidity is looking for a place to hide. Our interest rates are higher than in any other major industrialized country, some of which have negative interest rates. So a 10-year Treasury is very attractive to some sovereign entities, sovereign wealth funds and insurance companies. This has enabled us to build up the debt without an onerous interest rate. I would have never predicted it, but that is what has happened. Globalization and technology have something to do with it.

As a result of that, particularly in New York, there is a broad coterie of people who believe that we should have not a $1 trillion budget deficit, but a $1.5 trillion budget deficit, and we should spend money on infrastructure, social services, and research and development, because those would insure our long-term well-being and growth.

That sounds like the Modern Monetary Theory (MMT) strategy we have been hearing about. Do you think we should do that?

No, I don’t think so. But the trillion dollar deficit can be accommodated.

I know that the debt can grow at the same rate as GDP without increasing the burden from debt service, although I haven’t worked out what exact dollar amount that comes to. But just because we haven’t reached the debt capacity limit doesn’t mean there isn’t a limit. It is like a person getting closer and closer to the edge of a cliff saying, “So far, so good.” If the debt continues to increase faster than GDP then real interest rates have to go down even lower than they are now to maintain the affordability of debt service, and it’s hard for me to envision how that will happen.

Well, the key number that you mentioned is that debt shouldn’t be growing faster than GDP, and we will see whether that happens.

Looking more closely at inflation, overall wage inflation has been relatively stable at 2.5% for the last two years. But over the last nine months, it has been higher. Many observers would consider this a welcome development, because it has been concentrated in production and nonsupervisory employees. But what risks does this pose for inflation and interest rates? How do you react to this development?

Well, the number I look at is 4%. If average hourly earnings were increasing 4%, I would be very concerned. But as long as it’s 2.5% to 3%, I am less concerned. At 4%, wages will have a big impact on inflation.

The way I look at it is this: the stated unemployment rate is 3.8%. Somehow more workers seem to be coming into the system. The work force participation rate has dropped from 66% to 63%, but I can envision it coming back up again. There must be a lot of people who, if you offer a reasonable wage, will come back into the work force. So, even though the unemployment rate is low, I am optimistic that we are not going to see 4% average hourly earnings increases for some time. I am not worried about wage inflation over the next year or two.

Your comments make me want to express a concern: If you’ve ever hired one of the people who dropped out of the work force and then came back in, you see why they dropped out. The participation rate might have been too high. Many marginal workers have serious knowledge or behavioral deficits and can’t really do the work. When I see the quality of the work force outside of professional and technical people, I get discouraged. 

I am mostly reflecting on the native-born marginal work force. Immigrants seem pretty good. They are not marginal.

I agree with you.

You wrote recently, in Advisor Perspectives, that there is no recession in sight. But the first few years of the post-2008 recovery were so slow that it felt like a recession unfolding in slow motion. In that sense, the expansion doesn’t feel like it’s 10 years old at all, but much younger. Is there anything in history you can compare this to? And why did it happen? What made this recovery so different from earlier ones?

The period like this was the 1990s, and the reason that that cycle went on so long is because of technology. That was when the Internet and, later, the smart phone were being integrated into the economy. The reason that this cycle has gone on so long is monetary policy around the world. We’ve provided liquidity to sustain the economy, and that has prevented a recession from taking place.

We are reversing that increase in liquidity. The Federal Reserve is trying to shrink its balance sheet, raising interest rates. The European Central Bank is talking about tapering. Nevertheless, none of the signs that I usually see before a recession are in place. So I don’t think we are going to have a recession until 2021 at the earliest.

I have two more brief questions. What publications and analysts do you rely on for investment and economic insight, and are there any books that you have read recently that you would recommend?

The obvious answers are the Wall Street Journal, the New York Times, and the Financial Times. But I also read Foreign Affairs. I read the New York Review of Books. I read Barron’s. But I also read ISI research.1 I read Strategas and 13D (Kiril Sokoloff’s publication) and the work of Ian Bremmer, founder of the Eurasia Group. Ian Bremmer and 13D are especially valuable.

Ian is great. He has spoken at a couple conferences that I have organized and I respect him tremendously.

There is also a book that I would recommend – Graham Allison’s book on the Thucydides trap,2 the idea that a rising power and an established power usually come to blows.

Is there an asset class, or sector, or geographic region that you think is exceptionally undervalued and why?

I expect the price of oil to go up, and energy is undervalued. There are certain technology stocks that are undervalued, and particularly biotechnology stocks.

Thank you for your time.

1 International Strategy & Investment Group, owned by Evercore and founded by Ed Hyman.

2 For a primer see Allison, Graham, “The Thucydides Trap: Are the U.S. and China Headed for War?” The Atlantic, September 2015, The full book is entitled Destined for War: Can America and China Escape Thucydides’ Trap? New York: Houghton Mifflin Harcourt, 2017.

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