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Saturday, March 18, 2017

Can Trump Deliver on Growth?

 by Roy C. Smith

“This is the winter of our [economic] discontent, made glorious summer by this son of [New] York.” Shakespeare’s opening lines from Richard III, modestly paraphrased, seems to explain the appeal of Donald Trump to his supporters.

Economic discontent? The average US GDP growth rate for the fifty years from 1950-2000 was 3.5%. But, the average GDP growth in the US over the past 16 years is 2%. The slowdown has occurred despite massive efforts by the government to stimulate growth through debt-financed fiscal and monetary interventions.

There is a huge difference between compounding growth at 2.0% instead of 3.5%. It shows up in lackluster performance of investment assets that are essential to pensions and health insurance funds and the states, municipalities, corporations and unions that sponsor them; it has reduced demand for labor to an extent that middle class incomes have been stagnant for decades; and efforts to spend-out-of-the-slump have increased debt-to-GDP levels to record heights thereby weakening the financial standing and capacity of the country.

No wonder, we have discontented voters. As my barber said to me yesterday, “I am a ‘deplorable’ (using Hillary Clinton’s term for a Trump supporter}, because my economic condition for my stage of life really is deplorable.”

Expectations of improved growth under this son of New York are still high – as seen so far in a 10% rise in US stock prices, a boost in consumer confidence, and sufficient increase in recent economic activity (low unemployment and rising consumer prices) to cause the Federal Reserve to raise interest rates a couple of times by small amounts. That’s good, but the hard data haven’t been so encouraging - fourth quarter 2016 GDP growth declined to 1.9%, and first quarter 2017 growth is tracking at only around 1.5%. Janet Yellen said she was “optimistic” about recovery because the Fed’s forecast of growth for 2017 and 2018 was 2.1%, which was better than the 1.7% average for 2016 and 2017.

Better, but hardly enough.

We are now five months since the Trump election, and little that we have seen so far encourages a picture of growth above 3% within the next two years. 

So far there have been a lot of executive orders requiring reviews of existing government programs with the idea of reducing regulatory costs. But as Mr. Trump’s executive orders on immigration have revealed, these can and probably will be challenged in courts and therefore take considerable time to affect meaningful change. Meanwhile, the effort to restrict immigration runs contrary to growth - we need more immigrants to prevent the US labor force from shrinking, which would reduce GDP growth.

Health care reform has also got off to a slow start, the Congressional Budget Office said 24 million Americans would lose health insurance over the next few years, but the plan would reduce the federal costs by $3.4 billion or so per year. The net effect would be an increase hardship and withdrawal of subsidies from about 7% of the population, resulting in a modest drag on growth. In any event, the plan will have to be revised to get by the Senate, which will also take time and divert focus from economic recovery.

Last week Mr. Trump announced his budget plans, which mainly consist of a 10% increase in military spending paid for by across the board slashes in everything except health care entitlements and social security. It is hard to see how such a budget would add to growth, but it is also hard to see what the real budget may yet be because the plan submitted is also unlikely to be approved without considerable change.

Next on the announced Trump agenda is corporate tax reform that is largely unnecessary. Yes, the US has a very high statutory tax rate for corporations (35%), but the average rate actually paid (27%, because of various deductions) is about the same as the world average. The $2 trillion in funds held abroad to defer taxes can still be loaned to US subsidiaries so domestic investment is not curtailed.

The Trump plan, however, will lower corporate taxes for those paying more than the average rate, but is meant to be “revenue neutral.” That is, it will be paid for by a complicated $100 billion “border tax adjustment” on imports, contrary to G-20 and WTO rules. This would be a considerable expense to large retailers and their customers, and to companies with global supply-chains. It too will be a highly controversial plan when Congress gets to it, and will take a lot of time and political capital to push through. But, it is hard to see how it would help increase US GDP growth.

The also promised cuts in individual tax rates, and a massive infrastructure spending plan promised during the campaign probably will be put off until later and probably not go into effect until 2018 or 2019, if ever. These will also be controversial because it is not clear that they are needed to boost growth or that they can be funded without adding considerably to outstanding government debt.  The relatively low rate of unemployment (4.7%) suggests the stimulus effect may increase inflation more than growth, and with government debt at 105% of GDP (the highest level since World War Two) there is little capacity or Congressional willingness, to increase it further.  

By contrast, the stimulative tax cuts of the Reagan administration, enacted in 1981, occurred when the unemployment rate was 8.5% and the government debt to GDP ratio was 32%.

Changes to the Dodd-Frank Wall Street Reform Act, which promise to reduce regulation on banks and free up lending, have been lost in the delayed Congressional schedule. It will probably not come up until 2018, meaning that any impact on growth will be at least two years away.

Discontent with the economic conditions of the country led voters to select Republicans to run the show. The President, a quirky son of New York with no experience in government, has now encountered some of the considerable difficulties of actually doing so, and most of his intended economic initiatives are stalled or in need of revision.

The President has not yet demonstrated a clear agenda for executing a credible economic recovery plan. Such a plan is certainly needed, but whether we will get one or not is hard to tell. In any event, indications now are that it will not have any effect for 2 to 3 years and will fall short of what is necessary to return growth to the 3% area.

The stock market has not curtailed its enthusiasm for Mr. Trump’s expected economic recovery. A great deal of new money has been flowing into US stocks since the election on the promise of greater growth. When the reality of reduced expectations finally catches on, then a major market adjustment will be inevitable.

Richard III reigned for only two years, during which he confronted two rebellions. At the end of Shakespeare’s play, Richard III cries out “a horse, a horse, my kingdom for a horse,” as he is killed in battle after an uprising led by Henry VII in 1485. The horse was unavailable, it has been said, for want of a nail to attach a horseshoe - a metaphor for good governance -- and as a result, a kingdom was lost.

Monday, February 13, 2017

Trump’s Executive Order on Finance Might Just Work Out Best

By Roy C. Smith

Mr. Trump’s executive order on Dodd Frank and financial regulation announced on Feb. 3 doesn’t seem like much of a shake up – all it did really was ask for a study -  but it may turn out to be the easiest way to address his tough anti-bank campaign promises, yet still ease the way for the financial industry to finance growth.

As a candidate Mr. Trump pledged to “dismantle” Dodd Frank and “break up the banks. “ The Republican Party platform on which he was elected also called for reinstituting Glass Steagall, the 1933 law that separated banking from securities activities until it was repealed in 1999.  Since the election, attention also has been drawn to Congressman Jeb Hensarling’s proposed Financial CHOICE Act that would enable large banks to opt out of Dodd Frank under certain circumstances.  And, during his confirmation hearings Treasury Secretary nominee Steve Mnunchin said the government might adopt a “ringfencing” plan similar to the one the UK approved to minimize systemic risk.

It now looks like none of these are likely to happen, but instead a new Trumpian solution will emerge that will fix the problems posed by the both “reckless banks” and the “disastrous” legislation enacted by the Obama Administration.

Critics of the 2010 Dodd Frank Wall Street Reform Act agree that it is too big, cumbersome and costly and it has negatively impacted economic growth by limiting corporate access to credit. Its supporters claim it is a necessary effort to prevent future bailouts of banks and to reduce systemic risk and misconduct in financial services.

The structure of the Dodd Frank law is to require each of nine financial regulatory agencies (headed by presidential appointees) to adopt 390 new “rules” that implement the various provisions of the statue.  Only about 80% of these new rules have been adopted so far; it takes time to write them, wrestle with lobbyists and industry opinions and finally get them in place. But the teeth of the law are in these rules. Change the teeth and you change the law.

The Trump plan apparently was devised by Gary Cohn, ex Goldman Sachs COO and now Chairman of the National Economic Council. No one knows more about the costs and benefits of Dodd Frank than Cohn who has spent six years supervising its implementation at Goldman Sachs and adapting to its strategic constraints. No doubt Cohn has collaborated with Jay Clayton, a respected securities lawyer at Sullivan & Cromwell, and newly designated head of the SEC.

These men know that there are some good and useful parts to Dodd Frank that strengthen the financial system. They also know that the financial industry has spent in the area of $35 billion setting up systems to comply with Dodd Frank, and they don’t want to see the whole regulatory structure uprooted and replaced with something new that they would have to adjust to all over again. They would rather see existing rules changed to eliminated the unnecessary, ineffective and burdensome parts while preserving the basic framework they have become used to.

The Trump executive order requires the Treasury Secretary (who is chairman of the Dodd Frank created Financial Stability Oversight Council) to report back within 120 days as to which of the existing myriad outstanding financial regulations (not just those from Dodd Frank) support Mr. Trump’s new “Core Principles” for financial regulation, and which do not. These Core Principles include many of the regulatory objectives of Dodd Frank, but, unlike that law, they also require that the regulatory system not impair economic growth or weaken financial markets.  

Some of the offending parts of existing regulations can be fixed by having new appointees change the implementing rules. Other parts may require a legislative amendment to Dodd Frank, which, if technical or only involve obscure details, could be inserted into some other law likely to be passed with the Republican majority. The basic idea, however, is to fix what you can in a timely way, but avoid a big battle in Congress (that could take 60 votes in the Senate that Republicans don’t have) to repeal the old law and to replace it with something new.

Even so, a lot of work will be required in the next 120 days to identify the offending, non-Core parts of all existing financial regulation, and then a lot more work and time will be required to write up the rule changes and get them implemented.  The net result is probably that the smaller banks will be given some well-deserved relief on the applicability of the Dodd Frank to them, and the bigger ones will get relief on rules affecting trading, derivatives, compensation and consumer financial protection, and on some of the burdensome compliance and reporting requirements.

But the banks will still be subject to the tough capital requirements of Basel III, and to the qualitative stress tests applied by the Federal Reserve. The Trump plan will not be a return to the status quo ante 2008, but it should help the industry on the cost side and allow more lending to companies seeking credit.

Indeed, it might just be about right. 

Friday, February 10, 2017

Financial Reforms Will Favor US Banks

By Roy C. Smith

Stock markets have been especially kind to US and European banks since the Trump election, and last week’s announcement of an executive order to reduce financial regulation added a further boost. But, regulatory relief will be slow in coming and may not be as much as markets seem to expect. Still, the net effect should widen the competitiveness divide between the large US banks over Europeans.

The Trump approach to financial regulatory reform is as chaotic as everything else.  In the past year, he has said he wants to dismantle Dodd Frank, to break up the banks, and to restore Glass Stegall. He has also said he supported the Financial CHOICE Act, for which Congressional hearings will soon begin. But, on February 3rd he took a different (or an additional) approach by issuing an executive order to establish “core principles” of financial regulation, which include remaining tough on the banks, but eliminating ineffective regulation and that not vetted by rigorous cost-benefit analysis.

That’s been enough to get markets thinking that Dodd Frank will be defanged, new regulations (and litigation) will be halted, rules limiting proprietary trading and derivatives will be loosened, and the whole compliance process will be made less cumbersome, costly and time consuming.  For the first time in years, all but one of the six leading US capital market banks are trading above book value (Citigroup is still at 78% of book). One analyst recently predicted that these banks will have $100 billion more to distribute to shareholders through dividends or buy backs because of regulatory relief.

Others, experts in Congressional and regulatory procedure, say not to hold your breath.

The revived effort by Jeb Hensarling, chair of the House Financial Services Committee, to enact his Financial CHOICE Act that substantially amends Dodd Frank and provides an opt-out from it, will require 60 votes in the Senate that Republicans don’t have.

Further, Mr. Trump’s heralded executive order, which aims to reduce the burden of the 400 new rules that Dodd Frank required regulatory agencies to issue, is at least two years from any significant impact. Rule changes are bound by administrative procedure and are subject to public comment and legal challenge in the courts. In any case, it takes time to sift through all the Dodd Frank rules and all the others on the books, as the executive order requires, and to figure out what to do about them.

How much relief this might provide large banks is unclear. Most of the regulatory weight of financial reform since the 2008 crisis is concentrated in the much-tightened Basel III minimum capital requirements, which Mr. Trump will not abandon, and in the qualitative stress tests conducted by the still independent Federal Reserve. 

Still, most observers believe that the US regulatory burden will not increase, starting from now, and is likely to be reduced over time by the Trump government, though the amount of benefit this will produce may be less than the markets now assume.

But any relief is better than none, and will free up funds with which banks can compete for market share and for shareholder investment with their shrinking number of European rivals.

More important than regulatory relief to the banks, however, is the positive market sentiment that expectation of Trump economic policies has brought. Higher US growth rates, more capital investment, more mergers and larger project financings than would have occurred under a Hillary Clinton government, and certainly more than can be expected in an EU split by political divisions and still stuck in a low growth mode.

The three remaining European capital market banks (Barclays, Deutsche Bank and Credit Suisse) have benefitted from the Trump rally too, but still lag their American competitors. Credit Suisse now trades at 68% of book value, up from 44% in the summer; Barclays is at 58%, up from 34%, and Deutsche Bank, is only at 37% of book, up from a miserable 23% last September.

None of these banks can expect much from US regulatory easement, and instead, are stuck with adapting to a gloomy European political and economic outlook, Brexit, ringfencing, balance sheet and income statement problems, and continuing worries about US litigation for misselling mortgaged-backed securities, money laundering and sanction-breeching, which led to Deutsche Bank’s full page apology to shareholders last week for another massive loss.

American banks will likely assume that the improving economy and the expectation of regulatory relief that has driven up their stock prices removes the pressure on them for any sort of strategic realignment – that is, to separate themselves into two businesses, commercial banking and investment banking, rather than continue to try to operate both under one roof. It is doubtful that this strategy is correct, especially for Citigroup and Bank of America, but the sharp rise in their stock prices has kept this wolf from their doors, at least for now. 

European banks, on the other hand, continue under pressure from the market to split up or back away from capital market activity which has proven so difficult for them to master.  More positive developments from the US will widen the gap between US and European capital market banks. But the Europeans still in the game believe they have little choice but to remain in it. At least for now.

Published in eFinancial News, 2/10/2017

Wednesday, February 1, 2017

Where’s Trump Going on Consumer Financial Protection?

Ingo Walter

            Before and after enactment of the Dodd-Frank legislation in 2010, concerns were raised that consumers often lacked the knowledge to evaluate and make informed decisions about financial services.  Some of the most important involve home mortgages, car loans, asset management, retirement planning, household credit for major durable purchases and credit lines for ongoing household expenses, life and nonlife insurance to keep a family secure, and many more. In the past, the government and employers often made some of the most important financial decisions on behalf of households - for example by providing Social Security or defined-benefit employee retirement plans. Today, households are mostly on their own.

Not such a bad thing, with plenty of financial products and competitors from all kinds financial firms to choose from. But with time financial products have become more complex and less transparent, and a there is bewildering range of options being pitched. Often financial salespeople are under heavy pressure to cross-sell, leading to unneeded new accounts or up-sold services, sometimes attached to an array of embedded and sometimes undisclosed fees. Certain products, such as some kinds of variable annuities, can be almost impossible for consumers and even salespeople to value and identify the associated risks.

And it’s not too late to remember the mortgage “affordability” resets, embedded options and prepayment penalties offered to eager households back in the glory days of the mortgage boom a decade ago. The financial crisis soon placed many of these issues in sharp relief in the US housing market’s mortgage-origination “fee machine,” and through financial contagion its contribution to global systemic risk.

As in any market, there are buyers and sellers, and it’s in the interest of both to come to market fully informed about the price and the exact terms of what is being bought and sold. There are always mistakes being made, but the playing field should be as level as possible for the market to do it’s work – wealth creation, rather than wealth redistribution.

The argument for regulatory intervention is that consumers frequently suffer from market attributes that are stacked against them, so that caveat emptor is an inappropriate model for conduct in the marketplace. The basic sources of consumer disadvantage are found in lack of education and financial skills, lack of transparency in financial products and services, lack of fiduciary responsibility on the part of financial services vendors, and exploitation of vendor conflicts of interest.

Few would argue that consumers should escape the need for proper due diligence, or escape the consequences of their own errors. Moral hazard alone makes an excessively robust consumer safety net untenable. There should be plenty of holes in the safety net. But a systematically biased playing field that aggressively steers consumer choice, provides incomplete and biased information, and creates conditions of financial exploitation is no less toxic. It drains trust from the system. Without trust, neither financial efficiency nor stability can be assured – and ultimately encourages excessive regulation when the political costs get too high. So there is a legitimate argument that both remedial and preemptive improvements in some key dimensions of consumer finance are a good idea.

First, consumers need to be financially literate in order to make well-informed choices in complex financial decisions. There have been some severe gaps. Consumers often do not understand fundamental financial concepts such as compound interest, risk diversification, real versus nominal values, and even the difference between stocks and bonds. Indeed, the evidence suggests that consumers   with higher levels of financial literacy plan better for retirement, while those with lower levels of literacy borrow more, save less, and have more trouble repaying their debt, making ends meet, planning ahead, and making important financial choices.

But seriously, who’s going to cut down on time devoted to their jobs and recreational priorities to take Adult School classes in basic finance? And sometimes too much information is provided and leads to information overload, which can cause consumers to focus on only a few pieces of easily understood information, not necessarily the key aspects for complex financial decisions – relying instead on a few simplified explanations.

There are of course counter-examples. One is lapsed life insurance that can be surrendered with total loss of capital, sold back to the insurance carrier at a substantial discount, or sold to third parties for securitization and marketed to investors - sometimes called “death bonds” or “mortality bonds”.  Another example is long-term care insurance, which can be an expensive but rational choice for consumers, or a combination of life insurance and long term care insurance to lower the cost.  Consumers sometime seem to display remarkable clarity in thinking about the options, even though pricing and disclosure specifics may remain obscure.

Still, consumers can be overly optimistic in interpreting information in a way that that helps lead them to a desired if irrational conclusion. And there’s concern that some financial firms purposely design and proactively advertise products to mislead consumers about benefits, leaving “financial health warnings” to the fine print. Some classes of consumers - such as older people preoccupied with life’s other challenges, minorities and women - may be particularly vulnerable to aggressive marketing practices for financial products and leave consumers disproportionately on the receiving end of exploitation. And it’s been argued that complex financial products survive in the marketplace because they enable cross subsidizing sophisticated consumers at the expense of the unsuspecting. Regulatory intervention in that context will tend to redistribute income away from sophisticated customers, who prefer less consumer protection.

The underlying argument is that fairness embodies more than moral or ethical content in the financial architecture. Failure to provide equitable treatment undermines confidence in the system and impact liquidity, efficiency and growth. It distorts financial flows on the part of ultimate sources and uses of funds, and undermines the political legitimacy of financial intermediaries and those who regulate them. So sensible government intervention is needed as a matter of the public interest.

Dodd-Frank and the Consumer Financial Protection Bureau

This is the logic behind the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, which created   the Consumer Financial Protection Bureau (CFPB) as an independent unit within the Federal Reserve System. Dodd-Frank was mainly about financial stability and systemic risk. But “consumer protection” in the title signaled the its political centrality in setting out the future rules of engagement.

Dodd-Frank’s consumer protection legislation covers depository institutions with assets exceeding $10 billion, mortgage lenders, mortgage servicers, payday lenders and private education lenders. It does not cover automobile financing.

The legislation created the Consumer Finance Protection Board (CFPB) with a mandate to aid consumers in understanding and using relevant information and shielding them from abuse, deception, and fraud by ensuring that disclosures for financial products are easy to understand. It is also mandated to conduct consumer finance research and provide financial literacy education. It has the authority to set rules under existing consumer financial law and take appropriate enforcement action to address violations. It is charged with collecting, investigating, and responding to consumer complaints. And it has a mandate to ensure that suitable financial products and services are made available to consumer segments and communities that have traditionally been underserved.

The CFPB itself is an entity of the Federal Reserve System, and its budget is self-determined and funded out of Fed resources, not by Congressional appropriation – thereby offering some protection against inevitable lobbying pressure. It is managed by a Director (currently Richard Corday) who is appointed by the President   with the advice and consent of the Senate, serving a five-year term and who (like that Chair of the Federal Reserve Board) can be dismissed only “for cause.”

The Financial Choice Act

The consumer protection provisions of Dodd-Frank and the CFPB were controversial from the start, with criticism spanning a range of issues from the constitutionality of its mandate and the heavy hand of overregulation to the “blank check” funding through the Fed and the early cases demonstrating its allegedly excessive use of enforcement powers. Much of the criticism was concentrated in the draft Financial Choice Act (FCA) tabled by Republicans on the House Committee on Financial Services in June 2016..There are two major themes in this proposed CFPB revision:

The first is governance and accountability. As a unit of the Federal Reserve System, CFPB governance was considered both indirect and lacking a clear public mandate and political accountability. Moreover, its budget (close to $1 billion in fiscal 2016) is thought to escape the kinds of checks and balances that apply to other Federal agencies. The Financial Choice Act would broadly extend to the CFPB the kinds of governance, accountability and budgetary appropriations that apply to other federal agencies.

The second key issue is the matter of consumer choice and cost. The CFPB is thought to preempt free consumer choice, transferring to CFPB bureaucrats key decisions about which financial products will be available and to whom, what product information needs to be disclosed, and how they are marketed and priced. The argument is that the CFPB has reflected a retrograde turn away from the market economy towards increased paternalism of the state. It highlights presumptive cuts in access to financial services to the un-banked and under-banked, increases in the cost of financial services, violates consumer privacy, and harms small businesses that rely on consumer financial products.

That said, convincing evidence suggests that tough consumer protection measures can in fact work. Take for example the 2009 Credit Card Accountability and Responsibility and Disclosure (CARD) Act, which capped credit card penalty fees that card issuers were using to make up for lost revenues during the recession.

A careful study of the CARD Act’s impact found that the reduction in fee revenue from cancelled "over-limit" and late fees did not in fact lead to banks increasing credit card interest rates or significantly raising other fees in the period through 2015, nor did it reduce access to credit for US households. In combination, the Act reduced cut the cost of financial services to consumers by about $11.6bn annually.

The Financial Choice Act proposes a range of specific reforms that would fundamentally change the operations, governance, accountability and funding of the CFPB, although it does not propose to scrap it.

Where Should the Trump Administration Be Heading?

Where the Trump Administration will come down on consumer financial protection and the fate of the CFPB and the Financial Choice Act is uncertain. But at least the FCA offers a considered road-map for change, one which deserves to be debated. It seeks to pare away some of the Dodd-Frank provisions considered superfluous or counterproductive, and increase the accountability and budgeting process of the CFPB to align it to governance of other important federal agencies, while increasing accountability to elected officials.

It is hard to argue against political accountability and financial discipline. Still, in a system driven by heavy lobbying and financial contributions by those who stand to gain or lose from consumer protection measures, the survival and impact of Financial Choice Act proposals, if enacted, are difficult to gauge. It is a major, highly complex exercise in cost-benefit analysis – one in which both costs and benefits are often obscure and second-best solutions are often welcome. Inserted into the coming overheated, lobbyist-driven political debate, it is not hard to imagine that consumer interests will once again come at the end of the line.

Of course there is always the threat of over-regulation, but there is also value in helping consumers gain financial literacy, in improving our understanding of how consumer financial markets work, in helping people access and use relevant  information, and in protecting them from abuse, deception and fraud.

Fintech is the wild card in the game. Several dozen players ranging from start-ups and proof-of-concept players to established veterans seeking “unicorn” status by disrupting a retail financial services considered overdue for disruption. They range from marketplace lending to robo-advising, from financial aggregation to retail remittances, from e-brokerage to retirement planning. As these “direct-connect linkages take root, some of the key household disadvantages in finance could melt away – especially as new generations of consumers come on the market – and the case for consumer finance regulation may weaken.

On the other hand, the legacy players weren’t born yesterday, and a wide range of fintech initiatives have already been internalized by the established financial intermediaries – even the independent “disruptors” themselves have found it opportune to link-up with fintech upstarts in joint ventures and as attractive acquisition targets. The fintech dynamic has its own ways of tilting the playing field and generating new forms of conflicts of interest. Good new or bad news? Some of both, no doubt, and time will tell. What is certain is that consumer financial protection will be a moving target.

What’s also certain is that there will continue to be many “sticky fingers” in finance, amply reflected in the waves of wholesale and retail banking scandals since the financial crisis. If nobody’s watching the store, bad things happen. The recent Wells Fargo case involving consumer cross selling - a core strategy deeply ingrained in Wells Fargo’s history, culture and incentive systems - shows how easily a good institution and good people can overstep even the most basic trust and fiduciary constraints in dealing with “soft target” consumers.

Indeed, in a highly competitive financial services market, profit often lurks in the shadows. Retail finance is particularly vulnerable to questionable financial practices given its gaps in information and understanding. So it is surely in the public interest to focus on remedies for market imperfections and professional malfeasance as they appear, and if possible preempt them. It may not be the “best” and most efficient approach, but “second best” can also leave the world better off – as always, the devil is in the details.

Whether the Trump administration and the Congress ultimately chooses the “high road” to consumer financial protection remains to be seen.

Wednesday, January 18, 2017

The Real Trump Effect in 2017

by Roy C. Smith

Suddenly, after Donald Trump’s surprise election in November, a weak economic outlook looked rosy and investors thrust caution aside as visions of tax cuts, infrastructure spending and regulatory reform danced through their heads.Stock markets around the world (except for Mexico and China) soared as, even before being sworn in, Trump demonstrated that he would be a powerful global player.

Now, with the price-to-earnings ratio of the S&P 500 above 26 (vs. a long-term average of about 15), some think the year-end rally was too much. This remains to be seen, of course, but what might we expect from the real Trump in 2017?

His agenda, based on many campaign promises, is more ambitious than any of his recent predecessors. But his plans lack important details and his cabinet and advisors lack the skills necessary to push complex bills through Congress. And, having trailed Hillary Clinton by more than 2% in the popular vote, his mandate to run things his way may be far weaker than he thinks.
He will probably start off with a wide-ranging repeal of Executive Orders issued by Obama, which will be welcomed by the private sector. Not all of these will make much of a difference, but they will be appreciated for their signaling effect – less regulation and government interference in business. The costs of regulation in the US have grown steadily over the years and now, according to some estimates, represent a drag on growth of 1% to 2% per year.

Next, he will attempt to bring forward two broad legislative programs – one involving a debt-financed economic stimulus package involving many components, and the other, the ”repeal and replacement” of two key Obama programs in healthcare and financial service regulation.

The stimulus program was never described as such – instead it was sold as a necessary reaffirmation of American values involving tax cuts, and enhanced spending for public infrastructure and national defense, together with a naming and shaming effort to recover jobs lost to manufacturing abroad. This initiative, however, is not supported by offsetting cuts in public spending so it would significantly increase the federal budget deficit and the amount of government debt outstanding (already at 104% of GDP, the highest level since WWII).

However, the debt component of the Trump stimulus effort is likely to meet considerable opposition among conservative Republicans. So, for this legislative effort to succeed there will have to be significant downsizing and compromise, and this could drag things out several months. Nevertheless, it is likely that some of the Trump stimulus plan will survive. How much it will boost growth and job creation in a still sluggish but recovering economy now operating at full employment is very uncertain, but it is likely to be modest in 2017.

The second legislative effort will be to “repeal and replace” Obamacare (the Affordable Care Act that provides health insurance for those otherwise uninsured), and the Dodd Frank Wall Street Reform Act, both of which narrowly passed with no support from Republican members of Congress. Trump has the votes to repeal these landmark legislative achievements of the Obama administration, but as yet no clear plans for their replacement.

Both issues are controversial and are unlikely to be settled quickly or without a lot of confusion as to what will happen next. The healthcare industry represents about 16% of US GDP, and banking another 10%. Health care could actually contract because of the uncertainty as to what will replace it and when. Republicans in the House of Representatives have a plan for replacing Dodd-Frank that many large banks will appreciate, but these banks are still required to comply with Basel III and its latest additions to capital “cushions” and similar requirements. Despite some considerable relief in the Trump stock market for healthcare and banking stocks, 2017 doesn’t look like a year of substantial profit improvement for either industry.

Finally, Trump will have to decide exactly what he wants to do to change trade relations with China and Mexico. His “America First” theme to recover manufacturing jobs lost to these countries either because of unfair trading practices or badly negotiated trade agreements (Nafta) has had a lot of popular support, but reflects little appreciation of legal and economic realities. He has threatened to raise tariffs significantly on imports from both countries, which some fear could start a trade war.
He can easily make a case that Chinese government subsidies of exporters and its non-tariff barriers to US exports and foreign direct investment, and the occasional case of dumping, have distorted trade relations to the point where corrections are necessary. President Nixon took such a position in the early 1970s when he raised tariffs suddenly on Japanese imports, gaining concessions as a result.
Trade of course is a very thorny issue, with US manufacturers’ supply chains and major agricultural exporters right in the middle of it. Mexico’s case is arguably more complex and less urgent, and Mexico has noted before that as its growth rate declines, illegal immigration to the US increases, wall or no wall.

Here we must rely on Trump’s long history of deal-making. He announces big objectives, threatens and blusters to get the attention of the other side, then finds a workable compromise that he can describe as a success. As with his Twitter-fed negotiations with Carrier, Ford and some other large US companies, a few moderate concessions can be enough for a victory celebration.

Deal-makers are not ideological; they just need to show that they can pull off big, unexpected transactions, often by conceding a lot themselves.

The good news for those scanning prospects for 2017 is that the Trump effect most likely will be less disruptive than many have feared, but will still be a net positive contributor to US economic growth, especially as compared to a Clinton presidency.

The bad news, however, may be that Trump’s bold, blustery, and populist approach to politics and economics will be seen as successful enough in Europe to encourage imitation in the several important political contests scheduled for 2017. There, however, even modest shifts towards nationalism could significantly impair the ability of the EU and the Eurozone to cope with increasing pressures that are developing to dissolve them.

Thus, an unexpected irony of Trump’s election, may be that it could have more effect in Europe in 2017 than in the US.

Friday, December 23, 2016

Trump Lives on his Popularity; Will it be Enough?

by Roy C. Smith

With the stock market rallied and his cabinet positions mostly filled, Donald Trump has given New Yorkers a break from the midtown congestion that his presidency-elect has created by relocating to Palm Beach where his signature comings-and-goings have continued at Mar-a-Largo as he contemplates what will be on his plate after January 20.

This, of course, is quite a lot. He promised to do a great many things during his anti-establishment, shake-things-up campaign: A tax cut and reform bill, the repeal and replacement of Obama-care, the dismantling of Dodd-Frank, increased spending for public infrastructure and defense, and the cancellation of hundreds of executive orders issued by the Obama administration.  That and renegotiating NAFTA, erecting the wall, sorting out unfair trade practices by the Chinese, and defeating ISIS.

But, Mr. Trump will soon experience a reality of Washington life that the colorful, long-serving former Speaker of the House, Tip O’Neill pointed out - that “running for office is much easier than running the office.”

From Jimmy Carter on, every incoming president except George H. W. Bush had no experience of government at the national level when taking office. Nor had many of their key advisers, though Mr. Trump’s key advisers as a group will be far less experienced in governing than any of the other administrations.

Tip O’Neill also is reported to have said that if a president is popular there are few limits on what can get done. That would be because Congress is a weather vane for popular opinion.  If it points to a tax cut, as it did for Ronald Reagan in 1981, then Democrats compete with Republicans for getting credit in delivering one.

Popularity has to be defined, however, as being beyond the base – i.e., having a majority support from voters, broad support from one’s own party, and preferably some support on important issues by members of the opposition party. Only twice in the last 100 years has the winner of the vote in the Electoral College (established in the Constitution to apportion votes by states) actually not received a majority of the popular vote – In 2000, Al Gore received 0.51% more votes than George W. Bush, and in 2016, Hillary Clinton received 2.09% more popular votes than Mr. Trump.

However, Presidential popularity is usually measured by job approval ratings from professionally conducted polls. The Gallup Organization has conducted such polls since 1945, and divides then into a president’s first and second four-year terms (4 of the last 12 presidents had only one term). Most of what most presidents accomplish is accomplished in the first term, after which (in 9 of 12 cases) – their job approval ratings declined.

The following is the Gallup first-term job approval ratings for the last 12 presidents:

            Lyndon Johnson           74%
            John Kennedy*            70
            Dwight Eisenhower      69.6
            George W. Bush           62
            George H.W. Bush*     61
            Richard Nixon             56
            Harry Truman              56
            Ronald Reagan            50
            Bill Clinton                  49.6
            Barack Obama             49
            Gerald Ford*               47
            Jimmy Carter*             45.5

One-term Presidents

Mr. Trump does not yet have a job approval rating, but his popular support was measured at 41% in national polls just before Christmas.

Job approval measures, of course, also reflect unexpected events - wars, terrorist attacks, economic problems, civil disasters, etc. Presidents can be lucky (Reagan, Clinton) to step into office just as a sharp economic recovery had begun, or unlucky to assume office when the economy is collapsing (Carter, Obama). Still, America’s greatest presidents are still seen to be those who guided the country through very difficult times (Washington, Lincoln and Franklin Roosevelt).

Of the 12 presidencies noted above, seven began with the president’s party controlling both house of Congress, which helps a lot in getting things done. But, holding on to that control is another thing, the last four presidencies began with control of Congress but lost it in subsequent elections.

This may be because of two relatively new elements in modern political life: first a deep cynicism about the ability of federal government to make much of anything better; government is run by self-serving politicians who let partisan or parochial interests get in the way of improving the common good. The 56.6% turnout in the 2016 presidential election suggests that a very large percent of the electorate no longer think their votes will change anything.

The other element is that a significant percentage of those who do vote are focused on just  a few main issues to which they are passionately committed – to the point of being uncompromising.
Because of a quirk of Electoral College voting allocation, Mr. Trump won the election with the support of only 47.9% of 56.6% of eligible voters (i.e., only 27.2% of the total electorate, some of which voted for Trump only because they liked Hillary less). This is hardly the popular landslide Tip O’Neill had in mind.

And as of January 20th, Mr. Trump is going to have to start running the office.  In significant part this means delivering at least some of what he promised to the disillusioned and discontented part of the electorate that turned to him to shake things up. But, it is hard to turn what he has called “disasters” (the economy, health care, nuclear treaties, trade policy, military activity in the Middle East) into “beautiful” things.

This would be a tall order even if there were clear cut plans waiting to be taken to a supportive Congress. Given the mercurial support recent Congressional majorities have received from voters, Mr. Trump must keep his eye on maintaining Republican control in the Senate, which contains many Republicans who strongly opposed Mr. Trump’s nomination and who must run for reelection in two-years. If he loses their support, or if voters shift control of the Senate to Democrats, he will be left with nothing much but reversible executive orders to establish his legacy with, just like Mr. Obama.

Governing is hard enough. Doing it with a government of anti-establishment types without governing experience is even harder. But the economy may be picking up on its own, the markets have been very supportive of Trump policies so far, and it may be that the best solutions to today’s difficult problems are those achieved by compromise, or trial and error, and deal men like Donald Trump know how to do both.

Wednesday, December 14, 2016

Letting the Deal King Loose on Trade

By Roy C. Smith

US manufacturing has been hollowed out, the President-elect has said, by unpatriotic American companies and poorly negotiated, unfair trade arrangements, and he will set things right. Will he?

Mr. Trump has tweeted complaints about several US companies that he says have inappropriately exported American jobs to foreign locations. In commenting about Carrier Corp., a division of United Technologies Corp. that was pressured into rescinding some plant layoffs, Mr. Trump said no more American jobs will leave the country without “consequences” being visited upon the offending manufacturer.

Indeed, US manufacturing jobs have fallen to about 9% of the labor force from about 17% in 2000, a difference of 5 million jobs. This is certainly a rapid rate of job erosion, but even so, US manufacturing output was near an all-time high in 2015, representing 36% of GDP. Outsourcing factories to low wage countries is part of the reason for the job losses, but so is improved technology, global competition and better supply chain management. 

During the campaign, Mr. Trump also said he would impose steep (35% to 45%) tariffs on imports from Mexico and China unless he could negotiate better terms of trade with each.  He has also said that he would abandon the Trans Pacific Partnership trade deal on “day one” of his Administration.

Many economists have expressed concern that Mr. Trump doesn’t understand the basic economics of world trade, upon which 28% of the US GDP currently depends, and his protectionist notions are only likely to upset established trade flows or, worse, lead to a tariff war reminiscent of the Smoot Hawley Act that helped grind world trade to a halt in the 1930s

Some of these economists may remember past efforts to publicly shame (“jawbone”) companies into doing what the president wanted, and other attempts from the “bully pulpit” to manage corporate behavior and alter trading relations with other countries. From Harry Truman on, these efforts have been fairly common, but ineffective. Sometimes they succeeded in the short term, but not over time. Corporations are unwilling, and arguably unable under their fiduciary obligations to investors, to defy the laws of economics and the pressures of competition in order to help presidents score political points.

But that was before the Master of the Deal took over the jawboning?

Even before taking office, Mr. Trump has chosen the role of the decisive on-field referee to call fouls and assess penalties on companies he thinks have failed to live by the new rules of America First. He hopes that by jawboning a few, others will get the message and follow his lead even though it may not be legally required or economically justified. No one yet knows what “consequences” he has in mind for the non-compliers, but large companies with multiple involvements with the US government may think twice before offending the White House-to-be. This opens the door for these companies to make private deals with the government to stay in good standing. This is a generally bad idea that can promote favors, favoritism and illegality.

Jawboning is also being used to set up renegotiations of trade relations with Mexico and China, the two countries Mr. Trump has said are most responsible for American manufacturing job losses.

After 23 years of NAFTA, the US now has a $58 billion trade deficit with Mexico, Mr. Trump can easily claim that NAFTA has been poorly enforced and needs rebalancing. Certainly, Mr. Trump’s comments about tariffs, rapists and walls, and the 10% drop in the peso since the election have pushed Mexico back on its heels. Surely the Mexicans want a settlement to bring things back to normal, even if they don’t think a settlement is justified. Maybe a list of administrative “fixes,” and a modest “contribution” to help pay for the costs of job retraining for displaced US workers could be agreed to settle things.

Based on Mr. Trump’s not-so-tough deal with Carrier (800 out of 2,000 jobs to be saved after a $7 million Indiana tax break), which the company (a major defense contractor) could easily live with, indications are that Mr. Trump won’t need too much to be able to claim victory.  But surely, after all the preliminary bombardment, he will expect something.

China will prove to be more difficult, depending on just how much Mr. Trump hopes to extract in improvements, but nevertheless there is room for some. Mr. Trump can point to a record $366 billion deficit (equal to more than half the total US trade deficit), even while the yuan was strengthening (which it was until recently) and the Chinese economy was slowing. China too has been bombarded with pre-negotiation rhetoric - Mr. Trump has already said China is a currency manipulator and engages in unfair practices that destroy American jobs.

In April, the US Treasury backed up Mr. Trump by adding China (and Germany, Japan, Taiwan and South Korea) to its list of suspected currency manipulators (as required by US Trade Facilitation and Enforcement Act of 2015) which it must “monitor” on several fronts to be sure trade practices are fair. There are several criteria, and China, even in the eyes of the Obama Administration, is failing in some.

The Chinese probably have more to lose from a curtailment of exports to the US than the US does, so they should be willing to talk about concessions even though their position is that they                    do nothing that is unfair. China, too, has geopolitical reasons to want to stand up to any bullying from the US.

So, Mr. Trump might want to revisit President Richard Nixon’s actions in the early 1970s when he suddenly announced a 10% “surtax” on all imports from Japan (the principal trade offender at the time) until the large trade deficit with that country could be addressed satisfactorily. This action followed years of trade disputes and rising public sentiment that Japan was not playing by the rules. Years of negotiations by establishment types had produced little, so Mr. Nixon swung his axe. The Japanese then agreed to some quotas on exports, to removal of some non-tariff barriers to US exports into Japan, and to greater Japanese investment in factories in the US. This was by no means the end of US trade disputes with Japan, but it smoothed them out for a time enabling the tariff to be withdrawn and things to return to normal after a few months. What was seen as a seismic event at the time was largely forgotten a year later, but Mr. Nixon got a lot of support from working class America voters in the 1972 election.

The world would issue a great sigh of relief if Mr. Trump’s trade issues were settled with pragmatic, even cosmetic, deals like these, unconventional though they may be.  It will be nice get past fears of tariff wars and recessions caused by bungled trade negotiations.

It may also give us greater confidence that the deal king knows his limits and will not wreck the world economy by reckless efforts to bully others into doing what he wants. Any good commercial negotiator knows that things are settled by comprise. We will have to see whether Mr. trump will follow his business instincts into international relations, or get hung up on projecting American power at whatever cost. 

Maybe these trade deals will turn out to be good practice for the tougher struggles with Iran, Russia and the Middle East that await his attention.