Tutor2U study notes on key areas

Full page with many more study note sections at the bottom is here.

Here are some short summaries of key exam context for topical economics exam issues ahead of the June 2018 papers. We will be adding to this resource on a daily basis.

Brexit and EU/UK Trade

Importance of trade with the EU:

• 44% of all UK exports were sold to the EU
• 53% of all UK imports came from the EU

Trade balance:

• UK ran a trade deficit with the EU in 2017 of £72 billion

Regional importance of trade with the EU

• 60% of Welsh exports go to the EU
• 59% of North East exports go to the EU

Average EU import tariffs (%) – relevant if a trade deal cannot be reached

• Dairy products 35%
• Cereals 13%
• Sugar and confectionery 24%
• Clothing 11%

Overseas aid from the UK

In each year since 2013, UK overseas aid spending has been 0.7% of GNI
In 2016, the UK spent £13.4 billion on overseas aid
Five biggest recipients of bilateral aid are Pakistan, Syria, Ethiopia, Nigeria and Afghanistan. Aid to India has fallen sharply.
Spending on humanitarian aid and supporting refugees has risen
Spending on cancelling debt is now zero
Most UK aid is project aid

• Building antimicrobial resistance 
• Sanitation and hygiene research
• Forest governance to help reduce the impact of deforestation

Unemployment in the UK Labour Market

• Unemployment continues to fall reaching 4.2% of the labour force in Feb 2018, 1.4 million people
• Youth unemployment has declined from 20% in 2012 to 12% in 2018 (520K people aged 16-24)
• Unemployment currently at lowest rate since 1975
• Long-term jobless rate also declining to 1.1% of labour force (less than 25% of total jobless)
• Estimated NAIRU has dropped to 4.5% of labour force – has the Phillips Curve flattened?

However … dig underneath the aggregate data:

• Continued high levels of economic inactivity
• Under-employment remains a major factor - where workers stay in part-time, temporary or zero-hours contract roles because they cannot access full-time jobs - Under-employment estimated to be above Unemployment
• Declining median real wages and also many people who have a job experience in-work poverty and continue to rely on benefits

Youth Unemployment

Unemployment for 16-24 year olds in UK is 12%, down from 20% in 2010
This is 525,000 young people
72,000 of young people have been unemployed for over a year
EU youth unemployment rates:

• Greece 44%
• Spain 37%
• Italy 34%
• UK 12%
• Germany 6%
• EU average is 16%

Relative poverty in the UK

Relative poverty line for UK – households with income < 60% of median income in that year
2017 – 10.4 million people in relative low income before housing costs
That figure rises to 14.3 million after housing costs (22% of the population)
2.7 million children live in relatively poor households, 4.1 million after housing costs
This is 30% of all children
Highest relative poverty is in London (28% of individuals)

The Minimum Wage

National Living Wage (NLW) replaced the adult minimum wage in 2016
Current rates from April 2018:

• Aged 25 and over £7.83 per hour
• Aged 21-24 years £7.38 per hour
• Aged 18-20 years £5.90 per hour
• Under 18 years £4.20 per hour
• Apprentice rate £3.70 per hour

NLW is not tied to changes in inflation
Living Wage is voluntary currently £10.20 per hour in London and £8.75 per hour elsewhere (employers can choose to pay)
Government target is that NLW must reach 60% of median earnings by 2020. It is currently at 57% of median earnings.

Sub prime credit & household debt

The UK Financial Conduct Authority is now responsible for monitoring high cost credit companies including pay-day lenders
2015 - price cap imposed on pay-day loans.
Interest capped at 0.8% per day
Default fees on a loan fixed at £15
Total cost cap of 100% of loan value in default fees and interest
Only two “roll-overs” allowed on each loan
Results:

• Market for loans has got a lot smaller
• Many lenders have left the market – sub-normal profits cause firms to exit
• Loan sizes remain similar, longer repayment
• Default rates have halved
• Signs of shift to credit unions but some groups of consumers no longer have access to credit

Inflation

CPI inflation was 2.5% in March 2018
UK inflation was 2.7% in 2017, peaking at 3.0% in January 2018
Contrasting inflation rates in 2017 (Source: IMF)

• Germany 1.5%
• Cyprus -0.4% (deflation)
• Emerging market & developing nations 4.5%
• Venezuela 8,500% (March 2018)
• Argentina 25% (April 2018)
• India 4.5%

Central banks have different inflation targets

• Argentina: 15%
• India: 4% (+ or – 2%)
• Kenya: 5% (+ or – 2.5%)
• UK: 2%, Euro Zone: 2%, Japan: 2%
• Zambia: 9%

UK Current Account (BoP)

UK ran a record deficit of 5.6% of GDP in 2016. In 2017, the deficit came down to 4.1% = £82.9 billion

• UK trade deficit in goods: £136 billion
• UK trade surplus in services £107 billion
• UK trade balance in goods & services -£29bn

Current account deficit was amplified by a deficit in primary income (investment income) and secondary income (transfers)
Trade imbalances in the global economy (2017)
Current account surpluses:

• Germany 8.2% of GDP
• Singapore 19.6% of GDP
• South Korea 5.5% of GDP
• Taiwan 13.6% of GDP

Current account deficits:

• UK: 4.1% of GDP
• United States 3.0% of GDP
• Rwanda 9.6% of GDP
• Ethiopia 6.5% of GDP

The Productivity Gap

The UK continues to lag behind many other advanced economies in terms of output per hour worked. Productivity growth has been sluggish since the recession ended in 2010.
Some key factors behind the productivity gap:

1. Low rate of investment – many UK firms do not operate at the cutting edge of new technologies
2. Legacy effects of the banking crisis affecting lending to businesses who want to expand
3. Slowing rates of  innovation – UK has low level of R&D spending (<2% of GDP annually)
4. Deep skills shortages in key industries
5. Relatively low levels of market competition – persistence of inefficient monopolies
6. Long tail of under-performing businesses and relative absence of globally-scaled corporations
7. Poor infrastructure e.g. in transport, telecoms and power leading to congestion & higher costs

AI, jobs, disruption & shocks

John Mauldin | May 03, 2017

When Robots Take All of Our Jobs, Remember the Luddites

If you don’t think the transformation we’re embarked upon is a profound one, consider this: Within two decades, half the jobs in this country may be performed by robots. What then of our unemployment rate and social safety net? Opinion is divided: Will the next technological wave further skew the wealth distribution toward the uber-rich, or will it ultimately create more entrepreneurial and job opportunities than it destroys?

There is an interesting historical precedent for our situation, an era during which the technological firmament shifted just as abruptly as it is here and now. In the United Kingdom in the year 1800, the textile industry dominated economic life, particularly in Northern England and Scotland. Cotton-spinners, weavers (mostly of stockings), and croppers (who trimmed large sheets of woven wool) worked from home, were well compensated, and enjoyed ample leisure time.

Ten years later, that had all changed. Clive Thompson, the author of today’s Outside the Box, tells us what happened:

(I)n the first decade of the 1800s, the textile economy went into a tailspin. A decade of war with Napoleon had halted trade and driven up the cost of food and everyday goods. Fashions changed, too: Men began wearing “trowsers,” so the demand for stockings plummeted. The merchant class—the overlords who paid hosiers and croppers and weavers for the work—began looking for ways to shrink their costs.

That meant reducing wages—and bringing in more technology to improve efficiency. A new form of shearer and “gig mill” let one person crop wool much more quickly. An innovative, “wide” stocking frame allowed weavers to produce stockings six times faster than before: Instead of weaving the entire stocking around, they’d produce a big sheet of hosiery and cut it up into several stockings. “Cut-ups” were shoddy and fell apart quickly, and could be made by untrained workers who hadn’t done apprenticeships, but the merchants didn’t care. They also began to build huge factories where coal-burning engines would propel dozens of automated cotton-weaving machines….

The workers were livid. Factory work was miserable, with brutal 14-hour days that left workers – as one doctor noted – “stunted, enfeebled, and depraved.”… Poverty rose as wages plummeted.

Enter the notorious Luddites. Angry workers began to fight back, destroying the hated wide stocking frames and cotton-spinning machinery and even killing factory owners. Soon they were breaking at least 175 machines per month, and within months they had destroyed some 800, worth £25,000—the equivalent of nearly $2 million today.

As we know, the owners retaliated, the English government intervened decisively, and the Luddite rebellion was crushed. However, says Thompson,

At heart, the fight was not really about technology. The Luddites were happy to use machinery – indeed, weavers had used smaller frames for decades. What galled them was the new logic of industrial capitalism, where the productivity gains from new technology enriched only the machines’ owners and weren’t shared with the workers.

The owners had taken to heart Adam Smith’s The Wealth of Nations, published a few decades earlier, in which Smith makes the case for a laissez-faire, free-market economy. In the ensuing centuries we have seen a seesaw battle between labor and capital, and it certainly appears that capital now has the upper hand; but clearly, the Industrial Revolution did lift all boats: It is inconceivable that we could support our present global population without our machines.

But will the Information Revolution that gave us computers, the internet, and social media – and the AI Revolution that is about to give us self-driving taxis and trucks and robot baristas – continue to lift our lower and middle classes, or further disempower and impoverish them?

When Robots Take All of Our Jobs, Remember the Luddites

By Clive Thompson
Originally published in Smithsonian magazine, January 2017

What a 19th-century rebellion against automation can teach us about the coming war in the job market

Is a robot coming for your job?

The odds are high, according to recent economic analyses. Indeed, fully 47 percent of all U.S. jobs will be automated “in a decade or two,” as the tech-employment scholars Carl Frey and Michael Osborne have predicted. That’s because artificial intelligence and robotics are becoming so good that nearly any routine task could soon be automated. Robots and AI are already whisking products around Amazon’s huge shipping centers, diagnosing lung cancer more accurately than humans and writing sports stories for newspapers.

They’re even replacing cabdrivers. Last year in Pittsburgh, Uber put its first-ever self-driving cars into its fleet: Order an Uber and the one that rolls up might have no human hands on the wheel at all. Meanwhile, Uber’s “Otto” program is installing AI in 16-wheeler trucks—a trend that could eventually replace most or all 1.7 million drivers, an enormous employment category. Those jobless truckers will be joined by millions more telemarketers, insurance underwriters, tax preparers and library technicians—all jobs that Frey and Osborne predicted have a 99 percent chance of vanishing in a decade or two.

What happens then? If this vision is even halfway correct, it’ll be a vertiginous pace of change, upending work as we know it. As the last election amply illustrated, a big chunk of Americans already hotly blame foreigners and immigrants for taking their jobs. How will Americans react to robots and computers taking even more?

One clue might lie in the early 19th century. That’s when the first generation of workers had the experience of being suddenly thrown out of their jobs by automation. But rather than accept it, they fought back—calling themselves the “Luddites,” and staging an audacious attack against the machines.

**********

At the turn of 1800, the textile industry in the United Kingdom was an economic juggernaut that employed the vast majority of workers in the North. Working from home, weavers produced stockings using frames, while cotton-spinners created yarn. “Croppers” would take large sheets of woven wool fabric and trim the rough surface off, making it smooth to the touch.

These workers had great control over when and how they worked—and plenty of leisure. “The year was chequered with holidays, wakes, and fairs; it was not one dull round of labor,” as the stocking-maker William Gardiner noted gaily at the time. Indeed, some “seldom worked more than three days a week.” Not only was the weekend a holiday, but they took Monday off too, celebrating it as a drunken “St. Monday.”

Croppers in particular were a force to be reckoned with. They were well-off—their pay was three times that of stocking-makers—and their work required them to pass heavy cropping tools across the wool, making them muscular, brawny men who were fiercely independent. In the textile world, the croppers were, as one observer noted at the time, “notoriously the least manageable of any persons employed.”

But in the first decade of the 1800s, the textile economy went into a tailspin. A decade of war with Napoleon had halted trade and driven up the cost of food and everyday goods. Fashions changed, too: Men began wearing “trowsers,” so the demand for stockings plummeted. The merchant class—the overlords who paid hosiers and croppers and weavers for the work—began looking for ways to shrink their costs.

That meant reducing wages—and bringing in more technology to improve efficiency. A new form of shearer and “gig mill” let one person crop wool much more quickly. An innovative, “wide” stocking frame allowed weavers to produce stockings six times faster than before: Instead of weaving the entire stocking around, they’d produce a big sheet of hosiery and cut it up into several stockings. “Cut-ups” were shoddy and fell apart quickly, and could be made by untrained workers who hadn’t done apprenticeships, but the merchants didn’t care. They also began to build huge factories where coal-burning engines would propel dozens of automated cotton-weaving machines.

“They were obsessed with keeping their factories going, so they were introducing machines wherever they might help,” says Jenny Uglow, a historian and author of In These Times: Living in Britain Through Napoleon’s Wars, 1793-1815.

The workers were livid. Factory work was miserable, with brutal 14-hour days that left workers—as one doctor noted—“stunted, enfeebled, and depraved.” Stocking-weavers were particularly incensed at the move toward cut-ups. It produced stockings of such low quality that they were “pregnant with the seeds of its own destruction,” as one hosier put it: Pretty soon people wouldn’t buy any stockings if they were this shoddy. Poverty rose as wages plummeted.

The workers tried bargaining. They weren’t opposed to machinery, they said, if the profits from increased productivity were shared. The croppers suggested taxing cloth to make a fund for those unemployed by machines. Others argued that industrialists should introduce machinery more gradually, to allow workers more time to adapt to new trades.

The plight of the unemployed workers even attracted the attention of Charlotte Brontë, who wrote them into her novel Shirley. “The throes of a sort of moral earthquake,” she noted, “were felt heaving under the hills of the northern counties.”

**********

In mid-November 1811, that earthquake began to rumble. That evening, according to a report at the time, half a dozen men—with faces blackened to obscure their identities, and carrying “swords, firelocks, and other offensive weapons”—marched into the house of master-weaver Edward Hollingsworth, in the village of Bulwell. They destroyed six of his frames for making cut-ups. A week later, more men came back and this time they burned Hollingsworth’s house to the ground. Within weeks, attacks spread to other towns. When panicked industrialists tried moving their frames to a new location to hide them, the attackers would find the carts and destroy them en route.

A modus operandi emerged: The machine-breakers would usually disguise their identities and attack the machines with massive metal sledgehammers. The hammers were made by Enoch Taylor, a local blacksmith; since Taylor himself was also famous for making the cropping and weaving machines, the breakers noted the poetic irony with a chant: “Enoch made them, Enoch shall break them!”

Most notably, the attackers gave themselves a name: the Luddites.

Before an attack, they’d send a letter to manufacturers, warning them to stop using their “obnoxious frames” or face destruction. The letters were signed by “General Ludd,” “King Ludd” or perhaps by someone writing “from Ludd Hall”—an acerbic joke, pretending the Luddites had an actual organization.

Despite their violence, “they had a sense of humor” about their own image, notes Steven Jones, author of Against Technology and a professor of English and digital humanities at the University of South Florida. An actual person Ludd did not exist; probably the name was inspired by the mythic tale of “Ned Ludd,” an apprentice who was beaten by his master and retaliated by destroying his frame.

Ludd was, in essence, a useful meme—one the Luddites carefully cultivated, like modern activists posting images to Twitter and Tumblr. They wrote songs about Ludd, styling him as a Robin Hood-like figure: “No General But Ludd / Means the Poor Any Good,” as one rhyme went. In one attack, two men dressed as women, calling themselves “General Ludd’s wives.” “They were engaged in a kind of semiotics,” Jones notes. “They took a lot of time with the costumes, with the songs.”

And “Ludd” itself! “It’s a catchy name,” says Kevin Binfield, author of Writings of the Luddites. “The phonic register, the phonic impact.”

As a form of economic protest, machine-breaking wasn’t new. There were probably 35 examples of it in the previous 100 years, as the author Kirkpatrick Sale found in his seminal history Rebels Against the Future. But the Luddites, well-organized and tactical, brought a ruthless efficiency to the technique: Barely a few days went by without another attack, and they were soon breaking at least 175 machines per month. Within months they had destroyed probably 800, worth £25,000—the equivalent of $1.97 million, today.

“It seemed to many people in the South like the whole of the North was sort of going up in flames,” Uglow notes. “In terms of industrial history, it was a small industrial civil war.”

Factory owners began to fight back. In April 1812, 120 Luddites descended upon Rawfolds Mill just after midnight, smashing down the doors “with a fearful crash” that was “like the felling of great trees.” But the mill owner was prepared: His men threw huge stones off the roof, and shot and killed four Luddites. The government tried to infiltrate Luddite groups to figure out the identities of these mysterious men, but to little avail. Much as in today’s fractured political climate, the poor despised the elites—and favored the Luddites. “Almost every creature of the lower order both in town & country are on their side,” as one local official noted morosely.

An 1812 handbill sought information about the armed men who destroyed five machines.
(The National Archives, UK)

**********

At heart, the fight was not really about technology. The Luddites were happy to use machinery—indeed, weavers had used smaller frames for decades. What galled them was the new logic of industrial capitalism, where the productivity gains from new technology enriched only the machines’ owners and weren’t shared with the workers.

The Luddites were often careful to spare employers who they felt dealt fairly. During one attack, Luddites broke into a house and destroyed four frames—but left two intact after determining that their owner hadn’t lowered wages for his weavers. (Some masters began posting signs on their machines, hoping to avoid destruction: “This Frame Is Making Full Fashioned Work, at the Full Price.”)

For the Luddites, “there was the concept of a ‘fair profit,’” says Adrian Randall, the author of Before the Luddites. In the past, the master would take a fair profit, but now he adds, “the industrial capitalist is someone who is seeking more and more of their share of the profit that they’re making.” Workers thought wages should be protected with minimum-wage laws. Industrialists didn’t: They’d been reading up on laissez-faire economic theory in Adam Smith’s The Wealth of Nations, published a few decades earlier.

“The writings of Dr. Adam Smith have altered the opinion, of the polished part of society,” as the author of a minimum wage proposal at the time noted. Now, the wealthy believed that attempting to regulate wages “would be as absurd as an attempt to regulate the winds.”

Six months after it began, though, Luddism became increasingly violent. In broad daylight, Luddites assassinated William Horsfall, a factory owner, and attempted to assassinate another. They also began to raid the houses of everyday citizens, taking every weapon they could find.

Parliament was now fully awakened, and began a ferocious crackdown. In March 1812, politicians passed a law that handed out the death penalty for anyone “destroying or injuring any Stocking or Lace Frames, or other Machines or Engines used in the Framework knitted Manufactory.” Meanwhile, London flooded the Luddite counties with 14,000 soldiers.

By winter of 1812, the government was winning. Informants and sleuthing finally tracked down the identities of a few dozen Luddites. Over a span of 15 months, 24 Luddites were hanged publicly, often after hasty trials, including a 16-year-old who cried out to his mother on the gallows, “thinking that she had the power to save him.” Another two dozen were sent to prison and 51 were sentenced to be shipped off to Australia.

“They were show trials,” says Katrina Navickas, a history professor at the University of Hertfordshire. “They were put on to show that [the government] took it seriously.” The hangings had the intended effect: Luddite activity more or less died out immediately.

It was a defeat not just of the Luddite movement, but in a grander sense, of the idea of “fair profit”—that the productivity gains from machinery should be shared widely. “By the 1830s, people had largely accepted that the free-market economy was here to stay,” Navickas notes.

A few years later, the once-mighty croppers were broken. Their trade destroyed, most eked out a living by carrying water, scavenging, or selling bits of lace or cakes on the streets.

“This was a sad end,” one observer noted, “to an honourable craft.”

**********

These days, Adrian Randall thinks technology is making cab-driving worse. Cabdrivers in London used to train for years to amass “the Knowledge,” a mental map of the city’s twisty streets. Now GPS has made it so that anyone can drive an Uber—so the job has become deskilled. Worse, he argues, the GPS doesn’t plot out the fiendishly clever routes that drivers used to. “It doesn’t know what the shortcuts are,” he complains. We are living, he says, through a shift in labor that’s precisely like that of the Luddites.

Economists are divided as to how profound the disemployment will be. In his recent book Average Is Over, Tyler Cowen, an economist at George Mason University, argued that automation could produce profound inequality. A majority of people will find their jobs taken by robots and will be forced into low-paying service work; only a minority—those highly skilled, creative and lucky—will have lucrative jobs, which will be wildly better paid than the rest. Adaptation is possible, though, Cowen says, if society creates cheaper ways of living—“denser cities, more trailer parks.”

Erik Brynjolfsson is less pessimistic. An MIT economist who co-authored The Second Machine Age, he thinks automation won’t necessarily be so bad. The Luddites thought machines destroyed jobs, but they were only half right: They can also, eventually, create new ones. “A lot of skilled artisans did lose their jobs,” Brynjolfsson says, but several decades later demand for labor rose as new job categories emerged, like office work. “Average wages have been increasing for the past 200 years,” he notes. “The machines were creating wealth!”

The problem is that transition is rocky. In the short run, automation can destroy jobs more rapidly than it creates them—sure, things might be fine in a few decades, but that’s cold comfort to someone in, say, their 30s. Brynjolfsson thinks politicians should be adopting policies that ease the transition—much as in the past, when public education and progressive taxation and antitrust law helped prevent the 1 percent from hogging all the profits. “There’s a long list of ways we’ve tinkered with the economy to try and ensure shared prosperity,” he notes.

Will there be another Luddite uprising? Few of the historians thought that was likely. Still, they thought one could spy glimpses of Luddite-style analysis—questioning of whether the economy is fair—in the Occupy Wall Street protests, or even in the environmental movement. Others point to online activism, where hackers protest a company by hitting it with “denial of service” attacks by flooding it with so much traffic that it gets knocked off­line.

Perhaps one day, when Uber starts rolling out its robot fleet in earnest, angry out-of-work cabdrivers will go online—and try to jam up Uber’s services in the digital world.

“As work becomes more automated, I think that’s the obvious direction,” as Uglow notes. “In the West, there’s no point in trying to shut down a factory.”

Key themes for 2017 - context from John Mauldin

 

If you find it too heavy, leave the "Help From Washington" section out; it does give a good background to how hard it may be to get some policies through, but is not really useful for the exams.

The following sections cover China, energy markets, Europe and AI; these sections all contain the sort of elements your essays cry out for - strong contextual justification for the sorts of statements you love making, but never back up. There is potential for a one-grade lift in this material alone, if you get the right question (most questions are open enough that you have a range of topics you can discuss).

Your choice to read (as ever), but time is running out and you need to beef up your essays from AS to A2:

 

“The shift from sailing ships to telegraph was far more radical than that from telephone to email.”

– Noam Chomsky

 

I’ll organize this letter around four key themes that I think we will discuss frequently in the next 12 months: US politics, energy, China, and Europe. Then I’ll wrap up with an overarching problem that’s also an opportunity – if we treat it as one.

Help from Washington?

Let’s begin with good thoughts. Markets have rallied since November on the expectation that Trump and the Republicans will quickly enact a growth-oriented economic agenda, including tax cuts, regulatory relief, and targeted economic stimulus projects. As I talk to people involved in the transition, I am gaining more confidence that a good part of that agenda will actually be realized. It’s clear to me that the right people want it to happen, at least. Whether they will get what they want is a slightly different question.

One reason I’m encouraged is that the Republican majority doesn’t have to start over. They already did some of the heavy lifting in the bills that passed Congress for the last two years, only to see them vetoed by President Obama, and in bills that never got that far because a veto was assured. The Republicans know who does and who doesn’t support these bills. With some minor updating, they can quickly pass the bills again, with a better White House reception this time.

The GOP is also intent on hacking back some of the regulatory tentacles that have impeded progress (and especially job growth) in some industries. They intend to employ a rarely used law called the Congressional Review Act to reverse some of the Obama administration’s regulations. They are also considering legislation that would require federal courts to stop accepting federal agencies’ statutory interpretations and defer to Congress instead.

Tax cuts are almost 100% certain, though their beneficiaries are not certain at all. Constitutionally, all tax bills must originate in the House, and their impact on the deficit will be important to some House Republicans. Passing a tax cut may depend on having a corresponding set of spending cuts ready. Seriously, we simply have no idea how the tax issue is going to play out. Fixing taxes could be problematic: Every dollar the government now spends (or gives in tax benefits) helps somebody, and whoever it is almost certainly has lobbyists on retainer. Nevertheless, we will get a tax cut, though we may not know the nitty-gritty details for a while.

I’m told the Republicans have a long list of relatively uncontroversial (at least on their side of the aisle) bills that they can pass very quickly. They want to show progress, and they think quick passage of some popular measures will buy them credibility to use later. I expect an initial burst of activity after January 20, probably followed by a lull as the Congress moves into more contentious issues like Social Security and healthcare reform. Things will keep happening, but we may not see as many votes.

The hard part is getting agreement on the big items like taxes and healthcare reform. I love seeing Trump and Pence and Ryan and McConnell and all the guys holding hands and acting as if they’re all ready to walk into the bright new future together, but the reality is that there are some quite different ideas in Washington about what serious reforms should look like, and a lot of congressmen want to put their personal stamp on the final bills.

The reform effort could fall apart for various reasons. The Senate majority is narrow enough that just a handful of GOP defectors will be able to stop any given bill, assuming Democrats stay united in opposition. I think Republicans should be on guard against hubris, as well. The decision last week to kick off the year by softening ethics rules was a terrible idea. They accomplished nothing and energized an opposition that was otherwise on its heels. (And I know that many of us are uncomfortable with the concept of a Tweeter-in-Chief, but all it took was one tweet to kill that really bad idea. I mean, Trump stopped it dead in its tracks. Which I believe the vast majority of us will think was a very good thing.)

Finally, as I cautioned last week, there is always the chance that some “bolt from the blue” could change everything. An international crisis, a large bank failure, terror attacks – any one of a long list of unforeseeable events could conceivably derail this train. Not to mention the endemic problems of Europe and China, which we will deal with below and which are entirely foreseeable. But if we can get through the first 100 days with this administration, then I think its agenda will have enough momentum to keep rolling.

Assuming no major surprises, I think the tax and regulation changes can boost GDP growth in the final half of 2017 toward the 2½ percent range. That will be a small improvement from this year and could set the table for a bigger feast in 2018 and beyond. Much also depends on how the Federal Reserve responds, as well as on any changes in its composition. 

But here again, if the Republicans get all timid or can’t cooperate and end up settling for the usual tinkering around the edges with tax reform and healthcare reform; and if they are stymied by an entrenched bureaucracy that doesn’t want to see its regulatory powers dismembered, then we can’t expect to get the economic boost that everybody is anticipating. If a policy-driven boost doesn’t materialize, the markets, which have jumped on the anticipation of Real Change, will reverse just as quickly.

That’s why I say, “Proceed with caution.” If my base case plays out and we get reasonable progress on healthcare reform along with regulatory reforms, the stock market could end the year higher, even from today’s elevated valuations; and earnings could really be improving by the third and fourth quarters – if the reforms are actually put into place in time.

If the reforms get hung up or are watered down and not really effective, this market could tumble out of bed so fast that it will make your head spin. I will be saying much more by March about how I think portfolios should be constructed, but my current core portfolio is basically long most of the US market (and long selectively all over the world as well) and has sidestepped the bond market (with some exceptions). All of that could change quite quickly – it’s no surprise to longtime readers that I think portfolios should be actively managed.

That said, passive management will also continue to work if my base-case scenario comes about, and that outcome will just convince more people to move their portfolios to passive management. A market mentor of mine, who had already been trading the markets for 50 years when he began to tutor me, always treated the markets as if they are a personality.

“The market will do whatever it takes to cause the most pain to the most number of people,” was the litany he repeated to me, over and over. The more people that are lured into the grip of passive investing, the greater the pain will ultimately be – which means that this market can go sideways for a lot longer than many of us who have a cautious nature can imagine. We are truly in new territory.

Energy Reversal

Energy stocks have been tearing higher since the election on bets that the Trump administration will relax environmental restrictions and open more federal lands to oil and gas drilling. Crude oil’s staying north of $50 hasn’t hurt, either. It is up there in part because OPEC threw in the towel and agreed to production limits. Unfortunately for OPEC, those limits don’t apply to US and Canadian shale producers. And the history of OPEC is that they all cheat like crazy.

My friend Art Cashin has an internal “friends and family” list to which he generally sends one or two short, pithy notes per day. For quite some time now, he has been noting the high correlation between the price of oil and the stock market. That correlation is why I have moved my thoughts on energy closer to the front of the letter. The price of energy is important to our portfolios in ways that are not clearly understood but can be observed.

I think it is entirely possible that we will see oil prices climb somewhat further by mid-year, possibly approaching $60, and then pull back as capped US production comes back online. Look at the chart below to see the wide variation among forecasts of major energy analysts working for the big banks.

I also think that this year we’ll start to see a new pattern: Production could keep rising even as prices fall. Conventional wisdom says that producers stop pumping at some point when it becomes unprofitable, but I think that is about to change.

If you are an oil producer – or really, any commodity producer – two things can improve your profit margin: higher selling prices for the resource you produce, or lower production costs. Some combination of both works as well.

Now, selling prices are mostly outside the producer’s control, though adept hedging can help. Cost reduction is therefore the place to concentrate your attention. Back in 2015 I wrote about new drilling techniques and other technology that promised to bring oil and gas production costs significantly lower. Now, in the last few weeks, people in the business have told me these technologies are moving rapidly toward deployment. They foresee considerably lower drilling and production costs by the end of this year.

I had a confidential briefing recently about some new energy production processes that are coming online in the oil patch. Let me just say that production from an oil well drilled with these new techniques is getting ready to increase substantially. In some cases the amount of oil produced per dollar spent on drilling is going to more than double. There are significant chunks of the petroleum-producing parts of the United States where $40 oil will not be a barrier to drilling and new production. Eventually – in a few years – these techniques will begin to show up in wells around the world, and there will be an explosion of oil.

Even as many oilfields dry up, there will be new fields developed from previously unprofitable sources. As I’ve been saying for 15 years, the whole Peak Oil thing is nonsense. I used to think that it simply meant the price of oil would go up to justify the cost of drilling, but I didn’t really understand how much technology would lower the cost of drilling.

This technology trend means that the current oil price range may well break lower, perhaps this year but certainly within this decade, without energy companies losing profits. Not every company will reap the rewards equally, of course; but the industry as a whole is excited. Energy exploration and production is quickly becoming a technology-driven industry, with the US as world leader. If Trump permits construction of more pipelines and natural gas export terminals, we could see North American exports rise considerably in the next few years.

Obviously, over time, a falling energy price will not be good for OPEC or for Russia. Those lower prices will create geopolitical challenges as well as economic ones. I don’t know how it will all shake out. We will likely see some big, energy-driven changes in the world order in the coming decades. But that is beyond the scope of an annual forecast.

Sidebar: every time I write about energy I get the following questions: “What about the environment? Won’t more oil and gas production aggravate climate change?”

Many wonder whether I care about the environment or accept the reality global warming. The simple and very short answer is that I can see the data as well as anyone, and I believe the Earth is in a warming cycle. I very much care about the environment. I don’t want to see the air I breathe or have polluting chemicals in the water I drink. We only get the one Earth, and we have to take care of it.

My full answer is longer and, as you might suspect, more complex. It will end up being a chapter (or a significant part of one) in the book I am writing, called The Age of Transformation. It will be out this year, and hopefully by the time of my conference, if I can at all get it all wrapped up. If you meet me at SIC and we have time for an extended conversation, feel free to ask about these issues. No one-paragraph answers will suffice. Now back to our forecasting.

Chinese Checkers

This is going to be a pivotal year for China. Having to deal with a US president who refuses to play by Beijing’s rules is only part of it, and not necessarily the most important part. China has defied gravity in more ways than I can count. We will see if it can levitate another year or whether it falls back to Earth in 2017. My base case is that they continue the levitation act, but we are going to see an increase in volatility.

I’m not sure how many people are aware that the overnight rate for offshore yuan reached an incredible 105% at one point last week. The Chinese created a massive short squeeze, trying to maintain the value of the yuan. They have spent hundreds of billions of dollars in that effort and are likely to spend more this year.

The natural direction for the yuan, if it were allowed to float, would be significantly lower against the US dollar than it is today. The Chinese are manipulating their currency, but they are manipulating it to maintain its current value and allow it to slowly fall to its natural rate. Any precipitous move in the yuan can unsettle markets quickly.

Further, some $2 trillion worth of Chinese currency has been converted into dollars and moved offshore in the last few years. Think about that in the context of quantitative easing and realize that individual Chinese wanting to move their money out of the country have almost as great an effect on the amount of money sloshing around the developed world as our central banks have. The sources of that money are another subject entirely, but it is enough to note that that money is out in the world, much of it in North America, much of it looking for a home, driving up prices of real estate and other assets.

The Chinese Communist Party will hold its 19^th party congress in the fall and will almost certainly give Xi Jinping another five years at the helm. He has become China’s most powerful leader since Deng Xiaoping and could well surpass even Mao before he departs. It could be awhile before he does, too, if this party congress goes according to script.

Xi may need to exercise all his power if he is to maintain both economic growth and domestic order. Sagging exports and rising labor costs are causing manufacturers to turn to automation, but that shift creates unemployment. Xi’s government is doing all it can to keep the masses happy, mostly by handing out generous benefits and subsidies to the usual suspects, including state-owned enterprises. This help makes it very hard to tell which of China’s many state-owned enterprises are actually turning a profit vs. operating at a loss because officials have ordered them to. That is why state ownership is problematic, of course, but for China the alternative may be worse.

A major side effect is that all the stimulus sloshing through an economy with few international exits has nowhere to go. The Chinese have fairly serious limits on the amount of money that individuals can take offshore in a given year. That means there is a lot of money in China looking for a home.

The results are predictable: asset bubbles rolling through regions and asset classes whose valuations follow no discernable logic. These imbalances can’t continue indefinitely, but I don’t know how the Chinese will arrest them. The direct route would be a currency revaluation. That seems to be what they are attempting, albeit very slowly. Ironically, I believe that both Xi and Trump agree they don’t want the yuan to move downward all that much in the coming years.

Xi’s hands are tied: Propping up the value of the yuan is going to force him to use his dollar reserves or to raise interest rates in an already volatile market. The Chinese are getting to a place where manipulation will be a lot more difficult than it has been in the past.

China is trying to do something that would be hard no matter who is in charge. The US is the world’s largest economy because we create most of our own supply and demand. It took us many decades to reach that point; China is trying to do it in about two decades. Their export-heavy model can’t work much longer, but they don’t yet have a way to create sustainable internal demand. 

A consumer economy is the opposite of what China has been for the last 30 years of its journey toward becoming a capitalistic society. The export-led model works for the first three stages of national economic development, but it is not what you need to get to and through the last two stages, as I have written in the past. This transition is going to be far more difficult than anything China has faced for a very long time.

Maybe Xi will balance his massive economy perfectly and skip right over the painful adjustments that developing nations (including the US several generations ago) typically go through. I certainly wouldn’t bet against that possibility. The Chinese have been doing things that nobody thought they could do for quite a few decades now. But I won’t bet for it, either, especially this year. All the conditions are in place for major problems in China. That 6.5% GDP growth rate, even if it’s close to correct (and I don’t believe it is), can’t go on forever.

China’s problems are everyone’s problems. I saw a report last week estimating that $1.5 trillion, yes trillion, in corruption proceeds escaped China between 1995 and 2013. That is in addition to the legal money coming out of the country. Most of it landed in the US, Australia, Canada, and the Netherlands, where it has helped to inflate some of our own asset bubbles. In my travels, I constantly run into people who tell me they manage Chinese money. Not trillions, just $50 million or $100 million here and there. It adds up. How much is really out there? I don’t think anyone knows, but it’s a big and growing number.

European Disunion

Our fifty states are essentially what the European Union’s founders wanted: a giant free-trade zone with a currency union and fiscal union. It’s working for us in part because our states, while unique, don’t have the centuries of cultural and linguistic diversity that Europe’s do. I think we underestimate how important our common language and heritage have been to our economic development.

The separate languages, cultures, and histories of its nations don’t mean Europe can’t develop better ways cooperate economically; but the EU structure, specifically the European Monetary Union and the euro, clearly isn’t the answer. I think 2017 will make this fact increasingly obvious to everyone – and possibly undeniable if the worst happens in Italy. Let’s start there.

Italy’s banks are holding something like €350–400 billion in nonperforming loans, depending whose numbers you believe. The vast majority of that amount is not just temporarily NPL; it’s dead money, up in smoke. The banks are pretending otherwise, and the government is letting them. So is the ECB. This is a fact Europe must face. Yet no one wants to face it, and so the leadership is trying to pull off an increasingly ludicrous shell game.

We forget sometimes that banks are themselves borrowers. Most of their lending capital is not equity. They get it by taking deposits and issuing bonds. If a bank can’t collect on the loans it made, it can’t repay the money it has borrowed, and the whole edifice collapses. Bank collapse is ugly, and minimizing the ugliness is one reason we have central banks. We expect our central bankers to remain sober even while everyone else imbibes.

The European Central Bank may be sober, but I’ll bet more that than a few of its member countries would like a drink. Especially in Italy. They are in a near-impossible situation. Huge imbalances exist within the eurozone with no mechanism to resolve them, and Italy is one of the southern-tier countries that is bearing the brunt. That’s not the ECB’s fault. The system was never going to work. Now people are realizing it’s broken, and they are fighting to get out with what they can.

Inflation last month finally reached 1.7% in Germany. You can bet the drumbeat for tighter monetary policy, in place of the all-out massive quantitative easing that we are currently seeing, is going to grow louder in Germany and most of the other northern countries. That is exactly the opposite of what Italy and the southern countries need. See the potential for conflict?

Last week I saw a Spectator article that was not encouraging. I can’t say the following any better than the writer, James Forsythe, did, so I will just quote him.

After the tumult of 2016, Europe could do with a year of calm. It won’t get one. Elections are to be held in four of the six founder members of the European project, and populist Eurosceptic forces are on the march in each one. There will be at least one regime change: François Hollande has accepted that he is too unpopular to run again as French president, and it will be a surprise if he is the only European leader to go. Others might cling on but find their grip on power weakened by populist success.

The spectre of the financial crash still haunts European politics. Money was printed and banks were saved, but the recovery was marked by a great stagnation in living standards, which has led to alienation, dismay and anger. Donald Trump would not have been able to win the Republican nomination, let alone the presidency, without that rage – and the conditions that created Trump’s victory are, if anything, even stronger in Europe.

European voters who looked to the state for protection after the crash soon discovered the helplessness of governments which had ceded control over vast swathes of economic policy to the EU. The second great shock, the wave of global immigration, is also a thornier subject in the EU because nearly all of its members surrendered control over their borders when they signed the Schengen agreement. Those unhappy at this situation often have only new, populist parties to turn to. So most European elections come down to a battle between insurgents and defenders of the existing order.

As James Forsythe says, the conditions that won Donald Trump the presidency exist in Europe as well and are possibly even stronger there. They manifest differently under parliamentary systems, but I see no chance that they will go away. They’re getting stronger, and I think we’ll see proof when France, the Netherlands, and Germany hold national elections this year. It is likely that the Italians will also have to hold snap elections because of the banking crisis, and it is not entirely clear that a majority would support a referendum on remaining in the euro (which is different from remaining in the European Union).

The anti-EU, anti-immigration parties may not win outright control in any of the four countries, but they can still exert enormous influence. These parties may not have the solutions, but the incumbents definitely don’t have them. Given a choice between unlikely and impossible, you have to go with unlikely. That’s what Europeans are doing.

I expect 2017 to bring many changes to Europe, but I’m not convinced it will be the end just yet. “Delay and distract” has worked well for the pro-EU, pro-euro forces ever since the sovereign debt crisis hit in 2010. The europhiles are true believers who simply won’t give up. At some point their determination may not matter, but I suspect they can keep doggedly kicking the can down the road until 2018 or later. It is just not clear when they will run out of road.

When they do, the result will likely be a very severe recession in Europe, which will embroil the world and could push the US into recession if it happens too quickly. Perhaps if we muster the reforms we need here in the US and actually get some sustainable growth going, then a fragmenting Europe might just knock that growth back to the sub-2% or even sub-1% range. But if China, too, loses the narrative in 2017, then all bets are off.

A Few Final Thoughts on 2017

Like it or not, we have entered an era in which machines are learning how to do much of the work that now provides our incomes and, in many cases, our self-worth. This is a topic we will explore in depth in future letters. But a brief summary needs to be interjected here.

The US is manufacturing more materials and goods than ever. Manufacturing is increasing at a fairly serious rate, well over 2% a year. The problem is, manufacturing jobs are not. A Ball State University study calculated that it would take more than 8 million additional jobs to produce what we currently produce today if we were merely at the productivity levels of 15 years ago.

Investment in automation and software has doubled the output per U.S. manufacturing worker over the past two decades. Robots are replacing workers, regardless of trade, at an accelerating pace. “The real robotics revolution is ready to begin” writes BCG and predicts that “the share of tasks that are performed by robots will rise from a global average of around 10% across all manufacturing industries today to around 25% by 2025.” (Source: fortune.com/2016/11/08/china-automation-jobs/)

This is a simplification, but robots and their associated machinery have been somewhere in the neighborhood of four times more important in the loss of manufacturing jobs than off-shoring of jobs has been. But it is hard to protest against increased automation and easier to point a finger at China or Mexico.

The real challenge the US and the rest of the developed world face is how to create new jobs in the face of this automation challenge. The problem is not one we can walk away from. The best estimates that I have read suggest that Korea may be 15–20% more productive than we are in terms of costs, because they are pushing further and faster into the automation process. That trend will leave US manufacturers and exporters – or those in Germany or Italy or any other developed country – behind in the global business contest. Think Japan is not seeing the same thing?

If we don’t automate faster, we lose jobs by being uncompetitive. If we do automate, then we see jobs go away. What we have to do is figure out how to make sure that new jobs are created, and that these jobs are simply not make-work but are rather meaningful and fulfilling. Tall order. For whatever it’s worth, we are programmed in our evolutionary DNA to value what we contribute to the community through our work. Simply getting welfare without a way to eventually make it on your own does not help personal self-esteem or your community.

Incidentally, in the process of writing a book on how the world will change in the next 20 years, with over two dozen chapters on all aspects of the transformation before us, the single biggest and most difficult challenge has been this very topic. One of the reasons the book isn’t finished yet is that I’m still trying to get my head around this very problematic issue. It is at the core of how our society will evolve … or devolve. Not all the paths forward are good ones, and it is critical that we make the right choices.

I gained a new appreciation for the social and political crossroads we are at when I wrote last year about the “Unprotected” voters (to use Peggy Noonan’s term) who flocked to Donald Trump and (to a lesser extent) Bernie Sanders. Both of those men understand that unemployment and underemployment don’t simply reduce people’s incomes, though that’s bad enough. People want to be real contributors to the economy, but the economy increasingly tells them they aren’t necessary.

I’ve been told by people in the transition team that Trump and those around him are laser-focused on restoring jobs and creating new ones, particularly in the Rust Belt states. I have been having more than a few off-the-record conversations with members of the team, and they leave me at least somewhat optimistic that they are thinking about the right problems. It is also clear that they are looking hard for solutions. This is only part of the reason why Trump is pressuring companies to keep jobs in the US. He knows the numbers are small. He’s trying to force a wider change. And the staff around him get this focus.

If Trump succeeds at boosting US jobs, the problem may just be offloaded elsewhere if unemployment rises in Mexico and other places where US companies once operated. We need solutions that bring in the tide and lift all boats at once. Otherwise, conflict will continue and worsen in many different ways and places.

As an economic matter, lower costs and higher productivity are deflationary. Excess supply in the absence of higher demand pushes prices downward. This is why we’ve seen such sluggish growth in the last decade. At some point, faltering growth may turn into outright contraction on a global scale. Then the real problems will begin.

For those of you with some classical economics training, it is as simple as the supply-demand lines that we drew in Economics 101. If you push the supply curve to the right, you are going to find that you are in a new price equilibrium. I am really coming to believe that it is this process that has been (at least partially…) responsible for the lack of inflation that we have seen in the past 15 years. I suspect it has a bigger role to play even than interest rates, though I have no real justification other than personal, anecdotal observation to make that point.

At some point this year, we will be talking about why the whole theoretical construct that nearly all economics is founded upon, that of a dynamic equilibrium, is a false premise. The base case for the economy is not equilibrium, no matter how you define it, but rather constant change and near chaos. Part of the reason that dynamic equilibrium models work so well in theory is that we actually have the mathematics to create them. The fact that these models are perpetually wrong should give us a clue that something else is going on for which we don’t have the math or even sufficient fundamental insight.

This discussion will not only bring us back to Hayek but forward to complexity mathematics and information theory, and I believe all three in combination hold a better way to explain the workings of the economy.

Mainstream economics keeps using the same models and theories, or variations on those theories, but some of the underlying premises of Keynes are simply wrong (not everything of course; he was a brilliant man for his times); and nothing built on a foundation of faulty premises is going to allow you to model the economy in any really useful manner. There’s a lot to tackle with this topic, but it will be fun to try to gain some insight together.

Let me warn you, there are no simple solutions or silver bullets. I’m reminded of the old Blackadder skit where the hero is handed a blank sheet of paper and told that it’s the map to where he is going. When he points out that there is nothing on the page, the man says, “Of course, you have to fill it in. Nobody’s been there” (paraphrasing of course).

2017 will certainly allow us to fill in a lot more of our map. But none of us have ever been there. It is my hope that 2017 will be the year when we start to recognize our true potential for abundance and begin adapting to it, in a way that everyone benefits.

Catch-up time!

Top 10 Economics stories this week - have a dabble:

A list of some of the week’s most interesting stories on economic growth and social inclusion 

1. Facts and figures. Business dynamism is slowing in the United States and market concentration is rising. It's threatening competitiveness and future productivity. (OECD Ecoscope; see also the Global Competitiveness Report 2016-2017)

Image: Census Bureau. Bureau of Economic Analysis

2. Medieval peasants had more vacation time than you. On the productivity of toiling. (Evonomics)

3. Surprisingly positive news about broad-based growth from Europe and the US. (Financial Times) 

4. As the gig economy grows, it becomes more pertinent to ensure the economic security of its workers and their access to equal social benefits. (Wall Street Journal, an earlier version is available on Brookings)

5. Absolutely everything you need to know about negative interest rates.(World Economic Forum)

6. What are the US candidates’ positions on fiscal policy, infrastructure and education? Here’s a 10-page overview. (The Economist)

7. Two columnists debate the free trade and populist backlash. (BloombergView)

8. The uneven distribution of the gains from trade can be cushioned by government spending. The US has failed in this regard. (Peterson Institute of International Economics) 

9. Is global fiscal activism needed to jump-start the world economy? Beyond infrastructure, global health is an area to consider. (Project Syndicate)

10. In case you missed it. 10 big ideas on inequality, presented in short talks by Harvard faculty from various disciplines. (Harvard University)

Extension material Y13 - Danger Ahead:

The video mentioned in this post can be found on this website; it may not be around for long.

Seven Reasons To Listen To Carl Icahn’s Danger Ahead

Posted date: October 04, 2015

By Worth W. Wray, Chief Economist, Evergreen GaveKal - EVA on Carl Icahn

EVA Summary:

This week’s Guest EVA features a video from the legendary activist investor, Carl Icahn, who is starting to make a lot of noise about frothy valuations, fuzzy accounting, and the corrosive consequences of zero interest rate policy.

In the video, the billionaire corporate raider approaches the United States like a firm turnaround, employing the same thought process he typically applies to troubled businesses with ineffective management.

While Mr. Icahn isn’t saying anything radically new, his warning deserves your attention. Investors who can weather the next downturn will find themselves well-positioned to capitalize on historic long-term opportunities.

This week’s Guest EVA features a rare video message from an indisputable Wall Street Legend. [While my colleagues and I know online video may not be the ideal medium for some EVA readers, let me say that you don’t want to miss this video. It’s getting a ton of attention in the press and for good reason. If you are adamant that you don’t “do” video, my text should give you a decent overview.

Still, there’s no question that Carl Icahn’s decades-long track record ranks him right up there with elite investors like Benjamin Graham, George Soros, and Warren Buffett. Time Magazine even called him the “Master of the Universe” and “the most important investor in America.”

The man clearly understands financial markets, Corporate America, and the tax/regulatory environment coming out of Washington… which is why his latest warning deserves your attention.

In the 15 minute video, Icahn basically treats the United States like a corporate turnaround, employing the same thought process he typically applies to troubled companies with ineffective management. First, he sets his sights on a country that is still not living up to its potential and where he’s already acquired a large, albeit a non-controlling stake ($22 billion across more than 10 industries). Then he lays out several steps for unlocking the economy’s productive potential and makes an aggressive push for the CEO (in this case, President) he believes should lead the charge (Donald Trump). And finally, with this video, Icahn is doing his best to sell shareholders on the overall vision (in this case, American voters).

Rather than getting bogged down by Carl Icahn’s politics – or what he stands to gain from the tax/regulatory changes he is advocating – I’d encourage you to focus on the very real reasons he sees “danger ahead” for US financial markets.

Here are some of the highlights from Carl Icahn…

(1)The United States needs meaningful tax & regulatory reform, which is unlikely without a strong President who can “move Congress” and “wake [this country] up.” At a time when the US electorate has become more polarized than at any other time in decades, it will take a special leader to win an election dominated by extremes and then unify the nation.

(2)The United States is “shooting itself in the foot” by double-taxing foreign profits, discouraging US-based multinationals from repatriating roughly $2.2 trillion, and driving some firms to leave the country altogether. We’re talking about overseas profits after foreign taxes have been paid – roughly equivalent to half of the Federal Reserve’s balance sheet. This massive sum could have a material impact on productivity and employment in the United States in the event that tax-free repatriation is allowed in exchange for investing a portion of those funds in people, plant, and equipment.

(3)Reported earnings in publicly-traded securities are highly suspect despite the broad adoption of GAAP accounting standards. In practice, headline earnings often do not account for stock compensation; they don’t amortize intangible assets, and they largely ignore restructuring and/or takeover costs. Thus, most investors are overestimating earnings, valuations, and debt sustainability at both the individual security and broad market levels.

(4)Financial engineering benefits companies’ income statements at the expense of their balance sheets. Low interest rates have enabled firms to engage in financial engineering through share buybacks and M&A. These practices – which both hit record highs in 2015 – boost earnings and stock prices temporarily, but leave firms with little buffer in the event of special situations, adverse economic conditions, or an abrupt increase in the cost of capital. The irony, of course, is that Icahn has forced these kinds of financial engineering activities – especially stock buybacks – on a number of firms in recent years.

(5)Ultra-low interest rates are fueling asset bubbles & threatening to trigger another financial crisis. With interest rates so low, savers are being forced to take more risk in asset classes like equities and high yield bonds. And the longer rates stay at zero, the greater the misallocation it feeds within Corporate America. Icahn says the Federal Reserve should raise interest rates immediately before the asset bubbles forming across the US financial markets give way to another 2008-style crash. [Our view at Evergreen GaveKal is that these bubbles have already formed and some are currently in the process of bursting.] While we have all heard this argument a thousand times in recent years, it has never been more compelling than it is today.

(6)Low-rated bonds are almost certain to collapse. While he believes an equity market crash is likely, Icahn says the risk of a crisis in high yield is a “no brainer” which he handicaps as a “98%” probability. It’s also worth noting that Mr. Icahn is heavily short junk bonds in anticipation of that event. He may be talking his book, but we agree the risk of wicked spread widening, and even defaults, in junkier ratings is higher than most investors realize. As Icahn outlines in the video, the retail rush away from high yield ETFs and mutual funds – which investors have piled into in recent years – could lead to the same kind of forced liquidation that we saw in 2008. [It’s worth noting that Evergreen believes “high-grade, high-yield” credits remain attractive, though we have been trimming some of those issues due to “collateral damage concerns.”]

(7)Liquidity is an illusion. If interest rates begin to rise or economic conditions begin to deteriorate – especially in the credit markets – investors may find themselves in a situation where the markets cease to function. That means that investors may find themselves in a position where they cannot sell at any price. That’s when the low interest rate party bus goes off a cliff… and when large cash positions will become invaluable.

Carl Icahn

Wild stuff, isn’t it?

Before you dismiss this message as rambling from a perma-bear selling fear, note that Carl Icahn is actually one hell of a risk-taker.A quick look back at the Forbes billionaires list reveals that Icahn’s personal net worth fell from $14 billion in 2008 to $9 billion in 2009 and then surged to $22 billion by 2015. He made a fortune by sticking to his discipline during the financial crisis and then capitalizing on the recovery in asset prices.