The Emerging New World Order plus other global revolutions
Thoughts on Rachel Reeve's poor fiscal choice, how quickly can the BRICS dedollarise, are the good times over for US stocks, what the Nobel laureates get right and wrong, and what next for media?
In this post:
Reeves’s Poor Choice: the chancellor takes a fiscal risk
Building BRICS: America holds the key to dedollarisation
Peak Stocks: As good as it gets?
Peak China: what the Nobel laureates get right and wrong
Media Darlings: the revolution will be automated
1. Reeve’s Poor Choice
It is hard to think what could be left for Rachel Reeves to announce in her budget next week that could surprise us, so heavily trailed have been all the key announcements. Even before the election, the key question was how Labour would square its “mission” to make Britain the fastest growing economy in the G7 with its commitment to stick to the previous government’s fiscal rules and to not put up taxes on “working people”. Now we know the answer: it will change the fiscal rules and put up taxes on the people who employ working people.
Personally, I don’t have a problem with that. Reversing the previous government’s pre-election two percentage point cuts to national insurance, which is effectively what Reeves intends, is obviously the right thing to do, even if it were preferable from a growth perspective that the higher rate fell on employees.
Those cuts were an act of pure cynicism by a desperate government that over 14 years through a combination of incompetence, recklessness, cod-Thatcherism and a ruinous Brexit had wrecked the economy. They thought they had set Labour a clever trap. The fact that they, and their media cheerleaders, are attacking the government for springing the trap, rather than apologising for their political games, merely confirms that they remain manifestly unfit for public office.
As for Rachel Reeves’s decision to change the fiscal rules, this is something Wealth of Nations has consistently advocated. Nonetheless, I am not convinced that the reform she is proposing is the right one. In her Mais Lecture in March when still in opposition, Reeves correctly identified the problem with Britain’s current fiscal framework: that it takes no account of whether debt was used to fund spending or investment. In response, she said that,
As Chancellor I will report on wider measures of public sector assets and liabilities at fiscal events, showing how the health of the public balance sheet is bolstered by good investment decisions.
So it is certainly surprising that she has come up with a new fiscal target that does not in fact include public sector assets - or at least not the sort of physical assets such as infrastructure that she cares about. She has instead opted to target Public Sector Net Financial Liabilities (PSNFL), which only takes account of financial assets such as the government’s student loans book and funded public sector pension scheme assets. The only new infrastructure spending that would be included under the new definition is investments made by the National Wealth Fund, which would be recognised as a financial asset.
Of course, what matters from Reeves’s perspective is that this new definition will give her an extra £50 billion of fiscal headroom to spend on public investment. But her choice confirms that this rule change is simply a fudge to allow higher borrowing rather than a serious attempt to improve the transparency and accountability of the UK balance sheet. For that, as Wealth of Nations has consistently advocated, she would have needed to adopt a new framework based on Public Net Worth and the adoption of accrual-based accounting.
Indeed, I fear that she has adopted the least good option. John Crompton set out some of the shortcomings in PSNFL in a guest post a few weeks ago:
PSNFL-based rules do not take into account the scale of our unfunded public sector pensions liabilities or the rate at which they are being incurred... They also do not measure non-financial assets [such as infrastructure], or recognise their consumption [depreciation]. Overall, there is a risk that PSNFL-based rules would prove to be no more than a short-term fiscal fix to allow the government to expand investment for the short term without strengthening, and perhaps weakening, long-term fiscal sustainability.
To overcome these shortcomings, Reeves is proposing to put guardrails in place to convince the markets that she will not use this extra headroom in a way that recklessly endangers the public finances. She has indicated that she only intends to use £20 billion of the £50 billion of extra headroom. And she will entrust various bodies including the new National Infrastructure and Service Transformation Authority and Office of Value for Money with scrutinising investment decisions to assess whether they provide a long-term benefit.
I suspect these guardrails will be sufficient to prevent a Liz Truss moment. Although bond yields have risen slightly in the past week or so, they have broadly tracked rises in US Treasury yields, and are well within the typical range ahead of a budget, as this excellent post in the FT’s Alphaville noted.
Nonetheless, the best guardrail would be for Reeves to commit to adopt accrual-based financial statements as the basis for all budget decision-making by the end of this parliament. Not only would that deliver on what she outlined in her Mais Lecture, it would pave the way for a future switch to Public Net Worth. As I argue in this essay for Bloomberg published this weekend, New Zealand May Have a Solution for the World’s $100 Trillion Public Debt, better accounting does not just mean greater transparency, it can drive better long-term decision-making.
Reeves has helped spark a global debate on fiscal rules. What an over-indebted world needs now is a global revolution in public sector governance.
2. Building BRICS
Rachel Reeves announced her new fiscal rules while in Washington DC for the annual meetings of the IMF, no doubt hoping that the approbation of the great and good of the global financial system would help inoculate her against accusations of profligacy. But it is hard not to conclude that the more significant gathering last week, at least as far as long-term global economic governance is concerned, was the BRICS summit in Kazan in Russia.
The BRICS started out as a useful acronym coined by a Goldman Sachs economist to describe what were then the world’s largest emerging markets (Brazil, Russia, India, China and South Africa). It has since morphed into an annual boondoggle with nine full members who account for a third of the world’s GDP, half its population and nearly half its oil reserves, with dozens of others queuing to join.
The attendees at last week’s summit included 24 world leaders among representatives of 36 countries, plus, shamefully, the secretary general of the United Nations, Antonio Guterres, making his first visit to Russia since Vladimir Putin launched his full-scale of Ukraine in flagrant breach of the UN charter.
The conventional wisdom is that BRICS are too diverse, with very different interests and lacking a permanent secretariat or common funds, to turn into a serious geopolitical rival to the West. Yet reading the rather grandly-named Kazan Declaration issued at the end of the summit stated, that looks complacent.
For all that divides the BRICS, what comes through is a clear common agenda. They want to deepen commercial, institutional, cultural and social ties among themselves, reform global governance to give the Global South more power in institutions such as the IMF and UN, and reduce reliance on the dollar. In other words, they seek a multipolar world in which they have options other than to align with the US-dominated model being celebrated in Washington last week.
This is not just a reaction to the western weaponisation of the global financial system via the increasing use of sanctions, though these were roundly condemned in the communique. It also stems from a familiar complaint that the dollar-based system does not always work well for the Global South, exposing them to volatility as a result of policy decisions taken to serve domestic US interests.
It’s true that the BRICS did not make any obvious progress towards advancing this multipolar world at the summit. The idea pushed by Brazil of creating a BRICS common currency didn’t even merit a mention in the Kazan declaration, while Russian proposals for a BRICS payments, settlement and clearing systems based on central bank digital currencies was given deliciously short shift:
We acknowledge the importance of exploring the feasibility of connecting BRICS countries’ financial markets infrastructure.
Nor is the dollar about to be displaced any time soon (as the commumique acknowledged). Two of the BRICS members, the UAE and Saudi, operate long-standing currency pegs to the dollar. All commodity trading is conducted in dollars, Moreover, both India and China have restricted capital accounts, making it impossible for either of them to become an alternative reserve currency.
But the BRICS do not need to supplant the dollar to reduce their reliance on it. They are already settling an increasing amount of trade in local currencies. Their central banks have also been buying significant quantities of gold to diversify their reserves, contributing to a 50 per cent rise in the gold price this year. As Mohammed El-Erian noted in the Financial Times this week:
No other currency or payment system is able and willing to displace the dollar at the core of the system and there is a practical limit to reserve diversification. But an increasing number of little pipes are being built to go around this core; and a growing number of countries are interested and increasingly involved.
As it develops deeper roots, this risks materially fragmenting the global system and eroding the international influence of the dollar and the US financial system. That would have an impact on the US’s ability to inform and influence outcomes, and undermine its national security.
How many little pipes the BRICS build will depend as much on choices made by America as elsewhere. Can tensions between America and China continue to be managed under existing global arrangements, where goods and capital still flow between the two superpowers, albeit via entrepots like Vietnam and Mexico. Or will the new Cold War lead to a rupture and a new world order? Will America remain a hospitable place for the rest of the world to park their savings?
As David Bowers, the co-founder of Absolute Strategy Research, pointed out when we discussed this last week:
What makes this more interesting is the symbiotic relationship between America’s current-account deficit and the BRICS current-account surplus. The surpluses of the BRICS look increasingly like the counterpart to America’s deficit. This is no longer just about China. As investors ponder their long-term capital market assumptions, maybe the time has come to consider what a move to a multi-polar world might do to future returns.
In other words, can you have trade decoupling without some degree of financial decoupling? And who will the Global South side with if forced to choose? Depending on the outcome of the US election, we may not have long to find out. Much hinges on the answer and none of it is in the price.
3. Peak Stocks?
Geopolitical risks are on the mind of the IMF too. It warned in its latest Global Financial Stability Report of a "widening disconnect" between escalated geopolitical uncertainty and low market volatility increases the chance of a market shock. Investors were clearly not paying attention, however, as the Nasdaq hit a new record high this week, driven yet again by AI mania, better than expected results from Tesla and above all expectations of a Trump victory.
The result is that US equites are on track for a stellar year, having surged 23 per cent since January, with many brokers now forecasting a further rally to 6,000 by the end of the year, a further 11 percent gain for this year. The most recent Bank of America fund manager survey showed investors reducing allocations to bonds at the fastest pace in the survey’s 23 year history and allocations to equity rising at the fastest pace since the end of the pandemic.
But could this be as good as it gets? Goldman Sachs thinks so. It put out a note this week in which its highly regarded chief US equity strategist, David Kostin, argued that he expects the S&P 500 to deliver a 3% annualised nominal total return over the next decade, or 1% in real terms. That would be far lower than the 13% returned over the past decade and the 11% long-term average.
Goldman bases this forecast on a number of assumptions:
Starting valuations: the cyclically-adjusted price earnings ratio, which compares current prices to 10 year average earnings, is close to the highest it has been at any time since 1930, with the exception of the dotcom bubble. A high starting valuation is usually a good indicator of lower future returns.
Concentration: at present, the 10 largest stocks in the S&P 500 account for more than a third of the total market cap. That is near the highest level of concentration in 100 years, which makes its performance highly sensitive to the performance of a few stocks.
Future growth: Goldman also notes that it is extremely difficult for any firm to maintain high levels of sales growth and profit margins over sustained periods of time. “As sales growth and profitability for the largest stocks decelerate, earnings growth and therefore returns for the overall index will also decelerate.”
Relative returns: US stocks will face stiff competition from other assets. For example, the forecast low levels of return of just 3% compare with the 4% yield on 10-year Treasury bonds. Goldman forecasts suggest the S&P 500 has roughly a 72% probability of underperforming bonds and a 33% likelihood of lagging inflation through 2034.
The conclusion seems to be, enjoy the party while it lasts. Meanwhile, the better bet from a longer term perspective may lie in the equal weight S&P index as opposed to the aggregate index with its extreme skew to the Magnificent Seven.
From a historical perspective, the equal-weight S&P 500 index has typically outperformed the aggregate S&P 500 index during 10-year horizons. Since 1970, the equal-weight benchmark has outperformed the aggregate S&P 500 index during 78% of rolling 10-year periods by an annualised average of 2 percentage points.
4. Peak China
There has been plenty of excellent commentary in response to the award last week of the Nobel prize for economics to Daron Acemoglu, Simon Johnson and James Robinson for their research on the role of institutions in economic development. But two essays in particular for me stood out.
The thrust of Nobel Laureate’s work in various books and academic papers is that successful countries have inclusive institutions as opposed to extractive ones. Inclusive institutions provide for property rights, equal protection before the law, neutral contract enforcement, and human rights. These encourage investment and increase prosperity. Extractive institutions, designed only to benefit the elite, discourage investment and produce lower growth over time.
That prompted this delightfully waspish essay by Brendan Greely, a historian at Princeton, writing for the FT’s Alphaville. He accuses the laureates of cherry-picking history. In particular, he accuses of ignoring the considerable scholarship that offer a much more nuanced account of the development of why inclusive institutions developed in Britain and America but not in the Carribbean.
London merchants and Barbadian planters, well represented in Parliament, became powerful advocates for inclusive institutions in Britain not in contrast to the extractive institutions on the other side of the ocean, but because of them.
Acemoglu and Robinson read a book called American Slavery, American Freedom, used the bits about American freedom and tossed the bits about American slavery. The new economic institutionalists treat work on institutions by a celebrated historian not as a coherent argument, but as a source of anecdotes.
The result says Geely, is “a treatment of early modern institutions so selective it functions as a bedtime story for capitalists”. His is a plea for economists to engage more deeply with the rest of the social sciences, particularly history, to understand better how good and bad institutions are connected. As a historian by background myself, I endorse this message.
Meanwhile George Magnus, a respected economist and authority on China, addresses another criticism frequently levelled at the Nobel laureates in this excellent essay for Engelsberg Ideas: if inclusive institutions are so important to prosperity, how do you explain the rise of China?
Magnus’s answer is that for three decades following the death of Mao Tse-Tsung, China did in fact pursue a path towards more inclusive institutions.
China’s best years of economic progress were the result of the Reform and Opening Up initiative launched by Deng Xiaoping in 1978, and pursued mostly – with a hiatus following the 1989 Tiananmen protests – until Xi Jinping came to power in 2012. This campaign gave a political blessing to some separation of party from state, private initiative and privatisation, liberal reforms, civil society institutions, and international exchanges. Importantly, it also introduced markets and prices into key parts of the state-led economy, and substituted the institutionalisation of law and rule-making for diktat and decree.
But since the 2010s, China under Xi Jingping’s leadership has backed away from the earlier reforms, introducing far greater political, economic and social control and subjugating private enterprise to the party state. The result has been that China’s economic performance has faltered:
Indeed, the relevance of institutions to China’s development prospects could not be more topical, as it wrestles with a host of systemic economic problems, which also present acute and awkward political policy problems. Economic growth and productivity have slowed down significantly. The economy is characterised by severe debt constraints, a real estate bust, a chronic weakness in demand, high youth unemployment and a dearth of good job opportunities, social malaise, and a private sector and middle class lacking in confidence.
China is now embarking on radical measures to try to revive the economy, as discussed in previous posts, including measures to boost the stock market and housing markets, bail out banks and local governments, and encourage more consumer spending. But in line with the analysis of the Nobel prizewinners, Magnus is doubtful that these measures will tackle the root of China’s problems:
What is missing from these palliatives, is a root and branch programme of economic reforms, which, unfortunately for the Chinese government, require political reforms and new attempts to open up and liberalise China’s institutions. These will be mostly impossible for a Leninist government to endorse.
Magnus’s conclusion is that “Peak China” may be closer than we think. A heartening thought.
5. Media Darlings
This episode of the Media Confidential podcast is well worth a listen. The main item is interesting enough: an interview with Eric Beecher, the author of The Men who Killed the News, a new book about how media moguls abuse their power. Much of the discussion focuses on Rupert Murdoch and the extent to which he may have been complicit in scandals at his media enterprises over the decades. Beecher was an editor of one of his top Australian newspapers.
Nonetheless, what most intrigued me about this episode is a prank played by Alan Rusbridger on co-host Lionel Barber when he plays a recording of another podcast discussing something Barber had written. I won’t give the game away. But suffice it to say, it left them asking whether the media revolution may be about to devour its own children.