Pressure is building again for politicians all around the world to make critical decisions on the directions of their economies. As the US stock market sold off, everyone in Washington began making happy talk about a solution to the fiscal cliff – a problem that the Congress made up and can just as easily resolve if they have the political will. In Europe, ten year notes are rising again in Spain and Italy as the latest patch on their banking crisis began to peel off with questions about Spanish and Greek commitments to reform. In Japan, the call for new elections next month sent the yen plunging as front runner Shinzo Abe is widely expected to call for increased quantitative easing to drive down the currency and break the deflation cycle. And, in China, the new Party leadership was announced, with few surprises suggesting continued economic and financial market reform. Right now, China seems in the lead on stimulus, but the realities of economic weakness around the world have politicians turning to aggressive quantitative easing as the path of least resistance when compared with making the tough decisions on enhancing their nations’ productivity. It looks to us like high deficits are here to stay, and that the strong leader we are all hoping for to lead the way out of this malaise is still nowhere to be found in either politics or economics.
Washington has spent the post-election period negotiating in public on the fiscal cliff while the US equity markets sold off. President Obama staked his position with comments that $1.6 trillion in tax hikes should be included in any final plan – twice what was offered by Republicans a year ago and $400 million more than his own earlier counter. He also made clear that he would not back off on higher taxes for individuals with over $200,000 in income or couples over $250,000. Bottom line, that is what he campaigned on and that is the minimum he will accept. His only concession appears to be that the higher revenues do not have to come through a return to pre-Bush tax rates, if a reduction in deductions and other loopholes will produce the same effect. Meanwhile, Speaker Boehner indicated that the Republicans had put revenues on the table, with a similar caveat that higher tax rates were not allowed, but reducing deductions was ok. So far, so good. Unfortunately, many studies have shown that there are not enough tax expenditures (deductions like mortgage, charity, state and local taxes, etc.) to provide a revenue increase equivalent to returning to the pre-Bush tax code. That is, in part, because lower marginal tax rates (and the AMT) have already reduced the benefits of deductions significantly. Still, baby steps.
Meanwhile, the US economy appeared headed for a soft quarter even without allowing for Hurricane Sandy. After roughly 3% annualized growth in third quarter real GDP, weakness in the Philadelphia Federal Reserve index, initial claims and industrial production all point toward anemic 1% real GDP growth in the fourth quarter. Sandy is certainly to blame for some of the weakness, but even after adjusting for those effects it looks like growth was relatively soft coming off the stronger than expected third quarter. Adjusted industrial production has now been increasing only 0.1% a month on average for the past six months as the auto boom has subsided. Lower interest rates have worked their magic on the housing and auto sectors, but more and sustained stimulus is needed. Indeed, financial markets widely expect the Federal Reserve will expand its quantitative easing by converting the $45 billion in bonds it is currently buying under Operation Twist (financed by selling short term debt) into pure outright purchases. The markets also expect a relatively quick solution to the fiscal cliff, and on that score they may be right. The commentary coming out of the White House and Congressional leaders suggests a kick the can down the road approach similar to the European solution to their need for fiscal consolidation. True, a recession looms if the fiscal cliff is not resolved – or delayed – but the underlying economy appears to be geared for sustained tepid 2% growth if the cliff can be dealt with. While a Grand Bargain may be devoutly to be wished, we see little political conviction in that direction, and once the Cliff if delayed for six months (or whatever) we expect both sides to return to their earlier combative stances – just as Spain has failed to capitulate even after being offered a way out. We hope we are wrong, but without the strong, widely accepted, leadership of an FDR or John Maynard Keynes or Reagan or Friedman, it will be tough to corral this herd of cats. We do not see a leader of that stature in the current mix.
Changing of the Guard in China
This week, China revealed the new team that will run the country for the next five years – and gave some hints of what will happen beyond that. The top tier of the new leadership has received the most attention, but in many ways their elevation was a foregone conclusion. Xi Jinping and Li Keqiang have been tapped for the positions of President and Premier since their elevation to Vice-President and Executive Vice Premier five years ago. Indeed, they are the only members of the nine member Politburo Standing Committee who did not retire. Nor are the names of the five other additions to the now narrowed Standing Committee unexpected. Only ten of the wider twenty five member Politburo were not scheduled for retirement in 2012. Three of the new Standing Committee members: Zhang Dejiang, Yu Zhengsheng and Liu Yunshan, are all serving their third five year term on the Politburo. Zhang Gaoli and Wang Qishan were also promoted. The three left behind were Liu Yandong, the only women on the old Politburo, Li Yuanchao and Wang Yang. Much has been made of the last two’s failure to achieve promotion because they are associated with outgoing President Hu Jintao and are seen as liberal political reformers. However, they were also the youngest on the old Politburo and are highly likely to be promoted to the standing committee in five years – when all of the five new standing committee members will retire. Thus, continuity more than politics may be central to the leaderships promotion selections.
Just as interesting as who was promoted to the Standing Committee is who was added to the wider Politburo. Fifteen of the twenty five slots were open due to retirement – and in the case of Bo Xilai expulsion. Nine of these new selections will also be of retirement age in 2017, meaning that of the just selected Politburo only ten will be available for promotion to the next Standing Committee. Whether the Standing Committee in 2017 is seven or nine, the list is already pretty well set – showing that stability is a key goal in designing the Politburo every five years. Two names stand out in this regard, as Hu Chunhua and Sun Zhengcai are the only two selected this term who will be young enough to continue in ten years. Hu Chunhua, in particular, has long been tapped for promotion as he was leader of the China Youth League, like Hu Jintao. Indeed, their careers are so alike and Hu Jintao’s mentoring of Hu Chunhua so strong that the younger man is called Little Hu.
Several elements of the new leadership point in the direction of increased financial and economic reform, but political reform not so much. First, all of the new Standing Committee members are considered conservative on political issues. However, even the “reformers” left of this year’s list are hardly liberal by US standards. Americans often look for a trend toward democracy which does not exist in China. Yes, there are always some protests, particularly in Hong Kong, but most are over local issues in townships, not directed at the central leadership. Looking for politically liberal Politburo members in China is like looking for moderate clerics in Iran – on an American spectrum there are only shades of conservative.
A shift toward financial and economic reform is likely as there will be significant change at the top of the financial leadership. Many well-known names like Zhou Xiaochuan (Governor of the People’s Bank of China), Chen Deming (Minister of Commerce), Xie Xuren (Minister of Finance) and Zhang Ping ( Chairman of the National Development and Reform Commission) will all be replaced due to retirement. Many see the hand of 86 year old former President Jiang Zemin in the design of the current leadership. This is re-emphasized by the fact that current President Hu Jintao will also give up his leadership of the military, something Jiang held onto for two years after he stepped aside as President ten years ago. Jiang’s Shanghai clique had been aggressive in exploiting paramount leader Deng Xiaoping’s message that it is good to be rich. However, under the Hu and Wen leadership of the past decade, much more attention was given to development of the interior and West, state owned enterprises were more favored, and the more market oriented east coast provinces saw some of their luster dim. The downfall of Bo Xilai and the massive concentration of wealth that occurred during this period has undermined the Party and there is a backlash underway. Wang Qishan, known as a top notch problem solver, has been named the head of Party discipline, rather than to a financial post. Three of the five new members of the Standing Committee took their most recent positions to clean up after a corruption scandal. Looks like there is a new sheriff in town. Even in China the drift is toward more regulation.
Much has been made of the competition between the Princelings and the China Youth League (Tuanpai) coalitions within the Party, but as we have commented before this is largely a function of education. Most of the new leadership was born between 1945 and 1955, meaning they went to college when very few received higher education due to the Cultural Revolution. One either had to be politically connected (the Princelings) or well regarded by the internal promotion ladder in the Party (the China Youth League). Yet, nearly half of the new twenty five Politburo members have advanced degrees, and both leaders have Ph.D.s – Xi in law and Li in economics. The only US President with a Ph.D. was Woodrow Wilson. Unlike, their predecessors whose education was primarily in engineering (at Soviet style institutions) the majority of the new group are trained in law, economics and management – reflecting the Party’s understanding immediately after the Cultural Revolution that these were skills that were in high demand. Four of the seven Standing Committee leaders were sent to work in the countryside as educated youths – including two of the Princelings and both leaders. This group has a much different view of the world if only because they came of age during a time where strong Chinese growth was a permanent feature. They are now tasked with fostering that growth into a new era where due to sheer size and changing demographics, growth will slow. The question is by how much and what are the consequences for debt and income distribution as a result. As the most likely locomotive of world growth, the decisions of this new group may be far more important than what the US does on the fiscal cliff or Europe does with fiscal integration. (Note we did not mention Japan.)