As President-Elect Trump chooses more cabinet leaders, we are learning more about how we can expect him to approach changes in policy. A heavy reliance on both military and business leaders suggests a significant reduction in bureaucracy in achieving results. Just as he ran a lean campaign, he appears to be developing a lean government, where layers of lobbyists are unnecessary – as he has simply gathered the best representatives of two of government’s key customers – businesses and defense – at the cabinet level. Government’s other two customers – the consumer and foreigners – are seen as previously overserved and that legacy will soon be dismantled. And as to serving government itself? That does not appear to be high on Trump’s list of concerns. While he has tapped policy experts from Congress, his choices suggest he is far more focused on results than on politics. The choice of Exxon’s Tillerson and not either Guliani, Romney or Corker for Secretary of State would confirm this approach – billionaire or general is better than elected office in Trump’s cabinet.
Trump leads – you follow or get out of the way. Earlier we suggested that he would fill his cabinet in record time, and that appears likely. He is acting presidential even before his inauguration, and the Republican-led Congress appears ready to follow. In this vein, our latest thought is that the exercise of the so-called nuclear option – eliminating the 60 vote majority in the Senate required to end a filibuster under the Byrd Rule – may be an early tactic. Similarly, we expect aggressive action on packing the Court and the Federal Reserve to bend policy his way. Every President pledges an aggressive first 100 days – but most are unwilling to undermine long-standing government politesse to do so. We expect Trump to shake Washington to the core – and to go over their heads directly to the people when he sees obstacles in his way.
In the short to intermediate term, a strong leader who points unambiguously in a direction – any direction – will usually achieve strong results. Bottom line, that points unambiguously to solid growth for the two years our crystal ball can usually see. However, given our view that the US is the suburbs of the global economy – and benefits from growth no matter where it occurs – our major concern is that President Trump’s international policies seem to take a different view.
Understanding the US Trade Deficit
Donald Trump sees the US trade gap as a sign that foreign countries are stealing our jobs, and promises to bring them back. Brexiters also took a dim view of the UK trade gap. We see this zero-sums game approach as flawed. Meanwhile, Steven Roach recently took Trump to task; noting the trade gap is financed by big bond purchases from Japan and China and messing with them could spike interest rates and weaken the dollar. This is a banker’s view and just as flawed. All of them interpret trade gaps and international debt as bad, rather than realizing that both the ability to buy more than you produce and the fact that foreigners are willing to hold large amounts of your debt are sign of success, not failure.
We are the United States, already the wealthiest nation on earth, not an emerging market struggling to save and invest its way to growth. To understand the US trade deficit and associated international borrowing, let’s look at my favorite metaphor – the US as the suburbs of the world.
Welcome to the ‘Burbs
The suburbs are by definition the richest part of a local economy, and so they have the most assets to sell to newcomers who have recently achieved success and want their share of the good life. Since newcomers have to buy land, houses and businesses in the suburb to gain entrance, they will bid up asset prices – making everyone already there even richer. The capital gains created in this process become a source of income (unrecorded in government statistics) that allows the suburbanites to spend more than they earn – yet still enjoy increasing wealth as long as they don’t spend more than they earn plus the capital gain. To access the wealth created by asset appreciation, the rich could either sell the assets – which also gives up control over future appreciation – or borrow against them. So long as the interest rate charged is less than the earning power of the asset, borrowing makes sense.
Indeed, if the spread between asset appreciation and interest rates is wide enough, suburban investors will borrow even when they don’t want to spend – using leverage to increase their return on assets and add to their wealth more quickly. When they borrow from abroad, they are importing the wealth of successful outsiders before those foreigners have accumulated enough money to buy into the suburb themselves. But where did those successful outsiders get this wealth ready to lend in the suburb’s own currency? By selling the suburbs what they wanted, and then saving the money rather than buying suburban produced goods and services – or buying suburban assets themselves.
Note that existing suburbanites have superior local knowledge and typically will identify investment opportunities faster – and probably have enough wealth or access to credit to exploit them before outsiders. Indeed, they are often suburbanites because they have already been better at identifying investment opportunities both inside and outside the suburb. Americans earn far more on their investments abroad than foreigners earn on their assets in the US. This net positive flow of investment income offsets part of the merchandise trade deficit. The current account gap that remains is financed by selling or borrowing against appreciating assets – which is how the rich get richer. Bottom line, the US trade deficit — and our foreign debt — reflect the fact that our country is so desirable to others.
But wait there’s more!
If a nation is the most successful globally – like Spain in the 1500s, England in the 1800s and America today – their currency becomes valuable in its own right. As the reserve currency, that nation gains the advantage of being able to print (for virtually free) IOUs for potential future purchases of their goods, services and, most importantly, assets — and trade them for real stuff from abroad. Obviously, being able to get stuff for free when other nations have to pay is a major advantage that helps keep the suburbs the suburbs.
There are many ways for a suburb (or a nation) to lose its mojo, but they all center on disrupting the virtuous cycle created by the inflow of capital creating higher asset values at the top of the pyramid. Successful suburbs recognize that they will get a share of growth no matter where it occurs so long as those beneficiaries want to move to the suburb.
Thus, maintaining growth among those hungriest for future suburban life is rule #1.
In this vein, though we understand Americans concern about Chinese equity investment in America, their desire to purchase assets is a natural extension of their earlier investments through treasuries. Like Japan and Europe before them, as they become wealthier and more sophisticated, they want control of assets, not just returns. Bottom line, by moving to the suburb they are becoming American – with a vested interest in our success.
This brings us to rule #2 – Always remain #1.
History is full of examples of empires that flourished as they grew, but imploded when territories – unhappy for a plethora of reasons – began to pull away. That diminished the advantage of scale and reduced the number of potential outside successes who would produce capital gains for the existing elite. Maintaining a slipping suburb’s status quo means selling assets at lower prices – which often is reflected as devaluation on a national scale. This is the imminent threat to the Eurozone — and to the US, if trade partners turn their attention elsewhere. The dollar bloc – and America — has been expanding for a century and exploded in scale after the fall of the Berlin Wall. However, new trade barriers could shrink that scale. Meanwhile, China is hoping to cash in on American isolationism to expand its own reach and power.
Rule #3 concerns a different kind of threat — overconcentration of wealth.
There is a risk when only a smaller and smaller pool of investors is capable of buying or borrowing – until they dominate all investments. At the heart of the suburban model is the possibility that success will buy access to a better community. If achieving that goal is viewed as too difficult – or unattainable – resentment builds. This could either turn successful investors from the outside to competing suburbs – or in the worst case, lead to revolution where outsiders try to take the narrowly held assets by force. This risk of overconcentration is apparent in the hollowing out of the middle class, which is undermining the status quo across the globe. So far the revolution has been at the ballot box rather than in the streets.
Trump’s rhetoric suggests he favors a more isolationist approach that saves already less competitive US industries. His cabinet picks suggest he favors those that have reached the peak of their pyramid. Among his own successes is the creation of Trump Tower – one of the most desirable vertical suburban neighborhoods in the city that represents the pinnacle of American suburbanization.
There is not much manufacturing and plenty of leadership, finance and education in Manhattan. Clearly Trump understands the system at a local level. Will he and his cabinet apply the same approach internationally or close the doors as a world-leading China did under the Ming Emperors? Obviously, nothing irreversible will occur in Trump’s first 100 days, but every march begins with a single step.
We will be watching closely whether his initial actions extend or reduce our confidence about the very likely positive direction for the first two years of his administration.