Richard Cluver is going overseas and so this is the last issue of The Investor until the end of June
Turning the screws on the Rand
by Richard Cluver
“I am very worried about what is happening to our Rand and the buying power of my small pension” said the retired schoolteacher whom I frequently bump into. “What can we ordinary people do about it” she asked?
My immediate response was “Use your vote in the coming elections to unseat the current team of kleptocrats who are running the country. While overseas investors continue to believe that money invested in this country is at risk of being stolen because of our poor fiscal management, they are unlikely to invest here and so the Rand is consequently punished.
Just how bad are foreign perceptions of our economy? Well one measure is the Big Mac Index which was created by The Economist in order to measure whether currencies are at their “correct” level. It is based on the theory of purchasing-power parity – the notion that, in the long run, exchange rates should move towards the rate that would equalise the prices of an identical basket of goods and services (in this case, a Big Mac burger) in any two countries.
The Big Mac is selected for comparison as the popular fast-food meal is widely available across the world, and remains fairly consistent in pricing; however, it is by no means an exact science. “Burgernomics was never intended as a precise gauge of currency misalignment, merely a tool to make exchange-rate theory more digestible,” The Economist said. The index has however, become a global standard, included in several economic textbooks while also becoming the subject of at least 20 academic studies.
In the map below, countries are coloured in terms of the Big Mac Index which indicates that the SA Rand is among the world’s most undervalued currencies. Using the Big Mac Index implies that the the official exchange rate of R15.81 to the US Dollar implies that the Rand is 64.1 percent undervalued. The correct rate should be R5.68 to the Dollar, worth at least twice its current buying power.
Relative to the British pound the current exchange rate is 23.10 Rands to the Pound but the Big Mac Index suggests that the correct rate should be R9.69 to the Pound. Relative to the Euro the current rate is R17 whereas the implied Big Mac rate is R7.53.
What a difference it would make for South Africans travelling abroad if these Big Mac rates were to apply! And how much cheaper would be all the goods that we buy that are either imported or that contain a significant imported component. The downside of such a valuation, however, would be a severe blow to the the mining and tourist industries which rely heavily upon the diminished value of the Rand…..and how many jobs would be lost if that were so!
However, to continue down the road that we have followed since 1994 is simply unsustainable. The chart below makes it clear that we cannot keep on allowing the Rand to depreciate. It is already 4th from the bottom among countries which are currently regarded as economic disasters.
So how can we set about rectifying this problem? In the short-term then it is probably desirable that we allow a weak Rand policy. But how much better off would we be is we did not as an economy rely just upon our natural resources for that is what mining and tourism actually depend upon, in the former case upon minerals in the ground and the latter upon sun and surf, mountains and wild life. But to be sustainable long term we need to foster the development of secondary industry both to supply local needs in the form of import substitution and competitive exports and that depends upon the development of skilled people and entrepreneurship to facilitate the creation of local industry and employment in the future.
That we need to achieve an immediate and dramatic change of attitude is currently recognised at all levels because of the fear of South Africa being downgraded by the ratings agencies to “junk” status which would have a massive depressive impact upon the economy. However, most observers do not believe that the Jacob Zuma administration really appreciates what needs to be done to bring about this change: that if the ANC remains in power junk status is probably inevitable some time in the immediate future. Indeed, as the graph below makes clear, continued ANC government probably guarantees junk status. The full story follows immediately after this one, but for now consider the graph below which illustrates how ANC policy has failed the South African economy over the past quarter century. A change of government and a commitment to job-creating economic growth is now desperately needed lest we go over the precipice into economic basket case status from which it will be nearly impossible to claw our way back in most current lifetimes.
Now the immediate other truth is that never before in the past quarter century have South Africans faced a greater opportunity for political change than in the next few months. Such is the disgust of the Average South African about the current government that over 90 percent of adults in a recent poll have expressed their mistrust of the current administration. South Africans are longing for change and the August municipal elections will offer them the opportunity to facilitate change at the level that most affects the day to day lives of most of us. So, for example, the DA has recently put out to all its members the view that if every person who voted DA at the last election could persuade just one other person to vote the same way as them, the DA would sweep the board in every municipality that matters in this country.
So the simple truth about my discussion with my retired schoolteacher friend is that we ordinary folk DO have it in our power to do something about the Rand. All we need to do is to persuade one more person to vote against the ANC in the coming election!
How the ANC has failed the SA economy
By John Maynard
The above is a nom de plume for a South African economist whose work can be viewed at http://www.southafricanmi.com/
South Africa is one of the most mineral rich countries in the world, with massive gold, diamond, coal, iron ore and platinum deposits spread across the country. It has vast amounts of agricultural land and the ideal climate for the production of wheat and maize. Its climate also provides perfect conditions for wine making.
During the Apartheid years, loads of sanctions were in place against South Africa. This necessitated that South Africa locally develop or manufacture goods that could not be imported. Leading to a strong manufacturing industry within South Africa to supply the local market. The economy was however very closed and very little trade took place between South Africa and the rest of the world during the Apartheid years. Strict rules regarding the flow of money out of South Africa was in place too, leading to little money leaving the country. This in turn lead to the development of a very strong banking system in South Africa.
Most of the technical and skilled labour was made up by white people as the Apartheid regime favoured the minority population, The same goes for access to education, water, electricity, health, transport routes etc. All leading to a very skewed distribution of income and quality of live in South Africa.
So with the background provided we will now look at South Africa’s economic history since the rise of democracy. This will include GDP growth rates, inflation and exchange rate performances per president of the Republic.
The graph below provides a snapshot of the economic performance of South Africa under its various presidents (including the last few quarters under president FW De Klerk who was the last president of South Africa before a new president was democratically elected.
While looking at the economic performance of South Africa per president is useful, one should also take into account who the minister of finance during their presidency was. As economic policy is to a large extent implemented by the minister of finance. Below the same graph as the above one, but instead of looking at the growth rates per president it looks at the growth rates under the various finance ministers.
Most finance ministers had a pretty successful track record as South Africa’s economy had very few periods of negative economic growth over the last 22 years. But South Africa has experienced a lot of slow to no growth. Thus not necessarily negative economic growth, but growth that seems to be stagnating around 0. The problem with such growth is that if the population keeps increasing and the economy grows at a slower rate than the population, the average citizen in South Africa gets poorer over time. A useful measure of this is what is known as GDP per capita. GDP per capita measures the value of the economy expressed per person living in it,
Below a graph showing South Africa’s annual GDP per capita (Rand value of the South African Economy per person living in it, as calculated by South African Market Insights). As can be seen from the graph during Thabo Mbeki’s tenure South Africans enjoyed a surge in GDP per capita, while more recently the GDP per capita has remained relatively flat (hardly any growth from 2010 to 2015). This is partly due to low/no economic growth, while the population steadily kept increasing (thus more people sharing the spoils of the South African economy). If the population growth keeps outstripping the economic growth the country will grow poorer per person.
While the graphs above gives a good indication of South Africa’s economic performance since the rise of democracy, another indicator of a country’s economic performance is a country’s exchange rate. In particular its exchange rate to the most traded currency in the world (the USA dollar).
A strong/appreciating local currency shows a willingness of foreign investors to invest in a country, while a weaker/depreciating currency shows a lack of willingness of foreign investors to invest in a country. I.e the higher the demand for a country’s currency the stronger it will be, and visa versa. The graph below shows the average exchange rate per year under each of South Africa’s presidents. While the exchange rate is influenced by a lot of factors, it is a very good indicator of economic sentiment towards a country. As can be seen from the exchange rate graph below, sentiment towards South Africa has been deteriorating at an increasing rate over the last couple of years, further adding to South Africa’s list of economic problems, as less foreign investments into South Africa, leads to less growth and development, and the continuing cycle of stagnating economic growth.
The graph below combines the annual GDP per capita (in Rand terms) and the average Rand/Dollar exchange rate per year and calculates South Africa’s GDP per capita (expressed in US Dollars). As can be seen from the graph its been an abysmal performance for the last 20 odd years.
The following sections will take a look at the economic growth rates, social development, interest rates etc per president of the republic:
May 1994-June 1999: President Nelson Mandela
During President Mandela’s reign as leader of the country South Africa experienced massive Foreign Direct Investment (FDI), as the country had sanctions lifted against it an foreigners and foreign businesses could invest in South Africa again. Strong FDI usually leads to a strong currency as the demand for the domestic currency increases. It also drives construction and infrastructure development (which bears fruit in later years as this lifts the capacity of an economy to handle greater growth, in terms of population and trade, The fruits of this can be seen in the strong growth experienced during Thabo Mbeki’s tenure as president). Increased foreign trade was experienced too as sanctions were lifted.
During President Mandela’s presidency the South African economy grew on average by 2.5% (quarter on quarter annualised data) and inflation averaged 8% per year.
14 June 1999 to 24 September 2008: President Thabo Mbeki
During President Thabo Mbeki’s tenure as leader of South Africa, South Africa experienced an average GDP growth rate of 3.25% (quarter on quarter annualised) and inflation averaged 5.6%. The combination of president Mbeki and finance minister Manual proved to be the most successful economic combination in South Africa’s young history. South Africa experienced 36consecutive quarters of positive economic growth during the period in which Thabo Mbeki was president and Trevor Manual was finance minister.
It has to be said they were in charge of the country and finances during a “sweet spot” for South Africa. Demand for commodities were surging (largely driven by China), prices for commodities were surging ahead, all leading to South African companies making massive profits from the exports of commodities. Some economists have lamented the fact that SA did not grow at higher rates during this time, focuses more on improve the levels of education, and invested more into infrastructure and other less volatile and vulnerable industries, to ensure future job creation and a lesser dependence on volatile commodity markets and prices.
Thabo Mbeki was recalled by the ANC before his term was over, and a care taker president was appointed until the next general elections were held. The care taker president was Kgalema Motlanthe.
24 September 2008 to 9 May 2009: President Kgalema Motlanthe
During President Kgalema Motlanthe tenure as leader of South Africa, South Africa experienced an average GDP growth rate of -2.2% (quarter on quarter annualised) and inflation averaged 9.9%. Sadly he presided over the country during the global financial crisis set on by the subprime mortage crisis in the USA and never had much influence over policy or the implementation thereof. and to a large extent economic policy set out by South Africa, could not prevent this slump in growth during the financial crises as the whole world was affected by this, and South Africa is an extremely open economy (I.e a large part of its economy comes from trade with and from the rest of the world).
It has to be said that South Africa’s financial system coped extremely well during the financial crisis. This is largely due to the fact that South African banks and consumers did not have large scale exposure to sub prime mortages in the USA. Strict financial controls on SA citizens and companies investing and taking money offshore shield our banks and citizens from large exposure to the sub prime mortgage market.
9 May 2009 to current: President Jacob Zuma
Under Jacob Zuma’s rule, South Africa experienced an average GDP growth rate of 2.1% (quarter on quarter annualised) and inflation averaged 5.23%. This during a period in which commodity prices dropped off a cliff, then rose to new heights and dropped back down to multi year lows. Unfortunately SA did not diversify enough away from commodities during the good times, and it’s economy is still very much linked to the fortunes of resources and commodities.
Sadly the recent drops in commodity prices are used as an excuse for poor economic growth, yet we never experienced massive economic growth when commodity prices were sky high. Cant have your bread buttered on both sides, so if we were to blame commodity prices for poor economic performance, the question has to be asked why did we not perform better with high commodity prices?
Why Zumanomics has failed South Africa
by Richard Cluver
Assume you are in your late 50s and have been retrenched with a million Rand golden handshake. It is not easy to get another job at your age in a depressed South Africa and so two options face you.
The first and obvious option is to invest the money and try to live off the income for as long as you can, drawing down capital to supplement your interest income while you look for another job. That way you are in fact hoping that luck is on your side and another job will come along before all the money is exhausted.
The alternative view is to use the money as seed capital to fund the start up of a business. Provided you did your homework and opened a business that serviced a real public need and you were prepared to work hard enough to make it succeed, you could grow wealthier than you had ever dreamed of and provide employment for many others like yourself.
What do these two options have to do with the ANC and South Africa’s economy? Not surprisingly they have everything to do with the options that face national governments like ours. And the Zumanomics option can be likened to the first example. President Zuma inherited a healthy economy with a lot of fat in it at about the same time as the world economy went into free fall after the 2007 Wall Street Sub-Prime crisis. He could have used the Government’s cash reserves and extensive borrowing power to expand national infrastructure creating jobs for thousands of people along the way…and in part he did. We got the World Cup and a lot of people found work building soccer stadia. But when the event was over we were left with a series of white elephants instead of productive dams, power stations and enhanced transport networks.
So when the stadia were built, the jobs ended whereas dams and power stations would have provided work for thousands for half a century and they would have fuelled private enterprise which would have expanded also needing additional workers. Instead, when the stadia building was over and unemployment began to surge, he doubled the number of government jobs and expanded the dole for the unemployed.
Furthermore the ANC has failed to learn the lesson of the World Cup. The ANC-controlled Durban City Council recently bid for and got awarded the next Commonwealth Games in respect of which it has no budget and only vague promises that central government will step up to the plate!
Now it is a truism that unemployed people on the dole lack the dignity and the social contentment that self-sufficiency provides, but the political bonus is that you can tell unemployed people that you know how they vote and that the dole goes to those who vote for your party. So Zuma’s choice was perhaps understandable.
The problem, however, was that neglect of national infrastructure left us with lack of electricity which has blighted industry and cost the economy both jobs and taxable profits and so Zuma’s treasury had to borrow money to pay the salaries of all the additional workers who had government jobs created for them. Sadly, the consequence of increased bureaucracy was that getting things done now takes twice as long because there are twice as many people having to rubber stamp paper and, of course our national debt has doubled with the result that we have very little borrowing power left.
Once Zuma goes, and go he must because his failure to pump prime the economy has guaranteed an increasingly unhappy and frustrated public, whoever follows will have their job of re-building the South African economy made twice as difficult because there is no money left and in our overborrowed state we are facing “Junk” status which means that it will be prohibitively expensive to borrow any seed capital that we need to prime the pumps of business and industry in the future.
So, thanks to Jacob Zuma and his misguided colleagues, we will all have to tighten our belts and work twice as hard as we would have needed to do back when Zuma assumed power. Re-building now will be twice as difficult. That’s why the ANC brand of socialism has failed and why South Africa jobless rate increased to 26.4 percent in the first three months of 2015 from24.3 percent in the precedent quarter. It is the highest rate since 2005.
It is accordingly fitting to recall the words of DA leader Mmusi Maimane in his response to the State of the Nation address in Parliament:” We known that unemployment, poverty and inequality are a result of a deeply unfair history of exclusion and oppression, but your job is to fix it. Not overnight, nobody is expecting miracles. We just want our country to move in the right direction.
“Instead of redressing the structural inequalities of apartheid, you built yourself a big house on the backs of poor South Africans. Instead of breaking down barriers that keep young, black people excluded from the economy, you introduced BEE codes that keep empowering the connected few and instead of dismantling Bantu education, you have allowed the education of the African child to deteriorate.
“Every single poor child still stuck in our failing education system will never escape the poverty trap in our lifetime.
“If the DA wins elections we will cut the size of the Cabinet in half, saving R4.7-billion, privatise failing state-owned enterprises beginning with SAA and Eskom. WE will improve BEE so that it rewards companies that invest in their workers, instead of simply re-empowering the same connected individuals.”
Enough said!
The optimum competition policy
by Brian Kantor, chief economist and strategist, Investec Wealth & Investment
Is there a true public interest in employment retention, either at Optimum Coal Mine or anywhere else in the economy?
The controversy surrounding the purchase by Tegeta Exploration and Resources, a Gupta controlled company, of Optimum Coal Mine for R2.5bn from Glencore has been grabbing the headlines in the local media. Optimum Coal Mine supplies Eskom and enjoys a near 10% share of the Richards Bay coal export terminal. Part of the controversy was about the alleged role of Mineral Resources Minister Mosebenzi Zwane. According to a report in Business Day by Natasha Marrion on 23 February: “Mr Zwane said his only interest in the deal was to ensure that no jobs were lost under the new owner.”
Business Day further reported “that the Competition Tribunal has cleared the way for the Gupta-controlled Tegeta Exploration and Resources to acquire Optimum Coal, on condition there are no merger-specific job losses. The approval comes as the Treasury is reviewing all of power utility Eskom’s coal and diesel contracts.”
There is heightened public interest in the terms of this deal, for many reasons. What is of interest in this instance though is that the Competition Commission and Tribunal however chose to interest themselves only in the employment implications of the deal, following their mandate to consider the public interest as well as the competition implications of any deal of this magnitude. As the Appeal Court indicated in its precedent making judgment in 2011 on the Massmart-Walmart merger, the task of Competition Policy is to determine:
1. Whether or not the merger is likely to substantially prevent or lessen
competition;
2. If the result of this inquiry is in the affirmative, whether technological,
efficiency or other pro-competitive gains will trump the initial
conclusion so reached in stage 1 together, with the further
consideration based on substantial public interest grounds, which in
turn, could justify permitting or refusing the merger; and
3. Notwithstanding the outcome of the enquiries in 1 or 2, the
determination of whether the merger can or cannot be justified on
substantial public interest grounds.
The legislature sets out specific public interest grounds in s 12 A (3):
“(3) When determining whether a merger can or cannot be justified on
public interest grounds, the Competition Commission or the
Competition Tribunal must consider the effect that the merger will
have on –
(a) a particular industrial sector or region;
(b) employment;
(c) the ability of small businesses, or firms controlled or owned by
historically disadvantaged persons, to become competitive;
and
(d) the ability of national industries to compete in international
markets.”
Clause 3d, “the ability of national industries to compete in international markets”, as well as clause 3b “employment” might well have also have been used to examine the contract. Clearly the competitive terms on which Eskom sources its coal will affect its costs and the prices it will ask the regulator to approve. The ability of all SA industry to compete effectively depends on the price and availability of electricity.
That the Treasury is apparently also investigating this Eskom contract, among other Eskom contracts, might be a reason for the competition authorities to have ignored this public interest in the terms of the contract. Be that as it may be, the Competition Commission’s determination of the mandated public interest as in 12a clause 3 of the Act, in employment retention, following that of the Competition Appeal Court judgment in the case of the Walmart Merger, and further pursued in the Tegeta case, needs to be seriously examined.
The case of the entry of WalMart to the SA economy. The welcome mat was not laid out.
An important case for competition law in SA, resolved in 2011 on Appeal to the Competition Appeal Court headed by Judge Dennis Davis, involved the purchase of a majority stake in a local JSE-listed retailer and wholesaler, Massmart, by the largest retailer in the world, Walmart. Approval of the deal was given by the Competition Tribunal because it was “common cause” – to quote the Judgment of the Competition Appeal Court, on the Tribunal – “that there was no threat to competition”. Indeed it was so conceded by the counsel for the parties contesting the approval of the merger in Court, to quote a report on the proceedings: “Paul McNally, who submitted closing arguments on behalf of the union… said his clients accepted that there would be lower prices as a result of the acquisition, but that these would come at the expense of local jobs.” 1
Surely this common cause should have been sufficient to approve the merger and to extend a warm welcome to Wal-Mart, especially from SA consumers, who were bound to benefit from more competition for their spending power. Given the importance of foreign capital for the economy and its growth prospects, a warm welcome too might have been extended in recognition of the confidence that the world’s largest retailer was expressing in the SA economy. This friendly response to an important investor in the SA economy might well have encouraged more direct foreign investment that is very obviously in the broad public interest.
The Competition Tribunal however surrounded its approval of the deal with a number of onerous and complicated conditions. Such conditions were highly sympathetic to the arguments made by the trade unions interested in the merger, but costly to Walmart and therefore its ability to compete in the market place with other retailers and wholesalers.
The conditions required of the merged entity by the Tribunal included restrictions on retrenchments, preferences for previously retrenched workers when employment opportunities presented themselves and R100m to be invested in a programme to support local business, combined with a requirement to train local South African suppliers on how to do business with the merged entity and with Wal-Mart with the programme and its administration to be “advised by a committee established by it and on which representatives of trade unions, business including SMMEs, and the government will be invited to serve”.
However the merger was taken on appeal to the Competition Appeal Court by the concerned unions and Ministers of State who sought to have the merger disallowed on public interest grounds. The Appeal Court agreed to allow the merger but decided to largely support the Tribunal by surrounding the deal with the conditions as had been recommended by the Tribunal (somewhat modified) but clearly not to the advantage of Wal-Mart as a competitor.
This seems a very unhelpful and unlikely course to take for a body designed to promote competition. Mergers and acquisitions, friendly and especially hostile ones, are among the more important ways in which businesses realise economies of scale that allow them to become more efficient more profitable and by definition more competitive in the interest of its customers of whom they wish to win more over. Any synergies to be realised in a larger, combined entity almost inevitably involve retrenchments of staff. Indeed, the ability to avoid duplication of personnel and systems and to reduce operating costs and improve margins is often the prime motivation for any merger or acquisition.
A vibrant economy is one where, over time, workers and managers are continuously being allocated and reallocated to more efficient purposes. This requires that some firms will be reducing their complements of workers while others are increasing theirs and net employment gains are registered for a growing potential labour force. Without job losses, there would be far fewer job gains made possible. A system that made it very difficult to retrench workers is one that discourages hiring in the first place. It makes for a stagnant economy, with a feudal style labour market that treats jobs as an entitlement, not at all easily discarded and highly discouraging to job creation.
A flexible labour market, by contrast, gives firms a high degree of freedom to hire and fire and allows workers to freely choose their employers and move easily from one job to another. The favourable outcomes of such freedoms enjoyed over time can be observed in the US or UK, with a highly productive and well paid labour force and a significant rate of turnover of jobs.
The South African labour market, or at least the labour employed in the formal sector of the economy that provides the much prized, so-called “decent jobs”, is highly inflexible. Job retention, rather than job growth, has become the primary objective of labour market regulations and it would appear also competition policy. The prospect of an extended period of unemployment is an unhappily realistic one for many of those threatened with retrenchment.
This is a weakness of the labour market that policies for competition should be addressing, not reinforcing. The competition authorities, by their rulings on job retention, have made the economy less efficient and competitive than it could be. By setting these precedents, it also makes efficiency enhancing investments and acquisitions less likely and so the efficient use of capital and labour less likely.
There is a public interest in a more competitive and efficient market for goods and services and for labour. There is only a private interest in avoiding particular retrenchments. Competition policy misuses the public interest in employment. The public interest is in employment growth and a more productive labour force to which mergers and acquisitions can make a very important contribution.
Thought from across the Atlantic
By John Mauldin
Buying African Futures
Dear Presidential Candidates:
Many Westerners still think of Africa as the Dark Continent – a mysterious, unknown place brimming with danger. Many Africans think the same of the West. Faraway lands are always mysterious and a little forbidding until you visit them, or at least try to learn about them.
Having been, at last count, to 15 African nations, I have learned how little I know about Africa. It is a land of astonishing economic and cultural diversity. As president, you shouldn’t have an African policy – you should have a whole series of policies for different parts of Africa. One size will most definitely not fit all.
You should also remember that your actions as president will have consequences for future presidents. Demographic projections suggest that by the year 2100 Nigeria will have a larger population than China will. Africa is going to make up for lost time. From an economic standpoint, Africa as a whole is unlikely to directly impact the United States for years to come, but there is an opportunity in Africa that we have neglected for 100 years.
Owing to the original colonial presence of the European powers, the various nations of Africa are still economically connected to Europe. I remember being in Zaire (now Congo), and meeting a young man who, oddly enough, is now one of the country’s leading politicians. Kinshasa was a town of multiple millions of people, and the local TV station did a story on “the” American who was visiting and looking to do business. Talking with the European expatriates there, I was left with the impression that in the early 1990s there may have been fewer than 100 adventurous souls from the United States on the whole continent. Given the ease with which Europeans bribed their way into business in the countries I dealt with – and the fact that if a US businessman acted similarly, he would go to jail – US entrepreneurs started with one hand tied behind their backs.
Thankfully, attitudes and practices are changing, and there is an anticorruption movement in a host of African countries today. Africa is going to be one of the growth stories of the coming 30 years, and it is a place where US businesses should definitely be involved. The US can facilitate that involvement by appointing ambassadors who are not just career diplomats looking to check another box on their résumés but are instead actually US businessman with connections who can introduce US businesses that would like to get involved. Not only would this approach help our trade balance, it’s just good basic policy. In general, Africa doesn’t need aid, but it does need our business acumen.
Oddly enough, Africa’s relative lack of development may help it leapfrog the rest of the world. Instead of slowly replacing outmoded telecom and energy infrastructure, Africa is right now expanding mobile internet and solar energy capacity faster than some developed nations are. Kenya’s M-Pesa payments platform is helping millions of the “unbanked” enter a thriving economy, even as the US struggles to adopt microchipped credit cards.
South Africa, where I have many good friends, is struggling a bit from the commodities downturn and some unwise decisions by the Zuma government. (I have met with Zuma three times, and each time he affirmed that he wanted to create economic growth and change. Instead, he has done nothing and made the situation far worse.) Thankfully he will be leaving soon, and South African businesspeople may once again have an opportunity to prosper.
As president, you can set up the US to have good relations with Africa, or you can create damage that will take decades to fix. Choose wisely.
Latin American Limbo
Our next flight takes us westward to South America. Here we find a blend of good, bad, and very bad news. We’ll start with the country in the worst fix, which is definitely Venezuela. The word meltdown is no exaggeration here. Years of socialism are having the predictable result.
Unlike the Socialism Lite that Senator Sanders represents, Venezuela has the real thing. Government controls the means of production and so produces the wrong things. The result is massive inflation and a crazy mix of excesses and shortages – but no shortage of misery.
The oil price collapse hasn’t helped. Venezuela’s high production costs made it one of the first victims of the downturn and will also make the country’s recovery that much harder. I do not know a painless way to pull Venezuela out of its hole. I feel terrible for the people who must live in this manmade economic disaster zone.
A collapse in Venezuela could lead to a possible interruption in a significant part of our oil supply. It’s not that there’s not plenty of oil in the world, but many of our refineries are set up to handle the rather thick, low-grade oil that comes from Venezuela. Retooling the refineries would be time-consuming and very expensive. There is little that you as president can do to keep Venezuela’s oil flowing, but the situation is one to watch.
You will not be able to ignore Brazil, the world’s eighth-largest economy and fifth-most populous country. The outlook there is better than in Venezuela, but not by much. You are no doubt aware of the enormous scandal that is going on at the highest levels of government over bribery and corruption charges involving major government figures and Brazil’s national oil company, Petrobras. President Dilma Rousseff is deeply implicated and will likely face impeachment. A recent conversation between her and former President Lula has been made public and furthers the impression of corruption.
The Brazilian economy shrank 3.8% last year and is still heading south. It is not likely to turn around until the political situation has been settled. Ordinary Brazilians are making their displeasure known through massive street protests, but it is hard to know from afar exactly who is unhappy with whom. Brazil’s poorest have been in dire straits for a long time. The wealthy Brazilians caught up in the scandals also control the country’s media outlets.
Making a bad situation worse, the mosquito-borne Zika virus has brought to Brazil a heartbreaking wave of deformed infants, with more on the way expected. And the country will host this year’s summer Olympics, diverting resources from the other problems and showing the whole world a nation in distress. (The Zika virus is a real concern, as it is likely to come to the United States sooner or later, and the Southeastern part of the US is home to the type of mosquito that carries the virus. There are companies developing both a cure and a preventive vaccine, but their efforts are bogged down in bureaucracy, which you as president could cut through.
As with Venezuela, you may not be able to help Brazil much, but you also can’t ignore it. US businesses and investors poured capital into Brazil when it looked like a promising emerging market. Those investments don’t look so hot now.
Argentina is another economic basket case, but one that actually appears to be improving. Argentina cycles through huge ups and downs. The government defaulted on about $100 billion in international debt back in 2001. It is now in final negotiations with some creditors who declined to accept previous restructuring offers. If the parties can reach a deal, Argentina will again have access to global capital markets.
That deal can’t happen too soon. New President Mauricio Macri says he will reduce deficit spending and keep inflation down to “only” 20–25%. He has already lifted currency controls and done away with agricultural export tariffs. These are important steps but only a beginning.
Finally, let’s head up to Mexico, our North American neighbor and trading partner. I find it stunning how ignorant most US citizens are about Mexico. On a purchasing-power-parity basis, Mexico is the 11th-largest economy in the world – larger than Italy, South Korea, Canada, Australia, or Spain. It is generally growing faster than the countries ahead of it on the list. It is not located in a faraway continent like Africa – many of us could easily drive from our homes to the border in less than a day. Yet we still have a caricatured view of Mexico. The caricatures do fit in some instances, but Mexico is so much more.
My colleague George Friedman recently shattered some misconceptions in an excellent article, “Mexico as a Major Power.” A quick excerpt:
Mexico is commonly perceived, far too simplistically, as a Third World country with a general breakdown of law and a population seeking to flee north. That perception is also common among many Mexicans, who seem to have internalized the contempt in which they are held.
Mexicans know that their country’s economy grew 2.5 percent last year and is forecast to grow between 2 percent and 3 percent in 2016 – roughly equal to the growth projection for the US economy. But, oddly, they tend to discount the significance of Mexico’s competitive growth numbers in a sluggish global economy.
Here, therefore, we have an interesting phenomenon. Mexico is, in fact, one of the leading economies of the world, yet most people don’t recognize it as such and tend to dismiss its importance.
Some of you candidates are having great success spinning Mexico as some kind of conspiracy of nefarious people wanting to sneak into our country and do us harm. Yes, people do cross the border illegally and ought to be stopped. But the irony is that today more Mexicans here illegally are going back to Mexico than are coming in. This has been the case since the Great Recession hit. Over one million Mexicans, including US-born children, have left the US for Mexico since 2009, far more than have entered illegally. They cross the border headed south because they see better opportunities in Mexico than they do in the US. That is the real problem you should talk about – and try to change, if you reach the White House.
I am not arguing that we don’t need to control our borders. Of course we do. Every nation should. But we need to remember that we have right next door to us a country that is quickly becoming an industrial powerhouse. In 20 years Mexico is likely to be one of the five largest economies in the world. We need to figure out how to do more business with Mexico, not less. The country is going to become a huge potential market for us.
Canadian Capitalism
Our other neighbor, Canada, managed to avoid much of our last financial crisis, but its turn finally came. Instead of housing, it was energy prices that pushed Canada toward the edge. The country is now in a technical recession, one from which the new Justin Trudeau government promises it will escape by resorting to old-fashioned fiscal stimulus. Keynes himself would be proud.
Will Trudeau fail? Maybe, but it won’t be for lack of trying. The forthcoming deficit spending will add to an already significant debt burden. I would be very concerned if I were a Canadian. The government is well on its way to amassing the kind of permanent debt burden we enjoy here in the US.
The whole point of fiscal stimulus is to boost consumer demand. Give people cash and they will buy more stuff. Yet lack of demand is not Canada’s problem, especially in the energy-driven provinces. Depressed oil prices are the problem. Trudeau’s stimulus plans will do nothing to raise oil prices. That problem is far outside his control.
I fear Canada will fall into the same trap we are in. We ran deficits thinking they would restore growth, boost tax revenue, and let us pay down our debt. In fact, we got growth that is mild at best, not enough tax revenue, and yet more debt.
As I wrote recently, growth is the answer to everything. Enable economic growth and your other presidential mistakes won’t matter so much. Suppress growth and even your best efforts will not be enough to move us forward.
On that note, we finally arrive back home.
Pivot Back to the United States
Obama announced a pivot to Asia at the beginning of his last term. Given the importance of Asia to the world’s future, that is an understandable decision. But in the next four-year term, economic reality is going to force the president to pivot his or her focus back to the United States. There are a number of factors coming together that are going to require serious crisis management.
When you take office in January 2017, the weakest recovery in modern history will have stretched on for 81 months. It will already be the third-longest recovery without a recession since the Great Depression. By 2018 it will be the second longest. Only during the halcyon economic daze of the 1960s have we seen a longer recovery; but that record, too, will be eclipsed sometime in 2019 – if we don’t see a recession first. And note that we were growing at well over 3% in the ’60s, not the anaemic 2% we have averaged during this recovery and certainly not the positively puny 1.5% we have endured lately. As we have surveyed the economic scene around the world, it has been clear (and IMF and BIS data confirms) that global growth is slowing down. Given the fact that the US economy is barely growing at stall speed, it won’t take much to nudge us into recession.
The odds that you will see a recession during your first four years are therefore quite high. Maybe not in your first year in office, but a recession is something you need to plan for. Given the fiscal reality that you will be facing and the limited number of arrows left in the Federal Reserve’s monetary policy quiver, your administration is going to have a difficult time dealing with the fallout from a recession.
Let’s look at fiscal reality. Sometime in your first year the US national debt will top $20 trillion. The deficit is running close to $500 billion, and the Congressional Budget Office projects that figure to rise. Add another $3 trillion or so in state and local debt. As you may imagine, the interest on that debt is beginning to add up, even at the extraordinarily low rates we have today.
Sometime in 2019, entitlement spending, defence, and interest will consume all the tax revenues collected by the US government. That means all spending for everything else will have to be borrowed. The CBO projects the deficit will rise to over $1 trillion by 2023. By that point entitlement spending and net interest will be consuming almost all tax revenues, and we will be borrowing to pay for our defence. Let’s look at the following chart, which comes from CBO data:
By 2019 the deficit is projected to be $738 billion. Almost every president wants to run for a second term. To forge any hope of being successful with that second run, a president needs to able to say that he or she made a difference on the budget. There are only three ways to reduce that deficit: cut spending, raise taxes, or authorize the Federal Reserve to monetize the debt. At the numbers we are now talking about, getting rid of fraud and wasted government expenditures is a rounding error. Let’s say you could find $100 billion here or there. You are still a long, long way from a balanced budget.
But implicit in the CBO projections is the assumption that we will not have a recession in the next 10 years. Plus, the CBO assumes growth above what we’ve seen in the last year or so. Let’s contemplate what a budget might look like if we have a recession. I asked my associate Patrick Watson to go back and look at past recessions and determine what level of revenue losses occurred because of the recessions, and then to assume the same average percentage revenue loss for the next recession. We randomly decided that we would hypothesize our next recession to occur in 2018. Whether it happens in 2017 or 2019, the relative numbers are the same, and so is the outcome: it would blow out the budget. Here’s a chart of what a recession in 2018 would do. Entitlement spending and interest would greatly exceed revenue.
The deficit would balloon to $1.3 trillion, and if the recovery occurs along the lines of our last (ongoing) recovery, then unless we reduce spending or raise revenues, we will not see deficits below $1 trillion over the following 10 years. The deficit will climb to $1.5 trillion just as you dive into the thick of your second campaign in 2020. Not exactly a great campaign platform.
But before I get all gloom and doom on you, let me say that I think there is a path by which you can actually prevent a recession. There is a path to stimulating growth, creating new jobs, and spurring a real economic recovery – but not by doing the same things we have done for the past 16 years. If we continue in the same general direction that we have been going, the economic realities I talked about above are going to clobber you and what will be a very scared Congress in the next four years.
No Senator or Representative is going to want to run for election in the middle of a recession, with deficits topping $1 trillion. If you think people are vehement in demanding change today, they will re