Ten Years After Lehman: The Solution Was “More Lehmans”

The day Lehman went bankrupt I left the office in London for Waterloo Station and realized that something monumental had happened. The faces of the dozens of people waiting patiently for trains from the center to their homes were revealing. Most of them were, like me, City workers. Panic.

I remember when Freddie Mac and Fannie Mae — both government entities — were bailed out, because it happened shortly before the Lehman collapse. They were the largest originators of subprime mortgages.

Why were subprime mortgages originated by Freddie and Fannie given maximum rating and credit quality? Because they had the government stamp.

What had happened with Lehman? The CEO, Richard Fuld, had been saying for some time that its situation was impeccable, that solvency and liquidity ratios were strong and the viability of the bank was out of the question. He also repeated something we hear too often nowadays, that the shares were simply under the “attack of speculators”. Many of my readers will remember similar excuses in Popular, Monte dei Paschi, Abengoa, Tesla and so many others. This “speculator attack” excuse was used a lot years later during the Eurozone crisis.

Lehman Brothers was not a commercial bank, managing deposits of retail savers, it was an investment bank. Their clients were “competent persons” that is, those that regulators deem with sufficient knowledge of the risk and complexity of the financial products they are offered. It is not possible to contract the services of an investment bank without being a competent person. Lehman was not run by incompetent people. It was managed by people that firmly believed in the system and that analysed risk the way that central banks and governments tell them to. Lehman accumulated high-risk mortgages in its assets because it believed, as so many analysts, commentators and experts said, that these assets had very little risk.

Crises never happen due to accumulation in high-risk assets, but due to the massive accumulation of assets that the entire mainstream deems as “low risk”. Houses never fall, the economy is booming, etc.

Lehman was a prime example of mainstream consensus analysis of risk and economic opportunity. When asset prices fall, buy more.

Lehman did not buy low. It bought in the middle of an already building bubble. More importantly, it did not sell high. It kept riding the gravy train.

Lehman acquired five mortgage lenders in 2003 and 2004, including subprime lenders, when house prices were already soaring. Its acquisitions were lauded by many analysts as genius. As the bubble grew, Lehman’s real estate division led the capital markets unit profits to soar more than 50% between 2004 and 2006. it was the fastest growing division in the entire business. Valuations reflected that “success” sending the multiples at which brokers valued the Lehman stock at all-time highs.

Janet Yellen said in 2005: “In my view, it makes sense to organize one’s thinking around three consecutive questions –three hurdles to jump before pulling the monetary policy trigger. First, if the bubble were to deflate on its own, would the effect on the economy be exceedingly large? Second, is it unlikely that the Fed could mitigate the consequences? Third, is monetary policy the best tool to use to deflate a house-price bubble? My answers to these questions in the shortest possible form are, “no,” “no,” and “no.”” Her analysis would not be as clear later in her years as Chairman of the Fed, where she saw no signs of bubbles.

Yellen was not as clear on the housing bubble as it looks. She also spoke of “sophisticated financial products that mitigate risk and facilitate access to housing financing” and Bernanke spoke of “a slowdown, but not a fall“. In essence, she said what most were saying. “Housing is a relatively small sector of the economy, and its decline should be self-correcting”. No, it was not.

Bernanke, on the other hand, saw no bubble and no risk for the economy in 2005.  Even in 2007, he saw no risk for the broader economy as subprime mortgages started to collapse.

Lehman beat consensus numerous times and reported record earnings every year from 2005 to 2007. It was unstoppable, an analyst told me at the time. “They buy cheap and always deliver”. “Naysayers are always proven wrong”, he said.  In fact Lehman bought in the middle of a bubble and rode it like The Beach Boys sang. “Catch a wave and you’ll feel on top of the world”.

Until the music stopped.

In 2007, Lehman reported net income of a record $4.2 billion on revenues of $19.3 billion. Unstoppable. However, house prices were already showing signals of weakness and subprime mortgages were already cracking in the market. Enter the experts.

The voice on the street, the words of market experts were almost unanimous. It was a correction, nothing else. We were living a new paradigm.

Even holders of subprime packages refused to lend to shortsellers because they believed the assets were super safe.

We must now remember the herous, those investors and analysts who warned of those risks and who were accused of being stupid, almost terrorism for showing that the risjks were enormous. They should be praised today as well.

Bubbles always look like a new paradigm. Valuations soar and the prudent investors are left speechless, looking like fools because they “missed” the rally. 2007 was exactly that. And the hundreds of experts at Lehman as well as most mainstream repeated over and over again the same mantras. “Just a correction”, “value opportunities” and more importantly, when reminded of the tech bubble years earlier “this time is different”. Houses are hard assets, technology is a promise. This time is different. it wasn’t.

And, like all bubbles, it burst when the patience of even the most prudent analyst was tested.

Here is where we learned from Lehman. Or what we did not learn, considering the bubble of everything we are living:

The share price of a bank is the thin veil of hope between its assets and its liabilities. Risk builds slowly and happens fast. Lehman’s assets were falling in value as liabilities rose with margin calls being triggered everywhere. Those uniquely profitable assets that were so scarce they could always be sold higher to many investors found no bid at all.

We constantly hear that there is enormous liquidity in the market waiting to buy a correction and that investors are cautious and would jump at the opportunity created by a market drop. It does not happen. The marginal buyer disappears.

Lehman’s solvency and liquidity ratios evaporated in months. The bleeding became a massive hemorrhage.

Lehman also showed the futility of stress tests and traditional risk analysis. The impact of exposure to one asset class cannot be analysed believing everything else remains equal.

The two most dangerous words in economy are “ceteris paribus”. All else remaining equal. Nothing remains equal. It is such nonsense I cannot even believe that we still read thousands of pages of academic research and analysts’ reports based on that premise.

Lehman’s exposure to subprime was deemed “manageable” by bulls. It was not. The bank prided itself on having reduced debt, increased liquidity and sold assets throughout 2007.

By then it was too late. it did not survive the end of the year.

Lehman was not a cause of the financial crisis. it was a symptom of a more significant disease. A crisis created by excess risk and high debt has been “solved” by adding more debt and incentivising risk.

The timeline is always the same. First, deny the risk. Then, deem it manageable. Afterwards, take measures to “please” markets or rating agencies that are too small and too late. Stock collapses. Following that, blame speculators. Finally, close the shop.

The monetary and financial system learned something else from Lehman. To hide any new case under the massive monetary laughing gas cloud.

We have seen other cases, but asset prices have continued to soar under the excess of monetary policies. Central banks have injected more than $20 trillion in the economies sending financial assets to all-time highs.

However, Japan, China or Europe have showed how that placebo effect stops working. The ECB and BOJ examples are clear. Massive liquidity stops working as an asset price inflation machine when it becomes part of the liquidity. The Bank of Japan started buying ETFs and in 2018 the market stopped rallying while the Topix fell 7%, the ECB prolongued its quantitative easing program and European stocks still fell 4%. Chinese stocks fell more than 10% despite massive liquidity pumping.

More than $9 trillion in negative-yield bonds can cause much more damage to the economy than all investment banks in 2008 combined.

The world is well prepared to avoid repeating the 2008 crisis. The risk is that we are not prepared for the next one. Because global monetary and fiscal policies are aimed at increasing, not decreasing, risk taking and debt.

Monetary laughing gas has covered all asset classes with a fake blanket of security, disguising risk with ultra-low rates. We have solved a crisis of excess risk, debt and imbalances increasing debt, imbalances and taking more risk for lower returns.

We have learned a few things from Lehman, except that it seems that we want to replicate the same bubble with inflationary policies. The Lehman crisis was solved incentivising more Lehmans.

The next one will probably not be 2008-style crisis, it will likely be a Japanese stagnation solution, as the biggest risk today is in sovereign debt.

When the bubble bursts, governments and central banks will blame speculators and lack of regulation. And fuel the next bubble.

Daniel Lacalle has a PhD in Economics and is author of Escape from the Central Bank Trap, Life In The Financial Markets and The Energy World Is Flat.

Three New Deals: Why the Nazis and Fascists Loved FDR

[Three New Deals: Reflections on Roosevelt’s America, Mussolini’s Italy, and Hitler’s Germany, 1933-1939. By Wolfgang Schivelbusch. Metropolitan Books, 2006. 242 pgs.]

Critics of Roosevelt’s New Deal often liken it to fascism. Roosevelt’s numerous defenders dismiss this charge as reactionary propaganda; but as Wolfgang Schivelbusch makes clear, it is perfectly true. Moreover, it was recognized to be true during the 1930s, by the New Deal’s supporters as well as its opponents.

When Roosevelt took office in March 1933, he received from Congress an extraordinary delegation of powers to cope with the Depression.

The broad-ranging powers granted to Roosevelt by Congress, before that body went into recess, were unprecedented in times of peace. Through this “delegation of powers,” Congress had, in effect, temporarily done away with itself as the legislative branch of government. The only remaining check on the executive was the Supreme Court. In Germany, a similar process allowed Hitler to assume legislative power after the Reichstag burned down in a suspected case of arson on February 28, 1933. (p. 18).

The Nazi press enthusiastically hailed the early New Deal measures: America, like the Reich, had decisively broken with the “uninhibited frenzy of market speculation.” The Nazi Party newspaper, the Völkischer Beobachter, “stressed ‘Roosevelt’s adoption of National Socialist strains of thought in his economic and social policies,’ praising the president’s style of leadership as being compatible with Hitler’s own dictatorial Führerprinzip” (p. 190).

Nor was Hitler himself lacking in praise for his American counterpart. He “told American ambassador William Dodd that he was ‘in accord with the President in the view that the virtue of duty, readiness for sacrifice, and discipline should dominate the entire people. These moral demands which the President places before every individual citizen of the United States are also the quintessence of the German state philosophy, which finds its expression in the slogan “The Public Weal Transcends the Interest of the Individual”‘” (pp. 19-20). A New Order in both countries had replaced an antiquated emphasis on rights.

Mussolini, who did not allow his work as dictator to interrupt his prolific journalism, wrote a glowing review of Roosevelt’s Looking Forward. He found “reminiscent of fascism … the principle that the state no longer leaves the economy to its own devices”; and, in another review, this time of Henry Wallace’s New Frontiers, Il Duce found the Secretary of Agriculture’s program similar to his own corporativism (pp. 23-24).

Roosevelt never had much use for Hitler, but Mussolini was another matter. “‘I don’t mind telling you in confidence,’ FDR remarked to a White House correspondent, ‘that I am keeping in fairly close touch with that admirable Italian gentleman'” (p. 31). Rexford Tugwell, a leading adviser to the president, had difficulty containing his enthusiasm for Mussolini’s program to modernize Italy: “It’s the cleanest … most efficiently operating piece of social machinery I’ve ever seen. It makes me envious” (p. 32, quoting Tugwell).

Why did these contemporaries sees an affinity between Roosevelt and the two leading European dictators, while most people today view them as polar opposites? People read history backwards: they project the fierce antagonisms of World War II, when America battled the Axis, to an earlier period. At the time, what impressed many observers, including as we have seen the principal actors themselves, was a new style of leadership common to America, Germany, and Italy.

Once more we must avoid a common misconception. Because of the ruthless crimes of Hitler and his Italian ally, it is mistakenly assumed that the dictators were for the most part hated and feared by the people they ruled. Quite the contrary, they were in those pre-war years the objects of considerable adulation. A leader who embodied the spirit of the people had superseded the old bureaucratic apparatus of government.

While Hitler’s and Roosevelt’s nearly simultaneous ascension to power highlighted fundamental differences … contemporary observers noted that they shared an extraordinary ability to touch the soul of the people. Their speeches were personal, almost intimate. Both in their own way gave their audiences the impression that they were addressing not the crowd, but each listener as an individual. (p. 54)

But does not Schivelbusch’s thesis fall before an obvious objection? No doubt Roosevelt, Hitler, and Mussolini were charismatic leaders; and all of them rejected laissez-faire in favor of the new gospel of a state-managed economy. But Roosevelt preserved civil liberties, while the dictators did not.

Schivelbusch does not deny the manifest differences between Roosevelt and the other leaders; but even if the New Deal was a “soft fascism”, the elements of compulsion were not lacking. The “Blue Eagle” campaign of the National Recovery Administration serves as his principal example. Businessmen who complied with the standards of the NRA received a poster that they could display prominently in their businesses. Though compliance was supposed to be voluntary, the head of the program, General Hugh Johnson, did not shrink from appealing to illegal mass boycotts to ensure the desired results.

“The public,” he [Johnson] added, “simply cannot tolerate non-compliance with their plan.” In a fine example of doublespeak, the argument maintained that cooperation with the president was completely voluntary but that exceptions would not be tolerated because the will of the people was behind FDR. As one historian [Andrew Wolvin] put it, the Blue Eagle campaign was “based on voluntary cooperation, but those who did not comply were to be forced into participation.” (p. 92)

Schivelbusch compares this use of mass psychology to the heavy psychological pressure used in Germany to force contributions to the Winter Relief Fund.

Both the New Deal and European fascism were marked by what Wilhelm Röpke aptly termed the “cult of the colossal.” The Tennessee Valley Authority was far more than a measure to bring electrical power to rural areas. It symbolized the power of government planning and the war on private business:

The TVA was the concrete-and-steel realization of the regulatory authority at the heart of the New Deal. In this sense, the massive dams in the Tennessee Valley were monuments to the New Deal, just as the New Cities in the Pontine Marshes were monuments to Fascism … But beyond that, TVA propaganda was also directed against an internal enemy: the capitalist excesses that had led to the Depression… (pp. 160, 162)

This outstanding study is all the more remarkable in that Schivelbusch displays little acquaintance with economics. Mises and Hayek are absent from his pages, and he grasps the significance of architecture much more than the errors of Keynes. Nevertheless, he has an instinct for the essential. He concludes the book by recalling John T. Flynn’s great book of 1944, As We Go Marching.

Flynn, comparing the New Deal with fascism, foresaw a problem that still faces us today.

But willingly or unwillingly, Flynn argued, the New Deal had put itself into the position of needing a state of permanent crisis or, indeed, permanent war to justify its social interventions. “It is born in crisis, lives on crises, and cannot survive the era of crisis…. Hitler’s story is the same.” … Flynn’s prognosis for the regime of his enemy Roosevelt sounds more apt today than when he made it in 1944 … “We must have enemies,” he wrote in As We Go Marching. “They will become an economic necessity for us.” (pp. 186, 191)

Originally published September 2006.

Texas Won’t Fund Schools at Illegal Alien Shelters

Rejecting requests from local school districts, Texas will not fund education programs for illegal aliens held at immigration detention centers in the state.

In response, the Harlingen school system said it will “re-evaluate” its presence in a Southwest Key contract shelter, which it had supported with about $5,000 per migrant.

Also rebuffed in its bid for $2.8 million of added state funding to serve aliens, a neighboring district in San Benito ended its partnership with another Southwest Key shelter.

Nationwide, the U.S. Department of Health and Human Services confirmed that more than 10,000 migrant minors are in federal custody, with a large portion of them in Texas. The vast majority of them arrived in the U.S. alone, without their parents.

Expending funds on illegal aliens was a quixotic gambit for Texas schools, which perennially complain they don’t have enough resources to educate children legally residing in their districts. School boards across the Lone Star State regularly push bond elections and property tax increases to raise more money.

The Texas Education Agency (TEA) says responsibility for educating children in shelters “remains solely with the federal government.”

“Local educational agencies that wish to provide services to unaccompanied alien children in federal custody may do so on a contractual or tuition fee basis, but may not do so with state education funding,” TEA stated.

Explaining the mechanics in an Aug. 31 directive, TEA said:

• A school district shall charge tuition for a child who resides at a residential facility and whose maintenance expenses are paid in whole or in part by another state or the United States.
• A tuition charge under this section must be submitted to the commissioner for approval.
• The attendance of the child is not counted for purposes of allocating state funds to the district.

State officials reviewed their policies after Promesa Public Schools, a charter school group originally founded by Southwest Key, sought permission to expand one of its Brownsville campuses “to serve immigrant students in federal detention.”

That’s when TEA laid down the law and drew the line on funding.

Health and Human Services rules mandate that migrant shelters provide children with six hours of schooling on weekdays, as well as special education services. HHS has not commented on Texas’ hands-off policy.

Educating detained illegal immigrant children has become a big moneymaker for Austin-based Southwest Key Programs Inc., which operates 16 facilities for unaccompanied alien children in Texas (26 nationwide). The nonprofit contractor received $1.5 billion from the federal government over the past decade and expects to earn more than $458 million this year.

Non-Citizens Face Jail for Voting in North Carolina

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Divided vote concept and split opinion symbol as cracked outdoor asphalt floor with road painted text as a democratic rights metaphor for election crisis or voting corruption.

In the run-up to the November elections, more than a dozen foreign nationals face prison time and heavy fines for voting in North Carolina, according to a new federal task force.

The federal indictments may be the tip of the iceberg. Federal agents have subpoenaed more than 20 million North Carolina voter records covering eight years as part of a deepening inquiry into voter fraud in the Tar Heel State.

Last month, 17 foreign nationals were indicted for falsely claiming U.S. citizenship to register to vote and unlawful voting in the 2016 elections. If convicted, they could be sentenced to up six years in prison and slapped with six-figure fines.

Separately, criminal charges of fraud, misuse of visas and unlawful voting were filed against Diana Patricia Franco-Rodriguez, 26, of Mexico. She could get up to 26 years behind bars and a $350,000 fine.

In addition to Mexico, the indicted foreign nationals hail from El Salvador, the Dominican Republic, Nigeria, the Philippines, Korea, Japan, Panama, Grenada, Guyana, Germany, Poland and Italy.

A U.S. citizen, Denslo Allen Paige, 66, was charged with aiding and abetting one of the Mexican nationals in falsely claiming U.S. citizenship to register to vote. Paige could receive up to five years in prison, along with a $250,000 fine.

The indictments stem from an investigation by U.S. Immigration and Customs Enforcement’s (ICE) Homeland Security Investigations (HSI) as part of a newly created Document and Benefit Fraud Task Force (DBFTF) in the Eastern District of North Carolina. DBFTFs combine federal, state and local law enforcement resources to investigate and disrupt fraud schemes.

RELATED: What do states and USCIS have to hide?

Meanwhile, research by the Public Interest Legal Foundation found that 3,120 non-citizens were registered to vote and/or removed from the rolls in 13 sanctuary cities across the U.S. from 2006-2018.

The 3,120 total is a lowball figure as some notable sanctuary jurisdictions, such as California’s Los Angeles and Alameda counties, refused to respond to multiple requests for data.

Fairfax County, Va., led the list of removals with 1,334 non-citizens purged from the voter rolls.

In the majority of cases, detection and removal of non-citizen voters came only after individuals self-reported their ineligible status at the risk of immigration jeopardy or deportation, PILF stated.

“Few sanctuary jurisdictions use systems established to actively detect unlawful registrations already in existence. None verify claims of citizenship during voter registration,” PILF noted.

Further problems arise when jurisdictions like Takoma, Md., and Chicago permit aliens to vote in local elections. Federal law dictates that only U.S. citizens may vote in federal elections. Most states only permit citizens to vote in statewide elections. However, some states allow municipalities to set their own voting rules for local elections.

Chinese Growth Spurt

Economic reality isn’t black and white. At any given time, both good things and bad things are happening. Ignoring one side because it doesn’t fit your preferred outlook is an excellent way to go badly wrong.

So it is with China. We hear a lot about that vast country’s problems and challenges. They are very real and could have major consequences… which we will explore soon… but there’s good news, too. We reviewed some of it last week in China’s Command Innovation. Today, we’ll add a few more positive data points.

This letter will be a little different than most. Below you’ll read several short vignettes about positive events in China. They aren’t necessarily related and won’t build to any particular conclusion. My goal is simply to demonstrate that China has good news, and even some fabulously great news, much of it quite compelling. Whether it is enough to overcome the challenges is a different question we will address next time. And frankly, the manner in which they are growing clearly makes Western countries uncomfortable, as it is not our usual playground.

First, a quick aside. We have been making an aggressive effort to keep the main body of this letter around 3,000 words, a length most people can read in a few minutes. We’ve had good feedback on it, too. Then in my personal section, I share a great story from Art Cashin from last Monday night. So you can read either part of this letter, or both, as you wish.

Now on with our China story.

Getting a Grip on Growth

Here in the US we are very excited at the prospect of seeing 3% real GDP growth this year. In China, that would represent an unprecedented crash. Here are the annual changes from 2010-2017, with IMF forecasts for 2018-2022.

Source: Statista

Now, you can fairly ask how reliable this data is. The numbers have a curious way of coming in at exactly the level Beijing expects. But I have no doubt that Chinese growth is far greater than the US or any other developed country has seen in the last decade. And I think the IMF is probably right that it will decline only gradually and remain impressive, by Western standards, well into the 2020s. Much, if not most, of this growth is debt driven, and eventually that debt has to come home to roost. But that doesn’t seem to bother them currently.

Yet I constantly hear predictions that China’s growth days are over. Often, this stems from a belief that China’s capital investment has been higher than it actually is, leaving excess capacity. And in some industries that is true—like steel production—but steel factories have been shutting down left and right. Axios reported recently:

By the end of the year, some 1.8 million Chinese coal and steel workers will lose their jobs, victims of the government’s shift to cleaner industries and a shutdown of small enterprises. To put that in perspective, the two industries employ just 192,000 workers in the US.

That is in addition to the millions of coal and steel workers who have already lost their jobs in the last 15 years. The Chinese are ruthlessly eliminating excess capacity. Peterson Institute economist Nicholas Lardy argued last month that most of the “investment growth” we hear about is simply higher prices and real investment barely grew. If so, China may have less spare capacity than we think.

In a follow-up article, Lardy further explained that personal consumption data—which is much harder to manipulate—is more in line with economic growth. He says this is more meaningful than retail spending since China’s fast-growing middle class spends much of its income on services like education and healthcare.

Source: Peterson Institute

If investment and consumption are both strong, as they appear to be, then the remaining threat to GDP growth would be falling exports. Trade tension might eventually bring that on, but it hasn’t happened yet and China is already working to replace any lost US sales.

Export Substitutes

I’ve talked before about Alibaba (BABA), China’s e-commerce juggernaut that is, if possible, even more dominant than Amazon.com (AMZN). One big question for both companies is how far outside their home countries they can expand.

Alibaba took a big step in that direction last week. On the sidelines of a Xi Jinping-Vladimir Putin summit in Vladivostok, Alibaba said it was buying a 10% stake in Russian internet giant Mail.Ru Group. They plan to use the latter’s Russian social networks to build an e-commerce platform. Aside from the benefits it brings to both companies, the platform will be a new conduit for Chinese exports to Russia.

Source: Wall Street Journal

Now, it will be a long time before Russian consumers buy enough online goods to replace what China will lose in US exports if the trade war heats up further. The broader point is that Chinese businesses are not at the mercy of US trade policy. They have other options and are actively pursuing them.

Combine this with China’s massive “One Belt, One Road” infrastructure initiative, and you can see where the game is going. Alibaba, Tencent, and Baidu will be following the yellow brick, I mean One Belt, One Road, as will other big Chinese companies. Beijing intends to dominate as much of the Asian economy as it can. North America and Western Europe aren’t going anywhere but we aren’t the world’s growth centers anymore.

Perhaps strangely, that thought doesn’t bother me. Who’s afraid of a little competition? I think we will do just fine, thank you very much.

AI Waves

Artificial Intelligence, or AI, is the new Space Race. This time the US faces China instead of the Soviet Union and the outcome is not nearly as certain. Beijing wants to win and is pouring resources into doing it.

A new book, AI Superpowers by Kai-Fu Lee, is a must-read assessment of this battlefield. My friend Peter Diamandis recently shared Lee’s concept of “Four Waves” in AI development. Chinese companies are giving Silicon Valley a run for its money.

First Wave: Internet AI. These are the now-ubiquitous online “recommendation engines,” like the products Amazon says you should want, or the “suggested videos” that keep you on YouTube for hours. Those recommendations come from the data we generate with our clicks and other online activity. Lee thinks China’s data advantage gives it a slight lead over US counterparts in this segment.

Second Wave: Business AI. This is where we see computers analyzing data to make judgements once reserved for humans: loan underwriting, cancer diagnoses, and so on. AI excels in considering far-flung datapoints that a human analyst would discount or miss completely. Lee says the US has a commanding lead for now butChina’s lag may actually help by letting it leapfrog over legacy technologies. The country went straight from cash to mobile payments, for instance, bypassing the clunky credit card apparatus we have difficulty abandoning.

Third Wave: Perception AI. You’ve heard about the Internet of Things. The devices around us, once connected to each other, will merge the physical and online environments into one seamless world. China has the lead in sensor technology and is already using it in factories, retailing, and law enforcement. Already they have stores where you literally scan your face to pay the bill. No card, no device, just the face that’s always with you. That’s where we are all going and China is going there first.

Fourth Wave: Autonomous AI. Machines that can both make decisions and sense the world around them will eventually operate independently. Autonomous vehicles are the most familiar example but it won’t end there. Imagine drone swarms extinguishing forest fires or painting your house. Chinese scientists are working on such things.

These are controversial and sometimes risky capabilities. They will face opposition in the US but less so in China, if that is what the government wants. Hence, I think China will probably gain the lead and possibly hold it for a long time.

Automatic Automation

Even without AI, Chinese manufacturers are automating fast. This is partly out of necessity: the country lacks skilled workers, especially young ones who can work long hours. Competition from lower-cost Asian neighbors makes raising wages difficult. The best answer is to get more efficient via automation.

Increasingly, the same companies that once thrived by reverse-engineering and copying Western goods are building their own advanced products. The government’s “Made in China 2025” initiative helps with generous loans and subsidies.

For instance, The Wall Street Journal recently profiled a heavy machinery maker called Sany Group. Among other things, Sany makes the pump trucks that blast cement to the top of tall buildings, plus cranes and other equipment.

Source: Sany Global

It turns out, some 380,000 Sany-built construction machines are connected to the internet and constantly send data back to their maker. The company uses it to design better products, constantly adjusting production on the fly. That’s possible because the workers are robots who just need new software instructions, not lengthy retraining.

US and European companies make the same kind of equipment, of course. I suspect the quality is more than equal or better. Their problem is that even if a trade deal gives them full access to China, manufacturers like Sany are already way ahead, they don’t have shipping costs, and foreigners don’t get the kind of help from their governments that Sany gets from Beijing.

Now multiply this by thousands of other companies in many industries. Many are fully capable of competing anywhere on the globe, but they don’t have to. They have a giant market right there at home.

Some Random Bright Points

This next section comes from this short video on Facebook about some of China’s bright spots you might not know about. (The Science Nature Page has scores of other interesting videos, too, by the way.)

• China has recently become the world’s largest solar power producer.

• China is pouring $364 billion into renewable power generation.

• At least 40 hospitals in China have deployed IBM’s Watson AI technology.

• They are rolling out AI to improve healthcare and diagnoses at a prodigious rate.

• Chinese scientists have invented rice that can grow in saltwater that will be able to feed over 200 million people. That will be a big deal.

• At least 1 million Chinese could be using 5G mobile networks by 2023.

• Most Chinese consumers are now using mobile payments instead of cash, even at local street vendors. That means Tencent knows your buying habits even down to the type of noodles you like. And again, the Chinese seemingly don’t care others have that data.

• I don’t think they will beat Bezos or Musk or Allen to the moon, but China is teaming up with Europe to build a base on the moon. They are serious about it.

• They just built the world’s largest telescope to study the universe. Basic research is the font from which new ideas and businesses grow.

• The use of robots in China is growing at a prodigious rate. They actually have fully unmanned factories.

• (A personal sore point): China will begin work on the world’s largest supercollider in 2020. It will be twice the size of the current Hadron collider. The US poured billions into what would’ve been the world’s largest superconducting supercollider south of Dallas. After digging the holes and tunnels, Congress decided it was wasted money and walked away.

• China has the largest network of bullet trains in the world and they are expanding it to include all of those super cities I mentioned above.

• China allows genetically modifying human embryos and stem cells, and will soon catch up with the research we have been doing in the US and Europe. Especially since we publish everything we do.

• Rather than keeping things in the lab, the country allows CRISPR gene editing on humans. I can imagine all sorts of things that will go awry and it makes me cringe to use humans as guinea pigs, but it will speed up the invention of treatments for all sorts of diseases. And that’s a good thing for humanity. (Note: I think we should speed up the process but there still should be guidelines on gene editing in humans. Too much can go wrong.)

The Uncomfortable Nature of Chinese Growth

For years, China basically locked out certain US companies and let Chinese companies “copycat” foreign technology, often ignoring patents and ideas and so forth. It was a free-for-all but created Chinese “champions” in many industries. Think Baidu (tech holding company and second-largest search engine), Alibaba Group (huge diversified holding company—comparable to Amazon), Tencent (tech, internet, gaming, etc.), Xiaomi (phones and electronics).

Of course, now hundreds of American companies operate in China, but the Chinese government has a ring fence around certain segments. That’s one reason China has nine of the world’s top 20 tech companies. And now these companies are taking that local profit, creating state-of-the-art and often leading technology and using it to go global.

I showed this chart last week. Chinese venture capital is now over $50 billion and roughly at the US level.

Source: VentureBeat

This from my friend Peter Diamandis:

This astounding growth is part of China’s explosion in private equity. Currently, almost 16,000 limited partners have disclosed investments in private equity and VC funds totaling 6.1 trillion RMB.

But while many of these funds used to be poured into thousands of Chinese copycat companies and local tech startups, we’re seeing a dramatic outward shift in China’s biggest investments.

Let’s take a look at BAT-backed startups, for instance.

Source: CB Insights

As Baidu, Alibaba, and Tencent take on global leadership in AI, autonomous vehicles, and personalized medicine, China’s corporate VC targets are getting an even split between China and the rest of the world.

And this is just the VC expenditures of three companies, albeit big ones. Other Chinese corporations or state-owned enterprises (SOEs) are also pouring money into acquisitions and venture capital. They are all creating new technologies and buying whatever they need to compete, and they are all going to follow the One Belt, One Road as they expand. Count on it.

China is a growing competitive force and the rest of the world needs to step up its game. This is good from a strictly human perspective. Competition makes everybody improve their services and products. We believe that for US companies but it’s true on a world scale as well.

Do we have to like it? No. Nobody really likes having to compete aggressively in what they believe is “their” space, but that is reality now. And by the way, don’t dismiss South American or other Asian countries. I think over time we will see African companies competing at a high level as well. The world is going to look very different in 20 years.

Some Final Thoughts on China and Technology

An idea is circulating that the US should somehow rein in Xi’s and China’s drive for technological superiority. That is silly. First, it can’t be done; China won’t (and arguably can’t) stop progressing. Furthermore, if the US and other Western countries want to remain technologically superior, they need to devote resources to making that happen. As we saw last week, China now has more research, more scientists and engineers, and more capital. We are choosing to let that happen.

There is no reason China necessarily will surpass the West in technology, in artificial intelligence, autonomous cars, and a host of other technologies. We had an enormous advantage, but we have not kept up our drive. We call our entrepreneurs before congressional hearings to ask how they spend their capital, etc. We want to regulate one business initiative after another. We worry about monopolies. Cries to break up Amazon are part of that absurdity.

Consider what Chinese companies do with customer data. The average Westerner would blanch, maybe even run hysterically to their government, complaining about invasion of privacy. Most Chinese consumer purchases are on a small number of mobile systems like Tencent or Alibaba, which are using that data to improve and, admittedly, make more money. And you know what? The average Chinese person doesn’t care. That is just a foreign (literally) concept to the West and especially the US. It offends our notions of privacy.

Here is what you have to understand. Less than 40 years ago, most Chinese people lived at subsistence level, following an ox in a rice paddy, or its equivalent. Now they are living in megacities. They didn’t develop our Western privacy sensibilities over centuries as we did. This is all brand-new to them. They don’t understand why we would do it differently. Consider the vast cultural differences and leave your Western thinking behind when you try to understand China.

And with that, we will leave our bullish story behind, realizing that one could easily write several books about all the great things going on in China.

Houston, Dallas, Frankfurt, and Up in the Air

I’m in Houston tonight (Thursday) for a meeting at Rice University and dinner with the RISE committee (The Rice Initiative for the Study of Economics). This is an extraordinarily interesting group of people and it gives me a chance to get back to my old college stomping grounds. I will do some more business meetings Friday morning before I fly home in the early afternoon. I also know that I will have to make a few currently unplanned trips over the next month. The next actual trip I have scheduled is to Frankfurt in early November, and I know that Shane and I will have to get back to Puerto Rico at some point very soon. The schedule does seem to fill up.

I will be doing two presentations in Dallas on October 4 (my 69th birthday) at the Dallas Money Show, which is at the Hyatt Regency Dallas.

Normally when I have a dinner with Art Cashin the table gets crowded, and the conversations can get animated. Last Monday we went to the Friends of Fermentation gathering at Bobby Vans right next to the exchange. It wasn’t the usual group—just six of us in a private room. I found it special because two of the six had never met Art or heard his stories. And while we talked a little bit about the markets, I got us started and then the others chimed in with questions. Art held court, telling one story after another, many that I had never heard. Barry Habib had the presence of mind to pull out his phone and record it all, and Art, never camera shy, just stayed on his roll.

They were all great but one stood out as I was talking with Ben Hunt and Steve Blumenthal the next morning. Art’s father died just as he graduated from high school, and he had to go to work. He was applying here and there and his uncle, who was a bartender, was looking rather pensive and one of his clients asked, “What’s the matter?” He explained about Art’s situation. The bartender wrote a name on a card, handed it to Art and said, “Go see this man at the stock exchange.”

So Art took that card and went to the exchange (and I’m skipping a bunch of the story about how he negotiated to get on the floor where the action is rather than in the back room) and agreed to work for $75 a week.

Art had one other interview lined up that kept raising the amount of money that they would pay until he got $115 a week, his own office and a secretary. It was for a brand-new mutual fund. Art called the original company back and told them of the competing offer and the partner at the firm said, “Son, this is Wall Street. Your word is your bond. If you want to work here you better remember that. Are you coming to work at the price we offered?” Art hung up, thought about it and called back to say he would be there Monday to work at $75 a week. Art decided that his word was his bond.

Five years later, at 23 years old, Art had his own seat on the exchange, one of the youngest members. Twenty-five years later he was the sheriff of the exchange, a story I’ve told before. The next day we talked and I encouraged him to write his memoirs, as he has seen 50 years at the exchange and the era is ending. Today, it is not much more than a TV set for CNBC. It’s sad in a way, but 90% of NYSE stocks are traded off-exchange already. They could close the exchange and nothing would happen.

If you know or ever meet Art, bug him about writing his memoirs. I guarantee you it will be a bestseller. And one you want to get.

It’s time to hit the send button. You have a great week! And get together with some friends and swap a few stories. We all have them. I look forward to meeting you someday and hearing your stories.

Your nostalgic-but-still-looking-to-the-future analyst,

John Mauldin

subscribers@mauldineconomics.com

The DOJ/FBI ‘Media Leak Strategy’ Against Trump

More information comes to light showing deep-state efforts to build an anti-Trump narrative.

More information comes to light showing deep-state efforts to build an anti-Trump narrative.

Rep. Mark Meadows (R-NC) sent a letter Monday to Deputy Attorney General Rod Rosenstein requesting more information and explanation for texts between the two infamous anti-Trump FBI officials, Peter Strzok and Lisa Page. Meadows indicated that there is “evidence suggesting FBI/DOJ leaked to the media for their own purposes.” And those purposes were to damage President Donald Trump.

Meadows notes a couple text exchanges between Strzok and Page wherein a reference is made to “a media leak strategy.” The first text in question is dated April 10, 2017, and reads, “I [Strzok] literally just gone to find this phone to tell you I want to talk to you about media leak strategy with DOJ before you go.” The following day, The Washington Post published a story where it is learned that the FBI had obtained a FISA warrant to engage in surveillance on Trump adviser Carter Page back in 2016. Needless to say, this story served to further the media’s narrative of a Trump/Russia collusion conspiracy. On April 12, Strzok again texted Lisa Page congratulating her on a job well done regarding two negative news stories about Carter Page. He then alerted her to two more news stories that will be coming out that will be “worse” on Carter Page than the previous ones.

“While those two text messages alone are troubling enough, events surrounding these interactions call the motives of the investigative team into question,” Meadow’s wrote. He continued, “Other documents indicate DOJ officials, specifically Andrew Wiessmann [who is currently on Robert Mueller’s team] participated in unauthorized conversations with the media during this same time period.” Strzok was finally fired last month, but it would seem the culture of corruption continues.

Recall the reason for why former Deputy Director Andrew McCabe was fired — he lied to the inspector general specifically regarding his involvement in releasing unauthorized information to the media. Now with this latest news, the details of this concerted effort by several individuals in leadership positions within the DOJ/FBI to damage Trump is becoming more clear. Slowly but surely, more pieces of the puzzle are falling into place, and this fiasco has “deep-state quasi coup” written all over it.

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Addendum:

“There are dozens of documents that support the fact that Peter Strzok and Lisa Page had ongoing relationships with multiple reporters, and that they were feeding them information to spin a narrative. It’s not legal… They are denying it, and we have the proof.” —Rep. Mark Meadows

“The dossier was a big lie. What they did is, they said, ‘It’s a big lie. The more people we can get to talk about the dossier, the more likely it is they will believe the lie.’ So that’s why they had the leak strategy — to support a document that was the basis of everything.” —Rep. Jim Jordan

Children of the Mob

It was a beautiful day in Paris for a demonstration, brilliantly sunny and not too hot, and the crowds were out: obviously bourgeois, prosperous, well-behaved, and not at all multiracial or even multicultural. It was a march for the climate, as though the climate were an oppressed person wrongly imprisoned by a distant dictatorship. Such nice, good, well-intentioned people! I found it all terribly depressing.

The organizers estimated the crowd at 50,000, the police at 18,500. I did not actually attend it, my taste for clichéd speeches interspersed with snatches of popular music being very limited. But I watched the crowds on their way to the demonstration, mostly with beatific expressions on their faces, as if aware that they were doing something really good like feeding the hungry or healing the sick. They were both saving the planet and amusing themselves on a Saturday afternoon.

They had banners. One of them read:

TERRE (Earth) + ERREUR (error) = TERREUR (terror)

Only people who had lived all their lives in a state of the utmost comfort and security (try that slogan in Rwanda or Cambodia, for example) and who had hardly ever suffered fright, let alone terror, could have held up such a banner and believed that it really meant what it said. Terror for them was a distant prospect enjoyable to contemplate, as in a disaster movie, rather than something that was within their own experience.

I was particularly appalled that there were so many young children among the demonstrators (if you can call them that). It was not that the demonstration was likely to turn nasty, with police baton charges or anything like that. The parents were not exposing their young offspring to physical danger, such as being crushed to death by fleeing crowds. No, what horrified me was that they were willing, by giving them small banners to hold up, to turn their own children into an instrument of an ideology whose meaning or connotation they could not possibly understand.

Who uses children in this way? Of course, politicians have long liked to surround themselves with children to prove that they (the politicians) are human just like everyone else. How can a man who likes children be bad, pace W.C. Fields? He must have a good heart. Hitler and Stalin were often pictured receiving bouquets of flowers from little children, especially blond girls. Flowers + little girl = goodness of recipient.

In a like manner, a child at a demonstration, especially one so well-behaved as this, must be espousing a good case, for children are too innocent to lie, and out of the mouths of babes and sucklings emerges only truth. The children, by the way, looked almost as pleased with themselves as their parents, who were very pleased indeed.

I didn’t actually do the experiment, but I daresay that had I asked the children why they were at the demonstration they would have been able, like performing monkeys, to say something about saving the planet, making it safe for the whales, dolphins, and pandas, for example.

I hope it goes without saying that I have nothing against the whales, dolphins, and pandas, in fact I much prefer a world in which there are such creatures. (I am not so sure about Ascaris lumbricoides, the absolutely disgusting, large white roundworm that parasitizes the human intestine, sometimes in large numbers, and emerges through various orifices, but I will let this pass; nor am I sure about the use of fluffy pandas on the ends of carpet slippers or for tea cozies, but that is another matter completely.)

I think the destruction of the environment and pollution are very serious problems. No one who has been to Peking or Delhi could possibly deny it. Comparatively late in my life, much later in fact than it should have been, I have come to see public transport as one of the most important keys to the quality of life in cities; and this is so even for those who can afford to be chauffeured everywhere in luxury limousines.

What I object to is the indoctrination of children on contentious political matters. I am all for indoctrinating children so that they are polite and respectful to their elders, eschew pop music, do not chew gum, drop litter, or send text messages to their friends in restaurants, and so forth. But filling their minds with ill-digested slogans, from which they never recover their ability to think independently, seems to me altogether different. I do not want them to be indoctrinated even with things that I happen to consider right or correct. I want children to grow up so that they can think for themselves.

My impression is that our children have become increasingly like children who have been to madrassas, except that what they have been taught is not the Koran, but a vulgate of political correctness. Again, it is not that I want them to be taught the opposite; we should not fall for the easy assumption that if some point of view is politically correct, then its opposite must be the truth. Rather, I would like children not to have attended or been subjected to any kind of madrassa, parental or otherwise.

When I talk to young people (I mean young people of the middle class, of course), I have increasingly the impression that they have been brainwashed, and that some thoughts are simply beyond the range of their neuronal possibilities. Admittedly, my impression does not count as scientific evidence; I have not conducted anything like a Gallup poll, and my sample may possibly be unrepresentative of everything, or representative of nothing. But when I say to the young people whom I meet that I am uncertain about global warming—I acknowledge my ignorance and lack of qualification on this subject—they react as I presume people would if, in Mecca, I denied the existence of God and alluded to the less attractive characteristics of Muhammad even as depicted by early Muslims.

The evident smugness of the marchers for the climate revolted me. They thought themselves so virtuous! I wanted to tell them that, by reducing their children’s later capacity for independent thought, they were guilty of child abuse. Then I remembered that that was exactly what Richard Dawkins had said about those parents who bring up children in any religious belief whatever, a statement that appalled me. I will have to refine my thoughts, which is always a painful thing to have to do.

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