Financial Times Europe - 05.08.2019

Monday5 August 2019 ★ FINANCIAL TIMES 17

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y the early 1990s in Britain, verbal insults hurled at the EU had become common- place. Margaret Thatcher warned of a European super- state. It became normal to associate Brussels with stifling bureaucracy. And people imagined a gravy train full of idle European parliamentariansshuttling between Brussels and Strasbourg. This is how Brexit started. I see something similar going on in Germany — although the process is at an early stage. The target is not the EU, but the European Central Bank and the eurozone. The language has already got out of control. German media habitually refer to negative interest rates as penalty rates — a fine levied by the ECB to punish Ger- man savers.Tagesthemen, Germany’s

candidates such as Pete Buttigieg. A decade of loose monetary policy has bene- fited the former, who have seen their assets appreciate, at the expense of the latter, who cannot afford to get on the housing ladder. One of the big political battles will be over who gets what share of what looks to be a slower growing pie in what appears to be a slower growth economy. Another battle will be between capital and labour. Rising wages are taking a bite out of US corporate profit margins and, frankly, they should. When con- sumer spending makes up 70 per cent of the economy, we need a bit of wage inflation to ensure that people have money to spend. That’s particularly true at a time when governments aren’t investing, and the shift from a tangible to an intangibleeconomy has led to decreased private sector capital expenditure. But it has taken trillions of dollars in unconventional monetary policy to cook up relatively small wage increases. And for many Americans the gains are immediately eaten up by increases in healthcare premiums or prescription drug prices, two other hot topics on the campaign trail. That’s one of the reasons there’s now broad supportfor higher taxes on the wealthiest. It remains to be seen when and what form tax rises will take. But the age of wealth distribution is coming and will have major investment consequences. The value of US equities has probably peaked, and hard assets like gold, other commodities, housing, even art — any- thing in fixed supply— may benefit rela- tive to the equity and debt of multina- tional companies. This isn’t the end of the world — we’ve been going through cycles of wealth accumulation and distribution forever. But it does mean that the rules of the road for investors are changing. Some asset prices may fall, but it’s possible income growth will be higher. That would come with an upside of its own, economically and politically.

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shareholder capitalismand the merits of industrial policy. The signs of this new post-supply side era are all around us. Witness the rise of the B-corporations, which balance pur- pose and profit, and the growth of investing based on environmental, social and governance factors. In government, note the growing bipartisan enthusiasm for tougher anti- trust scrutiny and calls for trade protec- tion, as well as efforts to politicise the US Federal Reserve. It’s not just President Donald Trump’s tweet seeking rate cuts but also progressive Democrats who see “modern monetary policy” as a way to pay for their priorities without having to fund them through tax rises agreed upon by Congress. These views are increasingly part of the mainstream. Last week, two sena- tors introduced a bipartisan bill that would force the Fed to devalue the dol-

larin order to boost exports and balance current accounts with China. This isn’t passing populism, but something much bigger, argues Kiril Sokoloff, founder of 13D Global Strategy & Research, who has been ahead on recognising previous turning points, from supply side economics and the slowing inflation that began in the early 1980s, to the rise of China and the spread of smartphones. “What we’re about to see is a backlash against the second gilded era, and it will have a massive impact on the world — and the markets.” One likely impact will be fundamental changes in who holds wealth. The Democratic race reflects the growing conflict between two primary US voting groups — the baby boomers, repre- sented by candidates like Mr Biden,and the millennials, who backed Mr Sanders in 2016, and now like him and younger

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oughly four decades ago, America kicked off the developed world’s last major economic paradigm shift — the supply side revolution. Capital gains taxes were slashed. Pres- ident Ronald Reagan and UK prime minister Margaret Thatcher took on air traffic controllers and coal miners. The power of unions faded and that ofcorpo- rations grew. Some people got very rich. Butinequality rose, and eventually, overall trend growth slowed. Watching the Democratic presiden- tial primary debates last week, I couldn’t help but think that we may be witnessing the next great shift, from an era of wealth accumulation to one of wealth distribution. Moderates like Joe Biden and John Delaney tried to argue for middle of the road answers on issues like healthcare and trade. But the pole positions were set by Bernie Sanders and Elizabeth Warren, who hold similar views on everything fromshifting Americans on to a national healthcare system and relief for indebted students. Both also seek higher taxes for the wealthy and tougher rules for corporations. While little of this would seem radical in many other parts of the world, in the context of US politics, it was truly something new. The set point for economic debates, even for Democrats, used to be how the government could help the markets work better. Now it’s how the public sector can rein them in, and slic- ing the economic pie more fairly. What’s more, it’s not only Democrats. Some Republicans are looking for a paradigm shift as well. Marco Rubio, an influential Republican senator who hopes to be president someday, recently put out a paper on theproblems with

who is in power. Today they are tinkering with rules around loan losses. Tomorrow it could be rules around environmental and social issues. Regulators have given big banks three years to phase in the impact of the new standard on capital. CECL will not apply to community banks and credit unions until 2023. Banking supervisors can and should work with the institutions they oversee to ensure a smooth transition. Congress should not intervene. The Federal Reserve is once again cutting interest rates, citing weaknesses in manufacturing and business investment, slowing global growth and trade tensions. Rainy days may be upon us sooner than we think. Instead of resist- ing CECL, banks should be celebrating the new standard. It will ease the constraints they were under prior to the financial crisis and allow them to ade- quately prepare for the next storm.

The writer chaired the US Federal Deposit Insurance Corporation from 2006 to 2011

US economy is strong. But these reserves will need to come out of earnings, meaning that banks will poten- tially have less money to distribute to their shareholders. So bank lobbyists have convinced a handful of people in Congress to introduce legislation delay- ing CECL to allow time for more “study”. Trying to draw elected officials into this debate is ill-advised. The process of setting accounting rules is, by design, insulated from the politics. FASB is an independent, non-profit organisation of leading, private accounting experts, recognised by the Securities and Exchange Commission as the accounting standard setter for publicly traded companies. FASB spent many years ask- ing for public and industry input before finalising CECL in 2016. Investors rely on good-quality financial statements and do not want accounting rules subject to the vagaries of the election cycle. Getting Congress more involved in this process could well backfire on the banks, depending on

market conditions, and the maturity of the economic cycle. The new rule has two key benefits. First, banks will start putting aside money on day one of each loan so when trouble hits — as it did in 2008 — they will not be trying to play catch-up with their reserves. Second, it should make bankers a little more cautious in their

lending decisions, as they will have to account for likely losses when the loan is made, not kick the can down the road until the borrower is actually in arrears. Transitioning to the new rule will obviously require banks to add to their loan loss reserves. Now is a good time to do so, while banks are profitable and the

industry lobbyists want Congress to help them preserve the status quo. The rules from 2008, which are still in place, say that banks can only set aside money to cover losses that are “estima- ble and probable”. This essentially means that borrowers need to be well past due on their loan obligations before banks can start reserving for losses. This is akin to starting your rainy day fund after you have received a lay-off notice from your employer. By the time you see real trouble, it is too late to prepare. This was the case during the financial crisis, as bankers were desperately adding to reserves in 2008 and 2009 just as their earnings were plummeting. Now the Financial Accounting Stand- ards Board, which sets US rules, wants to switch to a new rule, known by the name of “current expected credit losses” or “CECL”. It says that banks should set aside enough to cover expected losses throughout the life of a loan, taking into account a wide variety of factors, including historic loss rates,

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s I was growing up, my Depression-era parents always preached the importance of having a rainy-day fund to deal with the economic hardships life inevitably throws at you, such as job loss or illness. Later, as a bank regulator, I valued the similar funds banks set aside to cover losses they would invariably incur on some loans. Unfortunately, in the lead up to the 2008 financial crisis, those funds — called loan loss reserves — were woefully inadequateprimarily because of accounting constraints that some bankers rightfully complained about at the time. But now that accounting standard- setters are trying to improve those rules,

top evening news programme, casually reported last week that the ECB was planning to use German taxpayers’ money to fund its asset purchase programme. Die Weltrefers to the “expro- priation” of the German saver — a phrase with alarming historical conno- tations. Even liberal newspapers, like the weekly Die Zeit, accept the view that the ECB is the cause of low interest rates. There are clear parallels with the early history of Brexit. Outwardly, it appeared that the UK had a wonderful deal in the EU: it was in the customs union and the single market, but not in the eurozone and the Schengen pass- port-free travel area. It secured policy opt-outs in a number of areas. And former prime minister David Cameron was able to wring further concessions from the EU before the referendum. Today, Germany is widely seen as the main beneficiary of the euro. Like the British, the Germans have little cause for complaint. This may be objectively true. But it is not the way things are seen inside Ger- many, where there is a sense that the monetary union is not working as it should. There have been hysterical

debates about imbalances in the Target2 payment systemand negative interest rates. What these show is that Germans are uneasy about being locked into a monetary union with countries whose leaders they do not trust. Not all of that unease is irrational. Germany has large savings surpluses, which it invests abroad. But it does not benefit from them. A recent study found that German returns on foreign invest-

ments are the lowest among all G7 countries. The assets Germans are investing in — like car plants in China — are heav- ily correlated with the domestic economy. Nor do the investments protect Germany against demographic risks. It invests in countries with similar demographic profiles. So when it rains, it pours. Germany will soon be confronting a

confluence of threats. It has been living for a long time off the inventions of the late 19th century. The champions of German industry have been the super- stars of the analogue age. But now they face an uncertain future. For example, none of them is a leader in battery technology— the technological core of the next generation of cars. Germany has some research capacity in artificial intelligence, but nothing on the scale of the US or China. Germany still has some of the best educated engineers in the world, but is lacking in cutting- edge scientists and research. Obsession with fiscal consolidation has caused public sector under-investment, even in areas such as renewable energy. It is impossible to predict how Ger- many will confront the dual threat of a fundamental technology shift and a monetary union plagued by imbalances. The best solution would be to fix the problem by doing whatever it takes to make the monetary union sustaina- ble; ending the obsession with fiscal surpluses; and increasing investment in sci- ence, technology, and military infra- structure. But that would be a triumph of hope over experience. Germany is

moving in exactly the opposite direc- tion. One could have made a similar argu- ment for the UK: that it is best to confront geopolitical and technological uncertainties inside the EU, and not become over-reliant on the US. Unfortu- nately, the Remain campaign failedto make this case, allowing Leavers to frame the debate. The same is happening in Germany, where it is the Eurosceptics who speak with greater clarity. Few dare challenge the consensus on fiscal policy — or say a nice word about Mario Draghi, the ECB president. The most radical fiscal pro- posal I know of comes from the Green party, which wants to insert a sustaina- ble investment clause into the balanced budget constitutional law. But that is tinkering at the edges. Pro-Europeans should remember how the battle was lost in the UK — through cowardice and bad strategy. The case for European monetary inte- gration has yet to be made in Germany. But it needs to be made, with confidence and with not a hint ofProjekt Angst.

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The age of wealth distribution

For many Americans, wage gains are eaten up

by increases in healthcare

premiums or drug prices

Eurosceptics speak with greater clarity and few

dare to challenge the

consensus on fiscal policy

Congress should stay out of new bank rules for loan losses

Sheila Bair

Investors do not want accounting rules subject

to the vagaries of

the election cycle

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limate change has been framed as an ethical issue for years now, with mixed success. But now the calls for socially responsible investing to save the planetare increasingly being reinforced by cold economic logic. Mainstream institutional investors are recognising that climate changeis not just a threat to the health of the planet, but also a threat to the wealth of their clients. The oil industry is on the front lines of rising investor fears about the long- term returns of fossil fuel energy sources. That is partly because of bitter experience. The Europeanutility sector has seen hundreds of billions of euros wiped off its market capitalisation by the roll out of wind and solar power in the past decade. The reason why wind and solar energy pose such a threat to the energy system established over the past 100 years is simple: they have a short-run marginal cost of zero. In other words, when the wind blows and the sun shines, the energy itself arrives for free. Nearly all of the costs of wind and solar energy are in the infra- structure required to capture it, and these capital costs have beenplummet- ingover the past five years. The same is not true for oil and gas, so those sectors will eventually have to recognise that the economics of renewables are becoming irresistible. BNP Paribas Asset Management’s research into the economics of oil and renewables as competing energy sources hammers home the point. We posited that an investor has $100bn and must decide whether to invest it in oil or renewables, knowing that the energy is destined to power cars and other light vehicles. Our analysis found that for the same capital outlay, wind and solar projects will produce 3 to 4 times more useful energy at the wheels than oil will at $

a barrel for diesel-powered vehicles. For petrol cars, the ratio is even less favourable — the renewable investment will produce 6 to 7 times more energy. It is therefore increasingly difficult to argue that oil is the superior fuel from an economic standpoint, let alone when environmental issues are considered. As electric vehicles proliferate, the long-term break-even oil price required for gasoline to remain competitive as a source of mobility could fall as low as $ to $10 a barrel. With nearly 40 per cent of current demand for oil coming from sources susceptible to easy electrification, oil companies should think very carefully about investing in new long-term projects that have break-even costs much above $20 a barrel. This poses a major strategic problem for the oil industry, which has tradition- ally made its highest returns from find- ing and extracting crude. Indeed, the oil industry often points to the “profitabil- ity gap” between investing in renewables and investing in upstream oil projects, arguing that for as long as the returns are better in oil they have no incentive to invest in renewables. But this is to miss the key point: over time the returns in upstream oil projects will inevitably decline as oil is forced to compete with an energy source that pro- duces energy at a much lower cost over the lifetime of a project. The oil industry today enjoys massive scale advantages over wind and solar. But this advantage is now one only of incumbency and time limited. The simple truth is that the oil industry has never before faced the kind of threat that renewable electricity and EVs pose to its business model. For the first time there is a competing energy source with a short-run marginal cost of zero, that is much cleaner environmen- tally and will be able to replace up to 40 per cent of global oil demand once it has the necessary scale. The economics of energy are now on the side of the angels. This should be a flashing red light on the oil industry’s dashboard.

The writer heads sustainability research at BNP Paribas Asset Management

Renewables are

good money, not

just good for

the earth

Mark Lewis

The oil sector will soon have to recognise that

the economics are

becoming irresistible

Germany is replaying Britain’s Brexit debate

Opinion

EUROPE

Wolfgang

Münchau

Rana

Foroohar

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Financial Times Europe - 05.08.2019

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