Episode 105: Financial Cold War with James Fok

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This is The WealthAbility® Show with Tom Wheelwright. Way more money, way less taxes.

Tom Wheelwright:

Welcome to The WealthAbility Show, where we’re always discovering how to make way more money and pay way tax. Hi, this is Tom Wheelwright, your host, founder, and CEO of Wealth Ability. So China and the U.S. are in this battle for global supremacy or at least from an economic standpoint. And so today what you’re going to discover is how this battle is really a financial cold war, and how currency, taxes, and technology play into this. I’m particularly interested in the currency and the taxes part of it. So we have a very special guest, James Fok, who is an expert in this area, wrote the book, Financial Cold War. James, it is awesome and a great pleasure to have you.

James Fok:

Thank you so much for having me, Tom.

Tom Wheelwright:

So can you just tell us a little bit about yourself and how you got into this area?

James Fok:

I stumbled into by accident. I grew up in Hong Kong, had a very typical middle class upbringing here and then I like a lot of people in Hong Kong had a bit of an interest in financial markets. There was a huge boom going on in my childhood, but after university, I got a job working in investment banking and so started to get an understanding of how the financial system worked. Had the opportunity to live in different parts of the world, looked at how financial markets really affected, not just people in their pockets, but whole societies as well. Working in Russia, living and studying in China, these countries went through massive transformations after they made that step, transition towards opening up to financial markets. Then I stumbled into this job by almost complete fluke at the Hong Kong Stock Exchange back in 2012 and spent 10 years there almost.

                When you talk about stock exchanges, you’re thinking about trading, clearing settlements. These are probably not the most exciting parts of financial markets, but the plumbing that goes into these things has a massive impact on how the system operates. It’s a really completely overlooked segment of the financial universe, and through my work there was dealing with a lot of policy makers and started to really get a very granular understanding top down and bottom up how the financial system worked. The reason why I wrote the book was because I felt that this was an area that actually even many top policymakers don’t have a great understanding of. I wanted to explain to people how imbalances in the system were driving a lot of the social tensions you’re seeing in both countries today, and a lot of the conflicts that you’re now seeing between them.

Tom Wheelwright:

No, I appreciate that. So if we just step back so that everybody’s on the same page here. Can you just briefly explain, what does it mean when we say, or people say that the dollar is the reserve currency for the world? Briefly, what does that even mean?

James Fok:

Well, it’s not just the reserve currency. So when you say it’s the reserve currency, the currency is held as a store of value by people all around the world. The dollar serves much greater purpose than that, it’s also the primary medium of exchange for trade and investment around the world. And so everyone from different countries who operate in different currencies, when they meet up to do business, most people around the world are using dollars. It is the demand for this international trade and investment for dollars, that is driving part of the serious imbalances that you’re seeing in the financial system today, which has had actually very negative consequences, not just on small emerging market countries that have been subject to a lot of the volatility, but also to the U.S. itself.

Tom Wheelwright:

Everything is trading dollars, particularly petroleum is trading in dollars. How does that affect U.S. consumers, U.S. business, compared to the rest of the world?

James Fok:

In very simple example, what happens is because you’ve got all this demand for dollars for trade and investment, the U.S. has to, as this trade and investment around the world grows, the U.S. has to supply more and more dollars to the rest of the world. This means running a balance of payments deficit with the rest of the world, which is all very well so long as the U.S. economy is growing, at least as fast as the rest of the world. The problem today is that the U.S. is already a huge developed mature economy, and it is not growing so fast. When you have to keep supplying more and more dollars to the world, but you’re not growing as fast, it means that you’re going into ever higher levels of debt to perform that function.

                That debt has been driving big problems for not just the U.S. government and a lot of U.S. individuals, but also when you think about how economies and how countries rebalance over time, generally when you have higher growth and higher productivity growth in one country over another over time, you see the currency of the lower growth country fall relative to the higher growth country, and that allows it to stimulate its exports and rebalance for jobs and exports to reach equilibrium again. But because the dollar serves this global utility role, the demand for dollars from the rest of the world has meant that the dollar hasn’t been able to adjust. How this hits you in the U.S. really depends a lot of where sit in society, so it’s not been all a bad thing.

                If you’ve been a shareholder of a large U.S. corporation, that’s been able to offshore part of your production to lower cost countries with undervalued currencies. You benefited hugely because you’ve seen your cost go down, your profit margins go up, your share price go up. You’ve generally done a lot better, but if you’ve been a U.S. manufacturing worker over this period of time, you’ve not done so well. What you’ve seen is, you’ve seen job losses, you’ve seen displacement and you’ve seen at best waste stagnation. And for a lot of America, this has been the reality for the last 30, 40 years.

Tom Wheelwright:

Do you think this has an impact on the current inflation? Because typically if you lose value, that’s what you’re talking about is that if the dollar were to lose value, that would help rebalance, right. It’s clearly losing value when we’re at the inflation rates we’re at. Do you think this is part of the cause or part of the result or not part of it at all?

James Fok:

Yeah, it’s related, but the relationships are quite complex. Even though you’ve got very high inflation rates today in the U.S., actually the dollar hasn’t seriously depreciated against other countries, in fact, against a lot of currencies, it’s actually seen its value go up over the last few years. In fact, one of the ironies is that even in 2008, when you had this massive subprime crisis in the U.S., when all hell broke loose in markets, people fled to dollars, and so the dollar went up.

Tom Wheelwright:

It’s all relative, right?

James Fok:

It’s all relative. Actually, when you talk about inflation today, what you’re seeing today is a rise in consumer price inflation.

Tom Wheelwright:

Right.

James Fok:

That really hurts people, because if their wages aren’t going up and year on year, their basket of groceries that they’re buying week in and week out is going up by 7% or more a year, that is going to hurt their lifestyle. That’s going to hurt their ability to consume. But over the last 30 or 40 years, although you’ve had low consumer price inflation, you’ve had at the same time very high asset price inflation. This is been driven by a steadily reducing interest rate, a downward trend in interest rates over time.

Tom Wheelwright:

Of course. Of course. As your interest rates reduced by definition it’s an inverse relationship, right? Interest rates reduce, asset prices go up. It’s true in any type of asset. Now China has clearly been making a concerted effort, for example, they want to get their currency in the basket of currencies. They made this concerted effort and there’s literally this cold war going on with U.S. and China. How’s the currency affecting that?

James Fok:

In essence, when you talk about interest rate policies, when you talk about exchange rate policies, when you talk about taxation, all of these mechanisms that distribute wealth and income around society. As these levers have skewed distribution of wealth and income in society to more narrow groups, and you’ve had greater levels of wealth and income disparity, you’ve generally had higher social tensions in the domestic society. What’s happened is as these domestic tensions have built up and started spilling over, there’s a great temptation to look for reasons for that. The reasons for most people are just way too complicated to fully understand. Sometimes the easier answers that they’ve been offered is that, well it’s because China’s stealing our jobs, they’re raping our country, et cetera.

                Similarly, when you have problems in China, there’s a great tendency amongst politicians to blame outside forces. Sometimes there’s some element of truth in some of what they say, but it’s not the whole picture. When they focus on dealing with these or blaming these problems on the outside, it really diverts attention from dealing with the domestic problems that often lie at the root of a lot of these problems. And so as these problems haven’t been dealt with, and as both countries to a greater [inaudible 00:12:40] have turned to a greater level of populous nationalism, this is fermented tensions between the two countries, which if you allow to continue, we’ve seen time and again throughout history, that the consequences of this type of environment can be extremely dangerous and catastrophic for the people who live through them.

Tom Wheelwright:

You mentioned this narrowing of who has the wealth, basically. Okay. The wealth disparity. Do you see that as a result of asset prices? You also mentioned taxation, can you just explain what you mean by that?

James Fok:

Ultimately, when you have monetary policy that drives the boom and asset prices, the people who have assets benefit usually from that.

Tom Wheelwright:

Sure.

James Fok:

At the same time, if interest rates are coming down because consumer prices are staying low, generally you’ve got stable prices, but also generally you’re not seeing a huge uptick in wages for most workers across society. So that is part of the monetary reason for wealth gain concentrated. In taxes, it comes down to a lot of different things, some of them practical, some of them ideological. In the 1970s, you had these huge rates of tax in the rest Western world, and they served as a big disincentive to innovation, to entrepreneurship, and job creation. We certainly don’t want to go back to them. But over time, when you have a swing back from these extremes, sometimes the pendulum swings too far to the other extreme.

                What I mean by this is that you quite often see in many countries today, the wealthiest people in society paying far lower rates of taxation than average middle class workers. Now, there’s a very good practical reason for this as well, which is that as economies have globalized, as trade and investment around the world has globalized, all countries want to attract investment to themselves. Inherently capital can move at the touch of a button. It’s a lot more difficult for people to sell their house up sticks.

Tom Wheelwright:

Of course.

James Fok:

Move their families to a different country or a different state even. It’s a lot easier for countries to tax labor than to tax capital. This fiscal competition between countries and even between different states in the United States has driven these slightly bummy tax systems that have become more and more regressive rather than progressive. They’ve generally become more and more unfair to average middle class workers, who’ve seen their tax burdens go up while the very wealthiest in society and large corporations have seen their tax burdens relatively fall.

Tom Wheelwright:

Well, let’s talk about that for a minute, since that’s my area. In fact, I’ve got a book coming out on this, is, are you talking about… I just want to be clear on who we’re talking about, because obviously if you are a football player in the NFL, you’re paying high taxes. If you’re an entertainer you’re paying high taxes. If you’re a doctor or a lawyer you’re paying high taxes. None of those people are paying lower taxes now than they were in the 70s and 80s, because in the 70s and 80s, we had huge tax shelters and huge opportunities to reduce taxes. Now the base for taxation in the United States is much, much broader since 1986. If you’ll recall in 1986, that was a revenue neutral bill. So we brought the tax rates down from 50 to 28% without decreasing revenue.

                Well, the way they did that was broadening the tax base, so more things were taxed. For example, an attorney who invests in a real estate deal, can’t get those tax benefits anymore. Okay. That’s called passive loss. Right. What they did was, and I think you’re right, I think there is much more of a burden on the wage earner and also on the professional. Now, when it comes to asset prices, and I’m curious as to your thoughts as to how to solve this, is that as the asset price go up, take the Wall Street asset prices. So you’re talking about public stocks, right? Those go up in prices, those who hold a lot of those stocks certainly have tremendously benefited and they’re paying no tax because they don’t pay tax until they sell the asset. Right. My question is, are you talking about those people, or are you talking about the business owner that puts all this money back into his business and doesn’t pay tax because he doesn’t take the money out?

James Fok:

As you know tax is a very complicated thing, and it’s very dangerous to generalize. But I think if I can pick out a few examples of what I mean. You’re exactly right, so how you get taxed quite often is a function of the composition of your income-

Tom Wheelwright:

Absolutely. How you make your money. Yep.

James Fok:

And a composition of your assets. Now, for most people the largest asset that they own is their home and they live in it, they pay their property taxes, that’s all fair. But for the wealthier part of the population, they not just own their home, but they tend to have other assets like stocks, like private equity investments and so forth. You do pay capital gains tax on your stocks, but you’re not paying capital gains tax at the same rate that you are paying with your income.

Tom Wheelwright:

Except you are. You’re actually paying a higher rate, because you’ve actually paid tax twice. You paid it once when the corporation earned the income, and then you pay a second time when you sell the stock. So the tax on the corporation is actually tax on the shareholder, right? Corporations aren’t people, so the tax on the corporations, is the tax on shareholder. So if you’ve got a 21% tax, and then when you distribute the money as a dividend, or you sell the stock, you’ve got really 24% tax now in the U.S. Now you’ve got actually a 40% tax rate on that income, so I’m trying to understand how this is a lower tax rate.

James Fok:

Okay. We’re going to have some fun here. I’m glad you brought up corporate tax, because this is an area where a lot of the games are played in a big way and where actually the U.S. has been a huge disadvantage, because when you had the beginnings of globalization of U.S. businesses, you had different tax regimes for those corporations, taxes in the U.S. and you had different views on how their overseas income should be taxed. Some argued that they should be taxed no higher than the local country in which they were doing business, because otherwise they wouldn’t be competitive with businesses who operating other countries. Others argued that they should be taxed at the U.S. tax rate, because otherwise it would give them an incentive to offshore those jobs. Ultimately it became a bit of a fudge where different types of income were treated in different ways [crosstalk 00:21:30] certain types-

Tom Wheelwright:

Very complex. Correct.

James Fok:

Passive income on patents and intellectual property were treated in a different way to earnings that were invested back into the business in other countries, whether it’s in plants, manufacturing and so forth. Ad so over time, companies got smarter and smarter in the way that they either structured themselves or they lobbied for tax codes to be changed. Where they’re now able to sell part of the patents or intellectual property into an offshore entity in a low tax jurisdiction, where essentially there’s a charge on, if they’re manufacturing in the U.S. or they’re manufacturing elsewhere. Irrespective to the fact that the intellectual property was developed in the U.S., it was developed because of the education system that was provided in the U.S. and all the infrastructure and other legacy investment that the U.S. has made. Those companies have been able to significantly reduce their tax burden by moving that so-called intellectual property or patent rights into low tax jurisdictions, and then make a charge back to the U.S. manufacturing or overseas production plants, manufacturing, whatever good or service it is.

                So the games that are being played by big corporations have contributed very significantly to two things. One is simply if the companies are not paying taxes in the places that they’re generating their income. Now you pointed out to me that, well, if you’re a U.S. tax payer and you are a shareholder in these companies, you might be getting tax twice.

Tom Wheelwright:

Correct.

James Fok:

Well, that may be the case, but also there are a huge number of foreign shareholders in U.S. corporations who may not be paying any tax whatsoever in the U.S., but who are also then benefiting from the tax sheltering that these companies are doing, and that the U.S. is not getting the rightful tax take based on the historic investment that’s been made in the U.S. to enable those companies to generate the earnings that they do.

Tom Wheelwright:

Right. Of course-

James Fok:

That’s just one example.

Tom Wheelwright:

The argument would be that changed substantially in 2017. The whole idea there was to prevent companies from going overseas, and then you have the global tax regime coming in with the 15% global minimum tax, which presumably would prevent those tax haven countries for example. It used to be a lot easier. You take, for example, Apple and Google, and some of these really big companies that have located in Ireland, right. Basically that’s where you’re talking about is they’ve got this 12% tax in Ireland versus what used to be a 35% tax in the U.S., which was a very big swing, which is a huge incentive to move to Ireland. Now you’ve taken that incentive substantially away and then if you move that Irish tax, which looks like they’re going to have to move their tax to 15% under the global tax accord. I’m just curious, the whole idea of going to a global minimum tax, do you think that will have a benefit here? Do you think that will help alleviate what you assert as that issue?

James Fok:

I think it’s a good first step, but you have to look at the substance of the G7 agreement that was entered into last year, and I won’t bore you with all the details of it, but the reality is that agreement so far lacks a lot of teeth.

Tom Wheelwright:

True.

James Fok:

The headline of 15% sounds really good, but in practice many companies can structure themselves in a way still that will allow them to avoid those minimum tax rates on their global income. It doesn’t avoid still a lot of the tax shifting activity that’s been going on.

Tom Wheelwright:

Your biggest concern is the big corporations paying those lower rates, so that the people own those assets and that that’s where the income is. You’re not talking about the business owner that puts their money back into their business, and doesn’t pay tax on that money because they’re reinvesting it.

James Fok:

The tax code has become so fiendishly complicated in the U.S. that the reality is that there’re so many loopholes, there’re so many little tax maneuvers that are possible that it’s almost impossible to follow the whole system. In theory, the small business owner, who’s creating jobs, plowing back into the local economy, of course he, or she should be supported. But there comes a point at which, that small business owner, may simply be plowing back into the business, not necessarily to create jobs, but really just to benefit from lower taxation. I know this is not an entirely analogous example, but you can look at the huge surge in share buyback activity that’s occurred in public markets in recent years, as an example of what I mean, in that, if they would-

Tom Wheelwright:

But you don’t have that issue with the small business, right? The small business in buying back its own shares, because it’s just got a few shareholders. You’re not talking about a public company here. So there’s no question there’s a different tax regime for the… Well, there’s a whole different economy for the public company than for the private company.

James Fok:

There is and that there necessarily has to be, but ultimately-

Tom Wheelwright:

Agreed.

James Fok:

You then need to look at the consequences of this over time. I happen to live in Hong Kong where we have very low income taxes [crosstalk 00:28:35] top rate of income tax of 15%. We have no taxes on dividends, interest income, capital gains, inheritance, and what you see over time is that wealth compounds very quickly.

Tom Wheelwright:

It does. When you don’t have the drag of the taxes, it absolutely does.

James Fok:

Whether you’re a small business owner or a large business owner, or just simply an investor in financial assets in real estate-

Tom Wheelwright:

Can I just ask you that question? Because you’re in Hong Kong, you’ve grown up in Hong Kong, you live in Hong Kong. Do you see that Hong Kong because of its low tax rates and it’s a pretty flat across the board, right. Do you see that’s created a big imbalance between the rich and the poor in Hong Kong?

James Fok:

Absolutely. Absolutely. It has. It is not been the only issue of course, we’ve had successive regimes failures in housing, policy, and in education policy, which have contributed very significantly to the wealth disparities that you have here. But the low taxation that we’ve had, that was instituted back in the 50s and 60s and which has persisted to this day. It was a very, very good thing to have in the early days of Hong Kong’s development, when we had a huge flood of immigrants from China, mainly who were fleeing a regime change there, who came to Hong Kong often with very little and who set up businesses, they set up factories, manufacturers. Now, Hong Kong, until the early 90s was a significant manufacturing center, that’s how Hong Kong first really established itself rather than as a financial center. That was a very successful policy for first and second generations immigrants in the Hong Kong. But over time, as those first and second generation wealth creators die off and they leave large inheritances to their successors…

Tom Wheelwright:

So does Hong Kong not have a big inheritance tax?

James Fok:

We have no tax on inheritance-

Tom Wheelwright:

Wow. Yeah. See, we have a 40% tax. You lose a lot of that when you transfer that.

James Fok:

You lose all that, but your thresholds before that bites [crosstalk 00:31:36].

Tom Wheelwright:

They’re pretty high. You’re talking about $12 million. It’s pretty high.

James Fok:

Most human beings will not pay-

Tom Wheelwright:

Will not pay. But when you really talk about the elites, those people are paying that inheritance tax one way or the other.

James Fok:

They are. My wife’s American, so we happen to spend a lot of time in America and own a home there, and I’ve unfortunately had to learn some of the intricacies of the U.S. tax code.

Tom Wheelwright:

You can postpone, but you can’t eliminate, basically. If you’re over that threshold, you can postpone and you can postpone generationally, but you can’t eliminate. So you’re either going to pay capital gains, you’re going to pay inheritance taxes in the end.

James Fok:

Once you hit a certain level of wealth, what keeps you going? What keeps you motivated?

Tom Wheelwright:

It’s an interesting question.

James Fok:

To continue to create jobs and build businesses. A lot of it’s about legacy and leaving something to your children, your family.

Tom Wheelwright:

Of course.

James Fok:

That incentive shouldn’t be taken away entirely. But I do think that having looked at the experience of Hong Kong, let’s not beat around the bush, it was just over two years ago, that we had people riding out in the streets.

Tom Wheelwright:

Right.

James Fok:

A lot of the root causes of that social dissatisfaction that led to that were around livelihood issues. Is young people not able to get on a decent career track because they’ve not had access to the level of education that they need. Young couples having to pay, sometimes, a million and a half U.S. dollars for a 250 square foot home, which-

Tom Wheelwright:

Unbelievable.

James Fok:

If you think about 250 square feet.

Tom Wheelwright:

Oh my heaven, that is smaller than my studio.

James Fok:

You’ve got a big studio. But-

Tom Wheelwright:

I do.

James Fok:

But if you aspire to have a family life and to bring up children, how do you do it in a 250 square foot space? Don’t get me wrong, I’m not a rabid socialist. I don’t believe that we should have absolute equality of outcomes, et cetera, there are many reasons why people’s lifetime earnings and lifetime wealth accumulation will be different. And so in that sense where the system has imbalances, which are leading to huge disparities, which in turn are leading to people out protesting in the street, whether it’s in Occupy Wall Street or other movements, these are symptoms that the system is not working. I’m not advocating that we should go back to anywhere near the punitive tax rates that we saw in the 1970s. But I do think that something needs to be done to make the tax system fairer.

Tom Wheelwright:

Hey, if you like financial education the way I do, you’re going to love Buck Joffrey’s podcast. Buck’s a friend of mine, he’s a client of mine, he’s a former board certified surgeon, and he’s turned into a real estate professional. So he has this podcast that is geared towards high paid professionals. That’s who he’s geared towards. So if you’re a high paid professional, you’re going, “Look, I’d like to do something different with my money than what I’m doing. I’d like to get financial educated. I’d like to take control of my money and my life and my taxes.” I would love to recommend Buck Joffrey’s podcast, which is called Wealth Formula Podcast with Buck Joffrey. I hope you join Buck on this adventure of a lifetime.

                It’s interesting. You’re right. The people who… Particularly the people, I call them the Wall Street people, right. Who have so much in financial assets, and I’ve never believed that Wall Street really produces a lot. Okay. I’m not a huge fan.

James Fok:

Don’t worry. I worked in finance all my life and I’m extremely cynical of that, all of it.

Tom Wheelwright:

Yeah. I’m a big fan of Main Street, not such a big fan of Wall Street. There’s no question, because the tax law is really a series of incentives, right. It’s just, are we incentivizing the wrong things? That’s really the question when it comes right down to it, because most of every tax law is a series of incentives. Right. Do you get a tax benefit for investing here? Do you get tax benefit for investing there? Do you get a tax benefit for moving to a different country? So whatever it is, taxes do incentivize people. I think there is a question and I’m not saying also that we don’t… Clearly, there’s this inequality.

                Actually I’m concerned from the standpoint, I think that if the wealthy don’t pay attention to this, I think the wealthy are in trouble. Because I think you do have upheaval and that’s what ends up. I’m not saying we don’t need to pay attention to it. I’m just looking for, okay. So how do we… One of the things, and we don’t have time to go into it today. But one of my big questions that I keep looking at, and I think you actually said the answer a little while ago, one of the big questions is, how do you remedy that inequality without losing the investment? Right. Without losing the investment where it needs to go, whether it’s housing or whether it’s energy or whether it’s technology, wherever it is, because we know Tesla would never have survived without tax benefits.

                Never would’ve. Okay. It survived primarily because of tax benefits. And every loves Tesla. Right? So there’s that side of it, but then there’s the other side that you need to make sure that it does need to be fair. You brought up, I think is the key and if we can wrap up on this, but you brought up education. I’ve thought for a long time now, really the biggest problem is education as opposed to anything in the financial institutions and it’s that people don’t get the education. What do you think?

James Fok:

You’re absolutely right. Education is one of the key levelers in society. You can never prevent the wealthy from giving their kids better opportunities.

Tom Wheelwright:

Right.

James Fok:

Just simply because they have access to different people, travel, and many other life opportunities that kids from poorer backgrounds don’t get. But education is the key stepping stone towards social mobility. That’s where I think the system, not just in the U.S. but here in Hong Kong as well, has been failing.

Tom Wheelwright:

We can end on that piece of agreement for sure, because I truly believe, and that’s why we do what we do is financial education. Because I think when we can get more people educated, we will have less disparity. I’ve always thought the difference between a Third World or First World country primarily is how educated is the middle class? Right. How educated are the workers? Because in the Third World countries, the workers tend not to be educated at all. The better we can get that education, I think what happens is, and with the more education we get on things like this. I really appreciate you taking your time, James, for this and you taking time to write the book. Because I think that financial education that you’re presenting in your book, Financial Cold War is so important to understanding what’s going on. Because once we understand something, we can actually do something about it for ourselves. So how would we get more information about what you’re doing and your work and your recommendations for what people do?

James Fok:

Well, please read the book. It’s available in all major bookstores and you can find more information about it, where to buy it and about myself on my website, Jamesafok.com, That’s J-A-M-E-S-A-F-O-K.com.

Tom Wheelwright:

Awesome. Thank you, James. Thanks so much for being with us.

James Fok:

Thank you, Tom.

Tom Wheelwright:

Enjoy the rest of your day in Hong Kong.

Speaker 1:

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