I was once told a story by a reliable source (the story is too good to bother verifying) that in the late 1980’s at a summit of European leaders, Greek prime minister Andreas Papandreou arrived by car in the courtyard of a sumptuous hotel. As he stepped out of the limousine, the windows of a suite on the fourth floor of the hotel were flung open and appeared Charles Haughey, Taoiseach or prime minister of Ireland, who at the top of his voice declared ‘Andreas Papandreou, you are my hero!’.

In many respects, Haughey was right, he and Papandreou were very alike – clever and corrupt, leaders of large grassroots political parties (political scientists compared Fianna Fail and Pasok, the party Papandreou founded, as the most enduring political machines in Europe).

Haughey and Papandreou both had interesting personal lives and tastes – Haughey in his grandeur sent the bill for 14,000 pounds (a lot of money back then!) worth of Charvet shirts to the Irish state. Papandreou had been the Dean of the economics faculty at Stanford, but couldn’t manage the Greek economy, and later couldn’t manage his personal life. I had the pleasure to spend a lot of time in Greece in the late 1990’s, when the behaviour of Papandreou’s third wife ‘Mimi’ provoked a lot of debate.

Both men, it could be said, opened up the way for their countries to perform into the early 2000’s but both also sowed the seeds of the downfall of their economies in the post 2007 period. In both cases, what were dominant political parties have been reduced to much smaller players.

This much was evident in last week’s Greek election – while the share of the vote that Pasok held rose to 11% from 8%, it is a shadow of the machine it was. Kyriakos Mitsotakis the son of Andreas Papandreou’s political rival Konstantos Mitsotakis, has won an impressive victory and will likely do even better in a second election at the end of June, such is the apparent desire amongst Greeks for prolonged economic growth.

 As an aside, recall that in the dynastic environment of Greek politics George Papandreou, son of Andreas, took over Pasok as Greece headed into the euro-zone debt crisis – and to reinforce the notion of dynastic politics, George Papandreou was also the room-mate at Amherst of Antonios Samaras – New Democracy prime minister from 2012-2015!.

Having gotten to know Greece very well in the 1990’s I visited there during the ‘Troika’ period. There is simply not enough recognition of the devastation of the Greek economy and of its society, by Greece’s own excesses, the euro-zone crisis and the medicine applied by the IMF and EU. For a country that suffered the worst depression in modern history to now begin to enjoy consecutive years of strong growth is a very good thing.

Greek society and the way the country is run have changed though there are echoes of some of the things I recall from the news in the 1990’s – corruption in procurement and transport (witness the causes of the trains crash in northern Greece in February) and there are still bugging scandals.

The great challenge for Mitsotakis now is not so much to prolong the uptick in the economy – investors are already re-rating it (bond yields are below Italy and the UK) but to make decisive departures with the modus operandi of the past in terms of the way the state is run. The other glaring (to my experience) area for reform is education – notably in creating a much better secondary and tertiary education system so that young Greek people are happy to remain in Greece for their education and to then work there.

A new development for Greece is a change in the fortunes and behaviour of its larger neighbour. In the 1990’s there was constant tension between Turkey and Greece over both Cyprus and the small Greek islands close to the Turkish coast, resulting in frequent close contact between the Greek and Turkish air forces. Recyyp Erdogan took power just before Greece hosted the Olympics and for a long time the performance of the Turkish economy, the scope of its infrastructure building and its growing role as a model for Middle Eastern states put Greece in the shade.  

Turkey’s progress has been squandered, and its economy is now not far from a crisis. The worry for Greece is that Erdogan tries to create tension with Greece as a distraction from the consequences of his own long term in office. While the Greeks are used to this (both Mitsotakis and Alexis Tsipras have handled relations with Turkey well), it could be an unnecessary complication just when things are going the right way.

Have a great week ahead,

Mike 

I want to get rich, powerful and famous so I have changed the name of The Levelling to ‘The LevAIlling’, to reflect the growing mania around the deployment and power of artificial intelligence (AI). Readers can rest assured however that all the output on these pages is organic (I had tried ChatGPT a few months ago but was not impressed).

AI has been around for a while, as have its many dangers. In ‘The Levelling’ we wrote about how algorithms were both causing and provoking inequalities and social injustice. Last summer we flagged the very sinister example of how the Spiez Laboratory in Switzerland (see the Final Problem) one of whose specialisations is the study of deadly toxins and infectious diseases (located not too far away from the Reichenbach Falls), where scientists performed an experiment where they deployed an AI driven drug discovery platform called MegaSyn to investigate how it might perform if it were untethered from its usual parameters.

In short, MegaSyn produced nearly 40,000 designs of potentially lethal bioweapon standard combinations (some as deadly as VX). It is an excellent example of machines, unconstrained by morality (humans have willingly crossed this moral threshold), producing very negative outcomes. In another recent note ‘Talos’ we explored some of the emerging philosophical issues around AI.

Two aspects of the AI story that we have not yet mentioned are the stock market and the labour market, both of which will be greatly impacted by AI.

A sure sign that AI has arrived is that it is creating a stock market bubble. Since the start of the year, ten companies have driven the performance of the S&P 500 index, nearly all of whom have some form of AI business.

 In particular, Nvidia which seems to have been at the centre of multiple market bubbles (bitcoin, gaming, semis) is the lead play in the AI investment trend. From a valuation point of view the price of the company’s stock trades at 30 times the value of its sales (for normal businesses 3 times is quite pricey), which is not far off the valuation levels that have marked the top of ‘fads’ or bubbles. What we do not yet have is a broad AI bubble in the sense that even companies with a passing association to AI and its necessary infrastructure trade at bubble valuations. Similarly, markets have not priced in the intensity of competition between the big AI centric technology firms (Microsoft versus Google), not the disruptive threats they face from open source AI projects.

Much the same is true in the venture capital world, where AI funds and companies are one of the few ‘hot’ areas in VC. The popular ‘discovery’ of AI by the media is having a sizeable impact on the VC world in terms of providing the catalyst for funds to deploy cash to AI centric projects. Notably a whole range of companies is now touting their AI credentials, and slipping the AI moniker into their business description, in the same way that in 1999 companies adding a ‘dot.com’ surged in value.

In addition, companies reporting earnings, discussing their earnings on conference calls or even those appearing on financial TV (i.e. CNBC) will slip the phrase ‘AI’ into their dialogue so that this is picked up by AI driven analytics that in turn feed into stock buying programs.

If one popular reaction to a new innovation is that it will drive an investment bubble, then another is that it will fatally disrupt the ‘old world’, in the way that bitcoin was supposed to supplant the dollar and euro. In the case of AI, the promise is that it will cost us our jobs.

Labour markets have already been softened up in the past five years from ‘stay at home’ to the ‘great resignation’ to the ‘digital economy’, and they (in the G7) have arguably never been as robust. While there are some fields that are being disrupted by AI (the EU no longer needs 17% of its translators apparently) the best examples I have come across are where high performing humans – from surgeons to soldiers – use robots and artificial intelligence to do their jobs better.

While there is now a growing consulting trade on the future of the labour market (the WEF Future of the Jobs market 2023 report is a good starting point). One of the areas that is missed by many such studies are emerging market workforces -where regulation, social welfare and training levels are not at all as developed as they are in Europe for instance.

In some of the large emerging nations like India, training and education can be formulaic (I am not a fan of Byju as a firm) and could well expose knowledge workers in those countries to disruption by artificial intelligence. I belief that this is the great faultline of AI as it concerns labour, because if the effect of artificial intelligence on work is as great as many say, it could slow the natural path towards productivity and higher incomes of many emerging nations, the vast majority of whom do not have the industrial/capital base or expertise to build their own AI platforms (as Google is doing).

As it stands, there is also very little policy coordination between emerging nations, which again leaves them vulnerable in the face of AI. AI versus EM might become one of the great contests of the 21^st century.

Have a great week ahead,

Mike

A friend of mine has a very attractive theory about stockbroking, which is that the interaction between the investor and the salesperson is like the World Wrestling Federation (WWF), where like the professional wrestling matches everything is done for entertainment.

In stockbroking, fantastic stories are woven to investors in order to get investors to part with their capital, and impressive as the marketing performances are – it is generally understood by both sides that tales of ‘blue sky’ profits or impending doom are a fiction. It is of course easier to go along with this fiction when the (institutional) investor is investing other people’s money and not his/her own.

The WWF analogy, where colourful characters appear to do each other great harm is a generally very useful one, and specifically apt in the light of the debt ceiling debate that is warming up in the USA.

The debt ceiling stems from a provision in the constitution that states that only Congress can authorize borrowing on behalf of the US, and a 1917 act stipulates a limit on this debt (today’s limit is USD 31.4 trillion), that can be adjusted by consent of Congress. Today, higher rates complicate matters – the US spends more on interest payments than defence.

Presidents with a friendly Congress (for instance George W Bush received eight debt ceiling increases) do not need to worry much about this fiscal hurdle, however it becomes weaponized in the face of a ‘cohabitation’.

A good deal of the weaponization follows the WWF script, both sides huff and puff and take each other to the limit of pain, whence a deal is arrived at. Donald Trump, as an impresario (he was close friends with boxing promotor Don King, and at times part of the WWF theatre) understands this, recently telling CNN ‘the US should default….the Dems will probably cave’.

The debt ceiling debate has gotten a little out of control before. Memorably for investors in 2011 as the deadline approached, the US debt was downgraded by S&P from AAA to AA+, provoking a slide in markets. In 2013, the debt ceiling debate ran right to the limit, the personal highlight of which was when the late Senator John McCain tweeted a piece of research I had authored about wealth inequality (in Russia – he was spot on then).

There is no reason for the debt ceiling to be a market issue, except for perhaps four questions – the willingness of markets to participate in the WWF like theatre, the historic levels of bitterness across the American political spectrum, an amalgam of economic faultlines the most pressing of which is weakness in the US regional banking sector, and the venality of US Congressmen and women.

In short, we have the tinder and the sparks for this to go horribly wrong over the summer. The timing of any debt ceiling imbroglio will depend on the exact moment that the treasury runs out of money. Janet Yellen has stated that this could happen in early June but interest rate and money market pricing suggests close to July for a default event.

First, let me sketch three broad scenarios

Bi-partisanship (15%) – President Joe Biden, when he was a senator, was renowned for his bi-partisanship and the friendships he cultivated on both sides of the House. That era is gone now, and American politics is radicalized. Under current party structures, there is no incentive – absent an external threat – for politicians to come together and pragmatically pass a ceiling increase. That is why I grant this ‘grown-up’ scenario a low probability. Indeed, the only thing that might send the Democrats and Republicans rushing into each other’s arms is a banking crisis.

Chicken (70%) – in this scenario the Democrats and Republicans bicker till the last minute, with the Republicans trying to curb the spending power of the administration as a quid pro quo for voting the debt ceiling increase. The important element here is how complicit markets are – if we see a spike in equity volatility, a deepening of the credit crunch and loud warnings of the ‘end of the dollar’ and American financial hegemony, then a ceiling rise will be passed.

Having spoken to many people in Washington, I find them overly focused on the debt ceiling and not some of the underlying stresses in the US financial system – namely a credit crunch and a periphery crisis in banking. The risks could very easily become the real problem and dwarf the ceiling debate. Two other factors to note here are that a drawn out ceiling debate will result in less market liquidity in Q3 and an eventual deal might produce a minor, negative fiscal shock.

Cliffhanger (15%) – the risk here is that enough Republicans (i.e. McCarthy) are in thrall to Donald Trump that they are willing to do to America’s financial reputation what he has done to American democracy, and that a historic default becomes likely. Such a scenario is not as wild as we might have thought six years ago, but it would likely be preceded by the enacting of Treasury emergency financing plans and stern words from the Chair of the Federal Reserve. A formal default may not just happen, but it could come close.

In the context of the WWF thesis, the middle scenario is the best one – we all have a fright, are fantastically entertained and enjoy a happy ending. Financially it is the best one for politicians. Members of Congress face little to no restriction on stock trading and some of them (e.g. Dianne Feinstein and Nancy Pelosi have better trading records than many hedge funds and are known to be very wealthy).

For instance, a New York Times report found that between 2019 and 2021, 97 senators and representatives or their family members bought or sold stocks in sectors that could be affected by their legislative committee work. Readers might think this is an all too cynical approach on my part to suggest that Congress members have an interest in market volatility, but it does nonetheless accord with the WWF thesis!

As it stands, few have an incentive for the debt ceiling to pass quietly, and many want and need a spectacle. Prepare to be entertained.

In the next few weeks we may see headlines like ‘Is America Greece?; ‘is it Italy?. The headlines won’t refer to wine, food and culture but to banks, because America now has a periphery bank problem. In the past three months the index of America’s regional banks has nearly halved. The speed (witness the demise of Silicon Valley Bank) and scale of what is happening is worrisome. At the height of the global financial crisis some 150 financial institutions – with total assets of nearly USD 500 bn – ceased to exist, though today a handful of American banks have expired, with assets of close to USD 600 bn up in the air.

With politicians and policymakers in Washington focused intently on the debt ceiling, the risk is that a periphery (regional and community banks) banks crisis overwhelms the debt debate and produces the sort of crisis that is consistent with the end of every Fed rate hiking cycle. My ‘breaking things’ thesis on the Fed remains intact.

The regional banks crisis is largely one of confidence (most bank crises historically have been), of monetary policy and of banking practice. In all too simple terms, banks have taken in deposits and matched these by placing capital in the Treasury market. As interest rates and inflation rose, the value of these Treasuries fell, thus reducing the capital available to banks should depositors want their money back.

The problem now is that depositors want their money back. Some of this is flowing to money market funds in order to avail of high interest rates that the banks do not offer. Social media and financial cable tv have not helped induce a sense of calm either.

Europeans of course have seen all this before, though our problem was one of the structure of the monetary system, in the context of a brittle banking system. Since the euro-zone crisis, a good deal has been done to bolster the euro-zone monetary system, but very little to advance capital markets and banking union. Looking at the USA, Europeans will also recognize the brutal way in which market stress leads policymakers to reverse policy rules put together in calmer times, to rush to provide market liquidity and to predictably blame speculators (they are not without blame but are not the root of the problem).

From here there are two risks for America. The first is that many of the policy measures that should induce some faith in the banking system (generous deposit guarantees, a liquidity provision mechanism (the BTFP)) are already in place, so that in the absence of a new broad program of support for the regional banks (that would break many of the rules of financial policy making), the pressure on the banking system persists and could unravel into a full-fledged crisis. Some of the underlying conditions in the US banking sector – such as a weak commercial real estate sector and a sharp drop in lending are a concern.

What is more worrying are the enduring effects of the decimation of America’s periphery banking system – there is a credit crunch going on in Silicon Valley and beyond that will also lead many venture firms to write down the value of investments. Then, in other parts of the US, individual states will be hit by the consequences of weaker regional banks, the shift of deposits towards behemoths like JPMorgan may mean that the costs of banking are higher.

This shift in capital from periphery to core mirrors a deeper trend in the US, which is that in terms of its society, economy and financial system it is becoming pyramidical, with a successful core at the top of that pyramid and a very large base or periphery.

Wealth in the US is highly unequal – 35% of all wealth is held by the ‘top 1%’ a high for the developed world and a figure that is exceeded only by emerging nations (India, Russia and Brazil). For comparison, in Canada the top 1% own 25% of total wealth. The wealth outlook in the US reflects in part the growing concentration effect in the stock market (the top five technology companies make up close to 25% of the market capitalization of the stock market), and now in the banking system.

It may also reinforce a narrative that American politics has become a system that favors insiders (core) at the expense of outsiders (periphery), and in terms of other markers such as the quality and provision of education and healthcare, and metrics like life expectancy there is a significant difference between the core and periphery (there can be a difference in life expectancy of up to seven years between ‘mid’ and ‘southern’ states like Mississippi and wealthier coastal ones like California and New York). More generally, overall life expectancy is plummeting in the US, at a rate only seen in Russia around the fall of communism. 

In that respect, deposit flight may reflect the innate fears Americans have about their country, and this is a warning sign for a much deeper malaise.

Have a great week ahead,

Mike