Cheap and Cheerful

Quite some time ago I attended a seminar by Carlota Perez, a British-based Venezuelan scholar whose work focuses on the ways in which technological innovations, finance and economics work together to produce great waves or periods of investment and periodically, prosperity. At the time, books like Thomas Kuhn’s ‘The Structure of Scientific Revolutions’ were fresh in my mind, as was the recent aftermath of the dot.com bubble.

Perez’ work (much of which is on her website) is best explained by the title of her well known book ‘Technological Revolutions and Financial Capital: the Dynamics of Bubbles and Golden Ages’, where she describes the phases that accompany technological innovations as they acquire investment and begin to ripple through economies, and change the structure of those economies. In common with scholars of developmental waves (for example she was awarded the Kondratiev Silver Medal in 2012) she maps how major technological revolutions (such as the 18^th century Industrial Revolution, steam engines, railways, manufacturing in the form of automobiles and oil drilling for instance, and telecoms/internet) develop in phases.

The principal phases she outlines begin with the Installation phase, where capital rushes towards the new technology, fuelling the build of new infrastructure and new sub-industries and economic activity, but also driving asset bubbles which inevitably crash or hit a ‘turning point’ as she politely puts it. The next phase is ‘Deployment’ where the new technology is widely used, and public policy, regulation and society accommodate it. Investment-wise, the economic applications of the technology enter into the mainstream. Readers will quickly spot the relevance to the AI capital expenditure boom.

An interesting distinction Perez makes, which I think is highly relevant, is that between ‘financial capital’ by which we can understand fast moving speculative money, and ‘production capital’ which is devoted to building of specific technologies, skills and infrastructure and is by nature more ‘committed’. Nicolas Colin, a French economist has written a lot on the emergence of ‘production capital’ in his blog, Drift Signal. I am tempted to say that Europeans might hold that ‘financial capital’ is American and ‘production capital’ is European, but Europe has a deficit of both.

It seems to me that the difference between AI and the historic phases of technological innovation mentioned by Carlotta Perez, is speed. The speed with which models are improving, the speed with which capital is being deployed, the take-up by users, and the speed with which the winners and losers are emerging at the corporate level.

A couple of months ago, we wrote about the mixture of wonder and panic created by Anthropic’s Mythos model. Then, it was assumed that Chinese developers were some seven months behind the Americans, but last week, Moonshot, the Chinese AI developer released test results of its Kimi K3 model (conveniently, they are in the middle of a fundraise), which apparently match some of the capabilities of Mythos. There has not been much of a market reaction to this in the US but, the red-blooded capitalists of Silicon Valley and the AI industry are crying alarm, running for Washington and calling for the US government to ban Chinese models.

Their dismay, consistent with the Perez framework, portends a speedy evolution in the structure of the international market for AI tools. China’s models are much cheaper than those in the US, partly because they piggyback on work done by the Americans, partly because of cheaper energy in China, and partly because of fierce competition amongst Chinese developers (and the winners get a boost from the Chinese government). In the near future, those who want cheap, cheerful and clever AI tools may well gravitate to the Chinese AI products (as Germans are now doing with Chinese cars, see last week’s note, Is China OK?))

The American AI models will still be useful for a number of things. The first is that they will continue to lead frontier AI development, in analytical power, and increasingly on specialised datasets and applications. Secondly, they will be favoured by Western corporates, especially in closed systems, and thirdly, they will continue to have a strategic role – either in applications across nations (from security, warfare or healthcare for example) or as strategic exports (here I am thinking of G42, the UAE’s AI firm that has an exclusive relationship with US AI models).

To that end, capital will flow more to cutting edge AI, sovereign AI and secure corporate AI in the US, and very likely in Europe (Mistral, Europe’s last hope is currently raising capital at a measly Eur 20 bn valuation). In my view, we are still some way away from a ‘reckoning’ in AI stocks, and proof of the hubris in the market is that the large investment banks involved in the SpaceX IPO continue to issue research notes, with embarrassing justifications for their lofty price targets (Morgan Stanley thinks SpaceX, which trades at USD 135 is worth USD 300).

Still, markets are beginning to sniff the weaker players – Oracle, whose balance sheet is far weaker than rival hyperscalers, has seen its value halve in the past two months. Writer Sebastian Mallaby, amongst others has stated that there is a high risk that OpenAI might run out of money. For the time being, the show goes on.

Have a great week ahead, Mike

Is China OK?

China's economy grows at one of lowest rates in decades

For much of the last decade or so, Chinese friends and acquaintances, as well as many people I know in Singapore and Hong Kong, have remarked that their view of Europeans is a lazy and decadent people, too tolerant of the problems that beset their societies. This view is in part gentle mockery, and part sincere. Europeans, not used to being mocked, will look up from their Aperol spritz and ask what they are doing wrong?

Indeed, according to the latest (and fourth) University of Alberta ‘How China sees the World’ survey, it seems that most Chinese don’t rate the EU as a major geopolitical player, though a significant economic partner and more importantly, a tourism destination.

The survey highlights that the Chinese have a strong view of their country’s importance on the international stage, pitting it ahead of the USA in a bi-polar world order. The interesting elements in the survey are the casting of Russia as an indispensable, trusted partner on the international stage for China, and the confidence with which participants gauge a war with Japan as a likely geopolitical event.

To an extent, it is welcome to consider Chinese views on the rest of the world, granted the irony that for such an important economic and geopolitical player, there are relatively so few Western experts on China, and in Western public discourse there is not a well-developed conversation on Chinese culture and politics. Consider that there are very few Irish public figures who know China well, and the evolution of China’s economy does not get enough detailed attention in the Irish media, despite China’s enormous role in the world economy.

This might be because China makes it increasingly difficult for outsiders to understand it. In the past seven years, Western investment in China has dropped significantly, and the flow of Westerners to work in China has also fallen. A further illustration is that there are now fewer than 2000 Americans studying in China according to the Straits Times (down from 11,000 in 2019) while there are still some 250,000 Chinese studying in the US (down from 354,000 in 2019), and a further 150,000 Chinese studying in the UK (and close to 4,000 in Ireland).

The reduced social, political and commercial connection between China and the West makes it harder to read what is happening to the Chinese economy, with the additional concern that official Chinese data is not helpful either. Granted that China last week printed one of its lowest official GDP growth readings, this is a significant hurdle. Indeed, there is a sense amongst many Western economists that only an amalgam of very detailed, micro indicators (e.g. electricity usage) can help build a picture of what is really happening in the Chinese economy.

For example, In the USA, the Conference Board has reconstructed China’s economic data, and has concluded that not only has the performance of the Chinese economy overestimated, but it has been driven by the flow of huge amounts of capital into the economy that has steadily become less productive (in the sense that one dollar of capital leads to a decreasingly small return). It may be that the Conference Board team has gotten it wrong, but there is simply neither the forum nor the spirit for an open debate on Chinese data. Also, a prominent Chinese economist Gao Shanwen, who died of cancer last month, had stated publicly that the trend rate of growth in China is far lower than official figures suggest.

Despite that, the most interesting element is that the Chinese authorities have managed their economy better than most have thought, and to use a headline from the New York Times, China’s economy ‘has failed to fail’ in the sense that it has not had an obvious cyclical recession in decades.

If there is a strategy behind this, it looks from afar, as the state pushing activity from one economic engine to another. The Chinese property market has steadily deflated over the past six years, and the financial consequences of this have in my view not fully registered with banks and households. At the same time, through a mixture of state guidance and ruthless industrial competition, China has shifted the locus of activity to manufacturing (and the last Plenum, policy making forum, has ordained deep tech as the spearhead of the Chinese economic effort).

One consequence has been the creation of over-capacity, but in goods of sufficient quality and low production cost, that they displace European markets. Last week, exports of Chinese cars to Europe have just topped a monthly tally of 1 million, while European manufacturers (even Porsche) are struggling in China. The result is a crisis of confidence in German manufacturing, and a policy debate on how to curb the flow of Chinese exports into Europe.

In the past year, China has pursued an ‘involution’ policy, of reducing spare capacity across a range of industries, but this does not yet appear to have borne fruit and raises the risk that there is still a lot of operational leverage in the economy. Two other risks loom. One consequence of the funding of real estate and manufacturing through the banking sector is that in terms of assets, China’s banks are amongst the largest in the world, a systematic risk in the event of a downturn, and its public (including local and regional authority) debt, is dangerously high.

With trading partners, such as Germany, beginning to react to China’s export boom, the policy options for Beijing are increasingly limited as they try to maintain economic momentum. Another bad GDP print and investors will start to fear the worst.

Have a great week ahead, Mike

You’re in the army now

At a recent dinner event three people, myself included, referenced Valery Gerasimov, chief of the general staff of the Russian army, and famous in geopolitical circles for a 2013 essay where he outlined the concept of ‘total war’ as seen through Russian eyes. It is a view of conflict that covers many strategies such as cyber, border testing, propaganda, intensive social media and covert attacks, for example. This approach has been very much on display across Eastern Europe and the Baltics – the encouragement of discord in Bosnia, the hollowing out of Hungarian politics and in particular the harnessing of Belarus as a form of geopolitical attack dog. Indeed, the fact that General Gerasimov has entered our minds is a sign that the doctrine is succeeding.

An excellent steer as to the tactics of ‘total war’ is David Kilcullen’s book ‘The Dragons and Snakes’ where he examines the new, unconventional forms of conflict pursued by the likes of Russia and China. One striking example Kilcullen describes is Russia’s efforts to drive immigrants and asylum seekers through the border with Norway, the aim being to test Norway’s reaction, its border security and to generally aggravate NATO.

Total war is highly effective. The ongoing destabilisation of adversaries through unconventional means is relatively cheap and effective, especially so when many governments in the West refuse to publicly acknowledge the manipulation of the infrastructure of democracy and public life. Other efforts, such as assassinations and the incursion of drones and jets into European airspace, with the added spice of cyber-attacks, are harder to ignore. They likely amount to signs of Russia stressing and probing European defences, and most importantly, testing the commitment of the US to NATO.

In this respect, NATO should be highly focused and motivated, but in the context of its gathering in Ankara, consistent with the view that all of the institutions of the post WW2 era are unravelling, dangerously on the brink of irrelevance. The danger is that it ceases to be an alliance, and instead serves as a mere organisation.

The reasons for this are well known. Whilst military level ties between the likes of France and America are very strong, Europeans (and Canadians) fear that Europe and the US no longer share the same enemy and worry that even in a post Trump 2.0 world, the stance of the US will not revert to an embrace of NATO.

In short, if NATO’s Article 5 was to be invoked, Europeans are still (despite comments from the summit) not convinced that the US would pick up the phone. Indeed, the only person to have triggered Article 5, Ambassador Nick Burns (former US ambassador to NATO who triggered Article 5 on 9/11) has said that Donald Trump’s repeated view that he wants to ‘take’ Greenland, is ‘breaking the bonds of trust’.

To that end, many officers in European armies increasingly regard the NATO command structure as an organisational framework through which European armies can coordinate, plan and organise, and to that end it still has value. Europe is re-arming, and as Germany showed this week, balance sheets are swelling with the issue of new debt to finance defence spending. This re-armament is urgent, in view of warnings from intelligence agencies of a clash with Russia within the next five years. One nod to this risk is the upgrading at the NATO summit of the Baltic Air Policing mission to an air defence one.

By their nature, democracies are vulnerable to the tactics of ‘total war’ and the rise of social media has made populism an easy and attractive strategy, and thoughtful rebuttal a near impossible one. Two important reminders of this came last week.

Nigel Farage, who according to some is Britain’s prime minister in waiting appears to have made a tactical error in resigning his Westminster seat, so as to recontest it. Farage did so in order to head off an inquiry into donations he has received (note that the former head of Reform in Wales is serving a lengthy jail sentence for pro-Russia bribery). With the exception of the satirical independent candidate Count Binface, no other parties will contest the seat, undermining Farage, with potentially enormous consequences for British politics given the rise in popularity of Reform.

Across the Channel, where on repeated occasions the French authorities have warned of foreign influence in French elections, the French judiciary have confirmed Marine Le Pen’s culpability in a finance scandal, but effectively opened the way for her to stand in the 2027 presidential election. The court battle is not yet over, and Le Pen will face several constraints (possible house arrest or electronic bracelet). Most voters should feel disdain in voting for a politician convicted of corruption, though Nicolas Sarkozy stills enjoys an allure in France.

But, Le Pen, whom Emmanuel Macron has accused of being funded by Russia, will likely play the martyr card, that the elitist French system is set against her. She has a hard-core support approaching 30% of the electorate, and the only person who can stop her is Edouard Philippe, the former prime minister, who has been far too mild mannered. He needs to take note from the evisceration of Keir Starmer, otherwise the next NATO summit in Tirana in 2027, may be marked by Marine Le Pen leading France out of NATO’s command structure.

Have a great week ahead, Mike

Modern Times

On May 15, 1932, there was an attempted coup d’etat in Japan, led by a militant, nationalistic faction in the Imperial Army. The principal victim was the Japanese Prime Minister, Inukai Tsuyoshi. The perpetrators of the coup were given relatively light prison sentences, a pointer to the less democratic and belligerent Japan that would soon follow.

The bizarre element of the coup, which fortunately did not succeed, was a plan to murder the actor Charlie Chaplin. The thinking was that such a deed would incite popular fury in the US, and thus lead to war, in which Japan would prevail. At the time of the coup, Chaplin was watching a sumo wrestling match with the Prime Minister’s son, and thereby escaped the assassins.

This was more than lucky and in many ways Chaplin’s film The Great Dictator is a fine riposte to the destructive nationalism and totalitarianism that took hold across the world from the mid 1930’s. It is a film that still resonates today in our world of ‘predators’.

While our view of Japan today is of a placid, highly civilized country, its history in the past two centuries is a reminder of the pitfalls of isolationism, nationalism and war – concerns that are now echoing louder across the international political economy debate. It should be said at the same time that the post second world war relationship between the US and Japan is a good example of how two feuding countries can come together (Al Alletzhauser’s ‘House of Nomura’ is good on this topic).

Yet, such was Japan’s economic rebound after the second world war that America feared the rise of Japan as it now does China, and fans of economic history may know that during the 1980’s and 1990’s Donald Trump was an eminent Japan-trade basher. For instance, the April 13 1987 cover of Time magazine carried an image of Uncle Sam pitted against a sumo wrestler under the banner ‘Trade Wars – the US gets tough with Japan’ (the stock market crashed five months later).

Now, following decades lost to the after-effects of its economic crisis, Japan is undergoing an awakening, spearheaded by the historic election of the first female prime minister of Japan, Sanae Takaichi. This awakening takes different forms, a more assertive diplomatic stance on China, a ramping up of defence spending amidst greater public comfort with the idea of Japan as a budding military power. Also, Japan’s government is ambitious for its economy and has announced a record state budget of 122 trillion yen (over Eur 600 bn), and Japanese firms like Softbank are in the vanguard of the AI boom.

There are two other financial aspects of this awakening. In an attempt to revitalize the Japanese economy, the Bank of Japan had kept interest rates at or below zero for some time. It has abandoned that policy recently and with both growth and inflation picking up, bond yields have surged. For much of the last fifteen years, the ten-year bond yield in Japan has been well below 1%, but in 2024-25 normalised toward the 1.5-2% range, and is now 2.7%, whilst the longer term 30-year bond yield is 3.95%.

As one of the world’s most indebted countries (Japan’s headline public debt to GDP ratio is well over 200% according to the IMF), the effect of this is that fiscal policy is increasingly smothered by the effect of interest payments on that debt, and policy is trapped between trying to grow the economy, control inflation and not upset the bond market.

Equally the yen is grabbing attention, falling to a forty-year low this week. Indeed, it might well be lower, but traders are wary of a market intervention by the Japanese authorities. There are several factors driving this, the hedging of foreign exchange risk by investors buying Japanese assets, real interest rate differentials, and worries over the effects of expansionary fiscal policy. A costly bout of yen intervention might be close.

As Japan’s asset prices hit records for largely the wrong reasons, it serves as a reminder that many large indebted economies exist on a financial tightrope between growth and calamity. Britain is the most prominent example, but Japan is a more systematic case and over the summer could be the source of a market wobble, if not outright crisis as bond market sell-offs become more common in our ‘age of debt’.

It’s all enough to make me think of Charlie Chaplin’s depression era film Modern Times.

Have a great week ahead, Mike