Coherence

Kim Hong-Kyun is not a name that very many Europeans know, but they really should, given his grave diplomatic intervention last week. Hong-Kyun is the South Korean ‘first foreign minister’, who last week summoned the Russian ambassador to Seoul to register South Korea’s displeasure at the news that up to 12,000 North Korean soldiers are in or on their way to Russia to fight in Ukraine.

While North Korea’s contribution to the Russian war effort is already known (their armaments industry is producing as many shells as Russia itself – and more than all of Europe), the prospect of an Asian state sending soldiers to fight in a European country is unprecedented, and I am perplexed that European governments have not reacted to this (though South Korea, Australia and Japan sent representatives to a recent NATO meeting).

The South Koreans have pledged to arm Ukraine if North Korean troops fight there, raising the complicated prospect of an Asian proxy war in Europe – again something that would have been inconceivable years ago, and that also tilts us towards the notion of a world war.

Whilst some readers might find this an exaggeration, we are at a moment of coherence, when threads that have been developing over the years become clearer and begin to describe the contours of the emerging geopolitical order.

One of the notable formations here is the SCO or Shanghai Cooperation Organisation, which I wrote about in the Levelling (p. 245) describing them as a geopolitical ‘gang’ of the future and sort of anti-NATO coalition, or at least an anti-AUKUS group. Despite this, few of the university post-grads in international relations I have come across in recent teaching sessions knew of the SCO.

There is a sense that the shadow or the logic of the SCO was lurking behind last week’s BRICS meeting, given the perception that the BRICS is becoming an anti-Western alliance, which in reality is not true. Reinforcing this are the very different cultures across the BRICS countries, and the risk to their project that relations between them depend on individual autocrats rather than institutions or peoples.

Yet, a sign of the times is the manner in which large emerging nations like India and Turkey are hedging their bets in the sense of maintaining good relations with Russia and the US. For India in particular, the BRICS meeting was a chance to begin to repair relations with China.

They could be forgiven for doing so granted the impact that the outcome of the US presidential election will have on international relations. The choice is one between an effective continuation of the foreign policy of the Biden/Democrat administration in the context of growing pushback against American power, versus a Trump foreign policy that is unsure, opportunistic and likely goes against the deep grain of Republican foreign policy as established by Ronald Reagan, George H Bush, Colin Powell and Condoleezza Rice.

2025 will hopefully see the end of wars in Ukraine and the Middle East, following which the notion of the coherence of rival systems will come into sharper focus. It is increasingly clear that the leading autocratic states (Russia and China) are hell bent on undermining the democratic world, and any nations that toy with the idea of joining it (witness the heavy handed Russian interference in last week’s referendum on EU membership in Moldova, and it’s obvious interference in Georgia’s election which takes place this weekend).

The danger is that the sharpening coherence of the SCO is like the development of AI – it has been gathering pace amongst specialists for some time, and then a public event (the launch of ChatGPT) brings it into the public domain.

One of the obvious casualties of the emergence of the SCO and indeed the geopolitical trials the world is suffering, is the diminished influence and credibility of world institutions like the UN and WTO (World Trade Organisation), which are being reduced to the role of bystanders in this emerging geopolitical contest.

The scene is set then for the November 5^th election to either reinforce or undermine the world order.

Have a great week ahead, Mike

Act of Union

There is a theory abroad that the British Empire was so vast and dominant, simply because a large country (England) was attached to a brilliant small country (Scotland). It is true that many of the individuals we associate with the advancement of Britain are Scottish – economist Adam Smith, scientists James Watt, Alexander Fleming and Alexander Graham Bell, and writers like Arthur Conan Doyle and Walter Scott. More recently, some of the more prominent political figures in Westminster have been Scottish – such as Gordon Brown.

This year is the tenth anniversary of the Scottish independence referendum, which whilst the motion for independence was defeated, set in train a groundswell in favour of independence and the resulting electoral landslide for the Scottish National Party in the subsequent general election. At the time of the referendum, the SNP was led by Alex Salmond, who died last week, and who was the founding father and driving force of the independence movement (and a subscriber to this note).

At the time of the referendum, there was great interest in the prospect of Scotland going it alone, and the way the Scots might dis-engage their economy from England was the focus of attention. In many respects the downfall of the independence side was that they became mired in an argument over the kind of currency arrangement Scotland might have, and the resulting impact that this could have on household finances. In the land of Braveheart, this battle by spreadsheet proved too much.

The independence referendum also brought into focus the kind of socio-economic model that Scotland might enjoy, and this spurred me to start researching the model of small, advanced states, a theme I have developed in collaboration with David Skilling over the years.

Simply put, our thesis is that while the likes of Sweden, Switzerland, Singapore, Ireland and the Netherlands are culturally very different they, and a handful of other small states are all highly successful. Alex Salmond used refer to the northern most small, advanced economies as the ‘arc of prosperity’.

Small-advanced states dominate the lists of ‘happiest nation, ‘most innovative’ and ‘most open economy’, and share a common set of factors upon which their success is built (strong institutions, a healthy regard for the rule of law, prioritisation of education and innovation for example).

Indeed, this ‘secret sauce’ tallies with the work of the winners of this year’s Nobel Prize in Economics, Daron Acemoglu, Simon Johnson and James Robinson, the body of whose works links growth to institutions and laws (the book ‘Why Nations Fail’ is worth a read).

One of the first occasions that David and I presented our work was with Alex Salmond, in Singapore, and since then David in particular has been an active adviser to the Scottish government.

My sense is that the death of Alex Salmond, and the near implosion of the SNP amidst a series of leadership crises (and the resurrection of the Scottish Labour party who have increased their tally of Scottish MPs in Westminster from 2 to 37) will gravely diminish the political momentum towards an independent Scotland. On the other hand, the limits that Brexit places on the UK in general will serve as one of several motivators for the Scots to go their own way.

One of the underlying theses behind the small state model is that they are adaptive and strategic – nimbly ducking around the imbalances of a chaotic world. To a large extent this is still true – the Nordic countries, as well as the smaller Baltic states have impressively upped their game on the security and defence front (Ireland has not), and Sweden and Finland have thrown off their neutrality.

In addition, and a marker of how policy is changing in the Western world, the Nordic state – once a near parody of tolerance – are adopting much tougher stances on immigration, and after too much patience, organised crime. If they are really canaries in the coal mine of world politics, this turning point suggests that in Europe, there is now little welcome for an increase in immigration.

To that end, having been in the vanguard of economic advancement during globalization, small, advanced states are at the forefront of dealing with the challenges of an intensely geopolitical world.

Have a great week ahead,

Mike

From Cranes to Crypto

Madrid, Spain cityscape at Calle de Alcala and Gran Via

Regular readers will know that I travel a lot, always with a preference for boats and trains and by air when necessary. Having spent much of the summer without the need for a plane, the next few months will see an intensification of my travel schedule across Europe, the Middle East and Asia.

In most places I will be talking about the economics and politics of a changing world, but the virtue of visiting so many cities (Hamburg to Abu Dhabi for instance) and regions (the Cotswolds to South East Asia) is the opportunity it grants to witness the kinds of growth and development happening in the world, and the measures we can use to compare economic activity across countries.

Here, a few favourites come to mind. In the 1990’s and early 2000’s it was commonplace for economists and investment strategists in the large banks to rush back from trips to Asia with tales of how many cranes they had seen across the skylines of major Chinese cities and estimates of what this meant for the growth of the Chinese economy. Nowadays, those economists sit on a deck chair in the Marina Bay Sands hotel in Singapore, look out onto the bay and count the number of tankers anchored there as a proxy for global supply chain disruption.

Another tell-tale indicator is taxis. A former colleague, friend and reader of this note, with whom I used to travel to Japan in the late 1990’s referenced the length of taxi queues as a proxy for Japan’s then moribund economy (often unoccupied taxi ranks would snake around office blocks).

Then on a visit to a thriving Abu Dhabi in 2012, my taxi driver got lost (on the way to the airport). He apologised, saying it was his ‘first day’. I assumed he meant it was his first day as a taxi driver, but it turned out that it was his first day in Abu Dhabi. I politely took this as a sign of a vibrant labour market and a strong economy.

A risk that travelling economists face, not unwittingly, is that they normally stay in the centre of a city, and often in a decent hotel. I wrote a note some time ago describing this as ‘Grande Bretagne’ syndrome, after the teams from the IMF who oversaw the austerity programme of the Greek economy during the euro-zone financial crisis who stayed in the plush Grande Bretagne and Hilton hotels in the city centre. While this placed them near the seat of power, it meant that they were blind to the brutal impact of austerity across the country.

In general, travelling economists should get out and about. For instance, the quality of public transport in a country is a good indicator of the standard of infrastructure and to an extent, social cohesion and, is also a good way to observe a society. Someone observed that a city in which the wealthy use public transport is a well-balanced one (Zurich is a good example). In contrast, there is, inexplicably, no train from Dublin airport to the city centre, but a ride on the Luas tram will give a very good idea of the dramatic changes in Irish society.

In keeping with this approach, a favourite activity to beat jetlag and to either reacquaint with or discover a city is an early morning run (this week’s schedule took in the Tour Eiffel, the Tiergarten and Madrid (the park was closed due to bad weather)). In that idiosyncratic way, My eyes (and feet) are sensitive to the quality of the road surface, pollution and to the appearance of new buildings and signs of dereliction (Berlin scores on both counts).

There are other indicators of the economic prowess of cities, such as the rise of tall towers (the UAE for instance). In this tech driven age, a new category of indicators might comprise cities that want to become crypto-hubs (UAE, Miami, Zurich, Lisbon) and those that seek to attract large artificial intelligence (AI) firms (OpenAI has just opened an office in Paris).

As a final note on Madrid, I haven’t seen the city as ‘sleek’ or well presented (the 12^th was the national holiday), and it must be said, as expensive. Note that Spain now has a slightly lower interest rate (bond yield) than France, and a considerably higher rate of growth than Germany.

The economy appears strong, despite concerns that many people versed about the state of Spanish democracy and its finely balanced political situation – there is likely a contentious budget on the horizon towards 2025.

There were a lot more Latin Americans than I had expected, and this has both helped tourism, and pushed up house prices (to the ire of some locals). Spain’s golden visa system means that it is the recipient of wealthier Latin Americans leaving countries like Venezuela. At the same time, quite a number of Spanish businesses and executives are relocating to Lisbon, which is a warning sign for innovation.

Have a great week ahead,

Mike

Druk!

Winter it seems, across much of Europe, has come early. Two instincts that grow as the evenings darken are the inclination to have a tipple in the evening and to watch a good film. One Danish work that captures both sentiments is ‘Druk’ or ‘Another Round’, which won the Oscar for best international film in 2021. I recommend it.

In the film a group of four school teacher friends decide to test the hypothesis of a Norwegian psychologist that humans have a deficiency of alcohol in their blood, and the protagonists undertake an experiment to maintain a ‘warm’ level of alcohol in their blood. It is an experiment I attempt often, but the real lesson today is with central banking.

It seems that central bankers have decided that in the spirit of ‘Druk’, the liquidity in the world financial system is not sufficient and have set out to administer near daily injections of cheap money. The number of central banks changing policy (i.e. to negative) is the greatest it has been, apart from the global financial crisis and the COVID period. In September alone there have been 24 rate cuts from central banks around the world.

Chief amongst these has been the 50-basis point cut from the Federal Reserve and the very dramatic, multiple policy moves by China. In short China has cut rates, infused the banking system, made mortgages cheaper and generally tried to spread liquidity over the emerging cracks in China’s economy. In the spirit of ‘Druk’ it is the equivalent of going on a five day bender in order to cure a serious disease.

Nonetheless, the easing in policy from the Fed and China, together with what will likely be a couple of more rate cuts this year from the European Central Bank mean that the world financial system is flush with liquidity. Chinese markets – hitherto the worst performing markets of a major economy – show the impact and importance of liquidity. The market cap of the Hang Seng index has grown by a quarter in less than two weeks. China has overtaken the US in terms of equity market performance to date.

There is no change to fundamentals – I don’t see this policy move having a decisive impact on the downward trend in Chinese earnings, but that doesn’t matter in the near term – liquidity is coursing through the pipes of the Chinese financial system, and in turn might bring a temporary easing to conditions in the property market.

For all the analysts who devote time to measuring earnings and calibrating valuations, the reality is that in this era of ‘quick to please’ monetary policy, liquidity matters a lot for asset prices. My rule of thumb in constructing a measure of liquidity would encompass money supply, the state of central bank balance sheets, the key role of the dollar and net issuance of debt by treasuries.

The arcane notion of financial liquidity has attracted enough attention that the Financial Times recently ran an article breaking down its component parts. A couple of top-flight economics consultancies run their own measures of liquidity – such as LongView Economics and Michael Howell at CrossBorder Capital. The latter holds that we are on the cusp of a significant upswing in global liquidity.

If that is true, the implication for markets is ‘Druk’- a persistent giddyiness whilst central banks keep rates low and liquidity flush, amidst an acceptable level of GDP and profit growth. Friday’s job market figures in the US were very strong, suggesting that in fact there was no need for a large rate cut. This is the kind of macro climate we have seen in the mid and late 1990’s, and one that tends to dampen the market implications of turbulent geopolitics.

From the point of view of asset prices, there are a couple of possible trajectories. Historically, the Fed has started to cut interest rates when the price to earnings ratio on the S&P 500 has been close to 10 times (1960’s to 1990’s). Now, like in 2000, it is in the mid 20’s which suggests that extra liquidity now could run asset prices in bubble territory proper, and cultivate the next bout of inflation, something the central banks’ bank, the BIS, has warned about (helpfully the BIS has taken a counter view to that of its members ahead of a number of crisis).

For the time being, the upturn in liquidity may be most meaningful for capital markets activity and assets in the private economy. They have been in the doldrums. If the ‘Druk’ hypothesis is working we should see a rise in IPO activity into 2025, and intensification in private equity deals and a rise in funding activity (beyond AI firms) in venture.

Then, later in 2025, the hangover will arrive.

Have a great week ahead,

Mike

Another Tea Party?

The Boston Tea Party is an early example of how a trade dispute can reshape an economy (Boston) and foment political change. It is iconic enough that the first presidency of Donald Trump was prefigured by the rise of the Tea Party as a disruptive force in Republican politics.

With the presidential election not far off now, tariffs form the spear-end of Donald Trump’s economic strategy, potentially because he can implement them unilaterally (without the approval of the Senate). In addition, many of his acolytes, from Robert Lighthizer to Peter Navarro, are ‘trade’ obsessed, and have recently published books like ‘No Trade is Free‘ to underline the ways in which they would re-order the international trade system.

In addition, other members of the Trump entourage such as Robert O’Brien, the National Security Adviser (2019-21) has in the July edition of Foreign Affairs Journal invoked the idea that American can bring peace to a disordered world through ‘strength’. In this vision, strength comes in the form of 60% tariffs on Chinese goods and export controls, a message that has repeatedly been emphasised by Trump himself.

In that context, a second Trump presidency could begin with a trade war, and a verbal assault on the currencies of ostensible allies that have weakened in recent years, such as the yen. American consumers and potentially the bond market might pay the price of tariffs (we wrote last week that Trump wanted to fund the development of a sovereign wealth fund with revenues from tariffs).

Trade wars are generally not successful, and while Trump may have in mind America’s trade spats with Japan (1987), the weight of past trade disputes going back to the Smooth Hawley Act suggest that there are better ways to guard American economic power. China could respond with measures that cripple supply chains for at least a couple of years. In this scenario, a trade confrontation between the US and China would decisively shatter the axis of globalisation as we know it, and finally render the WTO (World Trade Organisation) obsolete.

A US-China trade war might have many other consequences.

One might be the rise of populous south Asian (and southeast Asian) from India to Bangladesh to Pakistan, Indonesia, Thailand and Vietnam, with Singapore as their organising locus. Many of these countries are urbanising and rolling out infrastructure, most of them need but distrust China, and in most cases aspire to closer commercial ties to the USA. Tariffs on China by the USA will accelerate supply chain de-risking by Western multinationals towards these countries, though this could well complicate their relationship with China.

A second consideration is Europe. The EU has been caught by surprise by the consequences of several Biden administration policies – the Inflation Reduction Act and the CHIPS Act – which illustrates that US international trade policy is usually made with a view to domestic politics. A second Trump presidency should be no surprise to Brussels, and there is a small but important team of officials working on a policy response to a potential trade war on Europe by Trump. Europe’s trump card may lie in its role as a partner with the US against China. It will be difficult for Washington to reshape trade relations with China, Europe and potentially Japan by taking each one on. Stymieing China is better done in collaboration with Japan and Europe, and Trump should really see the constraints of the policy situation that faces him.

A second Trump presidency will be different to the first in the sense that he has had time to prepare for it, and crucially, his supporters have had four years to concoct a policy strategy (‘2025’ seems to have dropped out of headlines). In the same way, a Harris presidency comes with deeper reserves of policy experts, and to a large sense on the international trade and economic outlook, the Harris case represents ‘more of the same’ in terms of the techn0-strategic economic policy that is currently pursued by the White House.

An idealised, and though I like the idea a lot, too lofty rendition of this policy is Walter Russell’s Mead’s September Foreign Affairs essay entitled ‘The Return of Hamiltonian Statecraft’ which argues for the very un-Trumpian notion of ‘enlightened patriotism’.

In this context, a Harris White House would use trade and investment policy to laser focus on America’s race with China for global supremacy. Driving Chinese economic and investment activity further inwards might be one goal, and ironically anything Washington can do to make Chinese public life more closed and repressive, the better (because it curbs innovation and wealth creation).

At the same time, the US and Europe, would both pursue parallel strategies of ‘strategic autonomy’ or what Trump refers to as ‘strategic national manufacturing’ focused on sectors like defence, new computing power (quantum, AI, data storage and management), batteries and new power sources and revolutionary medicine. Europe’s challenge is to find a way of reducing long-term energy costs.

Kamala Harris, who has trialled a few incoherent policies (taxes on unrealised capital gains, price controls) is likely to be more constrained in her fiscal policy – because her government is likely to instinctively focus more on tax and spending changes, for which she will need the help of the Senate (which in turn could tilt towards the Republicans). As such her fiscal policy will focus on not increasing the national debt, and like many other governments, encouraging the private sector to work with government to build out strategic technologies.

I am so far surprised that markets do not seem to price in uncertainty over trade policy, possibly because they are more focused on falling interest rates in the US, Europe and China. However, the next month will start to reveal how seriously financial markets take economic rhetoric of each of the presidential candidates.

Building Sovereign Debt Funds

One of the attractions of elections is that they throw up new ideas and policy proposals – and it is not unkind to say that one increasingly gets the impression of politicians throwing suggestions at the ‘policy wall’ to see what sticks. Aggressive tariffs on China and taxes on unrealised capital gains are two examples from the US.

One idea that Democrats and Republicans share is the proposed establishment of a sovereign wealth fund in the US. In the case of Donald Trump, his aim is to fund it with tariff revenues, whilst the Democrats conceive a sovereign wealth fund that might take stakes in firms in strategic industries, which is a very French idea (recalling the ‘strategic yogurt policy’ of 2005). The flaw in this particular idea, is that there is in fact no money to capitalise such a fund.

In stark contrast, I recall the last time Washington pondered a sovereign wealth fund was at the end of the Clinton presidency, when Treasury Secretary Bob Rubin had in a financial ‘end of history’ moment engineered a fiscal surplus (government earning more than it is spending). At the time, the sense was that surpluses would feed a ‘social security’ sovereign wealth fund, which would allow Americans to enjoy a prosperous retirement.

What is striking is that if you look at the history of America’s financial health, the Rubin/Clinton surplus is an anomalous blip. Since then, the US has registered nearly a quarter of a century of deficits, which irregardless of the level of growth of the economy, seem to get bigger (relative to the economy) every year. These burgeoning deficits are starting to take their toll on the US (and I should mention that many other large developed economies – Britain and France prominently so), as its debt level rises beyond 100% to GDP (expected to hit 122% in 2035). It is a very odd situation. In textbook economics, large deficits tend to exist in times of war, recession or crisis. As such, if any of these occurs, there will be scant room for governments to help the economy (and rescue plans may become a trial of strength of central banks).

That’s not all. Readers will sense that I am writing more and more about indebtedness, and it is indeed becoming a preoccupation of mine. The idea of the ‘Age of Debt’ is that debt is becoming pervasive, and as a factor will weigh on geopolitics, the tenor of political debates and the shaping of the financial markets of the future.

In that context, once we get beyond the rise of election campaigns and into 2025, governments will have to jettison dreams of sovereign wealth funds and instead subject themselves to debt sustainability analysis. It is akin to a household giving up a dream of buying a second home as their bank manager demands that the mortgage and credit card balance are paid off first.

Debt sustainability analysis is one of those arcane activities in economics, and I can count at least three friends who can run their own debt sustainability models, which is not something I should readily admit. The essence of debt sustainability analysis is that the future debt load (and its precariousness) of a country are driven by a set of factors – the rate at which a government spends, the inflation adjusted interest rate it pays, growth and demographics. These factors are inter-related – borrowing that is deployed to productive investment can produce growth and thus reduce the risks associated with debt for instance. Today, the rapid acceleration in the indebtedness of many countries, low growth and ebbing demographics are some of the factors that make debt increasingly unsustainable.

If that was a reasonably technical explanation, the best parallel I can think of to communicate debt sustainability is climate sustainability – or at least both sets of analysis point to a world that is heating up, and where there is relatively little reaction to this. Debt and climate sustainability analyses are long-term processes, and my sense is that governments gladly ignore them, until they become immediately problematic.

That is beginning to happen. France’s bond spread (over Germany) is elevated, and British bond yields are close to 4%. Neither country can afford to increase debt levels. The same is true for Canada. In the US, next February will see the installation of the new Treasury Secretary, and he or she will have the difficult task of telling the next President that there is no money in the kitty.

As such, the establishment of sovereign wealth funds is a distant, fluffy dream for most governments. A violent lesson here is that Ireland had a sovereign wealth fund in the early 2000’s, but it was swallowed up in the consequences of the euro-zone financial crisis, and is only now being re-established.

For those sovereign wealth funds that exist – in Norway or Saudi Arabia – the next trade may not be to buy quoted equities and private equity, but to either buy the discounted debt of developed countries when they have their sustainability crisis, or to engage in private lending to them. When that happens, a new shift in geoeconomic power will be under way.

Have a great week ahead,

Mike

Samuelson vs. Sahm

Next week the Federal Reserve will very likely cut interest rates, for the first time since the COVID related rate cutting cycle. Recall of course that at the end of this speedy sets of cuts, most of the leading central banks had declared inflation to be ‘transitory’. The Fed cut will come on the back of a series of rate cuts from ‘elder’ central banks – the Bank of England, Riksbank and the Swiss National Bank, as well as the European Central Bank from whom we had another rate cut last week.

The anticipated move by the Federal Reserve is instructive in several respects. Market based interest rates are lower than Fed rates and many investors expect (or rather crave) the Fed to make a 50 basis point cut, as opposed to a ‘standard’ one of 25 basis points. At the weekend, the lead headline in the Financial Times read ‘Investors raise bets on bumper half-point Fed rate cut’.

This is yet another sign of monetary addiction – the result of the conditioning of investors to financial liquidity. In mid-August, following a dip in the stock market, I wrote that the idea of the ‘Fed put’ – the notion that the Fed would react to a fall in asset prices by cutting rates – is very much alive in markets.

The market dip led several seasoned and apparently credible investors to call for an emergency cut in rates. However, the Fed has only ever taken such dramatic action in the thick of deep crises (LTCM/Russian economic collapse, the dot.com collapse, 9/11, the global financial crisis and the COVID crisis). Similarly, it has not begun a rate cutting cycle with a 50 basis point cut, outside of financial crises. There is no financial crisis today (though plenty of mounting financial risks such as very high debt levels), but a crisis of expectations.

That crisis of expectations is at play as investors position for the Fed meeting next week. In my experience, the Fed is, in normal economic conditions, a cautious and slow-moving beast, and it would be untypical for them to begin a rate cutting phase with an outsized rate cut. To do so would suggest that they are in a hurry to correct a mistake of their own making.

To the extent that investor behaviour demands a 50-basis point cut, this recalls the quip from Paul Samuelson, the first winner of the Nobel Prize in Economics, that the market has predicted nine out of the last five recessions.

Set against this apparent concern by investors (do they fear a recession or desire lower rates?) is a debate around a relatively new economic rule of thumb called the Sahm Rule, named after research by economist Claudia Sahm at the Federal Reserve. Her rule states that when the medium-term unemployment rate rises an impending recession is signalled (the three month average of unemployment needs to rise by 50 basis points). It is a surprisingly simple rule that appears to have prefigured eleven US downturns going back to 1953. Sahm’s aim in establishing a reliable rule was that stimulus checks can be sent out at the outset of recessions (as opposed to waiting for GDP data to indicate a recession).

I am tempted to trump the Sahm Rule with two observations.

The first is Goodhart’s Law, named after Bank of England and LSE economist Charles Goodhart which states that ‘when a measure becomes a target, it ceases to be a good measure’, or more colloquially that fame kills a good model.

More seriously, most of the last ten business cycles were conventional ones, whereas this business cycle bears the scars of reversing demographics, the lingering effects of COVID fiscal policy and labour market distortions (work from home) not to mention the contortions of strategic industrial policy (i.e. the CHIP’s Act, Inflation Reduction Act) and the political ramifications of high inflation and immigration. It is anything but a typical business cycle, and very hard to read.

Somewhat unusually at this stage in the cycle government finances are weak (from France to the US) whilst the large corporates of the Western world are in a generally healthy financial state. Of the major economies, China poses the greatest risk to the downside in the near-term.

With different components of the US economy moving in different directions, my expectation is for a slowdown than a deeper recession (this may eventually come at the end of 2025 if inflation rises again). Equally, I expect the Fed to make a series of rate cuts rather than deep cutting cycle. If that view is correct, the interest rates market will be very volatile, as investors periodically over react to data points and price in ‘booms’ and busts’.

Expect a market tantrum next week with investors complaining that the Fed is behind the curve. Samuelson would tell us that the curve has got it wrong.

Have a great week ahead,

Mike

The Tech Coup

In 2018, Pavel Durov the founder of messaging app Telegram, dined with Emmanuel Macron, and for his troubles was later awarded a French passport. Durov should have known that as a French citizen, the state will get you at some stage in your life, and so last week he was arrested in France. Durov’s story is layered with intrigue, and it is not immediately obvious what strategy is being played out here.

At the same time, it is one of a growing number of tales that illustrate what will be one of the great trends of the 21^st century, the tension between the power generated by technology and its effect on democracy. Other examples are the disputes between Elon Musk and diverse governments (the UK and Brazil), the difficult passage of the Californian AI Bill, and the apparent Department of Justice antitrust probe into Nvidia.

Equally, technology weighs on many public policy debates now – such as the access to mobile phones in schools, the demands that data centres place on electricity grids and the TikTok-ification of politics.

Technology is a source of wealth, economic growth and power. The historic outperformance of large US technology firms on the stock market is a manifestation of the first effect, while the ways in which governments in what could politely be termed less than democratic governments crave the means by which they can use technology (notably social media) to marshall their citizens is worrying. The countries of the MENA region post the Arab Spring are an example, and of course China is the benchmark here. Democracies at least, have better instincts, and most of them are trying to curb the negative side-effects of the power of technology firms and entrepreneurs.

However, many of them find the burden of oversight frustrating.

One of the striking debates I participated in over the summer was the Rencontres Economiques, where across a range of European policy makers there was great frustration at the dictum ‘America innovates, China replicates and Europe regulates’. In particular, there is frustration in Europe at the relatively shallow pools of capital available to scale up technology firms, but it must be said few politicians are willing to do much to help.

Europeans are vexed with the view that their competence is in regulation, rather than innovation, but I am beginning to wonder if Europe has in fact gotten out in front, notably so with its EU AI Act.

The EU AI Act is only just coming into operation, and it has its flaws, but its strength is that it is based on a broad, clear framework. In contrast, what is starting to become clear in the US is that in the absence of legislation (Senator Chuck Schumer’s AI regulatory initiative is seen as a ‘roadmap’) the effort to curb the power of large social media and AI firms on society will be piece-meal, and as a result much less efficient and more costly (since news of the anti-trust probe into Nvidia it has lost close to USD 700bn in value).

I suspect for instance there will be a lot more civil and corporate legal cases to establish the ownership of data-sets and the access to them by AI engines, as is the case between the New York Times and OpenAI.

At the same time, the lack of a regulatory framework to steer the development of AI and social media risks tension between different arms of the state. In the US the Department of Justice is taking aim at a range of social media sites that are suspected of coming under Russian influence, and the antitrust investigation into Nvidia risks cutting across the Biden administration’s security driven economic policy.

Many of these contradictions and challenges are laid out in an excellent, new book entitled ‘The Tech Coup’ by Marietje Schaake that, whilst written in the US, has a decidedly European tone (the author was an MEP). She argues for a more precautionary approach to the mass roll out of new technologies, with specific limits on technologies like spyware, facial recognition systems and crypto-currencies, and much greater transparency on the uses and finance of AI. These are sensible proposals, but likely the very opposite of what Donald Trump might instigate as a set of policies.

Thus, the tension between democracy and the power of technology will intensify – driven by at least two factors. The first is the geostrategic importance of technology – in particular data consuming and content producing technologies (which explains why the US has been so keen to limit the power of China’s TikTok).

The second, which many legal frameworks have great difficulty in encompassing, is the arrival of the ‘tech bro’, wealthy individuals, who consider themselves above the law, and in some cases, beyond common decency. While some politicians seem dazzled by these ‘bros’.

Democratic states should not bend to their wills and as a rule, democratic states tend to outlast tycoons.

Have a great week ahead, Mike

Wrong Turns

An early morning run through Berlin last week (down Unter den Linden and through the Tiergarten) underlined to me its role as one of the few cities to have been at the centre of several, major shifts in political power – from the dominance of Bismark and the Prussian Empire, to Berlin’s role as a scientific and intellectual hub at the start of the 20^th century, the two world wars, effective Russian occupation, and then the path from unification to its role as Europe’s economic powerhouse.

That the consensus view of Germany today is of ‘the sick man of Europe’ is also emblematic of a regime shift in globalization – Germany has neither the leadership, diplomacy, economic policy nor energy policy to succeed in a multipolar world. It is also an interesting vantage point to consider how some of the tectonic geopolitical shifts will evolve through the rest of 2024. Here are a few that preoccupy me.

We have written a number of times in recent years on the way in which the breakdown of the unipolar globalized world order is forcing countries and companies to ‘take sides’. Wars in Ukraine and the Middle East have made this trend more acute, as have growing supply chain centric protectionism. The messy evolution of the world order around three economic poles and value systems (China, EU, USA) adds complexity. Two recent events illustrate how different actors are becoming embroiled with each other.

First, Elon Musk’s interview with Donald Trump, combined with his castigation of Keir Starmer polarise the international consequences of the US presidential election. For instance, the EU Commissioner with responsibility for the Digital Services Act (Thierry Breton) hastily took sides and leapt to caution Musk. If Trump wins, there is a convincing argument that ‘global oligarchy’ will align with him, to the great inconvenience of Europe.

Second, the deepening of China’s support for both Russia (Chinese troops have recently been on exercise in Belarus) and Iran is puzzling and may increasingly put Xi Jinping at odds with colleagues. While this collaboration (of which North Korea is an important component part) is turning the SCO (Shanghai Cooperation Organisation) into a coherent strategic grouping, it is taking China down a narrow path diplomatically, and one that will sap its credibility on the international stage.

The admirers of Xi may argue that China is creating not just a new world order, but a new model of government (autocratic state development). But, from a Western point of view, and I hope a neutral stance, China has fallen in with a ‘bad crowd’ whose foreign policy modus operandi seems to be to ‘make things worse’ (especially for democracies). In that regard, Xi may come under greater pressure from within his party – some of whom think he has taken a ‘wrong turn’, and many of whom are concerned with the performance of the economy.

If China is in danger of taking the ‘wrong side’, Germany is at risk because it is not taking sides.

Returning to Berlin and looking ahead to September, Olaf Scholz may also come under great pressure from colleagues. The ‘back to school’ season brings state elections in Saxony, Thuringia and Brandenberg. In these ‘eastern’ states, the ruling coalition has feeble support (mid-teens for the three coalition parties together), the conservative CDU does much better (close to 30%) with the now notorious AfD enjoying close to 30% in the three above states.

Whilst these are regional elections, the prospect of a strong showing for the AfD (granted the highly controversial nature of its ‘eastern’ leaders) will embarrass Scholz. It might also further undermine the government’s energy policy (voters in these regions want the return of Russian gas and coal). It also brings into question the need for the government to spend more on structural social infrastructure.

Scholz coined the term ‘Zeitenwende’ (or turning point) to coin Germany’s strategic dilemma, but he has done little to steer it towards a better path. The consternation in Berlin over Ukraine’s use of German armour in Russia and the stasis in the government on producing a budget in the context of fiscal constraints suggest policy paralysis.

The new development for the second half of 2024 through 2025 may well be that both Germany and China, two of the important engines of the world economy, become embroiled in economic and political crises of their own making.

On that upbeat note, I am going on holiday for a couple of weeks, and will resume ‘The Levelling on Sunday’ on the 8^th September.

Mike

Let the Games begin

On Saturday morning I got up early to run the first and last parts of the Olympic marathon course, a few hours before the actual race. The course joins the most memorable parts of Paris with Versailles and is consistent with the spirit of the two-week Games in showing the accessibility of the city and its magnificence.

I have spent much of the past two weeks at the Games, mostly at the rowing, athletics and other endurance events like triathlon and bike (my favourite performances were Cork’s Paul O’Donovan and Fintan McCarthy –in the men’s lightweight sculls, Cassandre Beaugrand in the women’s triathlon, and the USA’s Grant Fisher in the 10,000m).

Once the security-driven tension of the opening passed, Paris relaxed and blossomed, and I think it is fair to say that the Games have been a huge success for Paris, France and the morale of the French people (their morale always needs boosting, their self-regard not so).

The success of the Games is a sharp contrast to the mood one month ago, when the country was confronted with the possibility that Jordan Bardella might be prime minister during the Games. Yet, Bardella has now effectively disappeared from public view. The question now is whether the success of the Games will colour the process of the formation of a new government?

My hunch is that it makes a government led by either the far left and far right less likely, and points to a preference for a centrist government – which I think is predicated on a split in the NFP left coalition (coming once they all return from holidays). I do not think that Emmanuel Macron’s reputation will be vastly enhanced by the Games, but they could be decisive in the race for mayor of Paris (Anne Hildago might opt to stand again, against the likes of Rachida Dati and Clement Beaune).

One reason that the atmosphere in Paris seemed so relaxed is that most of the Parisians left the city.

In my experience one motivation for this is that, unlike say England, there is no ‘sports culture’ in France (at least in the realms of the upper and middle classes). Achievement in sports is something for people in the regions, or the suburbs. Despite that, France does remarkably well in many sports like rugby, which is in effect played in a few regional centres (and professionally in Paris).

In this respect, the strong performance of France in the Games, allied to the even more impressive medal haul of Australia and combined with the lacklustre showing of larger countries like India, Brazil and South Africa (who have a combined four gold medals compared the six won by tiny New Zealand) begs the question as to what makes a successful Olympic nation, and whether these characteristics are correlated to economic achievement or even innovation.

Here, there are maybe three different models.

The first, which encompasses the English speaking nations (GB -5^th place in the medals table, USA – currently 1st, Australia – 3^rd, Canada – 11^th, New Zealand – 12^th and Ireland – 16^th) and some of the Nordics is based on what I call the ‘schools’ model, where sport is taught and practised competitively in the school system, and where this is valued culturally. In many cases, successful school athletes (especially so in Olympic sports) can continue sports at a very high level at university or clubs. Here the US university system stands out for the support it gives to athletes (from many countries, note that France’s hero Leon Marchand is a student at Arizona State University) and the vast resources that individual universities possess.

What is interesting from the point of view of the Olympics is that the national sports of the English-speaking countries – American football and baseball, hurling and Gaelic football, cricket, Australian rules – are not Olympic sports, and if anything draw talented athletes away from Games sports (and the Nordics have winter sports). It is still however an argument that a ‘sporting culture’ pays off.

The second approach is what I call ‘institutional excellence’, as exemplified by France (and it must also be said Australia with its world leading Institute for Sport), where promising athletes are funnelled through high level performance institutes and top flight clubs, and given support in terms of conditioning, psychology and diet. In the case of France, other institutions like the army also play a supporting role (19 of 52 French medal winners are soldiers). Japan and South Korea might also fall into this category, though it is worth noting the role that Japanese corporates play in supporting sports like running.

The third model is the ‘communist’ one which whilst communism has gone out of fashion, the communist system’s approach to manufacturing athletes has not, and is manifest in China, Romania and of course Russia. In these countries, within certain sports (rowing is one), promising physiological ‘specimens’ are channelled into specific sports and driven to compete. Whilst athletes from many countries have engaged in drug-fuelled enhancement, the ‘communist’ model countries have recently been the greatest offenders (Russia’s efforts here has been described as ‘state-sponsored and systematic’).

These are very broad sketches and will miss many elements such as the quality of individual coaching. One element they have in common is ‘age’ in the sense that most of the successful Olympic countries have been competing for a long time (the 1924 medal table was dominated by the USA, France, Finland, GB and Sweden) and I suspect that institutionalised expertise in many sports as well as a sense of ‘how to win’.

While my fellow Parisian Simon Kuper of the FT writes that there is a correlation between the level of economic development and Olympic achievement, I think it is more complicated. There does seem to be a correlation between sporting success and country pedigree (system longevity) and gender equality, and there does not appear to be a relationship between rate of development and Olympic achievement (China is the exception).

What is more interesting is the notion that the three above ‘Olympic’ models are related to different approaches to innovation. As we noted in last week’s brief, China has a state driven, ‘all-costs’, competitive approach to innovation, Europe’s is also state driven and resource-short, while the resource rich US university model (I would include Imperial and Oxbridge in the UK here too) tallies well with the centres of innovative excellence in the US.

If there is a lesson to countries like India, who perhaps want to be more successful (India sent a large business/socialite/media delegation to the Games) it is to focus on schools and colleges, develop a competitive sports program within its huge army, and copy Australia’s Institute for Sport.

Let’s see who does well in LA.

Have a great week ahead,

Mike