The Filatyev Diaries

Last Monday evening I was driving along the contours of Cork harbour, not far from East Cork. The area has many claims to fame – for example, a local (Edward Bransfield) is credited with having discovered Antarctica in 1820. Less triumphantly, some local villages like Whitegate, Aghada and Farsid lost one third of their male populations during the Crimean War.

At the time, a great number of soldiers died from disease and the lack of basic medical procedures – whilst the French and British armies fought side by side against the Russians, casualties were far relatively far higher on the British side because of inferior medical equipment and practice – hence the acclaim with which Florence Nightingale’s techniques were greeted.

I thought of this recently when I read a post on the very different medical kits supplied to Ukrainian and Russian troops, respectively. Setting aside propaganda and donations from the West, the Ukrainian kit looked modern while that of the Russian soldiers could well have come from a museum or horror show. In that respect, the apparent wilting of the Russian army is not surprising.

More supporting detail on this comes from the 140 page long diaries of Pavel Filatyev, a career paratrooper in the Russian army who, driven to despair by the chaos within his regiment (in Kherson), wrote a long account of his experience in the Russian army. Armies are not pleasant places but his account of the systematic mistreatment of the Russian soldiers, their undernourishment, disorganization in battle and embarrassing under-equipment is telling, not just of the Russian army but of the Russian state. Needless to say, he is now in hiding beyond Russia.

In that context, the mobilization of largely experienced soldiers to start with, and the co opting of prisoners into the Russian army, opens up many risks – for both Ukraine and Russia. Additionally, the coming referenda on the accession to the Russian Federation of the Luhansk, Donetsk, Zaporizhzhia and Kherson regions is a sneaky, deadly moving of the geopolitical goalposts. Any attempt to liberate these areas of Ukraine would now, in the eyes of the Kremlin, an attack on Russia itself, and it has the right to respond as it sees fit.

From a military point of view, this elevates the risks around Ukraine, and in particular heightens the probability of a strategic mistake or tail event (i.e. such as the destruction of a NATO satellite or an attack on a Baltic state). Putin’s move also increases the risk of socio-political risk within Russia. As I am not a military expert but prefer to write on economic development and the rise and fall of states, I will focus on that.

The Filaytev diaries say much about Russia. It is a country that until recently had poor levels of human development, especially in healthcare and life expectancy (which has been rising from low levels). In this context, Vladimir Putin’s vision of Russia as a superpower is hollow – unless a nation can sustain improving levels of human development (through education, good healthcare, freedom of thought) it will not sustain the core drivers of growth, such as productivity. This a lesson for China, the UK and the US to follow. In China and the UK (productivity is falling) whereas in the USA life expectancy had dropped sharply (below that of China).

 In coming years, I am sure many will write about the surprisingly poor quality of the Russian army, and in the context of this note, it is simply another marker for poor quality development. This is perhaps one reason why when emerging market crises strike, they happen slowly, then very quickly. Incompetent institutions, poor rule of law and a prohibition on intelligent policy making can for some time be camouflaged by superficial growth, but all very quickly melt away in moments of stress (Russia has sadly seen this before).

The risk is that other institutions go the same way. As Putin announced the mobilization there were rumours that the highly regarded head of the Russian central bank, Elvira Nabiullina, had resigned (she had apparently tried to do the same in March). This has not been confirmed but raises the question as to the seaworthiness of the full range of Russian institutions in a stormy geopolitical climate. Increasingly, the pressure will be on Russia, and from multiple angles.

As a last word, I want to return to the Crimean War. It is not inconceivable that Corkmen from villages like Whitegate were shelled by Leo Tolstoy, at the time a young artillery officer. Tolstoy’s experience of war affected him greatly. In the context of Putin’s recent mobilization it is worth recalling some advice he gave to a young man ‘all just people must refuse to become soldiers’. Many young Russians are thinking the same today.

Have a great week ahead,

Mike

Europower

Whenever there is a crisis in Europe, and the EU has to evolve, the rejoinder goes up that Jean Monnet, one of its founding fathers said ‘Europe needs a crisis to move forward’, and Europe then muddles through. It is, however, worth noting a different point of view. Monnet’s father, a merchant from Cognac is on record as saying, “Every new idea is a bad idea.”

Monnet senior’s views would not find as much favour in Brussels as before, largely because the world is changing rapidly, and Europe’s leaders are waking up to the new to realities of the end of the globalized world system and the arrival of a multipolar world, thanks in large part to the actions of three ‘strong’ men- Donald Trump, Vladimir Putin and Xi Jinping.

Trump has sowed doubt in European minds that the US may be in political decline and that it could be a less reliable partner, Xi has awoken them to the realization that trade with China involves a double-edged compromise, whilst Putin reminds them that Europe is again challenged by uncompromising evil, and needs to combat this.

I have written many times about the gathering momentum towards the notion of Europe as a geopolitical power. What is new is the speed at which this is happening. Europe took some five years to bring order to its fiscal and economic policy, and this is still half-formed. In contrast, European foreign, security, energy and political policies have been transformed in six months. The import of this transformation is not yet appreciated in Beijing, Washington, and London.

These capitals may feel that they are better off dealing with individual governments in Europe than the EU itself. Brexit, where the EU Commissioner was the trusted negotiator for the 27 countries, showed that this is increasingly less the case, and the response to the energy crisis also shows that EU countries are better together.

In the next few years, the idea of Europe as a power is likely to take hold. Practically what this means is that it will seek a more distinctive and powerful voice (at EU level) on foreign policy and that this will be informed by the EU’s social democratic values.

Correspondingly, Europe will have a more coherent, broader defense and security policy that will spill over to the idea of industrial sovereignty – effectively Europe will be ‘self-sufficient’ or have autonomy in key defense, industrial and technological areas. To a certain degree, Europe is simply catching up with the US and China here. From an investment point of view, we should expect to see deep secular trends in green energy, environmental technologies, defense and cyber security, and consolidation across fintech and healthtech in Europe.

Sceptics may feel that they have seen it all before.

There are clear hurdles. The first is the game-theoretic aspect of shaping ‘common’ policies, and then ensuring that the implementation of these does not fall foul of political developments in individual member states (e.g. Italy). Additionally, with Germany still in a state of geopolitical confusion, much depends on France getting on with the likes of Lithuania and Poland.

The second is the implementation – for instance fostering innovation in new technologies and building a tangible sense of what ‘European values’ mean to people, are best done bottom up (a very good example is the recent launch of Democracy Next http://www.demnext.org), than top-down as is the way in Brussels.

In that respect, there are a few proving points ahead. One is whether the EC will appoint a high profile foreign affairs commissioner and give him/her additional power and institutional capacity over policy, so that they do not play second fiddle to the French and German foreign ministers. Another test relates to the nature of defense spending and, apart from all the tanks and helicopters that individual armies like Germany need, whether more is spent on ‘common’ defense infrastructure such as heavy lifting aircraft. Related to this, a further test is whether the EU is prepared to take aggressive, as opposed to defensive, action against another state. An EU coordinated cyber-attack on one of a number of ‘Internet Research Agencies’ would be a significant development.

One ‘test’ that is looming is in the realm of democracy. Europe’s leaders have talked a lot about its democratic values, and the invasion of Ukraine has brought this into stark focus. What is new is that this debate was the focus of Ursula von der Leyen’s annual address last Wednesday where she criticized ‘Trojan horses that attack our democracy from within’ and notably stated that ‘many of us have taken democracy for granted for too long. Especially those, like me, who have never experienced what it means to live under the fist of an authoritarian regime’.

In that context, Hungary is the test case. It is likely to be deprived of billions in EU funding (up to Eur 40bn), and there is growing talk of finding legal means to exclude it from the European Council, and potentially the EU. The current mood in Brussels is, given Viktor Orban’s closeness to Russia, to push Hungary very hard. 

Brutal

In a very different age (2004) when the euro traded well above the dollar (1.30 in late 2004, as opposed to .999 today), Jean-Claude Trichet, the then chief of the European Central Bank declared that ‘brutal’ moves in the euro were unwelcome. His use of the word ‘brutal’ – it has a far stronger meaning in English than in French – and he, as the son of a literature professor might have known better – led to even more jumpiness in markets.

A couple of years later (July 2008), Trichet made another, school-boy error – raising interest rates in an apparent response to a spike in the price of oil. Coming one month before the biggest financial crisis in recent history, it was a clumsy move given, in any case, the tenuous relationship between the price of oil and euro-zone rates. It was also a mistake that set the scene for the rest of Trichet’s stewardship of the euro-zone during its crisis period.

It is a case study that is worth examining again in the light of last week’s ECB meeting where rates were raised by 0.75% and where the ECB expects inflation to persist above 5% through 2023, having confidently forecast it closer to 2% at the start of this year. The ECB cannot expect that the blunt instrument of monetary policy will have any effect on gas and electricity prices – both of which are driven by market micro-structures and the complexities of geopolitics.

At the same time, the ECB like the Fed, is privately aware of the embarrassing inaccuracy of its forecasts (see our note of November 2021 ‘Pantomime Monetary Policy’) and the risk that a decade of easy monetary policy has let the inflation genie loose (see property and service price inflation for instance). For that reason, I suspect that the ECB, like other central banks, will continue to lean against inflation, with the high risk that we see a recession in Europe by year end. Markets are currently pricing in 2% in interest rate hikes up to next March, even as European manufacturing activity and consumer sentiment collapse, and financial conditions tighten. Another mistake may be in the offing.

There is however an important change afoot.

In 2011, in the thick of the euro-zone financial crisis when Mario Draghi became the ECB President, he and the institution were effectively the glue holding the Union together. Many of the deep political and policy relationships at the EU were forged during the euro-zone crisis and helped to build the sense of solidarity that carried through to negotiations with Britain on Brexit, and the urgency that is now manifest at the Commission level.

To that end the EU is now evolving at a rate and a magnitude that is still largely unappreciated. It has Vladimir Putin and to a lesser extent, Donald Trump to thank for imparting a sense of urgency to the EU’s strategic deliberations across foreign, energy and security policy in particular.

In the last week it has begun to show that it can take aim at electricity(gas) prices – something that individual states could not do on their own without surrendering their moral capital (with the exception of Hungary). The EU itself will not be able to kill off broad inflation – that is the job of the ECB – but it can certainly curb the pernicious effects of the weaponization of energy by Russia, and in so doing avoid misery and the risk of social unrest. It may also need a coordinated framework for the institutional support of utilities and energy producers, many of whom are as financially stressed as the sub-prime sector was in 2009.

My own sense is that the ‘winter energy’ chaos that some speak of will not materialize in as extreme a manner as feared (nuclear, hydro powered electricity are rebounding in capacity), and that the ultimate consequence of the spike in gas prices will be to destroy the largest source of demand for Russian energy.

In that context, the EU will emerge stronger and better prepared from this crisis, in the same way as it has done in the aftermath of Brexit. As it evolves, the ECB should also examine how it can improve and adapt to a changing world.

Here I want to reiterate a few suggestions I have made in recent years, starting with diversity. Central banking is not a diverse place, made up mostly of middle-aged males. What is more telling is that all of these males, and the growing number of females that join them, are formed in the same way and look at the world in a similar fashion.

Most of the members of the policy committees of the Fed and ECB have spent their careers in central banking circles, with the odd jaunt in and out of academia. As a result there is little diversity of experience at the top of the main central banks, and central bankers are not well socialized to the implications of their policies on the outside world. In the future, in addition to greater gender diversity, it may well be useful for central banks to appoint decision makers with a greater variety of experience across industry and other related walks of life.

A really important sub-element here is to appoint policy makers with a sense of the consequences of their actions, and an ability to alter their view when it is wrong. Forecasting as they say is hard, especially when it is about the future and to a large extent the role of the central banker is about mapping and creating a vision of the economic future.

Where this vision jars with reality, policy makers should ideally be conditioned to rethink their positions or be equipped with simple devices like the Bank of England Governor’s ‘letter to the Chancellor’ (the Governor must write an explanatory letter to the Chancellor if inflation deviates from target by over 1%).

A further innovation, at least for the ECB is to give local central banks more autonomy over their economies. This will take a degree of experimentation but the idea is that depending on the structure of an individual economy (compare Ireland and Greece to Texas and Kansas), specific macro-prudential policy levers could be developed to cool or speed up local economies in the context of overall monetary policy.

My pessimistic conclusion is that many of these and other suggestions will have to wait until the next recession to get a hearing, when central banks start to prosecute QE4 to undo their most recent mistake.

Five More Years!

One of the (many) remarkable American political events of recent months has been the defeat of Liz Cheney in the primary race to regain her Republican seat in Congress. Cheney is republican royalty, at least as far as the Bush/Reagan Republicans are concerned. Her father (see Barton Gellman’s book ‘Angler’ as a reference point) was integral to many Republican administrations, and devious enough that when George W Bush asked him to search for a vice-presidential candidate, Cheney could find no-one better than himself.

In Congress, Liz Cheney’s voting record has been sufficiently red-blooded that there is no doubting her convictions, save that she is a rare example of a Republican resisting Trump sycophantism. She is experienced and learned enough to realise the threat that he represents to American democracy and is making this her stand. In so doing, and in promising to derail a 2024 Trump presidential campaign, Cheney may become the catalyst to split the Republican Party, which like the Tory Party in the UK, is a cauldron of venom and confusion.

If the Republicans were to split, the centre group of American politics might open up, whilst the Trump Republicans could amuse themselves on the fringes of the political establishment and social media. To that end, the coming mid-term elections – which have already been heavily influenced by the Supreme Court judgement on nation-wide access to abortion – will be telling. Interestingly, they may not be the most significant political event this autumn.

Against an international backdrop where democracies are fighting within themselves in an often-existential way, and where in the context of the invasion of Ukraine and tensions around Taiwan, the democratic and autocratic worlds are facing off in an increasingly hostile way, the key event will be the meeting of the Chinese Communist Party in late October, early November.

This event is key because it will likely anoint a third term in government for Xi Jinping, and usher in some important personal changes – notably a new prime minister for China and the retirement of Wang Qishan.

It is an underestimated watershed event in the sense that it marks a phase change in China’s rise from a one-party to a one -man state. If the example of America proves that democracy begets prosperity, China is the powerful counterexample that proves that a controlled, state directed economy can also thrive. The transition to ‘Xi for life’ could upset this, and in this context, there are several considerations to bear in mind (not least with markets looking complacent).

The first short-term one rests on Xi’s need for a show of force in the lead up to the CCP meeting. While we risk assuming that Chinese politicians have a ‘wag the dog’ (see the 1990’s book ‘American Hero’ by Larry Beinhart and film of this title) tendency in the same fashion as their US counterparts, a continuation of strongarm tactics around Taiwan (a blockade or even the seizure of a small island) is a possibility.

A more pernicious and damaging trend within China are the side-effects that Xi’s instincts for control are having – at least three have come to my attention. The first is the debilitating effect on public morale and the economy of the various COVID lockdowns, and the discrete rumblings that these are creating within the broad church that is the Communist Party. The second is the effective split between the Party and the business community that has developed because of Xi’s anti-corruption drives and his promises of a less unequal wealth distribution (‘common prosperity’) and the third relates to the hushing of open, intellectual endeavour and vibrancy of discussion around social and political affairs. By extension, this makes Chinese politics extremely hard to decipher.

In this respect, the great danger for China is that it has someone at the helm who smothers innovation at a time when China needs it most. With the demographic cycle shifting downwards, growth slowing and the property market looking precarious, the risk for Xi is that he fails to deliver on the ‘China Dream’ concept he started expounding in late 2012/early 2013. Bear in mind the sobering fact that youth unemployment in China is now 20%.

In the rise of a country from emerging to developed status, the key variable to watch is continuous improvements in productivity, and in China this is faltering. In that respect the great surprise would be that Xi is a lame duck president by 2027, when Liz Cheney might be starting her presidential campaign for 2028.

I am taking a break for two weeks and this column will resume on September 10th. Have a great week ahead, Mike 

Heat

Ireland is in a crisis. Temperatures have recently hit all-time highs and oddly persisted so that unusually, people enjoy weeklong stretches of warmth and blue skies without the punctuation of rainy showers. This has understandably bred some confusion.

Extreme temperatures in Ireland need to be considered relative to our geography – the recent peak of 33C was the highest since 1887 – a time when Oscar Wilde was writing plays and perhaps, the first inklings of ‘Dracula’ came into Bram Stoker’s head. Yet, the rest of the world might regard our ‘sub – 30’s heatwave’ as a luxury – in a week when the Rhine and Loire ran dry, the Lee and Shannon brim onwards.

By comparison, Britain has fared less well, with large tracts of land scorched and temperatures pushing into the high thirties. Interestingly, for those who care about the climate, the Met Office’s Hadley Centre keep an excellent database on temperatures, going well back in history to 1659, which permits fascinating comparisons of temperature with historical events. The series unambiguously shows the recent decade has been the hottest in history, what looks like a trend departure in climate dynamics.

The Hadley database shows that recent temperature highs in Britain have only been seen in 1990 (briefly), and 1911. 1911 was interesting in that like today it was a time of great political volatility. Secession and independence were prominent issues (Ireland then, as with Taiwan and Ukraine today) and the path toward a great war was materializing (Germany and Britain then, China and the US now), and public unrest was common (between 1911 to 1914). Additionally, as we have stressed on many occasions, globalization was coming asunder then, as it is now.

Whilst, I am not sure that climate change played a role in the fall of 19/20th century version of globalization, but it surely will in the 21st century.

What might be a more interesting proposition is whether climate impacts politics. In 1911, the close confines of the Westminster chamber meant that in the context of record heat, members of parliament became raucous, smelly and rebellious. This was mirrored across the country, and a warship was sent up the Mersey to protect food supplies.

Another obvious coincidence of politics and climate stress was the ‘Winter of Discontent’ when in the context of food shortages, ferociously cold weather and a lorry driver strike, Jim Callaghan’s return from the warmth of the Caribbean kickstarted a political crisis that led to his demise (Crisis, What Crisis?). With French and German electricity prices spiking to stratospheric levels, and Olaf Scholz pronouncing that it is unlikely that food and energy shortages in Germany will produce unrest, we can expect to see just that in Germany this winter.

There are other ways in which climate and our experience of it feed back onto our political behaviour.  In the United States, despite rigorous research by a dozen federal bodies to the effect that this period is now the warmest in the history of modern civilization owing principally to greenhouse gases, many Americans are skeptical that climate change is man-made.

For instance, only 30 percent of Republican voters believe that climate change is driven by human activity, yet academic research has shown that among Republican voters, there is a significant degree of difference of opinion on climate change. For example, Republicans living in coastal areas—in California and Florida, for instance, two states where climate change is increasingly evident—have a much higher than average (compared to other Republicans) sense that climate change is ongoing. Having noted this, it still doesn’t make sense to wait until the earth is entirely parched to convince people of the need for action on climate change.

In this respect the passing of climate legislation in the US is welcome, though a preoccupation for many governments will be less staving off climate damage but rather limiting its economic impact for fear of the socio-political effects that this may have. In a week when British newspapers talked of 5,000 GBP annual fuel bills, it is noticeable that the UK is the one country in Europe (Estonia also) where the burden of the rise in the cost of living is far greater for lower income households than wealthier ones.

The final link between climate change and politics that needs to be stressed is that at a time when the level and rate of climate damage have stepped up and are beginning to render parts of the world uninhabitable (the 2022 World Cup will be an homage to this), there needs to be close cooperation between the major regions, governments, large cities and corporations.

As we noted last week, a ‘Schism’ is developing between the large regions and this fracturing is now impacting corporate investment (China’s largest companies have announced that they will delist from the US stock market). Climate is becoming weaponized.

Have a great week ahead,

Mike

The Tech Schism

One of the key events in the rupturing of relations between the USA and China was a speech by Vice President Mike Pence in October 2018 at the Hudson Institute, which was breathtaking in its hostility to China. The speech was followed two months later by the arrest of Meng Wanzhou, chief financial officer of Huawei, in Canada at the bequest of the Trump administration. At this point, the fracturing relationship between the US and China begun to also run through the global technology industry.

The Trump administration’s policy towards China was a rare example of them fashioning and then leading the consensus across the American political, industrial and military complex. Many corporate leaders in the US who disdained the style and content of Trump’s politics in general, were glad of his scolding of China, and to a large extent felt that a watershed had arrived in this relationship where China would no longer ‘import’ innovation from the West in return for exporting deflation.

On their side, Chinese policymakers, many of whom had studied and lived in America in order to better understand it, only to be confronted by an untypical American leader, also felt that a watershed had arrived – China is a now a world power and needs to assert itself. Indeed, since that period, China has managed to aggravate most of its neighbours across Asia (skirmishing with India troops, haranguing Australia and provoking Japan for instance).

In that context, China’s (over) reaction to Nancy Pelosi’s visit to Taiwan, is itself a watershed. They might very easily have dismissed this event as showboating by a publicity hungry Western politician but didn’t.

The military led response betrayed much about Xi Jinping’s leadership, China’s reading of its military readiness and regional standing. The side-effect will be an acceleration in the game-theoretic scenarios around a Taiwan centric geopolitical contest. I am not an expert here so will leave the framing of this to others, save to say that as we posited a couple of weeks ago, Taiwan will now feature more prominently in thriller scripts (Thriller in Tanegashima).

From an economic and strategic point of view, what Pelosi’s visit does, following the Huawei thread, is to bring governments and technology companies closer together (appropriately her husband Paul’s trading record in tech stocks is second to none!).

The semiconductor industry is a good example. In recent weeks Taiwan’s MediaTek and Intel have signed a production agreement, the US has passed the CHIPS Act which encourages semiconductor chip manufacturing in the US, and forces overseas technology companies (e.g. Samsung and SK Hynix) to choose the US technology marketplace over that of China. Meanwhile China’s SMIC has reportedly made advances in its chip technology (this is one sector where China badly lags the west).

The great schism of globalization now means that technology companies (especially those in sensitive areas) need to choose sides. This is likely to be the same for consumer brands like Nike and Apple, though perhaps not for French brands who can pretend not to care.

There are several ways in which technology companies are becoming closer. Several American data, internet and communications companies have actively helped Ukraine, the same is true of the US cybersecurity community. Notably the invasion of Ukraine is reconfiguring the techno-defense industry, across the US and Europe.

Drones, AI, signals, space war (recall Trump’s SpaceForce), railguns and robotics are just some of the emerging fields in defense research and development, at a time when world defense spending is hitting a record USD 2.3 trn. The arms race has taken on a new, intensely tech driven aspect – we only need to read scenarios of what a South China Sean naval battle might look like (hypersonic missiles, lasers, cyber-attacks).

Away from the battlefield, in general, across the three large regions, technology companies at the centre of strategic activities are being drawn closer to their governments, and in some cases are spending more on lobbying them. A race is on, not just to build lead edge technologies, but to also lea ahead in setting the standards and norms that oversee them.  

In that light, regulation of technology and data is also becoming more region specific, to the extent that the activities of say Chinese companies in Europe and the US are becoming more problematic.

Other, newer technologies are witnessing this too. For example, one of the key battles in finance is between crypto centric defi (or decentralized financial networks) and the old fashioned’ financial world. The withdrawal of liquidity by an ‘old’ institution in the form of the Federal Reserve, has triggered a collapse in parts of the crypto world, where many exchanges have failed and the entire crypto exchange sector is being investigated by the SEC. To a large extent this effort is aimed at limiting fraud and bad behaviour, but there is also a strategic element, gaining control over the ‘defi’ world.

The ‘metaverse’ may well see similar treatment. Though it exists beyond our real world, the companies that are creating it ‘Facebook/Meta’ are well grounded in the public policy and affairs of the ‘old world’.

So, while the outburst of Chinese nationalism (expect more of this) is the manifest effect of around the Pelosi visit, the event is now just one of many that will see a world where technology – in its innovations, initiatives, regulation – also becomes more regional.

Have a great week ahead,

Mike

The Street Without Joy

One of the notable, early films to come out of the German speaking world was the ‘The Street without Joy’ based on Hugo Bettauer’s book (‘Die freudlose Gasse/The Street without Joy) and starring Greta Garbo. Set in Vienna during a period of economic hardship and high inflation, the story without getting into too much detail, is a morality tale borne out of the ways poverty stress tests our moral compass.

In today’s context of high inflation – still printing 8% in Germany for instance – and now an official recession in the USA (two consecutive quarters of negative GDP growth), moral compasses are whirring with the contortions that higher prices bring. Germany foreign policy is an example. As gas prices rise there is background chatter of taking a less aggressive stance on Russia. Hungary has long ago capitulated here.

In a number of missives this year we have noted that higher food prices in particular will make life difficult for incumbent centrist governments and relatively easy for populists (just look at Italy) and that there will likely be unrest in a number of countries (dramatically so in Sri Lanka).

Another profound effect of higher inflation is the socio-economic choice it pushes on central banks. If they decide to crush inflation, and continue rate increases until inflation overshoots to the downside then this will cause a recession but will likely result in a relative reduction in the wealth of the rich compared to the rest of us (though in absolute terms we are all likely worse off). If central banks veer away from monetary sadism, and permit structurally higher inflation, this could cause a run up in some asset prices which on balance will stretch wealth inequality to new, multi century highs.

Against this backdrop, if we bear in mind the results of research by some German social scientists and economists at the ifo institute (Funke and Trebesch) that showed how the echo of the global financial crisis manifest itself in the rise of the far right across Europe, then we must think of the social and political effects of higher inflation.

Looming behind all of this is the spectre of the 1920’s/30’s and while it would be nice to have the likes of Greta Garbo, and Marlene Dietrich back with us, a 20’s style collapse of economies and the political order is no longer an outlandish proposition.

The moral aspects of the pressures induced by higher inflation can be pernicious and extend well beyond the tendency for food companies to put fewer crisps in the crisp packet.

The first is that a range of companies will pass higher inputs on to customers and in the case of many banks, they will increase credit related charges to customers (credit card debt in the USA is at an all time high), with the end effect of further penalizing those who may most need credit.

A second is that in the longer run, what economists call ‘human development’ will suffer – people will arguably eat less well, may crimp on education and health expenditures – and it is now well documented (see Anne case and Angus Deaton’s work for instance) that human development scores (most notably life expectancy) in the USA are dropping sharply.

Third, geopolitically, the inflation wave is redistributing power, largely through the strong dollar on one side and emerging market stresses. Notably as the likes of Argentina go through more financial stress its position vis a vis its creditors and external institutions will diminish even further. It would be good to think that in such countries, yet another crisis will force a rethink on economic management, but it is likely to prompt more populism.

What also remains to be seen, and surprisingly was not the case, is whether there will be a decisive backlash against large businesses and landowners, internationally. Will Sri Lanka or some African states nationalize assets owned or loaned to China and will international property companies be targeted by protesters as is now the case in Spain.

In grave economic crises, this kind of political aftershock is often the result of an earlier macroeconomic crisis. We are seeing other signs – unionization in the USA is the lowest it has been in multiple decades, but in parts beginning to pick up. I am not sure that Andrew Yang’s new political party ‘Forward’ (very Macron-like) is a response to bad economics or bad politics, but such a bi-partisan effort is welcome (though I suspect it will not succeed).

Incumbent politicians reading articles like this might also wonder – what should we do? For that reason, I suspect we will see higher taxes on corporates (energy companies in the USA), potentially on property developers, and a greater effort to improve public services like transport and healthcare. The lesson of the global financial crisis is that policymakers did not go far enough in tackling the root causes and culprits of the financial crisis.  Let’s see if they have learnt this.

Have a great week ahead,

Mike 

From ‘whatever it takes’ to ‘whatever’

I have started to write a new book – this time on democracy and politics in France (with Pierre-Charles Pradier), but with the usual impeccable timing I think I may have chosen the wrong subject at the wrong time. Against a backdrop where the Tory Party is about to choose Liz Truss as its leader, and Italy has proven too much for the admirable Mario Draghi, France is a bastion of political peace and stability!

At the time of writing, it looks like Mario Draghi’s time in Italian politics is over (he may yet become president) and given the way he led the country during the COVID crisis, oversaw a rebound in its economy and restored the authority of Italy as a foreign policy voice, this is a loss for Italy. Moreover, that someone of his credibility and achievement can be spat out by a political system is deeply disheartening.

From a political labour market point of view Draghi is the ‘opposite’ experiment to the likes of Boris Johnson, Liz Truss, Donald Trump and Jair Bolsonaro and a growing list of other opportunists in the sense that he entered politics from a position of strength and accomplishment and was likely more motivated by public service than self-interest. He may have lacked the popular touch, but at a time when most people are put off public life by its viciousness, the potential exit of Draghi is a pity, and a costly mistake for Italy.

The government he led collapsed for several reasons. One is that the populist 5 Star party has found its support shrink given its role in government. The decision of Luigi di Maio to leave 5 Star and pursue a more serious political career shows that for some at least there is a viable transition from populism to power.

Similarly, to 5 Star, the two right wing parties in the Draghi government, the Northern League (Lega) and Forza Italia (recall Berlusconi) have lost their lustre with voters because of their participation in government and have been surpassed on the right by Giorgia Meloni’s Fratelli d’Italia party. She is interesting, for mostly the wrong reasons.

To start with, there are at least two similarities with France. The first is that in terms of parties, Italy’s system is fragmented – comprising a centre (France’s centre is larger and more robust) surrounded by parties of the ‘far’ right and left, that style themselves as being against the ‘system’.

In recent years ‘anti-system’ parties in Italy have positioned themselves against Europe and the euro, though the new development is that whilst being ‘anti-Brussels’ Meloni’s rhetoric is more ‘anti-globalist’ (Draghi is seen as a high priest of this movement, whose capitol is Davos). Similarly French politics has switched from a left-right wing axis toward one where disenchanted locals pit themselves against the elite globalists (as they portray Macron).

Meloni is also interesting politically in that she cultivates relationships with far-right politicians in other countries – Le Pen in France (whose niece is also building an international network of neo-facists), Orban in Hungary and some Republicans in the US. Whilst this is not a novel development, there are few such networks, and in this case, it is a menacing one.

This made all the more worrying by the links that Italian political parties have to Russia, notably Meloni, Matteo Salvini of the Northern League and of course Berlusconi’s personal ties to Vladimir Putin. Given what is happening to Ukraine, these ties have, in the context of elections and a new government, the potential to undercut support for Ukraine from Italy, and to permit Moscow an avenue through which to destabilise Europe’s response.

There will now be an election on September 25, and polls suggest that the next government (a technocrat led caretaker government till next spring is also possible) will be formed of (far) right parties, possibly led by Meloni, orchestrated by Berlusconi. It is still possible that Italians revolt against the populist parties (one thousand mayors have signed a petition in support of Draghi)

Broadly speaking the policy agenda of the right lacks originality, and squanders whatever fiscal space Italy possesses. The ECB’s new ‘anti-fragmentation’ policy toolbox complicates things even further because the conditionality it demands is only found in economically upright, cooperative euro-zone countries. To that end, Italy may become a source of political tension with Brussels, and volatility in bond markets. The one important carrot Brussels has in the EU Next Generation Fund, where further disbursements are contingent on ‘good behavior’.

The greater challenge for Italy’s political class, having jettisoned Draghi, is to come up with either a leader or a set of policies that bring growth to Italy, and give it more of the prestige that Draghi brought. Like most populists, they will likely do the opposite. 

Have a great week ahead,

Mike

AI – The Final Problem

The Swiss government’s Spiez Laboratory, one of whose specialisations is the study of deadly toxins and infectious diseases, is located right in the heart of Switzerland, incidentally not too far away from the Reichenbach Falls, where Sherlock Holmes vanquished Professor Moriarty (more about him later) in ‘The Final Problem’.

Nine months ago, scientists at the Lab performed an experiment where they deployed their artificial intelligence driven drug discovery platform called MegaSyn to investigate how it might perform if it were untethered from its usual parameters. Like many AI platforms MegaSyn relies on a large database (in this case public databases of molecular structures and related bioactivity data) which it ordinarily uses to learn how to fasten together new molecular combinations to accelerate drug discovery. The rationale is that MegaSyn can avoid toxicity in molecules, and thus sift ‘good’ ones.

In the Spiez experiment MegaSyn was left unconstrained by the need to produce good outcomes, and having run overnight, 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.

Another recent example is the reported conversation between Blake Lemoine, a Google employee, and a computer program called LaMDA which Lemoine reported publicly as being sentient. Whether this is true or not, we are at a stage where AI is advancing towards AGI or Artificial General Intelligence, where computers can learn and begin to think like humans, not unlike Alan Turing’s famous ‘test’. Indeed, an AI program called GPT-3 can write half decent fiction.

Scarily still, there is already plenty of evidence to suggest that AI is playing a military role. In Ukraine, drones have been programmed to recognise Russian military equipment and to attack it. Larger nations can harness AI to weapon systems to make them seek and destroy their enemy and having seen the effect that drone technology has had in the Nagorno-Karabakh war, we may not be far from an AI driven war.

This example and the broader emerging debate around AI give us a sense that in the new world order that is being formed, there are multiple, complex axes. For example, much is made of the growing strategic rivalry between the USA and China, and part of this rivalry will surely focus on AI – in terms of computing power and access to large public and private data sets (Europe is ahead of both the US in seeking to rein in how data is used in AI). Within these large regions, another line of tension will run between humans and the impact that AI has on their lives (such as on minorities).

It is, however, not all negative. In a widely reported experiment last week, a project called Democratic AI allocated the outcomes from an investment game, in a way that was more egalitarian than the outcomes chosen by purely human actors. It suggests that whilst the research benefits (and dangers) of AI in settings like biotechnology are more tangible, there are also very clear policy outcomes (for democracy and public policy) as well.

At this stage, it is not controversial to say that most governments are far behind where they need to be in understanding and better marshalling the effects of AI on our lives (from insurance contracts to airline prices to the interaction between social media and politics). While I can’t claim to have a clear insight myself, I can recommend a few decent resources – the State of AI report, Kai-Fu Lee and Quifan Chen’s book ‘AI 2041’ not to mention the entertaining ‘the Love Makers’ by Aifric Campbell.

Now back to Moriarty, another man with dark dreams of being ‘world king’. Rumour has it that one of the people that inspired Arthur Conan Doyle’s characterisation of Moriarty was George Boole, Professor of Maths at University College Cork from 1849. Boole, one of the great mathematicians, created Boolean algebra which laid the foundations for computer language and is this the structure around which scientists use machines to mimic and ‘improve’ on human behaviour.

I spent years in the basement of UCC’s Boole Library, slaving away on AI – though I didn’t know it at the time. The trouble is that back then it was called regression analysis, data sets were very, very limited and computing power was, from today’s perspective, prehistoric (see my account).

If I had known that the regression caterpillar would turn into an AI butterfly I might have stuck with it. My lesson is that computing power, and in certain cases data sets, will improve further, and as they do, they will push the boundaries of law, moral philosophy and strategic competition between the large regions.

Time to bring back Sherlock!

Have a great week ahead,

Mike

The Pain Trade

In the film Mutiny on the Bounty, Captain Bligh declares to his militant crew that ‘beatings will continue till morale improves’. This tactic doesn’t end well for Bligh, though he eventually makes it to safety. Yet, the notion of ‘beating till the morale improves’ is perhaps better applied to financial markets. As a very simple rule, in the case of underlying imbalances or economic stress, they (market prices) will often extend to levels that cause pain.

The past number of weeks have been an excellent case in point. Extreme moves in commodity prices for instance have caused hardship, political turmoil, and increasingly, unrest (Sri Lanka for instance). This introduces several levels of socio-political complexity into the debate on markets. The value of free moving prices (as opposed to those under the spell of quantitative easing) is that they send signals about the health of the world economy and its moving parts. Policy makers should pay attention to these and map their implications (will we have fuel shortages and power cuts this winter?).

There is also a countervailing argument that extreme price moves that harm people’s livelihoods should be curbed. To an extent that is hard to do on a consistent basis and is ultimately the role of central banks at a broad level – most of whom have failed their mandates. We should expect that for the rest of this year, many nervous governments will deplete their fiscal capital.

One market signal worth paying attention to is the dollar, whose recent strength has manifest itself as yen weakness, and is now driving the euro down towards parity with the dollar. A range of emerging market currencies – Chilean peso for instance – have also sold off. At one level these moves can be interpreted as individual regional stresses (German trade weakness notably) but a more comprehensive view is that dollar strength is signaling demand by investors for safe(r) assets and money. Should dollar strength persist, it should be a cause for concern, as a signal of what is occurring in portfolios, and for the spillover effects that could produce a mini ‘dollar’ crisis (see this ‘our dollar, your problem’ note from David Skilling).

With the half year point now here and having been through multiple sell-offs (commodities being the latest), the pain trade is still likely with us, but could be expressed in two very distinct ‘pain’ channels, both of which depend on the reaction function of central bankers and will have marked socio-economic effects in years ahead.

It is possible that, mindful of the drop in commodity prices and especially the more politically sensitive aspects of these (gasoline prices) and the implications of this for headline inflation, central bankers begin to soften their message on ‘killing off’ inflation. In particular, it is not yet clear that central bankers have the levels of monetary sadism required to stomach the collateral economic and political damage associated with thoroughly suppressing inflation. In that respect they might adopt a ‘living with higher prices, avoiding recession’ stance.

While to a certain extent this is priced into interest rate markets (they expect the Fed to cut rates through 2023 and mortgage rates are dropping from a high level) an ‘inflation permissive’ message from central bankers would set in train a new market and economic regime.

Bond markets would weaken, commodities rally as an inflation hedge, as would the stocks of companies with pricing power. It may also be that the equity value of companies with large debt levels would rise, given the real effect of high inflation/steady rates on debt. Economically however, the prospect of a higher trend level of inflation could lead to upward pressure on wages, at least for those who have bargaining power, and in broad terms would lead to a relative transfer of wealth from asset poor lower income workers to wealthier, higher earners.

Another monetary piste down which the Federal Reserve and other central banks can travel is to persist in the fight to flatten inflation (for the moment the most likely scenario). This bid to reinforce their credibility would occur in the face of weakening economic activity (the Fed has unusually been raising interest rates in the face of record lows in consumer confidence), where they would continue to ratchet rates upwards until inflation overshot to the downside (early next year).

The effect of this in wealth terms would be more vicious deflation in asset values, most notably property prices in the developed world (Australia, Canada, the US are vulnerable). The economic effect would entail a sharp recession, and a large negative wealth effect on the wealthier classes. Politically, a number of governments would, simply by association bear the downside (though Biden’s approval ratings are already strongly negatively correlated with inflation) and we may well likely see a sharp deterioration in relations between politicians and central bankers.

Many central bankers would understandably wish that inflation would melt away, and to a large extent supply chain blockages and commodity price rises are ebbing. There is still the risk that service price inflation and rents push higher, and that these rises prove sticky and hard to reverse. Resolving these pressures will be complex and will involve a coordinated effort between governments and central banks to best distribute the economic ‘pain’, and at a time of great change, maintain social cohesion (mindful of the political consequences of the 2009 global financial crisis).

Have a great week ahead,

Mike