This is a big-picture debate. Bigger than I’ve seen in decades. Perhaps my lifetime.
Everybody agrees that the great globlisation is over. The great moderation may be over with it. Not to mention the peace between great powers.
On the one hand, we have what might be described as a school of conventional monetarists worrying up a storm about the consequences for liberal powers of accumulated debt stocks, future martial spending and social pressures, and rising inflation.
On the other hand, we have a smaller school of demographic and balance of payments experts that see liberal economies liberated from the illiberal mercantilists of the emerging world and the latter falling away.
Let’s begin with what we know. For that, Zoltan Poszar of Credit Suisse is leading the charge:
War cuts new financial channels.
What are G7 policymakers, rates traders, and strategists to do when threats to the unipolar world order are coming from every angle. They should definitely not ignore the threats, but they still do. How could they not? For two generations, we did not have to discount geopolitical risks. Since the end of WWII, the only Great Power conflict investors really had to deal with was the Cold War, and since the conclusion of the Cold War, the world enjoyed a unipolar “moment” – the U.S. was the undisputed hegemon, globalization was the economic order, and theU.S. dollarwas the currency of choice.But today, geopolitics has reared its ugly head again: for the first time since WWII, there is a formidable challenger
to the existing world order, and for the first time in its young history, the U.S. is facing off against an economically equal or, by somemeasures, superior adversary.China is proactively writing a new set of rules as it replays the “Great Game”, creating a new type of globalization with new institutions like the Belt and Road Initiative, BRICS+, and the SCO. Global warming is helping Russia add an “artic suspender” to China’s Belt and Road vision, and China, while under lockdown, forged a special relationship not just with Russia but all of OPEC+. And as Pippa Malmgren recently noted, commodity-rich Africa is now also a frontier in what I called the quest for “commodity encumbrance”. One Belt, One Road (and an Artic Suspender) means…
…One World, Two Systems. Maybe not in these words, but I am sure you have heard these themes before and that you are aware of them. And if you are…
…you should stop pretending that this means nothing for the U.S. dollar or demand for Treasury securities. If the world is going from unipolar to multipolar; if the world is gradually drifting from “one world, one system” (globalization) to “one world, two systems” (friendshoring and Belt and Road); and if the G20 is seemingly splitting into the “G7 + Australia”, “BRICS+”, and “the non-aligned”, it’s impossible that this split won’t affect the international monetary system…
Indeed, “G7 + Australia” is being challenged by the “original” BRICS plus the “+” – Turkey, Saudi Arabia, and Argentina. Recently, the first two of these countries started to apply to become members of BRICS, and the “non-aligned countries” of Indonesia, Mexico, and South Korea matter for different reasons: first, Indonesia wants a “lithium OPEC”, Mexico nationalized lithium mining, and South Korea – snubbed by AUKUS – was “told” to uphold the “Three Nos” policy.
Undoubtedly, these moves are afoot. But let us also remember that they have been so for many years. Africa has been a theatre of commodity contest forever. The SCO is old hat. The Belt and Road is also old, has considerably failed, and is in contraction. BRICS+ is a loose grouping of states with very different interests. The liberal states of India and Brazil cannot be easily lumped together with illiberal China and Russia in terms of ideology, strategic interests, economic integrations, or monetary dependencies. BRICs only comprises one-quarter of global GDP. There is more than a hint of the violent yoking of heterogeneous ideas to fit an overly neat model of history going on.
Don’t get me wrong. It is likely that shifting geopolitical dynamics will impact the global monetary order at the margin. They already are in Russia, for example. The question is one of degree and therefore kind, not the other way around.
For that, we turn to Michael Pettis who plays a very effective devil’s advocate to Poszar:
2/9
I think he is viewing the global balance of payments from a 19th and early 20th century view, when capital was scarce and countries with excess savings controlled the flow of capital. That is clearly not the world we live in today.— Michael Pettis (@michaelxpettis) January 4, 2023
4/9
These countries must export capital because they have no choice. For structural reasons that are very hard to resolve they are incapable of delivering enough domestic demand to satisfy their growth needs, and do have to run large surpluses.— Michael Pettis (@michaelxpettis) January 4, 2023
6/9
Put another way, what matters globally for the role of the US dollar is not who controls excess savings but rather who is willing and able to absorb them. That pretty much means the US (and the other Anglophone economies) plus India.— Michael Pettis (@michaelxpettis) January 4, 2023
8/9
What is more, since 2015-16 Chinese flows to developing countries (which were already a very small share of total outflows) have been declining as Beijing increasingly recognizes the riskiness of these economies.— Michael Pettis (@michaelxpettis) January 4, 2023
9/9
In the end while China, Saudi Arabia and Russia can incrementally increase gross investments in each other’s economies, they cannot do so on a net basis. This is just basic BoP accounting.https://t.co/d2ZZrCfyI1— Michael Pettis (@michaelxpettis) January 4, 2023
In short, how can Poszar’s Bretton Woods III regime develop at scale when the Chinese economic structure is squarely dependent upon continued US dollar hegemony? Is China ready, or even able, to become the global consumer of last resort? Not only is the answer “no”, but to do so will create a very large domestic economic crisis, instantly jeopardising CCP power.
Here we can add the demographic insights of Peter Zehan which illustrate that China is growing old much faster than it is growing rich. Who, exactly, is going to do the consuming?
The US is also trapped but not so fatefully. Niall Ferguson:
The war in Ukraine has provided a reminder that the disruption of trade is a vital weapon of war. It has also reminded us that a great power must be in a position to mass-produce modern weaponry, with or without access to imports. Both sides in the war have consumed staggering quantities of shells and missiles as well as armored vehicles and drones. The big question raised by any Chinese-American conflict is how long the US could sustain it.
As my Hoover Institution colleague Jackie Schneider has pointed out, just “four months of support to Ukraine … depleted much of the stockpile of such weapons, including a third of the US Javelin arsenal and a quarter of US Stingers.” According to the Royal United Services Institute, the artillery ammunition that the US currently produces in a year would have sufficed for only 10 days to two weeks of combat in Ukraine in the early phase of the war.
A February 2022 Department of Defense report on industrial capacity warned that the US companies producing tactical missiles, fixed-wing aircraft and satellites had reduced their output by more than half.
As I have pointed out elsewhere, the US today is in some ways in the situation of the British Empire in the 1930s. If it repeats the mistakes successive UK governments made in that decade, a fiscally overstretched America will fail to deter a nascent Axis-like combination of Russia, Iran and China from risking simultaneous conflict in three theaters: Eastern Europe, the Middle East and the Far East. The difference is that there will be no sympathetic industrial power to serve as the “arsenal of democracy” — a phrase used by President Franklin D. Roosevelt in a radio broadcast on Dec. 29, 1940. This time it is the autocracies that have the arsenal.
The Biden administration must be exceedingly careful not to pursue economic warfare against China so aggressively that Beijing finds itself in the position of Japan in 1941, with no better option than to strike early and hope for military success. This would be very dangerous indeed, as China’s position today is much stronger than Japan’s was then.
It is true that Chinese GDP is a much larger proportion of the US than Japan’s was at the onset of WWII. But China is just as dependent upon commodity imports to feed and employ itself. Cut that off with boycotts and sanctions and civil strife will erupt.
China might try to launch a broad-scale invasion of Asia for commodities to consume in its idle industrial base but, more likely, it would collapse into civil war. The unity of Chinese identity is not that of pre-war Japan.
My own view remains that, try as it might, China is destined not for increasing power henceforth but for an ever-accelerating decline. If it tries to manage this decline with external wars, they are likely to be small and ideological, such as the annexation of Taiwan or a skirmish in the Indian Himalayas. Ironically, this will only afford the free world the opportunity to give the Chinese decline a forceful push by robbing its economy of external demand as Cold War 2.0 advances.
In the meantime, we still need to invest. On that front Poszar has some suggestions:
- 60/40 won’t cut it anymore and should be 20/40/20/20 instead, with the weights representing cash, stocks, bonds, and commodities.
- Cash, while the curve remains inverted, is “king”. It provides a nice yield, has no duration risk, and, as Warren Buffet said, it has an option value.
- Commodities should include three types of gold: yellow, black, and white. Yellow gold is gold bars. Black gold is oil. White gold is lithium for EVs.
- Commodities should also include a range of other stuff like copper, cobalt, et cetera, and the general theme driving commodities is that…
- …after years of underinvestment, supply became extraordinarily tight, just as we re-arm, re-shore, re-stock, and re-wire the grid.
- The U.S. dollar won’t be de-throned overnight…
- …but on the margin, de-dollarization and digitization (CBDCs) by BRICS+ central banks will reduce dollar dominance and demand for Treasuries.
- The dollar’s strength or weakness should be thought of in the context of the four prices of money (that is, par, interest, FX, and the price level):
- The U.S. dollar will remain “FX” strong versus other DM currencies…
- …but will be become “price level” weak (that is, outright devalue) versus commodities and “FX” weak versus most BRICs currencies, which will guarantee plenty of volatility in all four prices of money this decade.
The base case for the short term remains that cyclical forces are going to overwhelm any structural shifts so I’d use that to pick and choose which of these makes sense. For me, it is 2, 3 and 10 as markets adjust to a global recession.
Beyond that is still up for grabs.
