“I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now, I want to come back as the bond market. You can intimidate everybody.”
— James Carville, Clinton campaign strategist, 1993, as told to the Wall Street Journal
My first experience of macroeconomic and market constraints came early, at seven years old. It was 1989, and Yugoslavia's last prime minister, Ante Marković, was trying his best to hold the country together. He was dealing with more than the rising nationalism in the constitutive republics of the country: Marković was at the center of a classic EM balance-of-payments crisis.
In Chapter 1, I explained how Yugoslavia was a Cold War knight navigating the chess game of capitalism versus communism: it was an entire country levered to geopolitics. Belgrade managed its promiscuous foreign policy while sitting astride the NATO–Warsaw Pact rift. Not only did Yugoslavia make friends in the East and the West, but it also provided the Global South with engineering knowhow, which Yugoslavia exported for lucrative foreign currency contracts.1
Unfortunately for Yugoslavia's balancing act, a succession of external shocks destabilized the economy. The oil crisis of the 1970s hit Yugoslavia, an oil importer. Then came the 1980s, when competition from South Korea bit into the profit margins of its engineering outsourcing business. Finally, the textile industry faced competition from emerging Asian markets.
Yugoslavia dealt with these shocks by knocking on capitalism's door and asking to borrow a cup of sugar. It did not adjust its imports and investments to fit the new reality. It did not adopt austerity, cracking down on the twin ills of currency depreciation and inflation with hawkish monetary policy (i.e., raising interest rates). Instead, Yugoslavia borrowed from its friends in the West. Unlike its communist peers stuck behind the Iron Curtain, Yugoslavia accumulated a significant foreign debt that allowed citizens to live beyond their means.
In the late 1980s, the gravy train stopped. The international community became unwilling to lend to an irresponsible debtor. Yugoslavia's geopolitical worth waned as the Cold War wound down amid Gorbachev's reforms, and it could not guarantee its capitalist friends that it would be able to implement austerity. In 1988, facing rising prices and a falling dinar, the government relaxed income controls. Nominal wages rose by 5% per month in the last quarter of 1988. By September 1989, real wages had increased by 20% in eight months. The annual rate of consumer price inflation reached 13,000% in the fourth quarter of 1989.2 Yugoslavia entered the dreaded wage–price spiral.
At the end of 1989, Prime Minister Marković tried to end the crisis. On New Year's Eve, he introduced a new currency pegged to the deutschmark, austerity, privatization of businesses, and wage freezes. He also instructed the National Bank of Yugoslavia to stop printing money.
Inflation was stopped in its tracks in 1990, falling to zero. Marković's austerity gambit worked!
It was a pyrrhic victory. The austerity led to a collapse in economic output. The collapse in turn primed the battleground for populists running the constitutive republics to sow separatism and ethnic conflict. Serbia's Slobodan Milošević soon instructed the central bank to ignore the federal government and print money so he could fund his election campaign. When inflation returned, the median voter preference was to blame the technocrat in charge: Marković.
I remember this period vividly, even at seven years old. I learned what inflation was before my baby teeth fell out. The consensus view in the West is that Yugoslavia fell apart because of ethnic hatred. Yes, there was a lot of that. But for many, their ethnicity was not a huge aspect of their identity. At the very least, ethnicity was insignificant enough that children didn't pick up on the identity battle lines. My father had to sit me down and explain what it meant to be a Serb, as opposed to a Yugoslav. Some of my generational peers have similar stories, whether Croat, Slovene, or Bosniak.
Since leaving Yugoslavia, I have lived, studied, and worked in a number of places with an underlying thread of ethnic and sectarian tensions. And yet none of them resorted to the type of bloodletting that occurred in the country of my birth. Why?
The 1989/1990 Organization for Economic Cooperation and Development (OECD)'s economic survey of Yugoslavia is a heavy read.3 The authors do not mention the bubbling nationalism and ethnic tensions, but their clinical dissection of the spiraling economic crisis is wreathed in foreboding. Yugoslavia had many problems – and yes, ethnic tension was one of them – but the macroeconomic environment limited how much political capital was available for the federal government to solve these problems. Had Yugoslavia enjoyed a different set of macroeconomic and market constraints, perhaps its story would not have ended in 1991.4 Reformers like Marković may have had more maneuvering room to buy the loyalty of federal armed forces and move against the nationalists with force. Alas, we will never know.
One of the greatest challenges of geopolitical analysis is that forecasters are often not well-versed in economics and finance. Or even worse: they know just enough to wield the tools but do not have the expertise to do so safely. And by “safely,” I mean without anything going so awry that crises and predictions blow up in their faces.
The Euro Area crisis demonstrates the consequences of forecasters' incomplete knowledge. Throughout the sovereign debt crisis (2010–2015), financial media breathlessly reported on the rising debt levels, deficits, and bond yields of the peripheral economies (Ireland, Italy, Greece, Spain, and Portugal). But these reports failed to factor in the symbiotic relationship between that profligate “periphery” and the “core” export-oriented economies: the supposedly austere Northern European economies that would refuse to rescue the common currency.
The doom-and-gloom prognosticators did not account for constraints on the breakup of the European monetary union. They focused on the preferences: on policymakers' supposedly pragmatic desire to either exit the Euro Area or kick another member out.
The deep geopolitical logic behind the union remained, regardless of peripheral economic struggles. Rather than creating centrifugal forces sufficient to send each country in a different direction, economics and finance actually played a centripetal force, playing a key role in the Euro Area's perseverance.
In this chapter, I deal with two constraints: macroeconomics and finance, or the market. The two exist in what George Soros calls a reflexive relationship, where investor perceptions can alter the economic fundamentals.5 Though they affect each other, the two constraints are distinct.
These are the types of questions that ECON 102 students learn to ask and answer. I use macroeconomic fundamentals like a doctor uses the indicators of health (blood work, resting heart rate, etc.). A single red flag – high cholesterol – is easy enough to deal with in isolation. The doctor's orders: hit the treadmill and stop eating saturated fats. But if there are multiple markers off course, the doctor orders more work done. Like the doctor, if I find enough surprising answers to diagnostic questions, I investigate more thoroughly to find the root cause (my net assessment of India in Chapter 9 is a good example of this process).
Greece did not become an unproductive, overindebted, low-growth economy overnight in 2010. The roots of its structural decline stretch back to the 1990s. However, investors ignored the fundamentals and plowed into its assets – particularly the bond market – regardless. Investor enthusiasm allowed policymakers to grow complacent.
The role of a functional market is therefore to discipline and constrain policymakers, but investors do not always foster such an environment. Markets are also not rational, but rather driven by narratives.6 These narratives can make a downturn worse by exacerbating a panic, but they can also amplify a mania.
In the case of Mediterranean Europe in the 2000s, investors cheered the advent of the European monetary union, plowing into the bond markets of each member state. The yield convergence that this process initiated rewarded policymakers through no effort of their own (Figure 5.1). The market failed in its job. When the market finally woke up, it did so with a scream. Bond yields can be more powerful than missiles.
In the rest of this chapter, I survey macro and market constraints by applying each to the Euro Area crisis. I illustrate why macroeconomic fundamentals and market forces acted as constraints to any country's preference to exit – even though the contemporary consensus was that such factors encouraged countries to exit the EU. Most investors and financial journalists thought the market was acting as a centrifugal force that would eventually send each country in Europe off on its own tangent. They reached that conclusion because they overstated policymaker preferences for exit, especially in Greece's case.
The economy is a direct constraint to policymakers. High inflation and unemployment can combine to produce an elevated Misery Index, as occurred in Argentina.7 However, forecasters need to look beyond the direct causal links and consider the subtler implications. One of the gravest errors Euro Area analysts committed was misunderstanding the power dynamic between Germany and the Mediterranean economies.
“The German Question” has been Europe's central geopolitical dilemma since the defeat of Napoleon. In the aftermath of the 1789 French revolution, Paris's new elite faced a dilemma: they needed to develop a system to control a heterogenous country no longer united by the monarchy.8 The answer was a new governance model: nationalism. For the next hundred years, the state bureaucracy focused on turning “peasants into Frenchmen,” in the words of historian Eugen Weber.9
Unfortunately for the Parisian elites, the advent of the nation-state in France was always going to end in the creation of Germany. Just as nationalism encouraged French peasants to become Frenchmen, it encouraged the German peasants, strewn across central Europe in three dozen sovereign states, to eventually become Germans.
German unification in 1871 created an economic and demographic superpower in the geographical heart of Europe. Due to its size and potential, from day one Germany elicited suspicion and fear in its comparatively diminutive neighbors. Aware of the target on their backs, German leaders sought to balance against the continent's other powers to prevent an anti-German bloc from forming – especially one led by France.
Twice, Germany chose to answer its own question through the application of force. Both times it failed, and the second time nearly wiped the nation out altogether. While Germany is a formidable country, it is no match for the rest of the continent united against it.
For Germany, unification with would-be opponents – the EU and the European monetary union – is an alternative path to resolving the German Question.
Contrary to popular belief, Germans did not create the euro as a ploy to undermine the economies of its European peers. Pundits point out that the European Central Bank (ECB) is headquartered in Frankfurt as proof of some Teuton conspiracy. It is not. Germany demanded that the ECB be housed in Frankfurt as a consolation for losing its currency.
The European monetary union exists so that the EU can function. A common market with no barriers to trade cannot exist without a common currency. Why? Because the temptation to depreciate one's currency – and gain competitiveness – is too great. If Italy were allowed to depreciate the lira by 15% every time its economy slowed, its trading partners would eventually balk and put up tariffs, and the European integrationist project would be over.
To prevent European countries from depreciating their currency for competitive advantage, members of the European Economic Community (EEC) did not turn to the common currency solution immediately. Initially, the EEC created a convoluted dollar peg (referred to as the “snake in the tunnel”). When that did not work out, it pegged all European currency to the deutschmark. But that solution gave the Bundesbank too much power over European monetary policy.
These first attempts to stabilize the EU economy demonstrate that the goal of the third attempted solution – the euro – was not to benefit Germany but to constrain its power over European monetary policy.
Germany benefited anyway.
By pegging its currency to the other Euro Area currencies, the deutschmark was devalued by roughly 20% vis-à-vis its competitors (Figure 5.2). Think of the euro as a currency smoothie. Germany diluted the chalky protein-powder taste of its deutschmark by blending it with the sweet banana currencies of Italy, France, and Spain. Take the deutschmark out of the smoothie, and German goods suddenly appreciate by anywhere from 20% to God-knows-how-much percent.
The German economy was also in dire need of reform in the 1990s. By the early 2000s, an over-regulated labor market and EU accession by Eastern European neighbors spurred Berlin to negotiate a reform package with its unions known as the Hartz IV reforms. These reforms caused a significant downtrend in the German unemployment rate and stabilization of its GDP growth (Figure 5.3).
Unlike the rest of Europe, Germany did not waste the early part of the twenty-first century. It rolled up its sleeves and undertook painful reforms. It cut long-term unemployment benefits and introduced short shift work. The long-term impact of the Hartz reforms was a dramatic decline in the unemployment rate, from a peak of 11.5% in January 2002 to 4.9% at the end of the current cycle. Reforms have also encouraged a steady increase in wage growth – albeit at a lower pace than productivity growth – despite the conventional view that they would have the opposite effect.
By the start of the Euro Area crisis in 2010, Germany had no choice but to bail out the Mediterranean countries. Berlin had spent two decades preparing for the monetary union, tooling its export-oriented economy to be successful. And according to plan, the German economy was extremely export-dependent. A whopping 55% of German exports were bound for the EU in 2010. While exports to emerging markets, like China, had been growing, they still only accounted for 28% total exports at the time (Figure 5.4). Germany's dependence on Euro Area countries – which comprised 42% of its total exports – constrained policymakers from exiting in 2010, regardless of their preference.
Economic dependence on EU countries is Germany's fulcrum constraint to leaving the union, and it is only growing. The German economy will not find a new customer base in its own demographics. With a fertility rate of just 1.46 births per woman and a generally anti-immigrant turn in its politics, Germany domestic demand is unlikely to skyrocket. The economy will be dependent on exports – mostly to Europe – for the foreseeable future. Rising trade protectionism in the US and China – as well as an increased growth slowdown in the latter induced by the reforms discussed in Chapter 4 – means Germany is stuck with its EU peers and their common market. Germany is caught between a rock and a hard place: between EU customer dependence and no opportunity for customer acquisition elsewhere.
Throughout the 2010s, financial media ignored these fundamental macro constraints to a German exit from the Euro Area. Perhaps the media silence was a symptom of journalistic laziness, but the coverage was also biased toward Euroscepticism. The British press was especially slanted, projecting its own Euroscepticism onto the German public and policymakers. The phrase “rising German Euroscepticism” became shorthand for the (now woefully incorrect) reports filed by a slew of London-based publications.
To find a more accurate prediction of Germany's behavior, the pundits needed look no further than the polling. It did not take German median voters long to realize that their well-being was directly linked to that of the common currency union (Figure 5.5). Policymakers in Germany – even the Eurosceptic ones – soon followed and approved one bailout after another.
The extraordinary journey of the German median voter toward the most Europhile position has now culminated in Chancellor Angela Merkel's aggressive push for mutualization of debt across the union, once a Rubicon that most pundits thought Berlin would never cross. The Macron-Merkel proposal for a European Recovery Fund is likely to pass at some point in 2020, even if the “Frugal Four” – Austria, Denmark, the Netherlands, and Sweden – oppose it.
What Merkel has understood for some time is that Europe is on its own. Alternatives to integration do not exist in a multipolar world where European sovereign states face off against China, Russia, India, Iran, and yes, the US. And what Eurosceptic pundits in the US and the UK have failed to understand is that European policymakers and voters are not… how to put this delicately… stupid. A dissolution of the EU would leave countries like Sweden, the Netherlands, and Spain – once strong global empires, now living museums at best – as two-bit players of the Great Game in the twenty-first century. Even Germany, France, and Italy would struggle to pursue their national interests in an era of continental-sized powers.
While I suspect that Merkel took this geopolitical imperative into consideration from day one of the Euro Area crisis, it was the election of Donald Trump that spurred the famously cautious politician into dramatic action. In May 2017, Merkel met with President Trump at the G7 summit in Sicily. At that meeting, Trump blamed Germany for its massive trade surplus with the US and generally treated his German counterpart as a rival.
Following the summit, Merkel promptly flew back to Germany, straight into a Munich beer hall, and addressing a crowd of generally Eurosceptic members of the Christian Social Union (CSU) declared “The era in which we could fully rely on others is over…”10 Her choice of location and the crowd for the speech was notable. The CSU – a sister party of Merkel's Christian Democratic Union (CDU) – had taken a notably more Eurosceptic line throughout the Euro Area crisis, with its MPs often voting against the Chancellor on individual bailout decisions. Merkel's intention was to descend straight into conservative Bavaria and impress upon the most Eurosceptic of her allies that there were no alternatives to integration.
I do not see risks to European integration over the course of the next decade. Mini-crises may come and go – Italy always being a potential source of drama – but the geopolitical imperative is clear: integrate or perish into irrelevance. Europe is not integrating out of some misplaced utopian fantasy. And it is not seeking an ever-closer union for the sake of its bloody past. Its sovereign states are integrating – and yes, giving up sovereignty – out of weakness and fear. Unions out of weakness are often the most sustainable over the long term. After all, America's original 13 colonies integrated out of fear that the UK would eventually re-invade. And Swiss multi-ethnic cantons united because a failure to do so would have left them at the mercy of their powerful neighbors.
With European integration and unity a moot point, investors will profit by allocating to the continent over the next decade. Yes, Europe will also engage in Buenos Aires policies, but I doubt that the pendulum away from laissez-faire will swing as hard and fast as in the US.
The flip side of Germany's economic constraints is the story of Greece. Throughout the crisis, commentators argued that Greece should leave the Euro Area, devalue its currency, default on all its debt, and enjoy smooth sailing after the initial shock. Nobel Laureate Paul Krugman urged Athens to quit.11 His fellow economist and euro Curmudgeon-in-Chief Hans-Werner Sinn penned an op-ed in solidarity at the height of the 2015 Greek crisis.12
The Greeks paid no mind to the op-ed wizards. On the contrary, Greek support for Euro Area membership steadily increased as the crisis developed (Figure 5.6).
So, are Greeks stupid?
Absolutely not! Unlike the armchair pundits, the Greeks actually live in Greece. They know that without the membership in the EU, theirs is just another country in the Balkans.
The economists cheering “Greek exit” did so in a ceteris paribus world, which only exists in their social science laboratory. In this eerie environment, political risk to Greece neither precedes nor follows abandoning the currency union, and all policymakers managing Grexit have PhDs in economics (and, presumably, op-ed columns in the New York Times). But the argument was theoretical and as such is most effective when executed in an Excel spreadsheet.
To blame Greece's currency for its uncompetitive economy is a straw-man argument. The currency is the straw man, and structure was Greece's real issue. Greece was in dire need of structural reforms whether or not it remained in the Euro Area. To benefit from its cheaper currency after “Grexit,” Greece would have to receive direct inflows of foreign investment. That was unlikely, given the subsequent political instability that would have bracketed a Euro Area exit.
Greece also had little export revenue. Over the course of 15 years before 2010, Greece lost nearly all export markets for what used to be its primary exports: apparel articles, clothing accessories, and textiles. Its export base became far less diversified, with petroleum refining essentially being the only one.
This specialization was not merely a function of its euro membership but also of globalization and competition from Asian producers. Even a 50% devaluation of Greek products might not have overcome the labor cost advantages of Asian producers. Asian economies monopolized the exact type of cheap manufacturing products that used to constitute the vast majority of Greek exports.
Manufacturing in 2015 accounted for only 28% of Greece's total exports (of which roughly a third were mining-related), compared to nearly 50% in 2001. The drop indicates that Greece had no manufacturing base left to take advantage of currency devaluation.
It is possible that the Greek policymakers who had just extricated Greece from the EU would have implemented the pro-market structural reforms necessary to attract foreign investors looking to capitalize on currency devaluation. But then, had Greek policymakers been willing to bear the pain of such a thorough policy change, they would have focused on the reforms – not exiting the Euro Area.
Perhaps I have the advantage of hindsight, but back in 2015, pundits calling for a Greek exit from the Euro Area thought Argentina a good example of a successful separation. Hilarious in 2020, but let's take the argument seriously. Argentina was a poor example for Greece because in 2001, Buenos Aires benefited from a much more favorable global context than the Greece of 2015. Argentina, a commodity exporter, had the good luck to default and devalue in 2001, at the beginning of a commodity bull market unlike any in history.
The macro context for a Greek exit in 2015 was much worse. Global trade was, and continues to be, in a downtrend. Again, especially compared with Argentina's situation in 2001, Greek devaluation would not yield much bang for the euro. Or the drachma.
Greece was also unlike Argentina in that it remains completely dependent on imports for energy. In 2015, Greece imported roughly 64% of all its energy needs. Because of its reliance on energy imports, devaluation would have likely led to an immediate spike in prices of everything involving energy…so, everything but the beach sand. Even food prices would rise due to the higher cost of transportation and production. Under the leadership of a steady government with strong support, the inflation spike would be short and vicious. But Greece's populist government would have likely panicked and printed money, moving the country toward the same hyperinflationary cycle that Yugoslavia experienced in 1989.
I assume the government in charge would panic and print its way out of the crisis because Greece has high levels of public employment and expenditure. The easiest way for the government to retain median voter support, and thus political capital, would be to print drachmas. To appease voters, the government would keep pensions and public wages in line with the higher cost of imports and skyrocketing prices. Over 50% of households depend on pensions for income. The median voter – who, as discussed in Chapter 4, dictates policy – would not take an inflationary shock lying down.
Inflation or no, tourism accounts for around 9% of Greek GDP and might improve on the back of a cheaper currency. But more tourism is not an optimal outcome for Greece. It is a low value-add and does not contribute much to a country's productivity growth. It also has a finite ability to absorb employment.
Ultimately, Greece did not leave the Euro Area. Its populist government, led by Alexis Tsipras, enacted the same painful structural reforms that pundits claimed would never happen. This is an extraordinary outcome given that Prime Minister Tsipras led the “Coalition of the Radical Left” (SYRIZA), which in 2015 was Eurosceptic. Yet he relented under the pressure of material constraints, tightened the country's belt, and bore the cross of reform and austerity. That cross has been passed to Prime Minister Kyriakos Mitsotakis, and he is maintaining its weight.
Since the reforms, Greek unit labor costs have fallen relative to the rest of the Euro Area. They are still high, but not egregiously so (Figure 5.7), eliminating a large part of the accumulated competitiveness gap built up since 2000. Greece accomplished the painful budget consolidation that most commentators thought impossible. Its primary budget balance (excluding interest payments on debt) improved from a deficit of 10% in 2009 to a surplus of 4% in 2019 (Figure 5.8). Such a fiscal adjustment would have caused other countries to tear themselves apart. But Greece held together thanks to the strong economic constraints that prevented the “easy way out,” a path that would have led – fittingly for the Greeks – to a pyrrhic victory. Because most of its debt is held by the official sector at negotiated rates, Greek interest payments account for only 3.5% of GDP – on par with the US and the wider Euro Area.
The pundits and economists cheering for Grexit knew less than the Greek median voter. Greek citizens and policymakers understood very well that they do not live in a ceteris paribus theoretical dreamland. They live in Greece.
The Euro Area sovereign debt crisis illustrates how economic and market constraints interact to force policymakers onto paths that are difficult to forecast using preference-based analyses. Even the least likely of politicians – Trotskyite communists like Tsipras – turn into Thatcherite supply-side reformers when faced with constraints. Material constraints force policymakers down the path of least resistance.
Forecasters should keep in mind that this path is not always easy to see from the vantage point of an investor. In 2010, it was out of consensus that Berlin would allow the ECB to directly purchase government debt, let alone that – ten years later in 2020 – the Commission would issue mutualized debt obligations on behalf of the Mediterranean and Eastern European EU member states. In 2015, it was definitely out of consensus that Greece would successfully adjust its budget balance by an extra 5% of GDP. In both cases, the analysts driving public opinion did not account for economic and market constraints. And they have not yet adjusted their forecasting methods. As of 2020, pundits and armchair analysts still expect Italy to leave, Germany to fall prey to populists, and the TARGET2 mechanism to end all human existence.13
Another dynamic where forecasters underestimate economic and market constraints is the US–China trade war.
There is a growing consensus that China and the US are destined to replicate the Cold War of the twentieth century. In this hypothesis, the trade dispute is the tip of the geopolitical iceberg.
I played some part in building this consensus – at least as far as the investment community is concerned – by publishing “Power and Politics in East Asia: Cold War 2.0?” in September 2012. For much of the past decade, Geopolitical Strategy – the investment strategy publication I created in 2011 with BCA Research – operated according to the thesis that geopolitical risk was rotating out of the Middle East and into East Asia. The risk relevant to investors was shifting from an area where risk was fading to one where it would soon increase – a red flag for investors. And China fell right into the zone of rising geopolitical risk.
This thesis remains cogent, but a potential “Silicon Curtain” does not automatically equate to two bifurcated zones of capitalism. Trade, capital flows, and human exchanges between China and the US will continue and may even grow.
Certainly, policymaker preferences in both countries are turning more confrontational. Nationalist sentiment is on the rise in China, and Beijing may even stoke the sentiment to distract its burgeoning middle classes from other, domestic, ills. In the US, a new McCarthyism is looming, with China hawks looking for any reason to ban or limit even innocuous economic interactions with China.14
Despite these preference sets, macroeconomic constraints – boosted by the multipolarity of the global order – will prevent a total bifurcation of capitalism.
Speaking in the Reichstag in 1897, German Foreign Secretary Bernhard von Bülow proclaimed it time for Germany to demand “its own place in the sun.”15 The occasion was a debate on Germany's policy toward East Asia. Bülow soon ascended to the chancellorship under Kaiser Wilhelm II and oversaw the evolution of German foreign policy from Realpolitik to Weltpolitik. While Chancellor Otto von Bismarck cultivated Realpolitik as a cautious balancing of global powers, Bülow and Wilhelm II sought to use Weltpolitik to redraw the status quo through aggressive foreign and trade policy.
Imperial Germany joined a long list of antagonists, from Athens to 2020's People's Republic of China, in the tragic play of history dubbed the “Thucydides Trap.”16
Students of world history know the underlying concept. Its name is derived from Greek historian Thucydides and his seminal History of the Peloponnesian War.17 Thucydides explains why Sparta and Athens went to war but, unlike his contemporaries, he does not moralize or blame the gods. Instead, he stoically describes the cause: revisionist Athens and established Sparta had no recourse but war due to a cycle of mistrust.
Graham Allison, a scholar of international relations, argues that the interplay between a status quo power and a challenger almost always leads to conflict. In 12 out of the 16 cases he surveyed, military conflict broke out. Of the four cases where war did not develop, three involved transitions between countries that shared a deep cultural affinity and respect for the prevailing institutions.18 In those cases, the transition involved new management running what is essentially the same world system. The final of the four non-war outcomes was the Cold War between the Soviet Union and the US.
What causes the Thucydides Trap to ensnare rivaling powers? The size of a status quo power's sphere of influence remains the same as when it stood at its zenith of power. Its inevitable decline relative to that zenith leads to “imperial overstretch.” To combat the problem, the hegemonic or imperial power erroneously doubles down on maintaining a status quo it can no longer afford.
To anyone who has played the board game Risk, this dynamic is well known. The status quo power is the player who already secured a continent. In Risk, controlling a continent comes with a bonus: extra troops every turn. The status quo power cannot allow anyone else to gain a foothold on a continent. It erodes their relative power. Regional hegemony is a perfect jumping-off point toward global hegemony. It gives the challenger power a home base it does not have to spend material resources defending (and the extra troops every turn to boot!).
The hegemon therefore feels threatened even if the challenger's intentions are limited and restrained (although they are often ambitious and overweening). The “tragedy of great power politics” is that the established power does not react to intentions, it reacts to capabilities. The intentions of the newcomer are immaterial – all that matters to the hegemon is that the challenger's capabilities are material and unchanging, whereas its intentions are perceived and ephemeral.19
The challenging power always has an internal logic to justify its ambitions. As of 2020, in China's case, there is a zealous belief among the elite that the country is reverting back to the way things were for centuries. Whether 2020 China is a challenger or status quo power depends on historical perspective. Twenty-first-century China is a “challenger” power to the status quo of the past 300 years. But it is the “established” power of the past four millennia. The consensus in China is to take the long view. As such, it should not have to defer to the prevailing global status quo. After all, the contemporary context is the result of Western imperialist “challenges” to the established authoritarian Chinese order.
To further justify its ambitions for global influence, China cites that it is at least as relevant to the global economy as the US, and therefore deserves a greater say in global governance. While the US still takes a larger share of the global economy as of 2020, China has contributed 23% to incremental global GDP growth over the past two decades, compared to 13% for the US. Over time, China's economic demand carries more weight.
Like China's claim to power, President Trump's aggressive trade policy also makes sense in a political theory context – to a point.
The political science theory of realism focuses on relative gains over absolute gains in all relationships, including trade. Trade leads to economic prosperity, prosperity to the accumulation of economic surplus, and economic surplus to military spending, research, and development. But two rival states that only care about relative gains produce a zero-sum game – along with zero room for cooperation. It is a “prisoner's dilemma” that can lead to suboptimal economic outcomes because both actors chose not to cooperate.
Figure 5.9 illustrates the effects of relative gain calculations on the trade behavior of states. In the absence of geopolitics, demand (Q3) is satisfied via trade (Q3 – Q0) due to the inability of domestic production (Q0) to meet it.20
However, a geopolitical externality – such as a rivalry with another state – raises the marginal social cost of imports. Trade allows the rival to gain more out of trade and “catch up” in terms of geopolitical capabilities. The trading state therefore eliminates such externalities with a tariff (t), raising domestic output to Q1 while shrinking demand to Q2. Imports fall to Q2 – Q1, a fraction of where they would be in a world absent geopolitics.
The result? In a bipolar world where two superpowers face off, relative trade gains dominate.
What about a unipolar world? In a unipolar moment, where a single hegemon is in charge, the hegemon relaxes its relative concerns as prospects of a rival dim. As political scientist Duncan Snidal argues in a 1991 paper,
When the global system is first set up, the hegemon makes deals with smaller states. The hegemon is concerned more with absolute gains, [but] smaller states are more concerned with relative, so they are tougher negotiators. Cooperative arrangements favoring smaller states contribute to relative hegemonic decline. As the unequal distribution of benefits in favor of smaller states helps them catch up to the hegemonic actor, it also lowers the relative gains weight they place on the hegemonic actor. At the same time, declining relative preponderance increases the hegemonic state's concern for relative gains with other states, especially any rising challengers. The net result is increasing pressure from the largest actor to change the prevailing system to gain a greater share of cooperative benefits.21
When a unipolar hegemon sets up the global system, small states are initially more concerned with relative gains because they are far more sensitive to national security than the hegemon. The hegemon has a preponderance of power, so it can afford to be more relaxed about its security needs. The states' different priorities explain why Presidents George Bush, Sr., Bill Clinton, and George Bush, Jr., all made “bad deals” with China.
Writing nearly 30 years ago, Snidal cogently described the current US–China trade war. He also predicted that the US would sour on the original arrangement as it became more aware of relative trade-offs. Snidal thought he was describing a coming decade of anarchy. But he and fellow political scientists writing in the early 1990s underestimated American power. The “unipolar moment” of American supremacy was not over; it was just beginning! As such, the dynamic Snidal described took 30 years to materialize.
When predicting what the transition away from US hegemony might look like, most investors latch onto the Cold War model, as it is the only period in the past 50 years that was not unipolar. Moreover, the Cold War provides a simple, bipolar distribution of power that is easy to model through game theory. The excerpt from Snidal's paper would be sufficient analysis – were a bipolar dynamic imminent. The US and China would divide the planet in two like the US and the Soviet Union. America would abandon globalization totally, impose a draconian Silicon Curtain around China, and coerce its allies to follow suit. Many policymakers in both Beijing and Washington would likely prefer this outcome.
But most of human history has been defined by a multipolar distribution of power between states, not a bipolar one.
The US–Soviet Cold War is a poor analogy for the world of 2020. In a multipolar world, Snidal concludes, “States that do not cooperate fall behind other relative gains maximizers that cooperate among themselves. This makes cooperation the best defense (as well as the best offense) when your rivals are cooperating in a multilateral relative gains world [emphasis added].” Snidal shows via formal modeling that as the number of players increases from two, sensitivity to relative gains drops. With each new player, countries maximize their absolute gains to remain competitive among a larger set of actors.22
The US–China relationship does not occur in a vacuum. It is moderated by the global context, which in 2020 is one of multipolarity where the EU, Russia, India, Iran, Turkey, Mexico, and Brazil are all major economic and geopolitical players. In a multipolar world, economic constraints behave differently than they do in a bipolar or unipolar one.
“Multipolarity” refers to a distribution of geopolitical power in which one or two powerful players no longer hold the lion's share of it. The post-2010 world is moving in this more pluralistic direction. Europe and Japan have formidable economies and military capabilities. Russia remains a potent military power, even as India surpasses it in terms of overall geopolitical power. Iran, Turkey, Mexico, and Brazil are all also asserting their independence in an increasingly complicated and messy world.
A multipolar world is the least ordered and the most unstable of world systems for three reasons:
Figure 5.10 is modified for a multipolar world. Everything, except the highlighted trade lost to other great powers, is the same as in Figure 5.9. In a multipolar world, the state considering tariffs in an attempt to lower the marginal social cost of trading with a rival must account for this lost trade. In the context of the Trump-era trade war with China, this gap would encompass all European Airbuses and Brazilian soybeans sold to China in place of American exports. For China, it would encompass all of the machinery, electronics, and capital goods produced in the rest of Asia and shipped to the United States. The US and China's lost trade in a multipolar world is the fulcrum constraint preventing both from an all-out trade war.
Washington, in the wake of its China tiff, could cajole its allies to take advantage of the resulting lucrative trade lost (Q3 – Q0) – (Q2 – Q1). But empirical research suggests that US allies – Europe, Japan, South Korea, Taiwan, etc. – would ignore such pleas for unity. Alliances forged in a bipolar system produce a large, statistically significant impact on bilateral trade flows – a relationship that weakens in a multipolar context.24
Unless the US makes a wholehearted diplomatic effort to tighten up its alliances and enforce trade sanctions – unlikely under any second-term Trump administration – the self-interest of US allies will drive them to continue trading with China. The US will not be able to exclude China from the global system, nor will China be able to achieve Xi Jinping's vaunted “self-sufficiency.”
Both World Wars I and II offer precedent for this view in the form of historical examples. They demonstrate that economic constraints can, and have, over-ruled geopolitical imperatives and policymaker preferences.
In 1896, a bestselling UK pamphlet, Made in Germany, painted an ominous picture: “A gigantic commercial State is arising to menace our prosperity, and contend with us for the trade of the world.”25 “Look around your own houses,” author E.E. Williams urged his readers. “The toys, and the dolls, and the fairy books which your children maltreat in the nursery are made in Germany: nay, the material of your favorite (patriotic) newspaper had the same birthplace as like as not.” Williams later wrote that tariffs were the answer and that they “would bring Germany to her knees, pleading for our clemency.”26
By the late 1890s, the UK government knew that Germany was its greatest national security threat. The German Naval Laws of 1898 and 1900 launched a massive naval buildup with the singular objective of liberating the German Empire from the geographic constraints of the Jutland Peninsula. By 1902, the first lord of the Royal Navy noted that “the great new German navy is being carefully built up from the point of view of a war with us.”27
To guard against the threat of Germany, London signed a set of agreements with France in April 1904 known as Entente Cordiale. Germany immediately tested the entente in the 1905 First Moroccan Crisis, which only galvanized the alliance. France and the UK brought Russia into the pact in 1907, creating the Triple Entente.
In hindsight, the alliance structure was an obvious solution to Germany's meteoric rise from unification in 1871. However, I do not underestimate the magnitude or ingenuity of these geopolitical events. For the UK and France to formalize the 1904 alliance, they had to overcome half a millennium of conflicts, many of them resolved in the past with blood. Their alliance signaled a tectonic shift — one that they undertook against the grain of history, entrenched enmity, and ideology.28
Political scientists and historians agree that geopolitical enmity rarely produces the bifurcated economic relations exhibited during the Cold War. Both empirical research and formal modeling show that trade occurs even among rivals and during wartime.29
Economic exchange certainly occurred between the UK and Germany, whose trade steadily increased right up until the outbreak of World War I (Figure 5.11). This behavior could be written off due to the UK's ideological commitment to laissez-faire economics. Or perhaps London feared for its lightly defended colonies (the least protected should the UK become protectionist).
These arguments suffice for the UK's behavior in isolation, but they do not explain why, during the same period, Russia and France both increased trade with the German Empire as well (Figure 5.12). Either naïve policymakers blind to the impending war led all three states into trading with the enemy – unlikely given the empirical record of war foreknowledge – or they could not afford to lose to each other the gains of trade with Germany. The allies were scared of losing absolute trade gains to each other. This fear kept them trading with the enemy.
A similar dynamic was afoot ahead of World War II. US–Japan relations soured in the 1930s when the Japanese invaded Manchuria in 1931. In 1934, Japan withdrew from the 1922 Washington Naval Treaty – the bedrock of the Pacific balance of power – and began a massive naval buildup. In 1937, Japan invaded China. Despite the clear and present danger these actions signified, the US continued to trade with Japan right up until July 26, 1941 – a few days after Japan completed the invasion of Indochina (Figure 5.13). On December 7, Japan attacked the US.
An analyst may attribute these trade patterns to policymakers' incompetence instead of deliberate intention, in which case, world leaders learned their lesson from these past events. Precisely because policymakers sleepwalked into the First and Second World Wars, they will not (or should not) make the same mistake in the new century.
But I am skeptical of the view that policymakers in the early and mid-twentieth century were somehow defective (as opposed to today's enlightened leaders). The constraint framework urges the analyst to seek systemic reasons for the behavior of leaders, as opposed to writing off unexpected behavior as outliers or preference.
Political science theory explains why London and Washington continued to trade with the enemy despite the clarity of the threat. The systemic nature of the multipolar economic constraint means policymakers are less sensitive to relative economic gains. Multipolarity confronts states with a collective action problem thanks to changing alliances and the difficulty of disciplining allies' behavior.
In the case of the US and China, President Trump exacerbates this mandatory self-reliance because he tends to skirt multilateral diplomacy and focuses to the point of obsession on mercantilist measures of power (i.e., the US trade deficit). If the anti-China trade policy included a magnanimous approach to trade relations with allies, the measure could have produced a “coalition of the willing” against Beijing. But trade deficit concerns prevent the Trump administration from monetarily rewarding US allies. After two years of tariffs and threats against the EU, Japan, and Canada, the Trump administration has already signaled to the rest of the world that old alliances and coordination avenues are up for revision.
I foresee two possible scenarios:
The constraint framework strongly favors the first scenario.
President Trump's Phase One deal is a giant concession to the multipolar nature of the world.30 So is his tweet on February 18, 2020, blasting a proposal by his own government to curb US sales of jet engines and other aviation components to China. Trump's reasoning for railing against his own documented antitrade preference:
We're not going to be sacrificing our companies … by using a fake term of national security. It's got to be real national security. And I think people were getting carried away with it. I want our companies to be allowed to do business. I mean, things are put on my desk that have nothing to do with national security, including with chipmakers and various others. So, we're going to give it up, and what will happen? They'll make those chips in a different country or they'll make them in China or someplace else.31
To paraphrase my favorite quote from one of my favorite movies: on a long enough time line, the ignorance rate for policymakers falls to zero. Material constraints – such as the risk of Boeing losing business to Airbus in China – are a disciplining mechanism that force policymakers back onto the path of least resistance. In a multipolar world, economic constraints to trade war are more restrictive than in any other system. As such, the trade war between China and the US is unsustainable. There are many things for investors to worry about in the 2020s, but the trade war is not one of them.
Armchair forecasters and pundits often invoke economic and market constraints but rarely wield specific barriers in their analyses. Economics and finance require some level of expertise that these talking heads do not always possess.
These constraints operate according to the well-known Keynes adage: “If you owe your bank a hundred pounds, you have a problem. But if you owe a million, it has.” The Economist later added a corollary: “If you owe your bank a billion pounds everybody has a problem.”
In a multipolar world, if any one state fails in a spectacular, Greek-debt-crisis fashion, there are negative implications for every other power, big or small. It is not intuitively obvious why this is so. During the Euro Area crisis, reductive reasoning consistently got the complicated web of relationships wrong. A Greek exit could have unraveled the entire Euro Area, which would have imperiled Germany's economic model. Fearing the impending domino effect, German policymakers would eventually do “whatever it takes” to ensure that their economy did not collapse.
As of 2020, forecasters still misuse macro and finance to predict geopolitical events. Experts often cite Euro Area TARGET2 imbalances as a sign that the monetary union is doomed.32 In 2010, the TARGET2 banking imbalance stood at €0.3 trillion. In 2020, that number is close to €1.5 trillion.
In a reality that acknowledges the influence of market and economic constraints, the TARGET2 mechanism is not a divisive force. It is actually one of the sinews that binds European countries together.33
The growing imbalance means that Germany's exposure to “Italian euro” assets has surged via the ECB's massive purchases of Italian debt. At the same time, Italian investors have parked their cash in German banks, meaning they are owed “German euros.” With such a TARGET2 imbalance, the lender – not the debtor – has the most to lose. The biggest casualty of the euro's disintegration would be Germany, as it would effectively mean Italy had declared bankruptcy and canceled its payment plan. This possibility gives Berlin yet another incentive to remain conciliatory and eventually concede to greater fiscal integration, which it did in summer of 2020.
Forecasters misuse economics and markets in their analyses for reasons aside from insufficient expertise:
Both forecasts were wrong because they misunderstood the interaction between policymakers and their constraints. Preferences were ultimately bent to constraints so that German policymakers accepted a dovish ECB monetary policy – and basically crossed every red line they ever set (Figure 5.14) that assuaged the bond market riot. President Trump negotiated a trade deal with China that saw Beijing commit to buying more US products that could lead to an expansion – not the end – of US–China trade relationship.
A final word of caution: the 2008 Great Recession introduced investors, journalists, and commentators to an alphabet soup of doom, from mortgage-backed securities (MBS) to collateralized debt obligations (CDOs). The COVID-19-induced recession has done the same, with the alphabet soup filling up our collective cognitive bowl faster than we can keep up. Still, everyone is on the lookout for the next complicated, technical acronym that ends the world.34 Many of those searching for doom have little idea what they are looking for. But due to confirmation bias, they usually find it in economics and finance: a fertile ground for overly technical, jargon-y horsemen of the apocalypse.
This tendency toward doomsday predictions is why my two main case studies in this chapter – the Euro Area crisis and the US–China trade war – demonstrate how economic and market constraints strong-armed policymakers into action that resulted in crises ending, not deepening.
I believe that the COVID-19 pandemic is another such crisis. In Chapter 8, I posit that the costs of sustaining the “flatten the curve” mitigation strategy are so astronomical they would likely produce a depression. The costs will prove prohibitive, especially relative to the objective dangers posed by the virus, constraining policymakers to alter the strategy. Politicians' response to COVID-19 is therefore another example where economics and markets will constrain policy behavior.
Constraints do not guarantee that policymakers always do the right thing or that the path of least resistance always leads to bliss. A pernicious macroeconomic context often leads to ruin, which is why I began the chapter with the tragedy of Yugoslavia. The absence of constraint-sensitive market feedback can often delay the necessary corrective policies – a delay that only exacerbates future crises. Such a delay in the case of the COVID-19 pandemic will lead to an economic depression; for example, if I am wrong and lockdowns are reimposed. If it does, feel free to use the pages of this book for…well you know what.
A good example of reflexivity is the relationship between currencies and interest rates. A rally in a country's currency, even if initiated by speculative and short-term inflows, allows the central bank to lower interest rates. The reflexivity continues as the lower rates create a virtuous cycle that helps the economy grow and, in turn, appreciate the currency further.
Eric Hobsbawm, Nations and Nationalism Since 1780, 2nd ed. (Cambridge: Cambridge University Press, 1997).
I do not review Snidal's excellent game theory or formal modeling, as it is complex and detailed. However, I encourage intrigued readers to pursue the study on their own.