Pax, Pax, and Pox - Regimes, Currencies, and Machiavelli (December 2021)
Institutional investors and risk managers are tasked with assessing major risks (and opportunities) and steering their organizations through uncertain times. Springing forward from our last installment (Punch Bowls, Parties, and Perdition) our current installment aims to address some macro issues that are likely to weigh on the markets for some time and require sound thinking to properly evaluate and more importantly, properly respond.
Just as a fish appears oblivious to its environment, many investors appear to be oblivious to the overall economic environment they are operating under. This installment goes beyond our usual pieces but provides a critical framework for evaluating issues which over time are likely to have a major impact on institutional investors.
We all operate in the framework of an economic system that is dominated by a handful of countries. Currently, the global economic order is dominated by the United States, with assistance from the EU, the UK, and Japan. However, this has not always been the case. Working backwards from recent history, it was previously England (as a result of the Industrial Revolution and its dominance of trade routes), France (with its dominance of Europe), Spain (courtesy of the riches found in the New World), Italy (with its dominance of the Mediterranean), Greece, and Egypt.
To be fair and provide geographic balance, we should probably add China and the Mesopotamia areas. Regardless, periodically, conditions change. While some might argue that it is the military might that is the determining factor in determining ascendancy, in our opinion, it is more complicated than that.
For an order to be established and persist, it needs to offer a benefit to all involved. Perhaps the quintessential example is Pax Romana. Essentially from 27 B.C.E. to 180 C.E. Rome offered both a carrot and a stick: join the network and you benefitted from the advantages of a near global trade network or alternatively, be faced with slavery. While for most it is easy to underestimate the advantages of a trade network, if you control a farming region which is very good at growing cotton, and little else, trade is critical for the survival of your area. Likewise with a fishing or mining area. Hence, communities benefited from being members of the trade network, not to mention the protection from enemies, which was critical. Hence the system worked.
Similarly, since World War I, most regions benefited from being part of the system dominated by the U.S. and the U.K. prior to World War II, and the U.S. after World War II. Skipping a few decades, the U.S.’s dominance continues, but not to the extent of prior decades. China has experienced rapid economic developments to the point that some claim that it will surpass the US over the next couple of decades. Others point to Japan, which as of the later part of the last century appeared unstoppable. However, cracks appeared when Japan’s real estate bubble burst and Japan has not been the same since. Eerily, China appears to have taken the same route, with a massive over-investment in real estate, and in China’s case, infrastructure. As mentioned in the prior installment, the item which gives many managers pause is the attenuated current situation with high levels of debt, high deficits, and low real yields. Ironically, during times of economic stress, the dollar is a beneficiary under the premise that the dominant country will be a safe haven. Furthermore, there are few alternatives. While China has attempted to broaden its global appeal via its Belt and Road initiative, the heavy hand in Hong Kong and the currency controls gives many pause. Perhaps an alternative is the crypto currency route; the area continues to experience regular gains and acceptance appears to be growing daily. However, if recent experience is any guide, the US is unlikely to relinquish its global leadership easily, especially to a group which rarely is seen in a suit. To be clear, control of a global financial system provides significant advantages. Without firing a shot, the US can enforce policies on regimes it deems rogue such as Iran, with the hope that some reforms occur.
Now for the pox part – normally pox is associated with dreaded diseases, with smallpox heading up the list. Our point is that regime changes entail massive pain. While few have direct experience recently with the pain, it is real and extends far beyond the physical pain. When Hitler invaded countries throughout Europe, one of the first actions was that of absconding with the wealth of the central banks, and then with the wealth of anyone who was on the “wrong side”. Since most fight for their lives, the loss of wealth was a tertiary consideration at best.
Machiavelli and Regime Changes
Regarding Machiavelli, per Niccolò’s teachings, regime changes are difficult even in the best of circumstances. While few would argue that that the US is going beyond norms with the FED’s massive purchases of Treasuries, it is not the first time. Nixon removed the gold standard, and despite kicking and screaming, others adjusted. The high level of debt is a concern as is the modest real interest rates. However, Japan and Italy have both those problems, and to a far greater degree than the US.
Now for the potential catalysts. The reality is that systems and regimes do change as mentioned earlier. However, typically they do only over long periods of time unless ownership changes. What we mean by ownership changes is that control over areas shifts. After the Normans conquered England in the 11th century, the order rapidly changed. Hence, investors will be well-served to watch developments in Asia. If China continues its current posture, some areas are likely to maintain a dual system, which appears to increasingly be the case. This is manageable. What is more of a threat is a wholesale abrupt change.
While this analysis is helpful, the message provided by the markets recently is that after decades of encouraging investment, China is changing its approach. The central government has determined that control over certain areas of the economy is more important than satisfying the investment community.
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