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26 May 2023

Nuclear odds

There will be no newsbriefing on Monday, May 29. In our main story, today, we discuss the non-trivial probability of a nuclear escalation in the Russia-Urkaine war; we also have stories on Raiffeisen's difficulties extricating itself from Russia; on round two of the Turkish elections; on whether Germany is really in recession; on the EU's too-little-too-late attempt to forget a strategic alliance with Latin America; and, below, on why the EU's green strategy is not working.

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Today's free story

Forget EU's green role model

Clean air is a public good that everyone enjoys, or lacks, at the same time.

The EU’s fit-for-55 agenda is full of goals and aspirations. It wants to set an example and lead the world to decarbonisation. But what if other countries won’t follow? We already reduced our carbon footprint by 25% over the past 20 years to 2.7 gigatons of CO2, which is half of the US's and a quarter of China's emissions. But without the efforts of others, this is a competition that is not worth winning.

In his op-ed for Les Echos, Eric Le Boucher made two important points: First, our strategy is inflationary. Second, we are not a role model for the world. 

The first point is related to whether we should pursue the green agenda through the supply or the demand side. The US puts all its efforts on the supply side with massive investments that eventually yield lower prices for green technologies which are then affordable to the consumer. The EU puts most of its efforts on the demand side by regulating what green energy sources are to be used and limiting imports from countries that are less regulated. The heat pump is a massive investment German house owners will have to shoulder with significant knock-on effects on their budget, consumption and house values. The demand side focus will cause an inflation shock similar to the oil price shock in the 1970s, according to Jean Pisani-Ferry. It comes in a time when Europe needs the opposite, a slowdown in prices and higher productivity. He calculated in his report that it will cost another 3-4% of GDP to finance this green transition. It is thus far from being neutral, as the initial strategy was set out to be.

The second point is our ideological blind spot. The EU no longer serves as a role model for others in other areas. Why would we think this to be any different when it comes to decarbonisation? The EU, by being completely engulfed with its own green agenda, seemed to have forgotten that there is another world out there that needs to partake in those efforts for it to be effective at the global level. Instead of subsidies to households so that they can switch over to heat pumps or regulating imports in our region that is already less carbon-intensive, would it not make more sense to invest that money in reducing emissions in Africa or India? Would this not constitute real leadership rather than the introspective, self-righteous way of how we go about right now?

We agree with Le Boucher in his conclusion that we need to let go of these sacrifice-based ideologies. They are too expensive for our economies. Instead we need more innovation and more finance to realise those. Most of all, we have to stop seeing ourselves as a role model for the world.

25 May 2023

When Europeans pick winners

The geezers amongst us will recall that Helmut Kohl and Francois Mitterrand had a pet project, besides the bigger political achievements they are both remembered for. This was high-definition television, a project they jointly pushed for in the late 1980s and early 1990s. They wanted consumers to have tangible benefits from the then-new single market. We see parallels to today's debate about technological neutrality in green policies in Europe. 

Back then, the Europeans, together with the Japanese, bet on the wrong technology. Their version of HDTV would have been the last hoorah of the analogue television age. Mercifully, that project died a quiet death. An article from the late 1990s recalls the episode, a cautionary tale of technological hubris:

"Both [EU and Japan] had adopted hybrid systems with both analog and digital features… Both had counted on their ability to market HDTV programming and equipment in North America, as well as in their home region. Now they were confronted with criticisms at home about the obsolescence of analog technologies and the need to keep up with the United States in digital technologies."

In addition, the broadcasters did not like it either because it was expensive, and in their view would not bring benefits to viewers. 

HDTV is a cautionary tale for politicians who think they understand technology. At the time, the Europeans were still overawed by their own success in creating Airbus as a viable competitor to Boeing. But Airbus turned out to be the exception, not the rule. There has never been anything like it since.

The prevailing future technology for home central heating systems, or that of motor cars, is sufficiently unknown at this point to make any firm predictions. There are car makers, like BMW, which have bet on hydrogen. Others, like VW, see the future as all electric. The controversial German domestic heating legislation is technologically neutral in theory, but tweaked in such a way that only heating pumps fulfil the criteria. Our European record of spotting technological winners is not great. Airbus succeeded because it broke a monopoly. It was a mature technology. Europeans had the engineering know-how. That is not the case here. We are dealing with technologies that have yet to be developed. Would we still want to plaster a large portion of our countryside with windmills, 2% in the case of Germany, if there is a breakthrough in the development of nuclear fusion reactors?

Technological neutrality lies at the heart of a newly emerging political division in European climate policies. France has now joined the camp of countries in support of technological neutrality. The German FDP, a leading member of the liberal Reform Europe group along with Emmanual Macron's LREM, is also pushing for technological neutrality and is causing rupture with the Greens inside the coalition. This debate is separate from the other divide we wrote about earlier this week, of the backlash against climate policies from farmers and rural communities. The latter is about the much overlooked social consequences of climate change policies. The debate about technological neutrality is more fundamental.

A much better way forward than trying to pick winners, or setting tight deadlines, would be to focus on the abandoned project of the capital markets union, without which it is hard to see how the private sector could generate the needed investments. We also have our doubts about Horizon, the EU's research programme. It is the world's largest transnational research programme, and yet the EU is a technological laggard in an increasing number of 21st century technologies. It has elements of a pork barrel project for academics. 

24 May 2023

Lucas and the business cycle - an obituary

Some years ago, we had a squabble with an academic macroeconomist that ended with a killer argument on his part: 80% of the profession agreed with him, and that was that. Parallels with the flat-earthers of the 17th century spring to mind. The economics profession is full of folk who invested their professional career in a framework that also did not stand the test of time. Out of this framework grew the so-called workhorse modes of orthodox modern macro, the most erudite of which is the dynamic stochastic equilibrium model, on which central banks had become reliant. Interestingly, at the ECB, for example, this is now starting to change.

The many gushing obituaries of Bob Lucas, the inventor of the framework, made us once more aware of the state of the profession. Paul Krugman, who has his own gripes with the mainstream, noted that the so-called business cycle models that Lucas pioneered in the 1970s had already imploded intellectually in the mid-1980s. We agree with his devastating conclusion:

"Unfortunately, by then many macroeconomists had invested all their intellectual capital in this failed project, and refused to give up."

That's your 80%. The models failed intellectually for a variety of reasons, the most important of which is that they were based on a version of rational expectations that has been resoundingly disproved by behavioural psychologists. At the heart of the model lies the notion that people take all available information into account when making decisions. Yet the devastating critique of the psychologists, like Daniel Kahneman and Amos Tversky, and many others, had no impact whatsoever. Rationality was needed for this model to work. It wasn't just a feature. 

At one level, Lucas's achievement constituted an intellectual master stroke. He brought various strands of economics into a unified whole. The model is not rocket science, but it is clever in the way that it was put together. In the world of statistics, there is a cliche that all models are wrong, but some are useful. Lucas's model falls into a different category: almost perfect, but useless. 

The reason for this harsh statement is that the model could not explain the many features of our modern economic plight, with the financial crisis in 2008 being a famous example. There is no place for finance in that model. There is no globalisation in it either. It is a world without the complex network effects of a digitalised global economy. 

Herein lies a difference to other academic disciplines. The Covid-19 model from Imperial College in London was just as wrong. We have to count the total impact on human lives and deaths from the policies adopted in 2020 and 2021. The world of epidemiology will, for sure, move on, and improve on its models. 

We ourselves witnessed a shift in one area which we rely on for our work: machine translation. It used to be based on linguistic algorithms. The current, much more successful, ones are based on computer-age statistical tools. New technical approaches have also started to appear in economics. Eventually, the 80% will become 60%, with the tendency falling. But remember, there are still flat-earthers around today.

23 May 2023

Why sanctioning is so hard

Leica, the German camera and binocular manufacturer, was one of the companies that until last year supplied Russia with goods that have potential military applications: laser rangefinder binoculars and night vision scopes. We are not in the finger-pointing business, but this story from the Insider highlights the difficulty with sanctions in highly networked, 21st century economies. 

To make it clear: Leica did not violate sanctions. In line with many other companies, Leica officially closed down its operations in Russia right after the invasion, but according to this article, the company changed its name from Leica Camera Russia to LLC Verchernaya Zvezda in order to be able to receive supplies. It filed three declarations for the import of binoculars and scopes, in July, November and December of last year. It was not until February of this year that night vision scopes and binoculars made it on the sanctions list. What it shows is that there are many ways and byways by which a good can make it to its final destination.

Handelsblatt has a story about Antwerp this morning, the centre of the world diamond trade. 80% of the world's raw diamonds go through the Antwerp World Diamond Centre. The G7 has now decided that it wants to add diamonds to the list of sanctioned goods. Russia is the world's largest supply of raw diamonds, with a global market share of 30%. There is no way that Antwerp can replace the sudden disappearance of close to one third of the market. Antwerp has already business in Dubai and Mumbai. The diamond folks in Antwerp are saying that the more sanctions you impose, the less control the west will ultimately have. 

Diamonds make up 15% of Belgium's exports. The country has so far blocked any attempt by the EU to put diamonds on the sanctions list. We would expect this to continue, leaving the G7 declaration as an empty piece of rhetoric. One further complication is that it is easy to conceal the origin of a diamond. This is something the international community as a whole is already familiar with, given the long and difficult struggle to prevent the sale of conflict diamonds from countries like Sierra Leone. Russian diamonds will ultimately find their way into global markets, just as Russian oil has done.

22 May 2023

Here is a leak, world-exclusive

We had a good laugh at the ECB’s essay on anonymous Eurosystem leaks because we have some direct experience of the matter ourselves, dating some years back. The authors are absolutely right. Leaking is going on, it is damaging, it is not as bad as it used to be, and it does not reflect what is actually happening.

There is an expression that first-rate people hire first-rate people, and that second-rate people hire third-rate people. Leaking is version of the latter: Second rate central bankers leak to third-rate journalists, who think they got a scoop. We recall a period when we saw articles claiming the ECB would take a particular action, based on comments from an implausible large number of central bankers that were said to be familiar with the matter. That's a give away. 

We doubt that any of these anonymous sources were members of the governing council. They may be assistants, or spokespeople, or even outside analysts with an agenda. They play the media instead. We suspect most of those sources would be located at various national central banks. We doubt very much that a journalist could find four or five members of the governing council leaking material non-public information to them, independently of each other.

We also would not exclude the possibility that some of these stories are entirely made up. In the UK, there has been a scandal of tabloid newspapers bugging telephones to get stories. The financial press is not quite so brazen. They use more subtle ways of misrepresentation. Our advice to readers is to disregard any story reliant on unlocated sources - like EU sources or central banks sources. Stop reading, cancel the subscription. As journalists we can attest that it is entirely possible to give specifics about a source without sacrificing its anonymity. For example, a journalist could, and should, be specific about whether the source is a member of the governing council. EU sources are even worse. Any one of the EU's 500m inhabitants is an EU source.

The ECB authors are right to say that leaks have an impact on financial markets. But not a lasting one. We think you could build a profitable trading strategy on systematically betting against them. Media reporting has contributed to the fact that financial markets persistently underestimated the rate increases of the last year. There are self-referential loops between reporters and market participants. They exist in a bubble fed by leaks. 

19 May 2023


It was always nonsensical to replace the entire volume of some 4000 EU regulations on a single day. The majority are unproblematic. The intellectual and operational difficulty with Brexit is to select specific areas where regulatory divergence makes sense. We all know about the costs of Brexit are transparent, but the opportunities are hidden, and dependent on how well this divergence is managed.

The UK government last week abandoned the end-of-year deadline for EU regulation, the so-called sunset clause, and opted for a more targeted approach. Had they persisted, it would been chaos. But it would be mistaken to conclude that the UK government is re-aligning with the EU.

As Joël Reland from the UK in a Changing Europe think tank explains, there are still 600 EU regulations that will be changed. What will also change is the end of the supremacy of EU law by the end of the year. UK courts will then be able to override EU law. We expect this alone to lead to significant divergence down the road. The government has also given itself fast-track authority on future changes.

But the most important aspect is that this reform is now going hand-in-hand with another initiative that is running in parallel: the pro-innovation regulation of technologies review, led by Patrick Vallance, the UK government’s former chief scientific adviser. The review is finally doing what we had urged the UK government to do right after Brexit, which is spot high-tech opportunities the EU is missing. Artificial intelligence is an obvious one, as is medical research and many other tech developments held back by the EU’s antediluvian data protection regulation. On high-tech industries, the EU has entered a regulatory death spiral, focused entirely on consumers since the EU companies no longer have skin in the game.

The EU’s problems with these industries has been building up over the last 20 years. Innovation and entrepreneurship have fallen down the ladder of political priorities. We also have doubts about the efficacy of Horizon EU, the EU’s research programme. It is large in volume, and a bureaucratic nightmare, according to this survey. But apart from the cumbersome application process, one has to question why it is that the race for several cutting-edge 21st century technologies is nowadays mainly between the US and China. The EU is also competing against the US and China in markets in which it had a strong position, like the car industry. Given the cross-border nature of this technological challenge, why did the EU not play a leading role in the transition from the fuel-driven car to the electric one? This is not just about batteries. Research, like a shift in regulatory regimes, requires focus to be effective.

We don’t see the UK so much as a threat to the EU in the way Emmanuel Macron and Michel Barnier had imagined, through low-wage sweatshops. The UK will simply exploit areas the EU has left to others. We don’t see any reason why that should impede on the mutual relationship, except that the narrative of Brexit as an inevitable economic disaster is unlikely to hold up. When BioNTech moves its cancer research from Germany to the UK, that should act as a warning sign for the EU.

We expect the UK’s shift in technology focus and regulations to persist under a Labour government. On the contrary, Labour will reap the benefits from what now appears the start of a post-Brexit strategy. Once you have spotted opportunities for investment and drawn in investors, you are not going to reverse to a status-quo ante.

18 May 2023

Habeck pulls the plug

Robert Habeck has finally pulled the plug on his right hand man, Patrick Graichen, over a nepotism scandal. Graichen was Habeck’s most important state secretary, the man responsible for the energy transition. Habeck tried to stick with Graichen, a long-standing personal friend, and widely considered very competent. But the pressure had become unbearable. The scandal broke after Graichen hired the best man at his wedding to a senior position. The heavy hitters of the Greens stem mostly from green think tanks. Graichen was one of them. As head of the think tank Agora, he was one of the leading figure in the Green movement before he joined Habeck in the ministry. As a relatively new party, the Greens have become more reliant on think tanks than other German parties.

Think tanks do not play the same political role in Germany as they do in the US or the UK. Their influence on politics is in general lower, except with the Greens. There are quite a few of them besides Agora, often founded by former MPs and focusing on different aspect of Green policies.

The Greens are a closely-knit community. It could be quite a challenge to find somebody who has not been to your wedding. This scandal has damaged Habeck. It is not fatal, but will radiate for a long time.

The scandal is a reminder that Green politicians make similar mistakes that others do. Habeck’s error was not to fire Graichen right from the start. In politics, you never sit through a nepotism scandal without lasting damage. The damage-minimising strategy is to act immediately.

But the bigger problem is that the Greens will struggle to use the power of moral arguments, which has been an important factor in their political rise. We should recall the intra-German debate on Nord Stream 2, when the SPD and the CDU said it was in Germany’s economic interests, and the Greens said it was morally wrong to make yourself dependent on a dictator. There is still substantial support for Green politics in Germany. But the Greens are currently not on course to replace the traditional parties in the foreseeable future. That was a possibility not too long ago.

17 May 2023

Are the Greek polls wrong too?

This coming Sunday, Greece is holding its own contested elections. The outcome may be as uncertain as the Turkish ones, and politicians are already bickering over what the polls actually mean. According to national media polls, New Democracy is leading by over 6pp over Syriza using traditional land-line telephone interviews. But those may exclude the younger generation and are thus biased, argues Syriza, which is calling for more transparency over how the data is actually produced. An elaborated questionnaire ran by private pollster on behalf of multinational companies suggest that this could be much more a neck-on-neck race, writes Euractiv. If the results are anything like the polls suggest, coalition talks are unavoidable.

It is the first time Greece is voting under a new proportional electoral system. To govern alone, a party would have to get about 46% of the votes in the first round. Winning less than that leads to one of two outcomes: either the leading party manages to secure a coalition with other parties, or there will be another round of elections in July, where a party will need almost 37% of the votes to govern.

Coalitions are not a thing for the Greeks and it may be quite alien to their political culture. What is said before the elections, may not reflect what will happen after the elections once the results are in. But the image is already telling. New Democracy continues to say it prefers to rule alone, and that its polling rates are good, but they still do not suggest that they could keep up this aspiration. What coalition options does New Democracy have? A grand coalition seems to be off the cards. New Democracy and Syriza are on opposite ends politically, and both have vehemently ruled out a coalition with each other. Pasok could become the kingmaker but won’t commit yet to anything. Kyriakos Mitsoutakis is appealing to Pasok voters to help him prevent Syriza from coming back to power in coalition with Pasok.

If coalition talks fail, which seems very likely, they go into second round elections in July.

16 May 2023

Will AfD become a government party?

There is looming political gridlock in Germany. When the AfD, the far-right party, polls at 17%, as it does now, and when the CDU/CSU polls at around 30%, which is their core support, it is virtually impossible to build a government other than a grand coalition between CDU/CSU and SPD. But neither of the parties want this.

We should recall that the current so-called traffic light coalition only came about as a result of a couple of electoral accidents that are unlikely to be repeated. The first is that the vote of the CDU collapsed to under 25%. The other was the under-performance of the AfD. It is a fractious party. It could happen again any time. But what changed since then is that the Ukraine war, the rise in inflation, and the compromises the FDP accepted while in government have driven many voters of the centre-right towards the AfD.

The Left Party might not make it into the next parliament. But even that would not help much. All the scenarios are putting us back into grand coalition territory.

After a disappointing performance in the Bremen state elections, Friedrich Merz, the CDU leader, is now contemplating whether to shift his party further to the right. Electorally, this would make sense, but it is risky. We would not be surprised to see CDU/AfD coalition at local or even state level at one point. The AfD is particularly strong in the state of Thuringia. So is the Left Party, which is currently leading a coalition there. But if the AfD were to become the largest party in that state at the next election, to be held in the second half of 2024, it might enter into government for the first time.

Nationwide, the SPD, Greens, and AfD are all polling around 15-20%. The CDU is around 30%, and the FDP around 7%. We think the FDP’s support will stabilise above the critical 5%, but the party has essentially failed to appeal to young voters, many of whom supported it last time. When in opposition, the FDP talked about modernisation. When in government, it ended up supporting the car industry and delivering austerity. The only three-party coalition option they could be part of would be a Jamaica coalition under Merz. But the likelihood of such a constellation dwindles if Merz is moving his party to the right.

Germany is heading towards a position where the AfD could become indispensable in the formation of a federal government at some point. Grand coalitions are the alternative, but we have to remember that we are where we are because of a long legacy of grand coalitions, and their failure to address foreseeable issues, like a Russia-reliant energy policy and technological decline.

15 May 2023

Nul Points

What Germans and Americans have in common is their belief that they are popular in the rest of the world. It is one thing not to win the contest. But quite another to be last two times in a row. The year before that, they were second last.

We make no judgement about musical quality, except to say that the times when German music was European music have long passed. But even that observation cannot come close to explain Germany's poor performance. Except for 2022, the UK shared a similar plight: it came second-last this year, and last in 2021. The Brits are not that popular either, it seems, except in a year when they went out of their way to support Ukraine.

The ESC is a system where each country has the same voting weight and where the vote in each state is by referendum. This turns it into a popularity contest of how countries perceive each other. It is to a large extent a protest vote against Germany's pro-Russian politics by many small countries perched around the Russian or Belarusian border. The vote does not yet reflect the recent shift in German foreign policy from best-friends-with-Vladimir to best-friends-with-Volodymyr, all within a space of a few months. Clearly a shift has taken place, as we saw yesterday when Zelensky visited Berlin, and got more money and tanks. And Scholz no longer uses backchannels to block the deliveries, as he did in the beginning of the war. We would advise Zelensky not to trust Scholz even now. We don't either.

It was not long ago when we heard Jens Plötner, Scholz' foreign policy adviser, saying the most interesting question about the war is how Germany and Russia patch up their relations afterwards. Comments such as these are nowadays considered seriously uncool even in Berlin. Witness the outrage last week when Gerhard Schröder celebrated 9 May with his friends at the Russian embassy, alongside leaders of the AfD.

There is an unspoken rule in European diplomacy never to allow one country to cast a vote on another. The EU is no stranger to referendums, but so far it has managed to avoid referendums on accession, for example. The ESC does exactly that. It is the quintessential panem-and-circensis distraction, where things are possible that are not possible in the real world. Which is a world in which Germany usually gets its way, for better, and mostly for worse.