26 April 2023
Don't gloat about the dollar
We note a lot of gloating from some US academics, who are telling us that, no, the global role of the dollar is not falling. And, no, there is no de-globalisation. The gloat is about comments from the Brazilian president, Luiz Inácio Lula da Silva, who said
“Why should every country have to be tied to the dollar for trade?… Who decided the dollar would be the (world’s) currency?”
Most of this gloating comes in the form of the straw man variety of arguments: China is running massive current account surpluses, which force them to invest their surplus in a foreign currency. Our all-time favourite is the assertion that there is no evidence of de-globalisation in the trade data. This falls into the category of Berlusconi economics. There can be no recession because the restaurants are full.
We understand the reasons why the dollar has emerged as the world’s largest currency. We also understand that this has nothing to do with the denomination of prices. Even if the oil industry were to start using the euro as the denominator, it would not make a difference. Lula has got that part wrong. But he still has a point.
The dollar has climbed to its position because the Europeans did not challenge it on purpose, and because the Chinese growth model, in its early phase, was critically dependent on large savings surpluses. Neither of these factors is likely to persist. There is big geostrategic shift happening in the world that allows the former Brics economies - China, India, Brazil, South Africa and Russia - to decouple from the west. A large part of the reason why this is viable now is based on the scarcity of some raw materials that are becoming increasingly important, like rare earths. And on the fact that China in particular has invested in production capacity in other parts of Asia, Africa and Latin America, much more so in recent years that than the US.
There is an awful lot of lazy thinking going on, by US economists and their uncritical fan club in the English-speaking media, that large current account deficits are a precondition for a currency to dominate. This argument falls into the same category as Lula’s crude statement: it is not quite right, but not completely wrong either. It is the converse that is true: you cannot be a Mercantilist, like China was, and have a dominant currency at the same time. But that only explains what happened in the past. As China is investing its investment from US treasuries to things like Chilean lithium mines, or German robotic companies, in other words from bonds to equity, the argument no longer holds. If the world splits into the west and the rest, it is perfectly viable for the rest to have its own dominating currency. Or for the euro to become the dominating currency for as long as Europeans act independently of the US, which is not the case now.
We noted with some interest that Stanley Druckenmiller, one of the most successful US hedge fund investors, is citing the weaponisation of the US dollar as one of the reasons why he is shorting the US currency. Druckenmiller even cited Lula’s comment. We see it in exactly the same way: the more you weaponise the currency through financial sanctions, the more likely you are to lose the status of the world’s currency. Which foreign sovereign wealth fund, outside of Nato, would still want to hold a large proportion of the wealth in US treasuries if expropriation is only one US election away? One foreseeably dangerous moment to watch out would be how the US reacts to a Chinese invasion of Taiwan. The US could repeat what it did with Russia and freeze the Chinese dollar reserves: some $3tn. You may call it a proportionate response. We call it a default. Do you believe that people will want to trade in dollars if and when that happens?
25 April 2023
How to change the EU treaty
This morning we noticed that the main new stories in the US and German papers are about famous national journalists getting fired. We don’t care about the characters, but what we find interesting is how such stories pop up independently of each other in different countries.
We made similar observations in our own reservation. An economic event in country A often has a mirror-image in country B. The media are treating those as national stories, whilst ignoring that the forces behind those events are the same. This morning, the underlying force has been the fictionalisation of news. In the case of the euro area, it is the force unleashed by the monetary union. EU leaders bask in media attention. But they have lost control over the narratives a long time ago.
When discussing the future of the EU and the euro area, one has to start with the observation that all monetary unions that refused to become fiscal unions have failed. This is because they unleashed economic forces national governments could no longer control. This is not a prediction of what will happen to the euro area, but a prediction of what will need to happen to prevent calamity. We know that our narrative is not popular right now. That does not change the fact that those underlying forces exist, and that they will increase over time. They will require a fully-fledged fiscal union, together with a proper banking union and capital markets union.
Such a union will not be established overnight. It can take decades. But it requires treaty change. That can take two forms in principle: a big leap that gets it done, or a small leap that stops short of the actual thing, but that sets the foundations for the actual thing to happen later.
Andrew Duff, who has done more deep thinking on EU constitutional issues than anyone else we know, argues that there is one particular technical change needed for the EU to be able to move forward: a change in the general passerelle clause. You won’t read about it on the front pages of newspapers, but this is critical for a future fiscal union.
A passerelle, in ordinary language, is the gangplank used to board a yacht. In EU jargon, it is a clause established in the Lisbon Treaty that allows EU leaders to take the next step towards European integration without referendum or the need for treaty change. They could, in theory, use it to establish a fiscal union right now. The reason why this clause has been essentially useless is the requirement for unanimity. The EU will clearly never find unanimity amongst 27 members for something as controversial as a fiscal union.
Duff’s proposal is to shift the unanimity requirement to a high-threshold majority vote, known as super qualified majority voting, or super-QMV. The EU has several voting rules depending on the political area a vote is taken. Foreign policy decisions require unanimity. Most decisions, for example on the single market, require ordinary QMV: a threshold of 55% of the member states representing 65% of the population. With super-QMV, the population threshold is the same, but the number of members states required to pass legislation goes up to 72%. With 27 members, that threshold would require ascent of 20 countries. Note that this is exactly the same number as the members of the euro area right now. This proposal would allow the euro area countries, as long as they agree unanimously amongst each other, to move forward. That is still a high hurdle.
The current passerelle clause also gives each national parliament a veto. It is unsurprising that this procedure has never been used. Several policy areas are also excluded from this procedure: increases in the EU’s own resources, and its budget, for example.
If the EU did one treaty change only, we think this would be the most important one. The best strategy right now is not to raise the issue of political and fiscal union directly, but to make it possible so that it can be done when the time is right. That is clearly not now.
The economic purpose of a future fiscal union is not to transact payments from one country to another, as has been the approach of the recovery fund, but to provide a bulwark against economic shocks, and to fund activities like defence procurement or bank deposit insurance, which national governments are not very good at. Large countries like Germany are more shock-resistant than others. But deposit insurance is an example where even Germany would struggle during a crisis because it is funded by the banks themselves. It reminds us of the old joke during the global financial crisis about credit default swaps: it’s like buying insurance against the sinking of the Titanic from someone on the Titanic.
24 April 2023
Economic sanctions - the denial phase
Remember Scrat, the pre-historic squirrel from the film Ice Age, who tried to plug water leaks that squirted out from a wall of ice? Scrat used his four extremities, then his nose. And then a sixth leak erupted with explosive force.
The US and the EU are now trying to perform similar acrobatics with their leaky Russian sanctions. These over-hyped sanctions were the work of foreign policy people with an imperfect understanding of global supply chains. The sanctions are not working because it is impossible to control networks as complex as that of the entire physical global economy.
We noted a story that the US had warned European countries about the methods used by Russia to circumvent sanctions through dual-use goods. The countries in question are Germany, Italy, Switzerland and Austria, the core of Russia’s old commercial buddies in the EU. The Russians are mostly after electronic equipment. The problem is not only classic dual-use goods. An example of those are digital oscilloscopes, instruments to read voltages, plotted against time. They can also convert other signals, like sound waves, into voltage. They are used by electricians for repairs, and by the military to test the function of military planes, amongst many other uses.
Another new category are hidden dual-use goods, where expensive electronic components are hidden in cheap casing: think of refrigerators that hide a defence component inside.
We now have a thing called sanctions diplomacy. The EU has a sanctions envoy. David O’Sullivan, a former EU ambassador to Washington, has recently travelled to the UAE, Turkey and Kyrgyzstan.
We have no doubt that the west will start to plug some of those gaps. What this overlooks is that new gaps will open as you plug old ones, as the unfortunate squirrel found out the hard way. There are no practical ways to trace the whereabouts of electronic components, unless you fit them with expensive tracking devices. And if we try, we will end up with an industry that specialises in disabling those devices. We might want to recall how VW cheated its diesel buyers with hidden software.
The bottom line is that if there is money at one end of a chain of transactions, and goods at the other, there are more ways for them to come together than foreign policy officials with a rudimentary understanding of industrial economics will ever know.
21 April 2023
A very British crisis
The energy crisis might not be over, but in many parts of Europe it feels like it is, as energy costs themselves start dropping out of headline inflation indices. But in one part of the continent they remain stubbornly high: the UK. Energy costs for March had risen 79% over the past two years, which is the highest in Western Europe.
Things are still bad, then, but why? One reason is because of the dominant role gas plays in the UK. Gas accounts for more than 40% of the UK’s final energy mix, a significant share considering that also includes oil usage for transport. Gas actually edges out oil in the UK’s energy mix, and also accounts for around 40% of its electricity mix. Germany, by comparison, gets just under 27% of its total energy from gas, and uses it for around 16% of electricity generation.
One of the reasons why gas’s share of the final energy mix is so high is because of the dominant role it plays in heating, with around 80% of British households having a gas heating system. While the boilers in these systems have gotten a lot more efficient over the years, homes have not. The UK’s housing stock is some of the oldest in Europe, and is relatively poorly insulated compared to other north-western European countries. The various attempts successive British governments have made to improve this situation have been underwhelming.
Then we have energy support and the price-capping system. While the mini-budget fiasco was what ended Liz Truss’s premiership, one of the most damaging legacies of the political chaos in the latter half of 2022 for the UK might be what it meant for the country’s energy support scheme. It both came too late, and was extremely badly targeted when it did come, applying a flat unit pricing levy with no regard to more consuming energy users, who tend to be better-off.
Price capping also means that when prices fall, it can take a while for the energy providers to respond. If you have a price cap, it’s important that it’s responsive enough to what’s going on in the energy market when prices don’t fall. The price maximum is effectively always the price, especially in an environment where energy utilities fear going bust more than they do losing customers.
But what sits behind all of them is a common theme: shorter-term dynamism decades ago, followed by a longer period of stagnation and ineffectual political will. When the UK switched from coal-generated town gas to natural gas in about a decade over the course of the 1960s and 1970s, it was one of the most impressive examples of an energy transition anywhere in the world.
But since then, things have stayed where they are. Buildings haven’t been upgraded, the grid and heating systems are still very gas heavy, and political solutions often come too late, like the energy support, or as sticking plasters, like the price cap. Watching successive British governments try and fail to manage the now-privatised British retail energy market is like watching someone stumble around a room in the dark, banging their shins on every piece of furniture possible.
20 April 2023
AI - a real Brexit opportunity
What economists are blissfully unaware of, as a group, is that there exist propositions that are fundamentally undecidable ex-ante. The economic consequences of Brexit is one of them. We can calculate the expected losses due to trade friction. But the gains are uncertain. The correct answer is that it depends on policy.
As we read in Sifted, artificial intelligence is now set to become an area of divergence in regulation between the UK and the EU. It looked at the recently published AI strategies of the two sides and concluded that they could not be more different. The EU, as ever, are focused on the dangers, and are trying to regulate and control it, as Italy just did with its ban on ChatGPT. The UK has produced a white paper which moves in the very opposite direction.
The UK is the world’s third largest investor in AI after China and the US. We reported recently that Biontech has moved its next-generation cancer vaccine research to the UK, precisely because the EU’s regulatory environment is too restrictive. The UK has become a favourite place for AI start-ups. The white paper talks about issues like interoperability with EU institutions, but the emphasis is clearly on exploiting post-Brexit opportunities.
It is unclear whether regulatory opportunities will outweigh the losses from existing trade. The economic impact of Brexit is complex. But AI and data protection are probably the clearest area where commercial opportunities of divergence are most obvious. We have identified competition policy as another one. This is not so much a matter of good policy versus bad. The EU’s competition policy regime is geared towards ensuring peaceful co-existence of 27 member states in a single market. It does not necessarily constitute an optimal competition regime for a single non-member. There is no need, for example, for the UK to follow EU rules on state aid. The UK can opt for tailor-made policies that would not be possible in the EU, on lines, for example, that are similar to the US inflation reduction act.
The Sifted article is also critical of the consequences of divergent regulations between the UK and the EU. It says ChatGPT is not the real issue. The bigger one is the use of AI in tackling climate change and global healthcare problems. If AI achieves successes in those areas, it is critically important that regulatory regimes are aligned.
We agree with that view, but we don’t think that you can front-load this process with harmonised regulation. The problem in the EU is that AI is viewed as a threat, not an opportunity. One reason is that fewer EU companies have skin in the game. The EU will ultimately have to change its regulatory environment once the opportunities are becoming more apparent. From the UK perspective, it still makes sense to break with EU regulation because otherwise the entire field will be left to the Americans and the Chinese.
Sifted also noted that the UK’s white paper, while full of aspirations, was also low on concrete regulatory proposals. Company founders and investors need regulatory certainty to commit. One specific problem in the UK is that responsibility for AI regulation will be shared across departments, leaving no one in charge.
The article says that AI is mostly dependent on one thing only: data. This is why data protection laws are critically important. The UK is trying to open up the data regulation framework it inherited from the EU. This is where the frictions will start to appeared relatively soon.
19 April 2023
Here is a story about about the politics of climate change at a time of droughts. This year, droughts in the south of Europe will have a severe impact on the harvest. It will throw up tensions between farmers, environmentalists, and present tough choices for governments. Spain is one of those cases after an extremely dry season in four of its regions, with 60% of its crop affected with irreversible losses. In Andalusia, this has become a political totem, according to Euractiv. The local government, led by right and far-right Partido Popular and Vox, is about to pass a law that would regularise the farmers' illegal use of water from the Doñana natural reserve. Doñana is considered one of the most important biodiversity hotspots in Spain and in Europe, characterised by its wetland, marshland and dune biomes.
Environmentalists as well as national and European authorities strongly condemned this move. But farmers and the local government warn that without the water, thousands of jobs are at risk for the berry picking season.
Blame is also passed on to former governments who did nothing to come up with alternatives although 59% of Doñana’s largest lagoons have been dry since at least 2013. And the latest data suggests that 80% of the lagoons dried out earlier than expected, probably due to the farmers irrigation activities.
There had been an attempt to strike a balance. The strawberry pact, negotiated between farmers, environmentalists and authorities in 2014 after seven years of negotiation, agreed to regulate only irrigation systems prior to 2004. But irregular irrigation continued. And now the regional government wants to regulate all the other ones too. This new law would breach the Strawberry pact as well as the EU water directives.
Some admonishment from Brussels is to be expected. In 2019 the European Commission took Spain to the CJEU over its failure to protect Doñana’s natural reserve and in breach with the EU’s water directive. After the CJEU’s ruling and formal notice from the commission in 2022, no action has been taken to implement the ruling. We are likely to see more conflicts like this coming up where environmental and farming survivals are opposing each other. It’s the nature of scarcity.
This stand-off will not dissolve itself. What is needed are innovative methods to recycle or reuse water. There are methods out there. A plan that would safeguard water in a farming region requires money, time, and political will. There is no quick fix. The new law the Andalusian government plans to implement would only buy time for farmers to adjust, but not solve the problem. This can only go so far as the remaining 20% of the lagoons still have water. It is only a matter of time until this is no longer the case. There goes strawberry farming around the Doñana reserve.
18 April 2023
Protecting the franchise
The Marxist historian Eric Habsbawm characterised what he called the 20th century as the age of extremes. Despite rapid technological progress, the century will forever be remembered by its ideologies and wars. The 21st century differs in one important aspect - not in that ideologies are dead, but that technology creates political realities.
Take crypto, for example. The other day, we noted someone panicking over crypto, noting that it was antithetical to the rule of law. This is true, but is a feature, not a bug. Fiat money constitutes an instrument of power for governments, like the ability to inflict financial sanctions. The anonymous creator of bitcoin stated in his white paper that the purpose would be to allow transactions that are not subject to the control of governments.
The Russians were amongst the first to try and restrict the use of crypto, only to discover its possibilities after they had become subject to western sanctions. Cryptocurrencies were not at the most sophisticated end of technology. Its algorithms were mostly old. Regulation will probably kill some pockets of current crypto financial bubbles, including dodgy constructs like stablecoins. But breaking a blockchain policed by a large decentralised community is beyond the capability of governments. Crypto, as a thing, will survive and prosper.
ChatGPT is a very different beast altogether. It is technologically far more advanced. But what crypto and so-called large language models have in common is their social impact. Both threaten established franchises, protected by barriers of entry. ChatGPT specifically threatens franchise of information gatekeepers. It is already killing jobs. We heard a story the other day that a company has fired its entire marketing department and replaced them with ChatGPT. Based on our own experiences in the media industry, we would not surprised to find that newspaper owners one day to do the same to their journalists, and improve the quality of the content at the same time. ChatGPT will never do investigative journalism. It won’t publish classified US documents. ChatGPT constitutes a clear and present danger to anyone who seeks to make a career in the think-tank industry, or the fluffier end of academics. Policy analysis is another area. The world is full of information gatekeepers.
ChatGPT or other LLM systems can give you legal advice for free. They will not replace a good trial lawyer, but large sections of the legal industry. Same for the financial industry, from financial advisers to the lower to medium end of the fund management industry. They exist only because of frictions in the financial system. The pennyless poet, the bane of the bourgeoisie of previous generations, may end up as financially more resilient than the respectable professions of the past.
ChatGPT is also not very good at plumbing. Countries with large manufacturing industries are likely to be less affected by large language systems than countries that have bet their future on the service economy, much of which consists of protected information franchises. As with any change, there will be winners and losers. This is where it gets interesting. The losers this time won’t be factory workers and coalminers, but university-educated people who streamed into the information industries.
16 April 2023
Torn over China
The other coalition crisis that is currently playing out in Germany is between the SPD and the Greens. It is about China. Normally, this is a fight the SPD would be expected to win: SPD+industry+media vs. the Greens. But it is more complicated than this. This time it is the Greens+Biden+Von der Leyen. Olaf Scholz is torn. He needs to keep both his coalition and the transatlantic alliance together.
As we saw last week with the furore created by Emmanuel Macron during and after his visit to China, divisions over China run deep across the EU. They also cut right through German politics. The conservative wing of the SPD is criticising the Greens over what it called an anti-China policy, and warns about disastrous economic consequences for Germany in particular. China is Germany's largest trading partner. The Greens retorted that the SPD has learned nothing from its catastrophic Russia policies. It is always doing business with autocratic regimes. This is not a lower level brawl. This is one of the fundamental ideological conflicts playing out in German and European politics right now.
We don't want to over-interpret these comments. Germany's China policy is driven by outside events, like the US ban on semiconductors, and data security considerations. Scholz is not inclined to show leadership in Europe, neither alone nor together with Emmanuel Macron. He has instead re-enforced the transatlantic partnership, a policy we think will last for as long as Joe Biden is in office. The pressure on Scholz to toughen policy on China is more likely to come from the US than from the Greens. But the Greens hold two critical ministries - foreign and economics - which collude on forging a new China strategy. Robert Habeck has been blocking a number of planned Chinese acquisitions and investments. The European Commission is also in the process of revising its China strategy. Ursula von der Leyen's recent speech is very close to the Green's own position. Both seek a greater representation of geopolitical and security issues in the EU's China policy.
At a much deeper level, this conflict is about the future of the industrial model. The SPD is the party of industry. This is where the majority of its ageing voters come from. We should expect some pushback in a time like this. But the bigger story, we think, is that this shift away from corporatist model is starting to happen. In the past, the commercial relationship with third countries was not even a talking point in German politics.
The bigger question is not whether the EU, and Germany, are starting to grow a spine in their relation with China. They probably will. But whether European industry can modernise. We should remember that the fax machine did not die because of a new trade policy.
14 April 2023
Three stages of de-globalisation
The most complacent and misleading argument in the debate about the future of globalisation is the reference to the currently high levels of trade and investment. It is true that you cannot see de-globalisation in the data, but there is a problem with this argument: today's trade is the result of decisions taken a long time ago. Last year, German companies invested €11.5bn in China, the highest ever. Trade volumes with China are also near record levels. The WTO's chief economist, Ralph Ossa, now warns that political decisions taken today will eventually be reflected in data on trade and investment.
He told FAZ that de-globalisation takes place in three stages. Stage one is complete. It is a change in narrative. The second is protectionism, like the US inflation reduction act, and various measures now taken by all countries, the EU included, to subject trade and investment to geopolitical considerations. The third stage is an actual fall in trade and investment. That has not happened yet. But it is only a question of time.
Ossa put the cost of global de-fragmentation in terms of a fall in global national income at 5.4%. He puts the total opportunity cost at 8.6% of national income if one includes the gains that would have been possible through tariff reductions. There are similarities to the debate on the economic consequences of Brexit. Fragmentation has a cost. A single country can offset this cost, for example by switching the economic model. The world, as a whole, cannot do that. This is going to be a real loss in income due to negative network effects.
We see global fragmentation as the biggest of the foreseeable structural economic risks the world economy is facing right now. Ossa's is the first numeric estimate we have seen of the total cost. We saw similar predictions ahead of Brexit. But there is one big difference. In the case of the UK, an electorate decided that it was ready to pay this cost. The world is now sleepwalking in a similar direction.
13 April 2023
The case for strategic autonomy
You could call it slow-moving train wreck, or perhaps more appropriately a high-speed car crash. We are currently witnessing a co-ordination failure of massive proportions.
Our story concerns the car industry, a case study that demonstrates a generalised policy failure. The story has three parts that also constitute a trilemma: the phasing out of the fuel-driven car in 2035; the failure to secure the raw materials for the cars that come next; and a simultaneous crackdown on China, the country that has a monopoly over those raw materials. What can possibly go wrong?
Emmanuel Macron has a point about strategic autonomy, though we don't think he chose the right format and the right language to make it. We, too, see an escapable logic to it, but to appreciate it, one would need to be honest about the EU's multiple failures.
Strategic autonomy is not primarily about military security. In this particular example, it should be about coordinating foreign policy with economic and climate change policies. Unfortunately, this is not how policy making in the EU works.
Strategic autonomy can be used to different ends. You might want to phase out the fuel-driven car on a particular day. Or you might prioritise your corporate sector. If you want to follow the US and crack down on China, you should probably start thinking about how to de-industrialise.
Europe's lost world is that of a functioning multilateral trading system, in which everybody did business with everybody. It was not too long ago when people saw the Eurasian continent as the 21st century power hub. What is emerging now is a fragmentation that cuts right through the middle of Europe, on a geographical line not quite along iron curtain, but close enough.
The reason we pick on the car industry is its central position in European industrial networks. A lot of other industries depend on it: steel makers, producers of paints and plastic, and a huge car component industry. That world is coming to an end, one way or the other. But why not manage the transition? Before you can board your shiny new electric car in 2035, would you not want to make sure that you can build it?
With its critical raw materials act the EU has recognised that raw material dependency is a problem. Unfortunately, China dominates the market for several raw materials on which electric cars rely. China is about to ban the export of rare-earth magnets, which are critical for wind turbines and electric engines. China is also the world's largest producer of lithium, an essential ingredient for car batteries, with a market share of 80 to 90%. The market share for rare-earth magnets in the same category. Beijing also controls 60% of the world’s entire rare earth production chain.
Olaf Scholz has recently visited Chile, another important global source of lithium, only to find that the Chinese have been there before him. Tianqi, a Chinese mining firm, holds more than a fifth of the shares SQM, Chile's lithium producer. China has spent years developing business relations with Chile.
The fundamental problem with the EU is that despite its size, its policymakers are mostly small country people. Small countries frame their foreign policy in terms of relations. Big countries frame it in terms of interests.