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14 October 2022

Ost Stream 2

The roadblock to a common European foreign policy is not the lack of qualified majority voting in the Council. It is Germany's continued attempt to subjugate security interests to the commercial interests of German companies. One would have thought that Germany would have drawn at least some lessons from Russia's invasion of Ukraine. For example, that it was a mistake to make yourself dependent on an aggressive ruler for critical raw materials. Not so. Olaf Scholz is now planning to reinforce Germany's strategic dependence on China. He has invited selected German businessmen to accompany him on his first visit to Beijing. A government plane full of CEOs ready to sign lucrative deals is the most visible symbol of what we call neo-Mercantilism. Modern Germany has subjected other legitimate foreign policy interests, including national security and considerations for human rights, to commercial interests. Scholz is very much in the same tradition.

What can possibly go wrong if Germany is now cuddling up to China? Germany is building up a massive security risk. China's BeiDou satellite system, which it exports as a GPS alternative, can be used to track the movement of people. We also know that China is using 5G mobile technology to track people's movements and to eavesdrop. There is virtually no hint of security implications in the German discourse.

Nor is there much acknowledgement of the sheer disaster of German foreign policy in the last twenty years. What many Germans do not quite see is that their reputation has suffered immeasurably as a result.

We noted an interesting comment by Thorsten Benner in Spiegel, who notes that the interrelationship between China and Germany is much deeper and more intricate than that with Russia. The primary goal of German foreign policy after Vladimir Putin's invasion of Ukraine should have been to reduce those dependencies, rather than create new ones. Benner makes the point that the problem is not trade. Nobody is asking Germany to abandon the Chinese market. The issue is supply chain dependency.

China, by contrast, focusses very much on supply chain autonomy with a view to withstanding US sanctions. President Xi Jinping said in 2020 that China needed to be independent in all areas with a relevance for security. He also said that it should be China's goal to increase other countries' dependency on China, to make China robust against international sanctions.

We see the Chinese thinking in similar categories as the Americans, and to some extent the French. The UK is also becoming more cautious on China, as exemplified by the recent warnings by UK's spy chief of China's dominance in global satellite technologies. 

The optimistic take, from the perspective of those who look at German-Chinese relations with a critical eye, is that the German approach is not really sustainable. Putin's war has essentially killed Germany's macroeconomic business model. Without cheap gas, Germany is not a particularly suitable place as a hub for industrial production, very much in contrast with China. Germany would become a technology service supplier to China, but we doubt very much that this constitutes a successful and sustainable business model. Germany discovered this when Chinese companies bought up the solar industry and the factories and jobs disappeared.

A much better approach would be for the EU as a whole to achieve a high degree of supply chain independence, and build out its relationship with third countries, the US and China, on that basis. For Germany to go alone is a disaster both for European integration and transatlantic relations at the same time. If you care about European strategic autonomy, as we do, do not applaud Germany taking a position simply on the grounds that it is in opposition to US interests. This is in opposition to European interests too.

The EU's biggest failing in the last two decades has been the refusal to stand up to German Neo-Mercantilism. There can be no meaningful foreign policy integration unless and until that happens. Our advice therefore is to postpone discussions on QMV and other technicalities, and focus on this issue first.

13 October 2022

European defence shield takes shape

Spiegel reports that Olaf Scholz's proposal of a joint European air defence system against ballistic missiles is supported by 12 EU member members states, mostly from Eastern Europe plus Germany, Belgium and the Netherlands. A letter of intent was due to be signed off by defence minister at the fringes of a Nato meeting. The group expects more EU member states to join. Scholz made this proposal in his big European speech in Prague a few weeks ago. The foreign policy part was, as we analysed at the time, a non-starter. But his idea of a missile defence system has legs. The main selling point is that a joint system is more cost effective and better-performing than national systems.

Spiegel also made the point that air defence systems were among the casualties of the austerity years in Europe. The system under discussion now is geared towards ballistic missiles and drone attacks. Spiegel speculates that the Europeans are likely to buy the Israeli Arrow system. Germany is currently using the US Patriot, which is also considered very effective, but is not suitable for a large defence shield across nations. What is not yet clear is how the system should be funded. Germany will take a leading role, but won't be able to bankroll the system on its own.

Two countries that will not join are Poland, which wants to build its own national system, and France, because of its nuclear arsenal. So this is going to be another European coalition of the willing. The good news is that EU countries no longer blindly apply austerity to defence budgets, and that this system will increase European security overall. That bad news is that this is not really a European system. Strategic autonomy is still a long way off. 

12 October 2022

Diamond and Dybvig

In an academic discipline as off-track as modern macroeconomics, it must be difficult to award Nobel prizes. There have been a few interesting developments in recent years, but they are not yet ripe for the highest honour. The interesting stuff resides on both sides of what we might call boomer-macro. One of the few very good old papers out there, whose authors are still alive, is Bank Runs, Deposit Insurance and Liquitidy by Douglas Diamond and Philip Dybvig from 1983. They explained the macroeconomics of bank runs like no one else has done before. The paper has influenced how we think about banks. It has given us theory of bank runs, and helped us draft policies for bank regulation, supervision, resolution and deposit insurance. It is macroeconomics at its best, the good old days.

But not everybody is happy. There is a furious debate going on in Germany, triggered by the economist Peter Bofinger, who accused the Nobel committee of having awarded the prize to advocates of the loanable fund theory. This refers to the view that money is created by bank deposits, which then act as a constraint on bank lending - the idea that a bank can only lend what it has in deposits. This is clearly not how it works anymore.

We think Bofinger's criticism is unfair to the authors. Bofinger reacted to the Nobel committee's ill-chosen words in their announcement of the prize. What Diamond and Dybvig did was try to explain a phenomenon that occurred in a different age. Specifically, they explained how bank runs can affect healthy banks and the economy in general. It is a story of market failure. But the Bofinger criticism is justified in one specific sense: we live in 2022. We have many financial stability risks out there. Bank runs are not the main ones. So why on earth are we talking about a 1980s paper dealing with a 1930s issue?

Our answer is that the bank run is probably the last of the big phenomena of macro-finance which economists have developed a deep theoretical understanding of. We at Eurointelligence and others have told the story of the global financial crisis and the euro area's sovereign debt near-meltdown in the last decade. Narratives come cheap. But we lack an as yet generally accepted economic theory of what happened. The global financial crisis had aspects of a bank run, but the issues, and especially the international contagion were not those described by the Diamond and Dybvig model. Banks remains important source of potential instability in our financial system, but the risks have clearly shifted to the shadow banking system, the part of the financial system that is not, or only minimally, regulated.

The main financial instruments of modern central banks are collateralised security repurchase agreements, or repos. Repos are also the instrument of the inter-bank markets. This, not bank deposits, is what we should be focusing on. The panic in UK gilts market, the subject of our lead story this morning, is deep down a story of a collateral crisis, triggered by the UK government's injudicious mini-budget. We shouldn't blame Diamond and Dybvig for not seeing this, but then again, it feels somewhat awkward that we should be discussing bank runs at a time like this.

11 October 2022

Does Putin have a plan?

Vladimir Putin's revenge attack may be, as one German commentator said, the last glimmer of a failing strategy. It was addressed at a domestic audience exasperated by military losses, to reduce the chances of a putsch from the hard-liners.

We have learned to be sceptical of scenarios that conform with our hopes, and with best possible outcomes. Europe remains in a very dangerous situation. There is the scenario where Putin decides to withdraw and then tries to sell this victory back home. We hear reports that his stock of missiles, of the kind he fired yesterday, is running low. But we also hear reports that this is not so. There are scenarios where he plays for time, and tests the solidarity of the west, which has yet to endure a cold winter.

Putin's strategy for now is focused on public infrastructure: energy, gas and water. To the Ukrainians, it does not come as a surprise that this is how he reacts to the military defeats in eastern Ukraine. As winter approaches, Putin plans to freeze his enemy to death, and create another refugee crisis. The situation is particularly acute in the areas recently liberated by the Ukrainian army.

As we learn from Die Welt, Putin is using S-300 rockets, which are normally reserved for air defence. Russia is now using them as ground missiles. It appears that Russia has large reserves of S-300 missiles, the article says, and it claims that the Russians have the capacity to increase their supply. We cannot verify that assertion. It runs counter to some of the reports we heard from the BBC. The paper also asserts that Ukraine military successes in recent days are unlikely to continue at the same speed going forward. Ukraine have retaken territory in Kherson and Zaporizhzhia, in the south east, but it will take a lot more to dislocate the Russians from the sea ports of Mariupol and Berdyansk.

We are also not in a position to pass a judgement on the strength of the Ukrainian counter-offensive, and on time-frames.

One of our main nuclear scenarios is one where Russia detonates a dirty bomb, or some other weapon of mass destruction, while trying to blame others. There is a lot of talk on Russian TV about a possible refugee crisis in Europe in the case of a nuclear attack. A nuclear attack would have dramatic effect on immigration flows, and, as we have explained previously, all sorts of other environmental, political and economic consequences.

The German tabloid Bild, a sister paper of Die Welt, noted in almost celebratory mood that Putin did not repeat his nuclear threat yesterday. They see this as a shift in strategy, and a sign that he is weak. Maybe. We see this as a shift in tactics because they are focusing on something else right now. But we believe that the nuclear threat is as present now as it was before, and it will rise in proportion to Russia's losses.

We conclude that the optimal path for Europe's security, and economic and political stability is a narrow one, where Putin withdraws and does not resort to weapons of mass destruction. Such scenarios exist, and are plausible up to a point. But it's a tightrope.

10 October 2022

Did Putin blow up the German railways?

There has been an awful lot of infrastructure sabotage going on in the last few days and weeks. Half of the German rail network came to a complete stop on Saturday because critical communication cables had been cut in two strategic locations. To say that this is the work of professionals would a bit of an understatement. That damage can only have happened with the collusion of insiders or members of the German security services, or both.

We read in Handelsblatt that Nancy Faeser, the German interior minister, is about to dismiss the head of the federal office of information security over his links with the Russian secret service. It is not clear whether this is related to Saturday’s attacks though the timing would at least raise the question. He is a member of a club which calls itself the cyber-security council of Germany. One of the more influential members of this club is a Berlin company, Protelion, previously known as Infotecs, a subsidiary of a Russian cybersecurity company.

One of the many reason why Germany is struggling to perform a 180-degree U-turn on its relationship with Russia is the presence of Russian spooks and supporters in the security services, including the Bundeswehr, and in industry. Vladimir Putin has spent billions building relations with influential Germans, not only Gerhard Schröder. It would be naive to think that all of those people would have turned against Putin. This is a generation of people who defended Germany’s strategic relations with Russia. They have not disappeared.

Last night a home-made explosive was found in a regional train station in eastern Germany, which caused delays in regional transport. This attack is not nearly on the scale of what happened on Saturday. In Saturday’s attack, communication lines were cut in two strategic places, in Berlin and North-Rhine Westphalia. Those two cuts led to the breakdown of the entire train network in northern Germany. 

What we do not know, however, is whether this is the work of Putin. We don’t quite see how the sabotage of German infrastructure would help him, unless it occurred on a scale that would be crippling to German industry. What we have seen so far may only be the beginning of something more serious and sinister. If the goal is to weaken Germany’s determination in its support of Ukraine, we don’t think that such acts of sabotage would help. What appears more plausible to us is that other terror groups see an opportunity to cause damage while everybody is staring at Russia. Left-wing criminal gangs have sabotaged the rail network before, but haven't achieved anything on this scale and with this level of sophistication.

7 October 2022

Model bias: nukes edition

One central feature of modern economic theory is the notion of risk neutrality. When financial economists marvel about the equity premium puzzle, they do so because their models are based on the notion of risk neutrality. A shorthand way of describing it is this: when faced with a choice of a payment of 50 cents, or a coin coss with a payoff of either €1 or nothing, we are indifferent. Behavioural psychologists know this is not true. So do the rest of us.

The concept of risk neutrality pervades many discussion in other areas, including the current discussion on a Russian nuclear attack. We have written about the difficulty in attaching probabilities to such an event. Today, we focus on a different aspect, on how to think about the event if it were to happen.

Even defenders of the concepts of risk neutrality would accept that it does not apply to Russian roulette. There is no mathematical midpoint between a financial gain and death. When you enter the territory of extreme risks, our standard models cease to apply.

Let us assume that Vladimir Putin, in some desperate last ditch manoeuvre, deploys a tactical nuclear weapon in Ukraine. We have no information on what the US or Nato will do in this case. Let us focus on another aspect in which we have a greater degree of confidence, and that will affect the decision making of governments at the time.

A nuclear strike in the heart of Europe would, in our view, produce the mother of all financial crises. No sane investors will continue to lend money to any European government at this point. Market interest rates would shoot through the roof. At those rates, euro area governments would be insolvent, and have to rely on illegal money printing to service their debt.

Now think this through the financial food chain. Would you keep paying millions for a townhouse in London? Or would you rather pay millions for a more remote cottages in the Hebrides? Western capitalism rests not only on cheap oil. It is rests critically on the certainty of a nuclear war not happening.

You may think that a financial crisis is the least of your problems when faced with a nuclear war. If you do, you could not be more wrong. Economics is absolutely essential in modern war. When Putin invaded, the west imposed economic sanctions, which have seriously impeded his own military supply chains. His war, and his subsequent decision to cut off the gas, is what is driving up energy prices and interest rates. The west is going to be hit by a recession. If he deploys a tactical nuclear weapons, the financial reaction will be so severe that economic life in Europe, as we know it, will come to an end.

We can think this scenario forward - a Nato hit against the Russian military, followed by a nuclear counter-attack. In this instance, we Europeans do have bigger problems than a financial crisis. Our scenario is only one of a one-off tactical nuclear strike on the territory of Ukraine.

We all understand the risks of Russian roulette. Even a financial economist would not play this game. But when it comes to nukes, quite a lot of people still live in a risk-neutral world when they are discussing risks.

One can still arrive at different conclusions from this observation. It does not imply appeasement. What it does imply is a more acute awareness of our strategic choices, and the consequences of the different scenarios.

6 October 2022

How not to think about China

One of the biggest fallacies in thinking about foreign policy is the two-camps-theory, immortalised by the Bush administration: You are with us or against us. You cannot fit China into that category, a mistake we see currently being made in response to a Henry Kissinger comment. The veteran former secretary of state said China would align itself with the west as a result of this conflict. Some commentators noted the unusual trip by Wang Yi, China’s foreign minister, as a strategic decision to mend relations with the west. No, that is not what is happening.

China is playing the same strategy now that Germany played during the Willy Brandt and Gerhard Schröder years, as the happy fence-sitters that deal with both sides. China is currently in the process of undertaking a massive domestic policy re-orientation, from investment towards consumption, a shift as difficult as the original adoption of an export-led growth model in the early 1980s.

China is a strategic ally of Russia, but it will not support the use of nuclear weapons. President Xi Jinping will not follow Vladimir Putin to the bitter end. But in a period of ongoing natural resource constraints, China is keen on maintaining its strategic interests in Russian commodities. The overtures we are seeing towards the US are not indicative of a foreign policy shift. They are more likely to relate to the role China might play in securing a diplomatic deal between Russia and Ukraine.

A reminder of the intensifying China-Russia relationship is the story that the yuan has now become the most traded currency on the Moscow exchange. The immediate reason for this shift is the repricing of gas contracts in roubles and renminbi, on a 50-50 split. This is one of several strategic shifts we expect to survive any outcome of this war, including the replacement of Putin by a democratically elected leader. The with-us-or-against-us mindset that dominates the US discourse misjudges not only China, but also the Russian opposition. Putin’s Russian enemies are not necessarily your friends. Also, we should not underestimate the permanent structural shifts that are now taking place in Europe. No matter how the war ends, Germany will not revert to a dependency on Russian gas. The west will be financially and strategically stretched with the reconstruction of Ukraine. China is in a good position to become the senior economic partner to an economically weakened Russia.

5 October 2022

Reflections on what is likely, or not

We read from a noted Russia expert that the probability of a nuclear war was low, but rising. Stated as such, this statement is abject nonsense. The probability is not low. Nor is it changing in one or the other direction. Both statements would require a level of knowledge of the situation that neither this expert, nor any other expert, has. Vladimir Putin falls in the rare category of politicians who lie but don’t bluff. Many experts predicted in February that he would not invade. If he makes a nuclear threat, we should take this very seriously indeed from the moment he makes it. We don't know the odds of an attack. Nor do we know whether they have risen or fallen. 

Assessing likelihoods of future events is difficult. As political commentators, we have made our share of mistakes, as a judicious reader only reminded us yesterday. All we can do is update our knowledge, and nudge our judgement as events intrude. What we absolutely cannot do is assess the likelihood of a nuclear attack. Yesterday’s reports of a train moving tactical nuclear weapons may be accurate or not. La Repubblica tells us that Nato has warned its members that the Russian nuclear submarine K-329 Belgorod, stationed in the Arctic port of Severodvinsk, has mysteriously disappeared. Before a nuclear attack occurs, weapons have to be moved. But we cannot infer from a lack of movement that they won’t be used. Nor can we infer that their use is more likely because we have spotted a movement.

Our own assessment is that the likelihood of a nuclear war rises in proportion to the likelihood of a Russian defeat. We are no military experts, but we are trained in logical inference. If we consider the likelihood of a Russian defeat in Ukraine as high, as so many experts now seem to believe, than surely, the likelihood of a nuclear attack cannot be simultaneously low. If we agree with Garry Kasparov that Putin will not personally survive a defeat, then why should he refrain from using nuclear weapons?

The risk, we conclude from the knowledge we have, is not small and rising, as the noted expert claims, but large and stable.

We have often noted that expert knowledge does not make you a better forecaster. Epidemiologists, doctors and political scientists are experts in their respective fields. But they are no experts in mathematical probability. The worst are those who have taken a Statistics 101 course at their university. Half-knowledge of statistics gives you a degree of confidence you should not have.

Expert knowledge and insights will remain invaluable. But there is no such thing as an expert in future events. 

4 October 2022

Pollsters, like forecasters, never learn

We are keen observers of, though no experts on, Brazilian politics. Sunday’s election result struck because it followed a pattern familiar to us in Europe. The pollsters and the media predicted a large win for the left - and got it wrong.

Brazilian opinion polls used to be very reliable, but they have suffered exactly the same problem opinion pollster faced in the UK during the Brexit wars, or in the US in 2016 and 2020. They just cannot deal with structural shifts. This is exactly what happened to the central bank forecasting models. When the underlying structure breaks, your model is not just wrong, but useless.

President Jair Bolsonaro got a surprisingly strong 43.2% of the vote. One of the polling organisations, Atlas, got the result almost right, but the others had him at 31-34%. The gap to the result was well outside of all error margins. They call Bolsonaro the Brazilian Trump. Trump’s election results, both in 2016 and 2020, were much better than forecasted. So why does this keep happening to the pollsters? They always err in the same direction. They never overestimate the share of the right. Trump, Boris Johnson, Viktor Orbán, Marine Le Pen, Giorgia Meloni: they all got more than expected.

What happened in Brazil is what happened in all of these countries. These politicians appeal to previous non-voters. They are the master of a strategy Angela Merkel once claimed for herself: of asymmetric mobilisation. In truth, this didn’t work as well as she claimed. She rules for four consecutive terms, not because of the votes she got, but because of the coalitions she was able to form. Asymmetric mobilisation works much better for politicians on the right than for those in the centre or the left.

The former president, Luiz Inácio Lula da Silva, got 48.4% in the first round, and remains the odds-on favourite to win at the run on October 30. It would be astonishing if Bolsonaro would squeeze past him. This can realistically only happen through an asymmetric turnout.

A smart polling organisation should be able to accommodate these structural shifts through qualitative polling. The silent Bolsonaro supporters, like the shy Tories of the 1980s, may not tell the truth when you ask whom they are going to vote for. But they will tell you what they think about current political issues. Pollsters would get closer to the results if they scored the qualitative statements. The media would get closer to the truth if they talked to voters rather to the same experts who keep getting it wrong. There is a reason why this is not happening - in the UK it is called the Westminster bubble, a space of delusion that is not exclusive to the metropolitan media, but extends to academics and pollsters.

3 October 2022

Erdogan - the middleman

Keeping strong opponents at arms lengths is an art in diplomacy that secures power for the middleman. Turkey just did that last weekend. Not acknowledging Russia’s referenda of annexation in Ukraine won them accolades in western circles. At the same time, Recep Tayyip Erdogan warned that Turkey won’t sign off on Nato accession for Finland and Sweden if they both fail to deliver what they promised to Turkey. Not choosing camps has been the hallmark of Erdogan's role in playing off the West against Russia.

A total of 28 out of 30 Nato members have ratified Finland's and Sweden’s membership. Only Hungary and Turkey would not send the membership bids to their parliaments for ratification. They have kept this card in order to haggle over the price. It seems that what is on offer is not enough to get their consent. What price will it be? Sweden on Friday announced they will lift its arms embargo on Turkey, one of the promises they gave Ankara. But some of the demands go deep into the workings of the Swedish democracy. We expect that there is a US angle in this arbitrage too. The end of this story is not in sight.