by Bill O’Grady | PDF
On September 15, the leaders of the U.S., U.K., and Australia announced a new security relationship which includes a nuclear submarine arrangement with Australia. Although it will likely take a couple of decades before Australia will have its own indigenous nuclear propulsion vessels, the treaty means that the U.S. and U.K. will likely begin sharing nuclear technology and other weapons systems.
The announcement not only marked the beginning of a new security relationship in Asia for the U.S. and U.K., but it also marked the end of another one, a $60 billion defense arrangement that France had with Canberra. France had previously agreed to provide Australia with diesel/battery submarines, but this new deal scuttled the French arrangement. The French were incensed; ambassadors were recalled, and European governments denounced the new arrangement.
It is not a huge surprise that the French were upset, but the degree of the reaction seemed strong given the violation. Diesel submarines pale in comparison to the capabilities of nuclear propulsion. The former is only useful in coastal protection. They need to resurface to use the diesel engines to recharge batteries; during this period, they are vulnerable to attack. They also require regular refueling. Nuclear submarines don’t need to resurface and can extend their patrol range significantly compared to a diesel-powered vessel. When the deal was made in 2016, diesel subs may have been adequate for the risks Australia perceived. That is no longer the case. So, it should have come as no surprise that Australia would consider an upgrade. Although France has nuclear propulsion technology, it is not as effective as American technology.
The U.S. decision to create this new security arrangement, Australia’s acceptance, the U.K. decision to join, and the reaction of France all reflect an evolving geopolitical situation in Asia. In this report, we will discuss why the three nations decided to create a new pact. From there, we will offer a short geopolitical analysis of Europe, followed by an examination of the French and European reactions. We will close with market ramifications.
by Thomas Wash | PDF
It has been more than a year since the U.K. and European Union (EU) came to terms with the Withdrawal Agreement, yet questions remain on how it will impact Northern Ireland, which was granted an exception to remain in the EU. Having decisively voted 56% to 44% to remain a part of the EU during the Brexit referendum, it is unclear whether Northern Ireland allegiance lies with the U.K. or the EU.
The exception, which went into effect earlier this year, keeps the Northern Ireland economy in the EU to prevent a hard border between Northern Ireland and the Republic of Ireland. This has angered pro-British Unionists who believe that the exception ostracizes Northern Ireland from the U.K. and draws it closer to Ireland. As a result, the Unionists have protested the decision and violence has erupted between competing factions in Northern Ireland. However, demographic trends have shown that the pro-British faction seems to be slowly dwindling, likely heightening concerns.
In this report, we will focus on the current relationship between Northern Ireland, the U.K., and the EU, and summarize the Good Friday Agreement. Next, we will discuss the impact of demographic changes on reunification efforts and what we expect to happen going forward. As usual, we will conclude with potential market ramifications.
by Bill O’Grady | PDF
(N.B. Due to the Independence Day holiday, the next report will be published on July 13.)
A global hegemon provides two broad categories of public goods. The first is security. A successful hegemon enforces some degree of global security as it has the ability to project power globally. This power projection ostensibly prevents regional wars from becoming world wars. Another way of thinking about hegemony is that if a world war occurs, it is evidence of hegemonic failure. In addition to war suppression, the hegemon’s global reach gives it the capability to secure sea lanes, which facilitates global trade.
The second public good is financial. The hegemon provides the reserve currency which enables global trade and investment. The reserve currency nation must have two characteristics to be a successful provider of the reserve currency. First, it must be willing to run persistent current account deficits. It is through trade that the rest of the world acquires the reserve currency. Persistent current account deficits put great strain on the labor markets of the hegemon and require a strong commitment from the reserve currency nation to absorb these imports. Second, it must have deep financial markets and an instrument that is considered safe and widely available so nations that accumulate the reserve currency can use this instrument to hold this saving until it is needed for trade or direct investment.
If the U.S. is going to be replaced as a hegemon, the successor will need to fill these two roles. Currently, there is no nation that is capable or willing to fully provide these public goods. However, it is not impossible to consider a situation where a partial replacement occurs. Such outcomes have occurred before. By the late 1800s, Britain realized that it could not defend any of its colonies in the Western Hemisphere from a determined American attack. The U.S. economy was too well developed and its navy and army too large; the costs of defending Canada, for example, would have been excessive. So, quietly, the British ceded regional hegemony, at least in terms of security, to the U.S. That allowed Westminster to focus on the other growing threat, Germany. In the current environment, the U.S. could cede a sphere of influence to China. It is arguable that the U.S. would like to see a regional hegemon arise in the Middle East to allow America to reduce its security burden there as well.
Something similar could occur on the reserve currency front as well. Some economists, notably Barry Eichengreen, have argued that there is the potential for multiple reserve currencies. Although we have had doubts about this possibility, recent developments have led us to consider the possibility that the euro could become a serious competitor for the dollar as a reserve asset. That doesn’t mean the euro would replace the dollar as the reserve currency, but it would mean the euro could be a parallel reserve currency and offer competition to the dollar.
The most recent development that could create potential competition for the dollar’s reserve status is the proposed new financial instrument designed to fund Europe’s recovery from the pandemic. The proposal evolved from a plan developed by Germany and France to create a €500 billion recovery fund. European Commission President Ursula von der Leyen expanded the proposal, increasing it to €750 billion. But the key element of the proposal is a specific bond backed by the full faith and credit of the European Union. The bond service would be tied to several EU-wide revenue sources, including a proposed digital tax, a carbon border tax and fees on transportation.
The proposed plan still requires approval by all members of the EU. The “frugal four”—Austria, Denmark, the Netherlands and Sweden—could still scuttle the proposal. But, Germany’s support is a reversal of its longstanding opposition to EU debt mutualization and will probably be enough to sway the opposition toward accepting the program.
The prospect of debt mutualization creates competition for the dollar’s reserve status. The EU doesn’t fulfill the other requirements for hegemony; its military strength has atrophied, and it has not shown a willingness to run persistent current account deficits. Nevertheless, a mutualized debt instrument does make the euro a much more attractive currency for reserve purposes.
In this report, we will examine why an alternative reserve currency might be attractive for several countries. An analysis of why Germany has changed its position on debt mutualization will follow. As always, we will conclude with market ramifications.
by Patrick Fearon-Hernandez, CFA
If you ever find yourself in Volgograd, Russia, you will visit Rodina Mat’ Zovyot. It’s unavoidable. The statue, depicting Mother Russia calling her sons to battle against her invaders, is one of the tallest in the world. Standing almost 280 feet high, she is nearly twice as tall as the Statue of Liberty. Her colossal height is accentuated by her position at the summit of Mamayev Kurgan, the high ground overlooking Volgograd, whose great, grassy green slopes were fertilized by the blood of a quarter-million Soviet soldiers who died defending it from the invading Nazis during World War II, when the city was still known as Stalingrad.
You never know when you’re about to have an experience that will stay in your memory, and haunt you, for the rest of your life. Such was the moment when I first entered the glittering round chamber below the statue, where an eternal flame keeps alive the memory of the 20 million or so Russians who died in the war. I entered just at the beginning of the ceremony marking the changing of the guard. Young Russian soldiers in ill-fitting uniforms and black jack boots marched in painfully slow goose steps up the ramp around the perimeter of the chamber to relieve the previous sentries of their duty. It was impressive in the extreme. But, more than anything, I remember the haunting, plaintive choral music playing in the background (see this video). It perfectly expressed the quiet calm and peace that all who suffer in war must yearn for, if only in death. But when I asked my guide what the song was, I was flabbergasted by her reply: “Daydreams, by Schumann.”
What?! A Russian World War II memorial playing the music of a German composer? How could it be?