Weekly Geopolitical Report – The Geopolitics of the Eurobond (June 29, 2020)

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.

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Weekly Geopolitical Report – Schumann in Volgograd (May 11, 2020)

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?

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Weekly Geopolitical Report – Could the Coronavirus Pandemic Break Up the EU? – Part II (April 6, 2020)

by Patrick Fearon-Hernandez, CFA

(Note: Due to the Easter holiday, our next report will be published on April 20.)

In Part I of this report we examined the history of the European Union (EU), how it works, and the political, economic, and social fissures that had already rendered it unstable when the COVID-19 pandemic took hold.  This week, we look at several recent policy moves that various EU countries have taken in response to the pandemic, and we explain why those policy moves could potentially push the EU over the tipping point toward disintegration if they are carried too far.  As always, we’ll wrap up with a discussion of the possible economic consequences of a break-up and the ramifications for investors.

The Temptation to Barricade
As we discussed in Part I, the founders of the EU believed that preventing another major war on European soil could be accomplished, in part, by an “ever-closer union among the peoples of Europe.”  The EU is often seen mostly as an economic arrangement (i.e., a customs union coupled with a free-trade area), but its founding principles are broader than that.  The EU aspires to the free movement of virtually all people, goods, services, and capital.  Unfortunately, the COVID-19 pandemic has tempted EU leaders to erect barriers in these areas.

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Weekly Geopolitical Report – Could the Coronavirus Pandemic Break Up the EU? – Part I (March 30, 2020)

by Patrick Fearon-Hernandez, CFA

In times of crisis, the future is a luxury.  Or, at least, thinking about the future can seem like a luxury, especially if you’re reeling from the death of a loved one, the loss of a job, the devastation of a retirement portfolio, or just the boredom and isolation of a quarantine.  Many people are overwhelmed with those challenges in the midst of the COVID-19 pandemic.  And yet the pandemic is changing the future course of the world in ways that we’ll all need to understand and respond to eventually.  Those future changes extend to politics and geopolitical relations.

In this report, we explore the recent signs suggesting the COVID-19 pandemic could potentially lead to a break-up of the European Union (EU).  In Part I, we examine the history of the EU, how it works, and the political and social fissures that undermine its stability.  In Part II next week, we will look at the recent policy moves by various EU countries that could lead to disintegration if carried too far.  We’ll wrap up with a discussion of the possible economic consequences of a break-up and the ramifications for investors.

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Weekly Geopolitical Report – Between a Rock and a Hard Place: The Gibraltar Dilemma (April 24, 2017)

by Thomas Wash

Days after Theresa May triggered Article 50 of the Lisbon Treaty, Brussels issued a nine-page document outlining its guidelines for Brexit negotiations. One of the guidelines gave Spain the authority to veto any deal between Gibraltar and the European Union (EU). The U.K. is currently recognized as holding sovereignty over Gibraltar and thus took exception to this provision, vowing to defend the will of the people of Gibraltar.

The provision is likely the result of heavy lobbying by the Spanish government, who would like to end this 300-year dispute once and for all. A war of words between Spain and the U.K. has already started in response to the announcement. Former Tory leader Michael Howard stated that the U.K. is willing to fight for Gibraltar. Although not responding to the threat, Spain has hinted that it would not block Scotland if it were to apply to the European Union upon a potential Scexit.[1]

Despite the bravado, it is likely that the two countries will come to some sort of agreement as they have deep trade ties. In fact, Spain has been the most vocal backer of a soft Brexit. That being said, the people of Gibraltar are stuck at a crossroads regarding the dispute. On the one hand, they voted 96% to remain in the EU, but on the other hand, they voted 99% against joint sovereignty with Spain. The situation becomes even murkier when its economy is taken into account. Gibraltar is dependent upon the U.K. for trade and Spain for labor. Nevertheless, it is unlikely that Gibraltar would have emerged from Brexit unscathed as its labor force is dependent on the free movement of immigrants permitted under the EU. Ironically, it was the free movement of immigrants that mostly caused British voters to leave the EU.

In this report, we will focus on the significance of Gibraltar, its historical context and the impact of the current dispute. We will conclude with possible market ramifications.

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[1] During the run-up to the Scottish referendum, it was believed that Spain would oppose any immediate transition by Scotland into the EU if it decided to leave the U.K. because it could encourage Catalonia to move toward independence as well.

Weekly Geopolitical Report – The EU at 60: Part II (April 10, 2017)

by Bill O’Grady

(Due to the Easter holiday, the next edition will be published April 24th.)

Last week, we began our retrospective on the EU.  This week we will examine the post-Cold War expansion of the EU, including a discussion of the creation of the euro and the Eurozone.  With this background, we will analyze the difficulties the EU has faced in dealing with the problems caused by the 2008 Financial Crisis.  We will look at several proposals being floated in the wake of Brexit about reforming the EU and, as always, conclude with potential market effects.

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Weekly Geopolitical Report – The EU at 60: Part I (April 3, 2017)

by Bill O’Grady

On March 25th, European Union (EU) leaders from 27 nations gathered in Rome to celebrate the 60th anniversary of the founding of the organization.  Although the EU currently consists of 28 members, the U.K. was absent due to its recent decision to leave the EU.

On that day in 1957, France, West Germany, Italy, Belgium, Luxembourg and the Netherlands signed the Treaty of Rome, creating the European Economic Community (EEC), which eventually became the EU.  Over time, new members joined the group.  This map shows the current members.[1]

(Source: EU)

It should be noted that this wasn’t the first attempt at a supranational European body.  France proposed the European Defense Community to be comprised of the six original EU members.  However, the French failed to ratify the treaty.  In 1951, West Germany and France built the European Coal and Steel Community which included the other four founding nations of the later EU and it became a forerunner of the EU.  In 1957, the same six nations agreed to cooperate on nuclear power.  Still, the EEC is considered the original source of what evolved into the EU.

The primary goal of the EU was to prevent another world war from being fought on European soil.  That goal, at least so far, has been successful.  The key to meeting this goal was to solve the “German problem.”  That issue continues to evolve.

In Part I of this report, we will discuss the German problem and how NATO and the EU were developed in response to resolving that problem.  In Part II, we will examine the post-Cold War expansion of the EU, including a discussion of the creation of the euro and the Eurozone.  With this background, we will analyze the impact of the 2008 Financial Crisis and the difficulties the EU has faced in dealing with the problems it caused.  There will be an analysis of immigration and European security as well.  We will look at several proposals being floated in the wake of Brexit about reforming the EU and, as always, conclude with potential market effects.

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[1] For the next two years, the U.K. will remain a member.  PM May did submit an Article 50 letter on March 29 which begins the two-year process of exiting the EU.  It is possible that this deadline could be extended depending on negotiations.  Britain is the first nation to exit the EU.

Weekly Geopolitical Report – Future of the Euro (January 30, 2017)

by Thomas Wash

January 1, 2017, marked the 18th anniversary of the induction of the euro, the European single currency. Once praised as the uniting force among European countries, the euro has become a source of populist backlash. From Greece to France, populist politicians have increased their political clout to the chagrin of the establishment.

The primary motivation of the European Union was to create a unified European identity so that countries would not be tempted to fight wars with one another. Special attention was paid to Germany, which had tried to dominate Europe in the past. Ensuring peace throughout Europe meant Germany had to be subdued. In order for this to happen, Germany had to become dependent on its neighbors such that waging war would be against its own interests. Although this worked in the beginning, the 2008 financial crisis exposed the flaws in this plan. Germany’s excess savings and fiscal discipline led to it assuming the dual role as creditor and lender of last resort within the European Union. This gave Germany unparalleled leverage to dictate fiscal and foreign policies over other European countries.

In this report, we will take a deeper look into the factors that contributed to the formation of the European Union, as well as the negative effects the single currency has had on certain countries, particularly those located in southern Europe. As always, we will conclude with ramifications on the financial markets.

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