Weekly Geopolitical Report – Back to the Future? Prospects for a New Cold War Against China (October 12, 2020)

by Patrick Fearon-Hernandez, CFA | PDF

This edition of our Weekly Geopolitical Report explores the prospects of a new Cold War between the United States and China.  Based on the author’s personal experiences at the end of the U.S.-Soviet Cold War, this report explores the various costs that would likely arise from a new Cold War and what those costs imply for investment strategy.

When I asked her if she had any trouble getting her ticket from St. Petersburg to Moscow to join me for the long weekend, she said, “No.”  Then, with a sly grin and a meaningful glance deep into my eyes, she added, “I just asked for help from a friend in the KGB who works for President Gorbachev.”  I suppose I grinned a bit, too, since she had just confirmed her association with Soviet intelligence, which I had suspected ever since we met in a hotel bar in St. Petersburg weeks before.  If I did let a grin slip out, it probably also reflected the irony of knowing how badly my office at the CIA was going to react to this forbidden dalliance when I got back to Washington.  But it was a beautiful, bright, crisp autumn morning in Moscow in September 1991, just after the attempted coup against Gorbachev, and I was still young.

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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 – The 2018 Geopolitical Outlook (December 18, 2017)

by Bill O’Grady

(N.B.  This will be the last WGR of 2017.  Our next report will be published January 8, 2018.)

As is our custom, we close out the current year with our outlook for the next one.  This report is less a series of predictions as it is a list of potential geopolitical issues that we believe will dominate the international landscape in the upcoming year.  It is not designed to be exhaustive; instead, it focuses on the “big picture” conditions that we believe will affect policy and markets going forward.  They are listed in order of importance.

Issue #1: The Big Picture

Issue #2: China Deleveraging

Issue #3: European Politics

Issue #4: North Korea

Issue #5: South American Populism

Issue #6: The Middle East

Issue #7: U.S. Domestic Politics

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Weekly Geopolitical Report – Germany: The Reluctant Superpower (February 27, 2017)

by Bill O’Grady

Two recent articles caught our attention.  First, the New York Times discussed growing worries in Germany about a post-American Europe,[1] given the potential withdrawal of the U.S. from the superpower role.  Second, an op-ed in Der Spiegel went so far as to suggest that Germany should become the world leader of an anti-Trump coalition.[2]

These reports are indicative of the rapidly changing views on how the U.S. manages its superpower role.  The fact that Germans are considering their options in response to American foreign policy is a significant development.

In this report, we will start with the background of American foreign policy post-WWII to the present.  This will set the stage for why Germany feels compelled to adjust its foreign policy.  From there, we will reflect on how Europe and the rest of the world could react to a hegemonic Germany.  As always, we will conclude with potential market ramifications.

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[2] http://www.spiegel.de/international/world/a-1133177.html

Weekly Geopolitical Report – Nuclear Blackmail (February 13, 2017)

by Bill O’Grady

(N.B.  Due to the upcoming President’s Day holiday, the next report will be published on Feb. 27th)

During the 1950s, in the early days of nuclear weapons, there was much discussion about the potential for nuclear blackmail.  The world had recently defeated fascism but the problem of an aggressive and amoral leader like Hitler worried geopolitical strategists.  If Hitler had developed a nuclear weapon, would the war have ended the way it did?  And, if a similar leader emerged and possessed nuclear weapons, would he engage in blackmail by using the threat of a nuclear attack?

As the Cold War evolved, the U.S. and U.S.S.R. (the superpowers during the Cold War) created a workable solution to reduce the chances of a nuclear exchange.  Both parties built formidable nuclear arsenals that had second strike capabilities, meaning that either side could not “win” such a war by attacking first.  By treaty, defense mechanisms against nuclear missiles were limited, reducing the likelihood that either party would conclude it could strike without fear of retribution.  Although the U.S. was not the only free world power to have nuclear weapons (the U.K. and France did, too), and China had developed nuclear weapons within the Communist bloc, the two superpowers generally controlled the decision to deploy a nuclear strike.  In other words, nuclear proliferation was limited and thus controlling the global nuclear arsenal was manageable.

As time passed, nuclear strategists became less concerned with nuclear blackmail.  The world was divided into areas of influence.  The U.S. managed and protected the free world and the Soviets did the same for the Communist bloc.

People usually explain outcomes in terms of narratives.  Stories are powerful tools for helping us understand why outcomes occurred.  Two characteristics often emerge from narratives.  First, the simplest narrative becomes the most powerful.  Second, because the narrative is simple, outcomes can sometimes be seen as inevitable.  A well-developed narrative not only explains why an event occurred but also critically examines the factors that might have led to a different outcome.

The Cold War narrative suggests that nuclear weapons are primarily defensive because of the threat of a second strike and nuclear annihilation.  Thus, unless a nation fears regime change, there is little reason to develop a nuclear weapons program.  However, this thesis assumes that nuclear weapons decisions will always follow the Cold War pattern.  Just because nuclear blackmail did not develop during the Cold War doesn’t mean it won’t happen in the future.

In this report, we will define nuclear blackmail and differentiate it from blackmail in a nuclear context.  We will discuss why this didn’t develop during the Cold War but why it could happen now.  We will also analyze how nuclear blackmail might be used as part of coercive diplomacy as well as part of conventional conflict.  Finally, we will examine the likelihood of either form of blackmail occurring in the future and how it may change international relations.  As always, we will conclude with potential market ramifications.

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