What every financial professional should know about geopolitics
The modern world began in the small US state of New Hampshire. Who knew?
Before World War II, there was no such thing as a global system. Neighbors weren’t for trading with; they were for invading. Any sort of economic interdependence was viewed as a vulnerability. If you saw something you thought you needed, you went out and took it. You confiscated it. You colonized it. You expanded it into an empire. These empires fought over resources, over market access, over populations. Those struggles escalated into ever-larger wars until they reached the logical absurdity of the Second World War, which brought all the empires crashing down.
That left it to the last men standing, the Americans, to figure out what was next. So the Americans drew their allies together here—in New Hampshire, at a place called Bretton Woods—and they held a conference.
What do you do at a conference? You’re baited in with a beautiful location, maybe the promise of golf and some drinking. . .and then you’re locked into a room with some tedious speaker who prattles on about how the world is going to be. We’ve all been there.
At Bretton Woods, the Americans laid out the rules for a new age. Instead of everyone having their own militarized, sequestered, imperial systems, all the world’s potential would be pooled. The US Navy—the only navy of size to survive the war—would patrol the global oceans for all. Anyone could purchase any material from anywhere in the world, ship it home safely, transform it into finished goods, and then export the goods anywhere in the world. After the tragedies of the war, everyone could now export their way back to affluence.
In addition, the Americans would provide security overwatch for everyone represented at the conference. You didn’t need a navy because the Americans would take care of the seas. The end result was a new global system, the first global system.
But there was one catch: You had to pick sides. You heard that right: The Americans bribed up an alliance to fight the Cold War. And it worked really well. Global GDP expanded by a factor of 10. The global population tripled. It has been the longest period of peace and prosperity in human history. But the plan had a fatal flaw: The Americans won.
Say what you will about the Germans; they may have a slow fuse, but once they get going, wow can they party! The Americans were so wrapped up in the Cold War that they had no clue what to do the day after it ended. Then President Bush Sr. put together a team: Brent Scowcroft, Dick Cheney, and Colin Powell. He sent them off to figure out Bretton Woods II. How can the United States take this alliance, the greatest alliance in human history, and play it forward for another half century of engaged American preeminence? Americans were so impressed that we voted him out of office. And in the next six consecutive federal election contests, Americans went with the candidate who celebrated his lack of foreign expertise. The economic aspects of Bretton Woods, the idea that the Americans will maintain global market access and serve as the market of first and last resort, continued. But the security quid pro quo—that the Americans could write everyone’s security policies—quickly faded.
And so the world got weird.
Places that, for geographic reasons, had always been truncated or weak or poor rose to prominence. Places like South Africa, Brazil, South Korea, Poland, India, Russia, and, of course, China. Powers that had never boasted meaningful economic strength became regional, and even global, players.
Trump has a point. Strategically, the Bretton Woods system is no longer working for the Americans. But never forget that economically it was never supposed to. The Americans subsidize the alliance; the alliance fights the Soviets. That was the deal.
Where do the Americans fit in this strange, new world without the rubric of the Cold War? The short version is, they don’t. But for them, that’s OK because the Americans never bet their economy on what was fundamentally a security play.
As a percentage of GDP, the United States remains the least involved economy in the world. Less than 8 percent of GDP came from merchandise exports last year, with about half of that going to America’s NAFTA partners. The Americans can easily, breezily have a regional trade system without maintaining a global trade system. But the converse isn’t true for anyone.
The entire global system is dependent upon the Americans’ ongoing commitment to a security program that is now 30 years out of date.
Whoever won the election in 2016 was going to be the president to preside over its abandonment. With a President Hillary Clinton, it would have been an organized process stretched over four to eight years. There would have been pamphlets and timetables and PowerPoints. Under Trump, it is happening somewhat faster—four to eight tweets. But we’re getting to the same place.
How deep does this attitude run? Take a look at this: The deeper the colors on this map, the more involved the American state is in international commerce. [visual] Can you see the relationship between these colors and the red-blue breakdown in American politics? No? That’s because there isn’t one. There is no correlation whatsoever. Meaning that the Americans can maintain globally devastating policies without a ripple of discussion back at home.
Let’s look at it politically.
The reason the Republican Party tends to win the really big elections is because it has a more coherent coalition: The evangelicals don’t care all that much about business regulations, while the pro-lifers don’t want to shut down the navy. Everyone has a short list of issues they are passionate about, but those issues do not contradict. It is easy to build those issues into a political platform that offends no one in the party. That platform can be taken to the polls; everyone shows up to vote. Reliable.
That’s not how it works with the Democrats. They boast a much broader coalition, but it fights. Single mothers see no reason why they should pay higher taxes so that the millennials can go to college for free. Black and gay Americans disagree over what the term civil rights even means. Unions and Greens have wildly different ideas of what industrial policy should be. Any candidate who attempts to run on the issues—a Hillary Clinton, a Michael Dukakis—will rip open the political fissures within the party. Entire sections of the party will become alienated and not show up. They cannot win.
But a candidate who runs on charisma—a Barack Obama, a Bill Clinton—can paper over the policy differences and attract voters on a personal level. Everyone then shows up, and since the Democratic coalition is broader and has more voters, he’ll walk away with the election.
In the middle, we have two groups who tend to be socially conservative but economically liberal. They are very hard to pin down.
For those of you who were not in a coma in 2016, you know that’s not how things went. Let me sum up an hour of American political analysis in 30 seconds: We had the social media revolution, the Sanders revolution, campaign finance reform, Trump picking fights with Gold Star families, Trump in two films of questionable repute, blacks on the Obama high not wanting to vote for a white woman who’d already lived in the White House, pollsters forgetting to ask pollees if they were citizens, and here’s where we actually ended up.
The two-party system that runs the United States is, for the moment, offline. Now this is normal. Healthy even. Demographics shift. The balance of power among the states evolves. Technology advances. Politics moves with all that. On a delay. The last time both parties broke down and reshuffled factions was in the 1930s. We had the Great Depression. We had World War II. It took 12 years for the parties to settle into the forms we recognize today. The Republicans used to be the big-government, high-tax, and high-tariff party.
What does that mean for today? It means that it really didn’t matter who won the last American election because whoever did wasn’t going to have a party to rule with or a party to negotiate with. And until all these factions settle into new, more stable alliances, Americans cannot even start the conversation about what they want from the world.
No conversation, no goal. No goal, no policy.
And so we’re out.
Let’s look at it by age bracket. [visual]
This is how most Americans born before 1946 still think of the baby boomers: those war protestors who just don’t understand. Sorry, but the boomers are starting to look more like they are aging into get-off-my-lawn conservatives.
What about the millennials? They were raised differently. They didn’t keep track of the score at soccer games. They picked colleges based on who had the coolest dorms. They only took jobs that fulfilled them. But other aspects of life have continued on. The oldest millennials turn 38 this year and, on average, they have two kids. They’ve discovered that they cannot raise two children in a San Francisco efficiency apartment, which has forced them to move back to their hometowns, so they can get the free childcare that comes from being adjacent to the Bank of Mom & Dad. Life has not turned out the way they were promised. The days of pooping and getting a trophy are long gone.
They’ve become bitter and angry. And 45 percent of them voted for Donald Trump.
The two great progressive generations in American politics are turning into narcissistic populists at the same time.
Now for the boomers, this is, to a degree, expected: You retire, you get a little crotchety. But the boomers will cease being a major factor in American politics around 2030 due to simple mortality.
The millennials, however, will be the dominant voting block in American politics until the mid-2060s, which means Donald Trump may well be the least populist, most internationalist, most inclusive president the United States has in our lives. And if you are a foreign leader and you cannot strike a bilateral deal with the Americans now, it is only going to get harder.
Anyone ever wonder why we Americans are so neurotic? Every culture has a series of experiences that shapes how they define themselves. For the Americans it is this: the pioneer era. For the equivalent of just over $10,000 in today’s money, a family could head west in a Conestoga wagon, lay claim to free land, and within six months, be exporting grain for hard currency. It was the fastest and deepest cultural, territorial, and economic expansion in history—and it lasted for five generations. Americans convinced themselves that it was normal. That things could be, would be, should be, and are ordained by God to get better every single year. But as you all know, that’s not true. So when the world reaches out and touches the Americans on any terms other than our own, we have no context. We become convinced the covenant with God has been broken. We lose our minds. We lash out with a fury that only the insane can muster. If you want to know whose fault this is, I blame Canada.
In the War of 1812, they burned our capital down (not cool!), which set Americans on a path that oscillates between periods of detached arrogance when we wallow in our greatness, and panicked fury in which we apply a continent full of resources to the task or our reinvention lest we vanish from the Earth. Here are a couple of quick examples.
Sputnik was a beeping aluminum grapefruit. When it went up, the Americans were ahead in metallurgy, electronics, and even rocketry. But we became convinced we had lost the Cold War before it had really even started. We forced through a reinvention of our industrial and educational systems that we have coasted on ever since.
Vietnam. We lost a postcolonial war to a rice producer. Even though it wasn’t our colony, and we were the world’s largest rice exporter at the time, we were convinced we were in our final days as a country. We married the nascent information revolution to military technology, which gave us everything from cruise missiles to cellular phones. Who knows how long we’ll coast on that?
9/11 was a tragedy by any measure. Over 3,000 dead. As a side effect of our reaction to the attack, we stationed the sharp end of American power on either side of every significant energy and trade artery on the planet. 9/11 was 16 years ago. Americans are due for another panic attack.
And the power imbalance this time around is immense.
The carrier on the left is a supercarrier. [visual] It has over seven times the power projection capability of the jump carrier. There are 10 jump carriers in the world. Not one of them is American. There are 10 supercarriers in the world. All of them are American. One American carrier battle group has more long-range, projection-based firepower (without nukes) than the combined navies of the rest of the world—and the United States has 10 of them.
Now the Americans are in the process of decommissioning their supercarriers to replace them with bigger carriers!
This, everything we’ve discussed to this point, is the first thing everyone needs to understand: The Americans designed the system for a different age; that age is over. Not only are they leaving the entire system to crumble, but they are maintaining a military power structure with global reach that has no global interests. Unfettered strategic freedom.
For the roughly 5 billion people on this planet who are dependent upon the Americans for their physical and economic security, that is quite possibly the worst-case scenario.
And that’s only the first issue that is upending our world.
The second is demography.
This is a standard demographic profile. [visual] Children on the bottom. Then young adults, mature adults, and retirees at the top. Men on one side, women on the other.
This is India. [visual] This is a consumption-led demographic. With any system that has a bulge in the population 45 and below, it is all about consumption: kids, cars, houses, college, pot. Spend, spend, spend, spend, spend. But their incomes have not yet expanded to cover their needs. So it is car loans, college loans, mortgages.
It is high growth—youth consumption is what drives most modern economies—but also high debt. Here is a fun fact about a young system like India’s: Since the youth can consume most of what the country produces, India does not necessarily need to be linked into a broader trade system.
That is not the case for the Koreans. When the bulge is between ages 40 and 65, there just isn’t all that much consumption: The house has been paid down; the kids have moved out. Yet they are at the height of their earning capacity. They’re stuffing money away for retirement. They’re paying a lot of taxes. This is the velocity of capital. This is an investment-led system. Systems like this boast great mid-career retraining. High levels of technological penetration. Excellent infrastructure. But, the Koreans must be part of a broader system; the lack of high-consuming youth means the country cannot possibly consume all the goods it produces.
And if your birth rate is too low for too long, you can end up like Japan. The Japanese have had to do something most thought was impossible: run a modern economy without a workforce. There’s a reason Japan is a world leader in robotics and automation. Funny thing about robots: They don’t vote (yet), which means you can locate robotic facilities anywhere. Japan chooses to put many of its facilities abroad. Not only does that put Japanese production on the right side of currency and political risk as well as close to end consumers, it also enables the Japanese to purchase strategic favors from other countries. Toyota’s four largest facilities are in Kentucky and Texas.
Here’s the United States. [visual] Let’s go through the generations, starting from the top.
The Silent Generation’s formative cultural experiences include World War II, the Korean War, Stalin’s Great Purge, the Ukrainian famine, the Great Depression, Pearl Harbor, and the Holocaust. They instinctively understand the advantages of a rules-based international order. But the youngest Silents are now in their 70s, and, as a generation, they’ve largely passed the baton to the next generation down.
The baby boomers are the largest generation as a percentage of the population in American history. Their numbers in that capital-rich demographic have made the United States capital rich. Fabulously capital rich. Unprecedently capital rich. Too capital rich. All that money chasing the same number of opportunities has pushed down the rate of return on that capital.
That has forced the boomers to invest their money into ever-riskier projects in order to generate that mythical extra 1 percent of return before they retire. This puts a lot of boomer money into projects that, in retrospect, perhaps were not the best idea. This is Enron. This is subprime. This is BRIC. This is disco. [visual] None of this should have ever happened.
By the year 2020, the majority of the American boomer cadre will have retired. All those investments will be liquidated. All that capital will come home, but it won’t go into stocks and bonds because the now-retired boomers will not be able to tolerate the volatility.
Instead it will go into T-bills and cash. The velocity of capital will not so much slow or even stop, but instead go into screaming reverse as the boomers don’t simply cease providing capital to the system, but instead draw from the system in the form of pensions and health care. Capital availability will plummet, and the cost of what is available will at least quadruple.
In just five years.
Next comes my generation: Gen X. I’m part of the smallest generation in US history, and the technical term for our situation is “screwed.” It’s a problem of relative size. There just are not enough Gen Xers relative to the generations above and below. Now, today, this imbalance works for us. All that boomer money has pushed down the cost of capital. I’ve been able to refinance my house five times in the last seven years. My mortgage rate is 2.04 percent. It’s awesome.
It’s also temporary. By 2022, the majority of the boomers will have aged from providing capital from the system to drawing capital. It will be up to Gen X to pay for the retirement of 75 million boomers, and there are only 11 of us (not 11 million, just 11). The tax base will collapse even as government outlays rise. We’re looking down the maw of at least a 50 percent increase in the nominal tax rate to make up the difference.
Finally, there are the millennials. Those neurotic, narcissistic, omnipresent millennials. Now, while the millennials do deserve every sideways glance I send their way, thank God they’re there. Three reasons.
First, consumption. All those circulation-constricting jeans, all those bedazzled flip-flops, all that fair-trade, gluten-free, soy-free, dairy-free, fat-free, sugar-free, cruelty-free beard butter adds up! Millennial consumption is what has kept the United States out of recession since 2010, and the millennials are young enough that their consumption pulse will last at least another five years.
Second, by the year 2030, when the millennials have matured (and define that word however helps you sleep at night), they will fill the ranks of the tax-paying class in a way Gen X never could. There is a light at the end of the tunnel. It is not a train. It’s simply a millennial wearing the new iBoxers or whatever.
Third, while here in the United States we think of the millennials as the be-all and end-all, they are actually all alone in the night. Everywhere else in the world a baby bust started around 1970. If you look at the rich-world demography without the Americans in it, it has all the economic dynamism of a retirement home. [visual]
So, today, courtesy of the boomers, the United States is the dominant financial power, and courtesy of the millennials, the United States is the dominant consumption power. But in just 12 years, the United States is the only financial power and only consumption power.
We are in the Great Transition. Just as the world really needs the Americans to absorb global exports, the Americans have lost all political, economic, and strategic interest in doing so.
Let’s look at a few other examples. Let’s start with Brazil. [visual] This is what we think of when we think of the developing world, right? A young population brimming with potential. The consumption base of the future. Er. . .no. This is Brazil in 1990.
Here’s Brazil today. [visual] Brazil is aging at six times the American rate. As soon as 2040, the average Brazilian will be older than the average American. Brazil is going to get old long before it has a chance to get rich.
Here’s Egypt. [visual] This bulge on the male side of the equation at 25 years old is what I call the “riot-prone population.” There’s a reason the Arab Spring started in Egypt.
Compare that to Iran. After the Shah’s fall, the Iranians suffered a baby bust, so the Iranians love to stoke instability because they have a demography resistant to civil unrest.
How about this one? [visual] This is the United Arab Emirates. This is what slavery looks like in the modern world. The UAE is a great example of the sort of country the United States had to be allied with to make Bretton Woods work. No longer.
Finally, we have the Shale Revolution. I’m going to sum up two hours of technical detail in one slide.
This is a price versus volume graphic. [visual] The broader the bars, the greater the volume of oil output. OPEC is in black on the far right.
The taller the bars, the greater the full-cycle, break-even cost of producing that crude. US shale is the light blue bar on the far right.
This data is from 2012. In that year, US shale was not all that strategically significant, in part because it was the most expensive crude in the world to produce.
Since then, the Americans have had a series of technological breakthroughs, including multilateral drilling, microseismic, and water management. And so here’s where we are today.
The breakeven in America’s big four shale fields is now under $40 a barrel, and as these technologies are combined into a best-practices suite, I expect the break-even price to dip below $25 a barrel by the end of next year. The United States and Canada combined became net oil exporters in late 2017, and the US will be a net oil exporter by itself by the end of 2020.
And that changes the way Americans look at the world.
This is a political heat map from 1985 at the height of the Cold War. [visual] Countries in deep blue are America’s front and backyard, the countries that we were willing to sling nukes to defend. Those in medium blue are the core Bretton Woods allies. Those in orange are the other guys (Americans don’t like to talk about them).
The light blue was the field of competition. Everything mattered. Everything was in play. It was a global contest with global consequences. Now, remove energy dependence. Change the way the Americans look at the trade and the alliance.
And this is where the Americans are going to be very soon. [visual] There’s a lot of gray on that map, a lot of places Americans don’t have opinions about. And if you remove Americans from the equation, let the chips fall where they may, there are a rapid-fire series of brushfire wars as countries feel obliged to take matters into their own hands, whether out of opportunity or desperation. Three of those conflicts have global consequences.
The first involves Russia.
Post-Cold War, the Russian birthrate plunged 60 percent, which means the Russian army in 2022 will be less than half the size it was in 2016. If the Russians are going to use military means in an attempt to shape their world, they have to do it now. Which means you have to look at the world from their point of view.
The deep red are areas of ethnic Russian majority populations. [visual] (The other colors are not unpopulated; they are just not ethnically Russian dominated.) On the western fringe of the red zone is 2,000 miles of wide-open terrain that’s hideously easy to march across (just ask the Germans). The Russians cannot defend this frontier with the army they have today, much less the enervated army they are about to have. But, so goes the thinking in the Kremlin. If they can forward-position that rapidly shrinking army into these five arcs and anchor their forces between geographic barriers like the Baltic Sea and the Carpathian Mountains, then 2,000 miles of great wide-open shrinks down to under 500 miles of constrained access. All they have to do is conquer all or part of 11 different countries. Say what you will about the Russians, thinking big has never been their problem.
But this is the former Soviet Union’s oil export network. [visual] Seven to nine million barrels of oil a day flow through the conflict zones. Even a brief interruption would be more than enough to trigger an energy-induced depression, global in scope, and a decade in duration. And that’s only war No 1.
The next war hits the Persian Gulf.
The reason the region has been so calm for the past 40 years—just marinate in that statement for a moment—is Bretton Woods. The Americans kept an aircraft carrier battle group in the region to make sure the oil could still flow. Not to themselves, but to the global system: Oil powers trade, trade powers the alliance, the alliance gives the Americans their security.
But the Americans now define their security differently. They’re no longer using the alliance. They’ve never used the trade. And courtesy of shale, they don’t even care about the oil.
Every link in the chain of logic that keeps the Americans wedded to this region has broken more or less at once. That leaves it to local powers to figure out who is in charge.
Two peoples in the region have strong opinions as to whom that should be: the Iranians and the Saudis.
Here’s the root of the problem for the rest of the world. [visual] These are the oil-producing zones of the two countries. Eighty percent of Iran’s oil and natural gas comes from the province of Khuzestan, while 90 percent of Saudi Arabia’s petroleum is produced in or flows through the Ghawar region. Khuzestan is populated by ethnic Arabs, but Iran is a Persian ethno-nationalist state. Ghawar is populated by religious Shia, but Saudi Arabia is a Sunni theocracy.
Intelligence authorities are burning the midnight oil attempting to foment revolutions in the opposing zone, working from the very accurate assessment that if you can crimp the oil income, you’ve strangled the country. In just these two zones, over 11 million barrels of daily oil output is threatened. And that assumes no shooting war and no one getting caught in the crossfire. Twenty million barrels a day might be a more realistic estimate of what’s actually at stake.
That changes the way oil moves.
Here’s global oil flows at the dawn of America’s Shale Revolution. [visual]
There were three big demand centers. First, the United States, which took imports from all points of the compass. At 15 million barrels per day, its import bill was by far the world’s largest.
Second comes Europe, more or less the same situation as the United States.
And then there’s Northeast Asia. Since there were no local supplies, the Northeast Asians had to import their crude from thousands of miles away at whatever price the market dictated. Typically, they had to pay a premium of $3 to $7 a barrel.
Seven years later, US imports had dropped by 7 million barrels a day. The Europeans proved they could make their financial crisis the new normal, crushing economic activity and taking energy demand along with it. Which meant if you were an oil producer, you had no choice but to find a way to get your crude to the only organically growing source of demand: Northeast Asia. The Asians went from being price takers to price makers, and started getting discounts.
Now, throw a war in the former Soviet space and the Persian Gulf.
The Americans exit stage left. They’ve no need for global energy.
The Europeans cannot trust the Russians and so are forced to dust off their own imperial how-to manuals and go out and re-interface with their former colonies in order to keep the lights on. Some of those re-interfacings will be less gentle than others.
That means there’s not enough left for Northeast Asia by at least half. So if you are Korea or Taiwan or China or Japan, you have no choice but to sail your navy around the Asian continent to the Persian Gulf, pick sides in a centuries-old blood feud that’s degraded into a knife fight, load up the crude yourself, convoy it home, and hope that no one tries to take it from you.
If this were to happen anywhere else in the world, I’d be worried, but if there is only one thing we know about the Koreans, Taiwanese, Chinese, and Japanese, it’s that they’ve got a centuries-old history of brotherly love and cooperation, and nothing could possibly go wrong.
We get hot, shooting wars in these zones, where maritime traffic isn’t simply a casualty; it’s a target. That’s three-quarters of global energy shipments. That’s three-quarters of global agricultural shipments. That’s three-quarters of global manufacturing supply chain steps. It is nothing less than the end of the world as we understand it.
What does it all have in common? The Americans just don’t care. They won’t be involved in the wars. It isn’t their energy. It isn’t their trade. For the most part, it isn’t even their allies.
It isn’t that the Americans are cold, or even ignorant. It’s that they are insulated.
The tan area is the Greater Midwest, the largest piece of high-quality farmland in the world. [visual] As important as that is—and it is—the real issues are the blue lines. These are the waterways of the Greater Mississippi River. Sometimes in finance, we forget that moving things from A to B is kind of a bitch, but if you float them, it is one-twelfth the cost. The Greater Mississippi is more miles of naturally navigable, interconnected waterways than the internal systems of the rest of the world combined.
In addition, there are mountains and deserts to the south, lakes and forests to the north, and ocean moats on both sides. Not only is the United States’ portion of North America the richest territory on Earth, it is the most secure.
Decades of bilateral effort have yet to screw it up, and the Americans aren’t going to figure out how in the next few years.
Compare that to China.
The North China Plain (creative name by the way) is roughly 15 percent the size of the Greater Midwest, yet it supports four times the population of the United States. The Yellow River is not navigable, making the region naturally capital poor, while the lack of internal barriers makes it difficult for a single political authority to consolidate control over the entire territory. It took over two millennia of war and ethnic cleansing for the ethnic group we know today as the Han to consolidate control over the entire zone. This is the land of the politicos, the militarists, the nationalists.
The central coast is a world apart. When most of the world thinks of China, they’re really thinking about Shanghai, at the mouth of one of the world’s great rivers: the 2,000-mile-long Yangtze. This is the land of China’s manufacturers, its economists, its mercantilists.
Down south is something different yet again. [visual] The green is the tropics and subtropics. And the same thing happens to the northern Chinese who show up in southern China as happens to Americans who find themselves in Guatemala. They get bit by strange bugs, they start bleeding strange colors, and then they die horribly. It’s a disease belt. The southern Chinese territories have always been the last pieces of territory absorbed into any version of an amalgamated China. That makes southern China a foreigners’ playground, and the land of the secessionists.
How do you get all these varied interests to work together for the greater good of greater China? Three things. First, you bring in an external security guarantor that prevents anyone from preying upon the coast and opens up China to global economic opportunities: That’s the United States and Bretton Woods.
Second, you beat the crap out of anyone who steps out of line. China is a national security state for a reason. It will never be a democracy.
Third, you bribe everyone. The Chinese government collects the population’s savings via the state banks, and funnels that money as loans to any firm that can guarantee high employment levels.
That, however, generates its own problems.
The biggest one is finance. [visual] The red bars represent Chinese loans volumes from the state banking system.
Take a look at this bar—2007. At the height of subprime, 2007 was the most overcredited year in American history, but total Chinese lending surpassed total American lending, despite the fact that the Chinese economy was but one-third the size of the American economy in that year.
Then the global financial crisis happened. People stopped buying Chinese exports, and Chinese lending proceeded to double in less than 18 months.
It appears that the Chinese got things under control, and the pace of increases slowed substantially, right?
Wrong. Financing simply flooded out in new ways with shadow financing taking over—that’s everything from illegal hedge funds to loan sharking.
Back in the first Obama term, we had the largest stimulus program in American history: $800 billion, 3 percent of GDP, over just two years. There was no small number of economists who had concerns that the American economy could not metabolize that much capital that quickly without a great deal of fraud. It was a legitimate concern. This is the equivalent of an Obama stimulus package every 17 days.
The Chinese system is cracking under the strain, and it couldn’t happen at a worse time.
Twenty-five years after the one-child policy, the Chinese are running out of 25-year-olds. The Chinese are not quite as good at math as they might have us believe.
Now, you may have heard Beijing has amended the one-child policy to make it a two-child policy. Riddle me this: How long does it take to raise a 25-year-old? China doesn’t have that kind of time. In fact, the flight from China has already begun.
Here’s foreign direct investment between the United States in China. [visual] In the 2000s, it is roughly what one would expect: The orange bars represent American investment flowing into China. A rich economy investing in a poorer one. But by the time we get to the mid-2010s, things had equalized.
Or they had, until 2016.
This is not the culmination of a decades-old strategy in Beijing to dominate the United States. This is Chinese businesspeople getting their money the “covfefe” out of town before it is too late. This is capital flight. This is Thailand in 1997 or Japan in 1989 or Europe in 2006.
We’ve seen this before. We know where it leads. And that’s before you consider the strategic situation.
When those wars erupt, there will not be enough oil left to power Northeast Asia.
Take a look at this shipping lane. [visual] It is the shortest path from the Persian Gulf to Northeast Asia: 7,000 miles from Ghawar to Osaka. Every weapons system the Chinese and Japanese have can interrupt it, so when the shooting starts, this route will not see much use.
Instead, the oil shipments will have to shift to the deep-sea option. [visual] It is 4,000 miles longer.
Japan’s blue-water navy can still interdict this route, but China is trapped within the first island chain, and it only has one weapon system that might reach this route. And that system might be able to destroy shipping, but it cannot capture or protect shipping.
The war will be hot. Brutal even. But I doubt it will last very long.
Which is why Japanese Prime Minister Shinzo Abe was the second world leader to visit Trump after the inauguration to strike a bilateral deal. Abe doesn’t need the Americans to be on Japan’s side in the coming war; he only needs the Americans to be neutral. To that end, he came to Trump with a $500 billion bribe from the Japanese central government, a promise of investment into US infrastructure and industrial plants. Will it be enough? We’ll see.
But good start! Abe certainly understands how the person across the table thinks.
Back in China, things are getting a bit dicey. The politburo knows full well that the economic model has run its course, and that efforts to shift to an American-style, internal-consumption model are, at best, incomplete. The solution has been political consolidation—to wage an “anti-corruption” campaign that is more accurately thought of as a root-and-branch purge of any and all independent voices—and the consolidation of all meaningful power into the personality of Xi Jinping.
Anywhere else and any other time, we’d call this a “cult of personality.”
It was recently codified.
Last November, the representatives of the Communist Party met here at the Great Hall of the People to anoint Xi’s successor. The way it works in China is that the president serves for five years, a successor is chosen, and then there’s a five-year transition period before the new guy takes over. Last November was Xi’s halfway point. At the Congress, Xi nominated his successor: his heretofore identical twin brother. For those of you who missed the subtext there, Xi not only put himself personally in the constitution, but he also eliminated term limits.
Say what you will about Donald Trump, the US doesn’t yet have a “Trump amendment” that extols how central Donald Trump is to the very existence of the country.
Xi isn’t doing this because he’s an egomaniac or because he feels secure. He’s doing this because he feels weak. He knows the Chinese system’s days are numbered.
And so Xi was the fifth world leader to visit the new American president. He called ahead to indicate he didn’t want to meet in Washington where the press and diplomatic corps could hear and report on everything he wanted to say. So Trump brought him to Mar-a-Lago, where Trump could control the environment.
Xi opened with something like this:
“Mr. Trump, you hold all the cards in the relationship. You control the global oceans. You control global trade. You control global energy. Global finance. The markets we have to have access too. We are struggling with a dangerous economic and political transition that you could derail if you wanted to. So please, please don’t pull the rug out from under us.
To that end, let’s talk. About the trade deficit. About North Korea. About cybercrime. About the South China Sea. About everything.”
The Americans and Chinese made more progress in the next 10 months than they had in the last three presidents. Is it enough? Hell no. But it is interesting.
If you ever have a bad day, consider President Xi. He now knows that the survival of his country, his culture, and his person are now dependent upon the even-keeled mood of the man on the left. [visual]
On a somewhat less cheery topic, there’s Europe.
The Northern European Plain is, in many ways, like the American Midwest—great land, good climate, densely rivered. It is the second richest geography on the planet. But that’s not all of Europe. Move beyond the NEP and Europe is full of islands and highlands and peninsulas and arid zones, regions that are as difficult to develop as the NEP is easy. Europe’s goal since 1946 was to make that all irrelevant, to capitalize upon the peace imposed by Bretton Woods and finally unify Europe economically and culturally.
The idealist in me is awed by the morality and audacity of that goal. The economist in me thinks it is the stupidest thing I’ve ever heard.
The problem is that the Europeans decided to create a common currency. What that did was expose the periphery to direct, unshielded competition with the NEP core. The euro has steadily ripped up the industrial and employment bases of the periphery—places where development is difficult—and transferred everything to the NEP core, places where development is easy.
And so with every passing month, the periphery falls further and further behind.
If you want to know how this will play out, you have to pay attention to the men in the middle. You have to pay attention to the Germans.
Germany sits on four navigable waterways, the densest capital zone in Europe. But it is in the middle of the Northern European Plain, with eight significant powers hard on its borders.
Germans can never outnumber their competitors, so Germans have to be better—better financing, better infrastructure, better education, stronger workforce, better industrial plant. But take anything as efficient as Germany and make it as large as Germany, and its very existence is perceived by its neighbors as a mortal threat.
European history is a pendulum swinging between periods of extreme German strength, which generates a pan-European coalition to tear Germany down, and extreme German weakness, which turns Central Europe into a black hole that sucks everyone in. The only way the Europeans have discovered to stop the pendulum is to bring in an external security guarantor who changes the rules of Europe and criminalizes military competition.
That’s Bretton Woods. That’s the United States.
And so Angela Merkel was the third world leader to come to Washington to seek a new bilateral understanding with the new administration.
She said, “Mr. President, do you realize that if you do what you say you are going to do, that that isn’t simply the end of NATO; it is the end of the EU; it is the end of Germany?”
Trump’s response? “Uh huh.”
Merkel didn’t understand the new transactional nature of American foreign policy. She didn’t come with anything to trade. She merely asked the Americans to keep doing what they had been doing for the past seven decades. And so, on her way out the door, Donald Trump handed her a gift. A bill. For services rendered. For defending Germany since 1946. You can imagine how well that went over back in Berlin. For all intents and purposes, the American-German, the American-European, the American-NATO relationship is already over.
The timing couldn’t be worse. [visual]
On the left we have the demographics of Italy, which show, in one graphic, why the European financial crisis will end in tears. Peripheral Europe has a terminal demography; consumption-led growth is flat out impossible.
On the right is Germany, even older. [visual] Here the financial crisis isn’t just hitting consumption; it is hitting bank stability. Think about how banks generate income. It is all about the spread between the cost of their funds and the cost of their loans. A decade of zero-percent interest rates have collapsed the spread, while a lack of people in their 20s and 30s has collapsed the number of loans. Fewer loans with a narrower spread, that’s how banks die. That’s why Deutsche Bank is in trouble. And that’s not even the worst of it. I argue that Deutsche Bank’s problems are Europe’s best-case scenario. You have all met Germans. They’re just providing an honest breakdown of their numbers. They are sticklers for things like accounting. Italians? Not so much.
Take a look at nonperforming loan data. [visual]
In the United States, any time a bank’s NPLs breach 5 percent of total holdings, the FDIC shuts the bank down. Here in the United States, we are currently at 1.9 percent, and at the height of the subprime crisis, we never breached 4 percent. The yellow bars are eurozone countries, with the Italians in red.
Here’s the kicker: Italy doesn’t use the same metric as the US for determining what is a nonperforming loan.
In the United States, if you are 31 days late on your loan payment, you get a warning. If you are 91 days late, the loan goes into foreclosure—91 days, that’s an NPL in the US.
In Italy, if you are 271 days late, but you’ve made a partial payment, you’re in good standing. This red bar uses that definition. [visual]
In relative terms, the Italian banking sector has an NPL stack 80 times higher than that of the United States at the height of subprime. Forget Europe’s sovereign debt crisis; the banking crisis is far worse.
And so Theresa May was the first world leader to visit the new president to seek a new bilateral accord. She said,
Donald, can I call you Donald? I’m British; of course I can call you Donald. Brexit is happening. A great many details remain to be worked out, but we are leaving Europe. That requires the United Kingdom do a few things differently.
First, we have to double our diplomatic and intelligence budget. We would like to share all the information we gain from that with you.
Second, we have two supercarriers we will be floating within the next few years. They will be the only supercarriers in the world that are not flying US flags. We would like to work with your navy to integrate those carriers into your preexisting battle groups so that the Anglos can have a single strategic policy the world over.”
Trump—remember this was his first meeting with a foreign head of state—thought this was going very well. This is huuuuge! He said, “Why thank you, Ms. Prime Minister. What can I do in exchange?”
May responded, “We’d love a bilateral free-trade deal.”
They started talks that day.
Here’s the fun bit. Technically, that’s illegal under EU law. So for the next year, all the talk in Brussels wasn’t simply how to punish the Brits for leaving, but also for having the audacity to plan for what happens the next day.
I’m like, really? This is what you want to fixate on? Europe faces a demographic crisis, a currency crisis, a sovereign debt crisis, a banking crisis, an export crisis, a Russia crisis, a Turkey crisis, and it’s drowning in amber waves of refugees, but you’d rather bitch about Britain? This is not what I would call an institution capable of flexibility in times of extreme change.
That’s more than enough for the time I had. If you happen to find yourself in need of a coaster, or perhaps a doorstop, I’d like to make a couple of recommendations.
The first is my book, The Accidental Superpower, which breaks down how it all started—how the world came to be in the shape it is today, how it is all breaking down, and the five international crises that Americans will be most concerned with.
The second, The Absent Superpower, picks up where Accidental left off. It explains the ins and outs of the Shale Revolution, how it is remaking the American industrial space, and the wars that will erupt around the world as a result.
Peter Zeihan is a geopolitical strategist whose worldview marries the realities of geography and populations to a deep understanding of how global politics impact markets and economic trends, helping industry leaders navigate today’s complex mix of geopolitical risks and opportunities. He founded his own firm, Zeihan on Geopolitics, in 2012. Today, his clients represent a vast array of sectors including financial institutions, agricultural interests, universities and the U.S. military. He is the author of “The Accidental Superpower” and “Shale New World.”