Tag: Eurozone

Weekly Geopolitical Report – AUKUS (October 11, 2021)

Posted on by Rebekah Stovall

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.

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

Posted on by Rebekah Stovall

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)

Posted on by Rebekah Stovall

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)

Posted on by Rebekah Stovall

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)

Posted on by Rebekah Stovall

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 – Reflections on Nationalism: Part III (September 11, 2017)

Posted on by Rebekah Stovall

by Bill O’Grady

Three weeks ago, we began our series on nationalism.  In Part I, we discussed social contract theory before and after the Enlightenment.  We examined three social contract theorists, Thomas Hobbes, John Locke and Jean-Jacques Rousseau.  In Part II, we recounted Western history from the American and French Revolutions into WWII.  From there, we examined America’s exercise of hegemony and the key lessons learned from the interwar period.  This week, we will begin with an historical analysis of the end of the Cold War and the difficulties that have developed in terms of the post-WWII consensus and current problems.  We will discuss the tensions between the U.S. superpower role and the domestic problems we face.  Next, we will analyze populism, including its rise and the dangers inherent in it.  As always, we will conclude with market ramifications.

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Weekly Geopolitical Report – Reflections on Nationalism: Part II (August 28, 2017)

Posted on by Rebekah Stovall

by Bill O’Grady

(Due to the Labor Day holiday, the next report will be published on September 11.)

Last week, we began our series on nationalism.  In Part I of this report, we discussed social contract theory before and after the Enlightenment.  We examined three social contract theorists, Thomas Hobbes, John Locke and Jean-Jacques Rousseau.  This week, in Part II, we will recount Western history from the American and French Revolutions into WWII.  From there, we will analyze America’s exercise of hegemony and the key lessons learned from the interwar period.

In two weeks, in Part III, we will begin with an historical analysis of the end of the Cold War and the difficulties that have developed in terms of the post-WWII consensus and current problems.  We will discuss the tensions between the U.S. superpower role and the domestic problems we face.  From there, an analysis of populism will follow, including its rise and the dangers inherent in it.  As always, we will conclude with market ramifications.

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Weekly Geopolitical Report – Are the Germans Bad? (June 5, 2017)

Posted on by Rebekah Stovall

by Bill O’Grady

At the NATO meetings late last month, the German media reported that President Trump had called the Germans “bad” for running trade surpluses with the U.S.  The president threatened trade restrictions, focusing on German automobiles.  Needless to say, this comment caused a minor international incident.

Although such incidents come and go, it did generate a more serious question…are German policies causing problems for the world?  In this report, we will review the saving identity we introduced in last month’s series on trade and discuss how Germany has built a policy designed to create saving.  We will move the discussion to the Eurozone and show the impact that German policy has had on the single currency.  From there, we will try to address the question posed in the title of this report.  We will conclude, as always, with market ramifications.

The Saving Identity
In the month of May, we published a four-part report on trade that is now combined into a single report.[1]  In that report, we introduced the saving identity.

(M – X) = (I – S) + (G – Tx)[2]

The saving identity states that private sector domestic saving (I – S) plus public sector saving (G – Tx) is equal to foreign saving.  If a country is running a positive domestic savings balance, either by investing less than it saves or by running a fiscal surplus, it will run a trade surplus (X>M).  In public discussion, trade appears to be all about jobs, relative prices, trade barriers, etc.  However, regardless of how nations interfere with trade, the saving identity will always be true.  As we noted in the aforementioned report, tariffs, exchange rate manipulation and administration barriers will, in the final analysis, be explained through the saving identity.

In the process of economic development, nations must build productive capacity through investment.  Both public and private investment are necessary for success.  Public investment in infrastructure, roads, bridges, canals, etc., are critical to supporting private investment.  In capitalist societies, a legal framework to adjudicate contract disputes and support the enforcement of agreements is also necessary and mostly provided by the public sector.  Private investment usually occurs along with public investment.  But, all investment requires funding, which comes from saving.  That saving can come from both domestic and foreign sources.

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[1] See WGR, Reflections on Trade (full), May 2017.

[2] Imports (M), exports (X), investment (I), saving (S), government consumption (G) and taxes (Tx).