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America, China, Russia and the Avalanche of History

Thought Leader: Niall Ferguson
May 20, 2022
Source: Link

Does the arc of history bend toward justice? Or is everything falling apart?

Philosophers of history have long sought a cycle of history. Ibn Khaldun offered one version in his “Muqaddimah” (1377): Islam in its infancy has “desert toughness” — but power leads to sedentary habits and luxury, while extravagance leads to fiscal crisis.

Oswald Spengler offered an alternative model in “The Decline of the West” (1918), in which the rise and fall of civilizations resembles the seasons. In our time, a number of writers have proposed their own cyclical theories, ranging from William Strauss and Neil Howe’s “The Fourth Turning” (1997) to the financier Ray Dalio’s recent “The Changing World Order.”

An alternative approach is the notion that history has some purposeful direction and ultimate destination. In a recent essay, Francis Fukuyama reasserted his old claim that history tends towards the triumph of liberal-democratic capitalism and the nation-state. In his words, “there is, indeed, an arc of history, with justice as its terminus.”

This bold assertion is hard to reconcile with the perception of those who follow trends in mass psychology, social media and education that democracy is in the grip of a “stupefaction process” (Jonathan Haidt’s phrase) in the US and elsewhere.

I disbelieve in both cycles of history and ends of history. History is the interaction of many complex systems. There are certain long-run processes (notably exponential gains in productivity through the development of technology and the “suprasecular” decline of nominal and real interest rates as a result of capital accumulation) punctuated by, well, one disaster after another. These disasters are either randomly distributed or follow a power law (i.e. there are lots of little earthquakes, pandemics or wars, but a few cataclysmic ones).

At unpredictable intervals, the global system is tipped into a major transition by a disturbance that can be quite small, if not quite as small as Edward Lorenz’s famous butterfly in the Amazon setting off a tornado in Texas. Russia’s war in Ukraine — destructive certainly, but still a relatively small conflict by 20th-century standards — can be enough to trigger a “conflict avalanche.”

In the same way, a belated tightening of monetary policy by the world’s most important central bank, the Federal Reserve, inflicts a sort of regime change not only on US households and businesses, but on the rest of the world, too. All the consequences of these two shocks — one geopolitical, the other economic — are very hard indeed to predict, but I am confident that we have seen only a small proportion of them so far.

There is quite a bit more trouble ahead before we perceive the restoration of “normality,” which is a term we use loosely to mean something like a period of more than one year during which economic, social and political events do not diverge too radically from the average of the previous 10 years.

The biggest losers in 2022 have of course been cryptocurrencies. With the failed “stablecoin” Terra (UST) now en route to zero (at 8 cents to the dollar, compared with 100 cents two weeks ago), there is palpable fear that other stablecoins and even some exchanges could be at risk. Bitcoin is down 35% year-to-date. Ethereum, 46%. In some ways, however, the major cryptocurrencies in the past two years have simply become substitutes for technology stocks rather than hedging devices. Tesla is down 33%. Amazon is down 36%.

Why are both crypto and tech stocks down? The answer is that the belated tightening of monetary policy has forced investors to rethink their narratives and metrics, especially when it comes to the preference for growth in user numbers over free cash flow.

Valuations that seemed to make sense at a time when the pandemic had driven people indoors and almost permanently online suddenly seemed less plausible as Covid fears receded, the real world of atoms bounced back (oil is up 48% this year and commodities overall up 32%), and the Fed caught up with Larry Summers, the former Treasury secretary who warned of inflation last February.

Owning gold has preserved capital but owning dollars has been a superior strategy. Other major currencies have all weakened relative to the US currency, a classic response to Fed tightening and global uncertainty. However, that trend could reverse if, after two more 50 basis-point hikes, the Fed blinks and stops hiking or even cuts rates in the fall.

The historical period all this most closely resembles is the 1970s, though the analogy is far from perfect. Then, as now, errors of monetary and fiscal policy dislodged inflationary expectations in the US. Then, as now, a war made matters worse. A geopolitical shock (the Yom Kippur War of 1973) added supply-side disruption in the form of the oil-price hike by the Arab members of the Organization of Petroleum Exporting Countries, in retaliation for US and other countries’ support for Israel.

Then, as now, the dominant feature of the international order was cold war. Today, the superpower rivalry is between Washington and Beijing. Then, it was with Moscow — though Russia remains a superpower in terms of the nuclear threat it poses, if in no other respect.

Then, as now, the credibility of the US had been significantly undermined by defeat. The shambolic departure of NATO forces from Afghanistan last year, recalling the chaotic abandonment of Saigon in 1975, partly explains the readiness of President Joe Biden’s administration to fund lavishly a proxy war waged by Ukraine.

Then, as now, China had withdrawn into itself, though the Cultural Revolution was a more disruptive event than President Xi Jinping’s “Zero Covid” policy.

Then, as now, generational divisions were part of a broader problem of social polarization that worried people throughout the Western world. Then, as now, there was an increase in both criminal and political violence in the US (the latter exemplified by the recent murderous rampages in Buffalo, New York and Laguna Woods, California).

If the experience of the 1970s offers any guidance to investors, it is not to expect a rapid return to stability, whether in macroeconomic or geopolitical terms. There were avalanches of conflict in the 1970s. “Peace” in Vietnam (the treaty of January 1973) was followed not only by the fall of South Vietnam but also by the beginning of the Cambodian genocide under Pol Pot, not to forget the Chinese-Vietnamese border war of 1979.

“Peace” in the Middle East (the Camp David Accords) was followed by the Iranian revolution. Detente fell apart as Soviet aggression ramped up from southern Africa to Afghanistan. We should prepare ourselves for a similar cascade in the coming years. This will make it very hard to bring inflation back to around 2% at an acceptable political cost.

However, public disaffection with inflation, not to mention violent crime, will likely see a political turn to the right in the US and other countries where left-of-center governments are in power. This will not benefit conservative parties currently in power (for example, the British Conservatives). It seems very likely to benefit Republicans in November’s midterm elections.

Because history is not cyclical, this exercise in pattern recognition cannot be prophetic. It is unlikely, for example, that the Republican Party will field a candidate as international in his outlook as Ronald Reagan was in 1980. It may yet pick former President Donald Trump. Candidates he endorsed are faring somewhat better than I expected in this year’s primaries (though the Trump effect shouldn’t be exaggerated). On the other hand, there is something powerfully symbolic about the Supreme Court’s impending opinion on Roe v. Wade (1973), a draft of which was leaked two weeks ago. We are literally relitigating one the most bitter controversies of the 1970s.

There is also a nontrivial risk that unexpected internal crises in Russia, or even in Ukraine, could provide some relief for nail-biting investors. Mao died in 1976, Soviet leader Leonid Brezhnev (finally, after a protracted decline) in 1982. The Grim Reaper will remove Xi and Russian President Vladimir Putin from the scene sooner or later, if political rivals do not preempt him. Right on cue, the UK’s Daily Mail ran a story on Monday that Xi is resisting surgery to treat a brain aneurysm, preferring to rely on traditional Chinese remedies.

Like the numerous rumors about Putin’s failing health, this may have political as well as medical significance. On Russian state television, we are starting to hear criticism of the war in Ukraine, while the US Defense Department says some Russian officers and soldiers are disobeying orders.

At the same time, a political rift can be discerned at the top of the Chinese Communist Party between Xi’s supporters and critics of his zero-Covid policy, apparently led by Premier Li Keqiang. Is Xi really sick, or are people just sick of Xi? Roger Garside’s speculative book, “The China Coup,” looks less fanciful every week.

Meanwhile, in the Philippines, a Marcos is back in power — Ferdinand “Bongbong” Marcos Jr., whose father ruled from 1965 to 1986 — while in Canada it is former Prime Minister Pierre Trudeau’s son, Justin, who rules.

In the US, the 1970s originals are still in office: Biden, who entered the Senate in 1972, and House Speaker Nancy Pelosi, who was elected to the Democratic National Committee four years later.  These days, it’s the 1970s who are calling to ask for their politics back.

What lies ahead? Well, after the inflation there usually comes the recession, with the danger of stagflation if the monetary medicine has been administered at the wrong time or in the wrong dose, driving up what used to be called the “misery index” (the sum of the inflation and unemployment rates).

How likely is that scenario? Very.

In the entire postwar period before 2021, there were six quarterly instances of inflation running above 5% while the unemployment rate was below 5%. From the start of such an episode, the median time to the start of a recession was 6.5 quarters, with a mean of 6.7 quarters. Since the fourth quarter of last year — and for the first time since 1973 — inflation has been above 5% and the unemployment rate below 5%.

If history is an accurate guide, this would imply a high probability of a recession beginning in 2023. While the GDP decline in the first quarter of this year was mostly driven by idiosyncratic factors — exports, inventories, and government spending — surveys suggest that consumers are suddenly more pessimistic than at any point since the 2008-2009 financial crisis.

Across the Atlantic, the longer the war in Ukraine lasts, the more likely Europe is to go into recession. The European Union is still debating the details of an oil embargo on Russia, but an accelerated phasing out of Russian energy imports now looks likely. This would drive the price of oil higher, as Russia would take time to find new buyers for the 2-2.5 million barrels per day it currently sells to Europe.

Natural gas prices are also rising sharply, due to the risk of Russia preemptively cutting off gas supplies to Europe. A complete stop would force many European countries to ration gas for major industry consumers, such as chemicals producers.

The British economic predicament is worse than either the American or the European. Unlike the US, the UK is a net energy importer, so higher energy prices subtract from its GDP. Unlike the EU, it is witnessing substantial wage pressures, so its monetary policy makers are under more pressure to raise rates.

The recession probabilities only go higher when you look at the plight of China, where the government’s refusal to abandon Zero Covid in the face of the more contagious omicron variant has plunged industrial output and retail sales into a severe contraction. Economic activity in Shanghai all but ceased last month. Literally zero automobiles were sold.

There are signs of further declines in Chinese household spending this year driven by Covid restrictions, rising unemployment (especially among migrant laborers and recent graduates) and an ailing property market. Despite efforts this year to prop up housing, home-price growth has flatlined while home sales and real-estate funding are in double-digit negative territory.

Remember that image of an avalanche? That is what we are now seeing around the world as higher food and energy prices combine with monetary tightening and supply-chain disruption. As in the 1970s, the most serious damage will be suffered by emerging and developing economies — the “Third World,” as they were then collectively known. Consider just a few examples, beginning in the Middle East.

Turkey’s currency has come under increasing pressure in the last two weeks. The government’s response is to try to force the country’s banks to use their dollar reserves to support the lira. Last week, Iran’s hardline government raised prices for basic goods including bread, cooking oil and dairy products, by between 100% and 300%. Thousands turned out to protest.

Lebanon is the region’s basket case. Having defaulted on its debt in March 2020, the government barely functions. Over 80% of Lebanese live in poverty and everyone faces hyperinflation. The situation has worsened this year because Lebanon imports over 60% of its grain from Ukraine and Russia.

A comparable disaster is brewing in El Salvador. Under the populist, authoritarian leadership of President Nayib Bukele, the country has enthusiastically embraced Bitcoin both as a reserve currency and as legal tender nationwide. The cryptocurrency selloff has likely pushed El Salvador toward a default next January, when $800 million of sovereign bonds are due.

The crypto-contagion doesn’t stop there. According to a 2021 report by the blockchain-data firm Chainalysis, the top three countries in the Global Crypto Adoption Index are Vietnam, India and Pakistan. Keep an eye on Pakistan, where surging food and fuel prices coincided with the toppling of Prime Minister Imran Khan last month.

Finally, Africa has witnessed an above-average level of regime fragility over the past 12 months. Governments have been deposed in Mali, Guinea, Sudan and Burkina Faso. In Ethiopia, civil war continues between the central government and the Tigray region in the north. Atrocities there have been overshadowed by those in Ukraine. With food prices soaring, exports of wheat from Ukraine and Russia severely reduced, and drought conditions in much of the Horn of Africa, famine looms wherever state capacity is weak.

Nigeria, Africa’s largest economy and most populous nation, ought to be doing better, as it is the continent’s largest oil producer. But it is stumbling toward a presidential election in February 2023. Religious strife bedevils the north, and there are growing demands that a candidate from the Igbo-dominated southeast lead the country. You really know it’s a global crisis when you hear the name “Biafra” for the first time since 1970.

So far, 2022 has been an annus horribilis, for consumers and investors alike. Do not expect it to get better in the short term. The pain is greatest in those few countries that have been invaded or have collapsed into chaos, or for those investors whose net worth has plunged by a quarter or more. But it is a crisis that all of us feel to some extent in the forms of higher prices, higher anxiety, less fun and lower wealth.

The sole consolation I can offer disheartened readers is that, though we tend to remember the Seventies mainly for the terrible clothes — not to mention the big hair, even for balding men — they were not entirely miserable. It was, after all, the decade that actually delivered to the masses the “permissive society” that the Rolling Stones and others had sung about (and pioneered) in the Sixties. Alex Comfort published “The Joy of Sex” (1972) and Erica Jong “Fear of Flying” (1973), which launched the quest for “zipless” copulation, unencumbered by any more enduring form of attachment.

A 2018 study by Nicholas Wolfinger, a sociologist at the University of Utah, concluded (on the basis of survey data) that “promiscuity hit its modern peak for men born in the 1950s.” For better or for worse, a lot of unhappy marriages ended in the Seventies; the divorce rate surged from below 3 per 1,000 of population in the years 1948 to 1968 to a secular high of 5.3 in 1979. As for the consumption of alcohol, tobacco and marijuana, the historian who turns his attention to the 1970s can only marvel at just how much people smoked, boozed and got stoned.

Unfortunately, because history is not cyclical and lacks an arc bending toward justice (or a stairway to heaven, for that matter), I cannot guarantee that our re-rerun of that Seventies show will include a revival of the decade’s shameless hedonism. But who knows what a couple of years stagflation may do for our collective mojo?

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