Niqnaq

War Makes for Clarity
Alastair Crooke, Strategic Culture, Jun 28 2022

Photo: Dado Ruvic/Reuters

The train wreck has been expected for so long that we have become comfortable living under its shadow. Life went on. Markets were sanguine that the market lifestyle subsidy provided by the Central Banks would continue unabated, and not without good reason, either. Any trader disappointment at Central Bank action, any dip in markets, brought forth a collective market hissy fit that usually strong-armed the Central Banks into immediate appeasement. We were hard-pressed to imagine differently. Now however we’re in a new era in many ways. The West has entered upon a war with Russia and China, it did not do its homework first, and now it is finding that the war is cruelly revealing the structural rigidities and flaws integral to its own economic system, rather than mining the weaknesses of its rivals.

Why is this new era so grave? Firstly, because of what lies beneath the stones. These structural contradictions have been accumulating over decades, lurking in the dark, damp underside to the stones. Kept hidden from sight by the serendipitous economic outcome of WW2 for the US, and the equally serendipitous combination of factors that kept inflation low, so low that western economists believed they had found the holy grail of monetary easing and had banished recessions for ever. So simple really, just turn on the money-printer! Hubris prevailed. It was magic: a new economics. And then inadvertently, Team Biden kicked over the stones in their eagerness to cut Russia down to size, instigating sanctions and stealing Russia’s foreign reserves. And Inflation was the serpent under the rock. Long latent, unseen yet always present, and no longer one serpent but now many.

And then they found they are fighting the wrong war: Ukraine was conceived as the urban war American and NATO trainers had absorbed from the jihadis fighting President Assad in Syria. But Russia knew this type of war well, and they did not bite. Instead, they fought a classic artillery war, something in which Russia traditionally has excelled. So at a time of structural economic checkmate, the serpents of inflation are loosed, as they always are in war. And as pressures mount, things and people get thrown under the bus. War makes for clarity. It becomes starkly clear what baggage must go overboard to save the vessel. Saving the vessel, of course, is imperative. Thus, America has decided to look after its own. The Davos-Brussels plan to eventually roll up the over-indebted European commercial banks into a single Brussels-controlled digital currency is seen suddenly, as if scales had fallen from the eyes, as potentially threatening to hole the hull below the waterline.

What this reveals is that the strong dollar–weak dollar play, in tandem with Treasury sanctions, has been not so bad for the NY Big Banks! Why let the Europeans scoop up all those distressed assets that pop up in times of crisis? Why allow the US big banking sphere to dissolve into a world of fintech Apps? Why deprive the former of their historic raiding rights? Why stop now because the Europeans want Davos? So, the US Big Banks are thinking, let the ECB and by extension the Euro Zone fall under the bus. Anyway, coordinating policy with the ECB has tied the hands of the Fed to manage affairs to its own advantage. With war, the serpents crawl out. Again, a stark clarity emerges: What worked when inflation was less than 2% doesn’t cut it when inflation is in double digits. The low-inflation era was dominated by monetarist dogma and so it also bred structural contradictions. Even moderate interest rate increases now risk eviscerating bonds and highly-leveraged US companies, and yet still will not be high enough to stem inflation. The Fed’s 0.75% rate hike is a drop in the bucket compared to what will be needed to slow the inflationary crisis.

What to do? With war comes inflation and a decline in those willing to fund the US government’s borrowing requirement, as interest due on $30t blows out. Interest rates therefore must rise, even if they do nothing to stem inflation, to keep value in Treasuries. Thrown under the next bus is the US consumer, as inflation will soar. Higher rates have not been enough to lure outside investors into Treasury markets, with Treasuries now facing the worst bond market collapse in half a century. This has led China to dump US Treasuries to the lowest level in 12 years, and Japan, once a stalwart pillar of US investment, is cutting its holdings as well. The decline in US treasuries along with the ongoing decline in the US dollar as the world reserve currency leads to one thing: more inflation, more pain.

Here is another structural contradiction thrown up by the monetarist era. Theoretically, should the Fed crash demand enough, by making people so poor they cannot afford things, inflation can quickly be lowered to 2%. A huge sigh of relief ensues. Can the Fed then get back to printing money again? Not so fast, please: this outcome is monetarist group-think. It is part of the hubris. Today’s narrative is that the Fed can hike rates until the year’s end, hammer the consumer senseless, and then start the printing presses again, so that the market lifestyle subsidy is on again. To misquote President Clinton, it’s the war, stupid. If you take a sanctions hammer to a fragile and complex just-in-time supply network, you will have supply blockages, and cost-push inflation is inevitable. Turning on the money tap when you face supply-generated inflation will only return the inflationary dynamic to the system. What the Fed is trying to do is to keep some of the benefits of a reserve currency intact, at a time when commodity value as a trading medium commands the world’s attention.

What is this likely to mean in terms of practical politics? Well, cost of living crises are already here, as is the beginning to the ensuing political ructions. The ECB last week announced the end of its asset purchases and did not put anything else in their place. All the ECB said was that it would work on an emergency instrument. So clearly there is an emergency, yet there is no new instrument and there won’t be one. The ECB can use an existing QE tool to buy an unlimited amount of sovereign bonds, or not. It’s a choice, not a new tool. The Euro is but a derivative of the dollar, which itself is a derivative of the underlying collateral. To use a military metaphor, the system of the Euro was built to protect existing static defensive lines. It is no roving, mobile expeditionary military force. The systemic basis to the Euro zone has been the ECB’s absolute commitment to keep German 10-year Bund at a managed premium over 10-year US Treasuries. These are respectively the two value anchors underpinning the functioning of the Euro zone. And as interest rates rise in the US, this must be reflected in the Bund, to preserve its value, for sovereign bonds represent the highly-leveraged collateral upon which the European banking edifice stands or falls. If the value of, say, Italian collateral declines, a financial doom loop sets in, as it did in 2012. The Euro Zone potentially would collapse. At 2% inflation, European sovereign bonds could be kept more or less aligned. At 8% they cannot. And the bond market is fragmenting. The spreads between states’ bonds have skyrocketed in recent weeks. As a stopgap, the ECB seems to be selling German Bunds to buy Italian debt.

What does this portend for the future? A hint of what might be coming came when Christine Lagarde left no doubt that the ECB will at least try to tough it out. She said during a conversation at the LSE that the ECB would not subject itself to financial dominance. Financial dominance is a broader concept than fiscal dominance, because it includes bailing out banks and other financial institutions as well as government borrowing needs. That sounds very much like her stating a readiness to throw either EU banks or countries or both under the bus. Hypothetically, the only remedy might be a mutualised Eurobond and full QE, though that would require EU Treaty renegotiation. QE would of course exacerbate inflation and the spreads. But would the frugal northern states acquiesce? Might they not prefer to opt for a truncated frugal mini-Euro Zone by throwing Portugal, Italy, Greece and Spain under the bus? This effectively might at least save the core of the Euro project by winnowing out the weaker states, and reserving the Euro for the less-indebted northern economies. The consequence would be a Europe emulating what Wall Street did to Russia during the Yeltsin era: imagine it as Italy, with its assets privatised and sold off for $1, as Mario Draghi once did to Banco Popular, which he took over as ECB chief and then sold to Santander for €1.

As of now, it seems the Euro élites have not sensed the danger they are in. They entered a war, and already three major geopolitical tectonic shifts are visible. Firstly, Putin’s rebellion has prompted the rest of the world to say that they have had it’with Westification, by which is meant the predatory, grasping type of colonialism that has characterised western foreign policy. By all means, be the West, but not Westified. By all means be European, but not an EU values missionary, the non-Westerners suggest. Secondly, European voters are not looking for more efficient markets or regulatory structures. As the cold winds of recession blow, they look to their leaders for protection from markets and regulatory absurdities. They sense the danger of unknown doom loops imploding parts of their economies. They are beginning to understand that in wars, rivals strike back, too. War is what it is.

The risk coming from the cost of living crisis is easy to grasp. The risk from additional food shortages is almost beyond calculation. But what we observe from America, and the recent round of the French Assembly elections, is normal politics checkmated, social distrust, widening reservations toward the legitimacy of central authority, and increasing scepticism and doubts about ideologised science. In the US, there is evident a centrifugal separation, reflected in migratory flows. The checkmating, the toxification of politics is leading Americans to want to live amongst their like-minded counterparts. It is, as it were, a political Ben Op (? – RB): a literal and geographic mass movement to live within encircled wagons. And in states such as Florida and Texas, with their clear tribal immigration, an increasing self-definition in opposition to the Federal government. Thirdly, in America as in Europe, there is fear and anger at system disintegration. Fear as cities become both violent and maladministered. The situation at Europe’s airports in these last weeks of sheer chaos and unbelievable queues gives a foretaste of the angst that is unleashed toward remote techno-fragile systems that simply freeze solid under pressure, triggering both anger and grievance.

War, even a war of choice, always reveals the fragility of complex systems. An article in the Atlantic recently noted:

If you, as a typical urban professional millennial, woke up on a Casper mattress, worked out with a Peloton, Ubered to a WeWork, ordered on DoorDash for lunch, took a Lyft home, and ordered dinner through Postmates, only to realize your partner had already started on a Blue Apron meal, your household had in one day interacted with eight unprofitable companies that collectively lost about $15b in one year.

It has been a Millennial lifestyle subsidy that may vanish in the twinkling of an eye, or in one hike of an interest rate. It is a mirage. One that reflects the absurdities of the ‘cult of tech’ in a zero-interest-rate era. It will soon be gone. Yet we shall be lucky if our various crises stop at such minor inconveniences. Rather we may well see splits in ideological movements, as likely upper-middle-class as drawn from the blue-collar sphere, with one part staying mainstream and others seeking violent revolution, as did the Baader-Meinhof and Red Brigade groups in 1970s Europe. In the US, there are already intimations of such armed actions stemming from splinters of the pro-abortion movement, but in Europe, and particularly in Germany, we may see the anger deriving from radical Climate Activists, furious at finding that it is the Energy Transition that will be thrown under the bus, as states struggle to do as best they can to keep a system afloat as cheaply as they can. Self-survival invariably takes priority, pushing other interests aside. Wolfgang Münchau has noted that a book by Swedish academic and climate activist Andreas Malm carries the title, ‘How to blow up a pipeline.’ Its most important message was a battle cry for climate activists to burn and destroy all CO2-emitting machinery. It also invoked Ulrike Meinhof’s most famous statement:

It’s time for a transition from opposition to resistance.

A violent late summer may be brewing.