The “Gift” of Coronavirus

In the past couple of weeks coronavirus cases outside of China surged. Particularly worrisome clusters emerged in South Korea and Iran, countries which serve as transport hubs for their respective worlds. US President Donald Trump is doing his normal rambling press conference thing, contradicting most of what little information that is out there. Data coming out of China is more positive, but the idea that China and only China has cracked the code on how to stop a highly virulent virus from spreading in dense population centers is, in a word, dubious. Is anyone not feeling at least a bit…twitchy?

Let’s shift the conversation: Coronavirus may be the most positive thing that’s happened to the global economy in recent years.

China is the world’s workshop. There are precious few complex manufacturing supply chains that don’t link to the mainland in at least some way, with computing, electronics and automotive by far the most exposed. China represents a bit more than a fourth of global manufacturing output all on its own and sports seven of the ten busiest container ports in the world.

The two zones in China most impacted by coronavirus are the Pearl Delta and Yangtze Valley. Most of the 150 million people in China under some degree of involuntary quarantine reside in these zones. The Pearl and the Yangtze are the two most technologically advanced portions of the country, sporting the most sophisticated industrial bases. These regions are by far the most internationally connected of China’s population zones.

The viral epicenter city of Wuhan is one of the largest automotive manufacturing centers in China. Nissan and Honda alone manufacture nearly 2.25 million automobiles there annually. Dongguan, a city in the Pearl River Delta, is known as “the world’s factory” and on its own produces an estimated one-fifth of the world’s smartphones and one-tenth of its shoes.

We’ve all read about how this or that product or company or industry faces pressure from the Chinese shut-ins. So far, shipping companies have cancelled over 80 sailings of container ships, meaning that tens of billions of dollars of goods, many of them inputs into other goods, either weren’t produced or couldn’t get where they needed to go. The sudden lurch in China’s $70 billion annual auto-parts exports industry is already stalling automobile manufacturing in South Korea and Eastern Europe.

But here’s the thing: China’s position in the global system is artificial, and it was going to end anyway.

A look back:

To distill America’s entire Cold War strategy: the Americans created a global Order to provide an economic incentive for membership in their military alliance network. The Americans broke the empires and paid everyone to be on their side against the Soviets. Of the many unintentional side effects was the fostering of an environment where no one shot at anyone else’s shipping, no matter how valuable that shipping might be.

In absolute terms, China is by far the biggest beneficiary of this American-led Order. Japan and the Europeans had carved Chinese territory into imperial spheres of influence. The Americans ended that. China’s manufacturing prowess required the economies of scale of all China being under a single government system. The Americans enabled that. China’s import-export model requires freedom of the seas for commercial shipping to sale the ocean blue without military escort. The American Navy guaranteed that. Without the American-led Order, the Chinese would have never been able to unify or industrialize or modernize or urbanize.

Today, as the Americans step back, there is less than zero hope for the Chinese to step forward. China’s navy is short-range, designed to recapture Taiwan.  Convoying clusters of slow-moving supertankers to and from the Persian Gulf is simply beyond China’s capability, much less enforcing the sort of all-ocean maritime safety that the Americans have done as a matter of course these past seven decades.

If anything, it is worse than it sounds.

Energy: China has had no equivalent of the American shale revolution. As the Americans have achieved net energy independence, the Chinese have quadrupled down on becoming the world’s largest oil importer, with the bulk of their oil needs sourced from none other than the Middle East. China lacks the ability to convoy tankers to and from the region (past oil-importing regional rivals Japan, Taiwan, Vietnam and India no less), much less intervene in a way that might preserve oil flows in the way the United States has done almost pathologically these past seven decades.

Agriculture: Some 80% of global foodstuffs can only be produced with imported inputs, whether that input be fuel or fertilizer or fungicide. China has plowed under its best farmland to build all those factories, making the country more input-dependent than most: China today uses some five times the inputs per unit of food of American farmers and still hasn’t achieved food self-sufficiency. In a world without trade China can neither import sufficient foodstuffs from a continent away nor grow its own. Failures in food distribution have crashed far more governments than war or disease. Just ask Mao how he rose to power.

Manufacturing: Modern manufacturing is a logistical marvel that taps hundreds of facilities in dozens of countries, but that system is based on frictionless international trade. Break just a few links and the entire network collapses. A modern car has about 2000 parts. If you are missing ten, you’ve got a large paperweight. Even if the Chinese could somehow magically maintain their globe-spanning supply chains without a globe-spanning navy, there remains the question of who would buy everything?

Demographics: The One Child Policy has gutted the country’s next generation of consumers far more effectively than anything the Cultural Revolution or Great Leap Forward ever did. The mean Chinese aged past the mean American about two years ago, so a consumption-led system at home is simply off the table. Slow-moving aging throughout the bulk of the world is doing something similar in Europe and Canada and Brazil and the former Soviet Union and Japan and Korea. Even if somehow the Chinese could make their manufacturing system work without the American security blanket, the export-based model upon which contemporary China is based would have ended this decade anyway for want of consumers.

In a world where the Americans do the security heavy lifting and guarantee the world access to their consumer market – one of only a few that will not contract in the 2020s and 2030s – China’s global integration efforts aren’t simply smart, they are doomed to succeed. In a world in which the Americans’ step back and the rules by which the world works change, China is doomed to do the other thing.
Which means coronavirus is giving us a rare gift. A glimpse into a future without globalized manufacturing in general, but in specific a glimpse into a world without China.
Any company or industry that can weather the suspension of industrial activity in the Pearl and Yangtze should be able to manage the coming global collapse with relative ease. Any that can’t, well, they now know precisely where their exposures are. The question now is whether impacted firms treat this as a one-off or the serendipitous peek that it is.

My new book Disunited Nations: The Scramble for Power in an Ungoverned World published March 3. It contains a big fat trio of chapters on what makes for successful empires and countries, much of which focuses on China. Spoiler alert: It doesn’t look good


The Cutting Room Files, Part 6: The Future of China

Read the other installments in this series:
The CRF Files, Introduction
CRF Files, Part I: The Future of Korea
The Cutting Room Files, Part 2: The Future of Mexico
The Cutting Room Files, Part 3: The Future of Canada
The Cutting Room Files, Part 4: The Future of Japan
The Cutting Room Files, Part 5: The Future of the United Kingdom
The Cutting Room Files, Part 7: Europe
The Cutting Room Files, Part 8: American Politics

by Melissa Taylor and Peter Zeihan

This piece is part of the Cutting Room Files, portions of the upcoming Disunited Nations text that were cut for length and adapted for the newsletter. Disunited Nations is available for pre-Order now on IndieBoundApple BooksHudson BooksellersBarnes & NobleAmazonGoogle Play, or Kobo

December 16 and 17 all the international news that was fit to print showcased announcements in both China and the United States that after some 18 months of talks, tariffs and recriminations, a Phase1 trade deal had been reached.
So we’re out of the woods? Right? The threat to the global trading system is now addressed?
Um, no.
Trade deals can come in all shapes and sizes but roughly put there are those that restructure industries, those that restructure countries, and those that restructure the world. When it comes to China, Trump is going for the latter. The problem is that you don’t restructure the world without restructuring the Chinese economy and you can’t restructure the Chinese economy without restructuring the political system all the way up to the very tippy top. The people at the tippy top have some say in how that all goes down… the question is how much.  
To figure out just how much say they have, let’s revisit what the Trump administration is demanding:

  • An end to industrial subsidies including the end to the Chinese practice of flooding its market with cheap capital. Favored companies today can expect those loans to be rolled over indefinitely. Given that kind of leeway, these companies went after market share rather than profits. In other words: China brims with overcapacity, a factoid which drives product prices down, commodity prices up, forces the Chinese to dump their products into other markets, and drives competitors in other countries out of business.
  • An end to all state-run cybertheft and an end to the systematic practice of joint ventures which require technology transfer. The Americans claim, reasonably, that this harms American companies that go through the effort of research and development. It adds to the cost of securing information and just generally sucks.
  • The immediate opening of nearly all sectors of the Chinese economy to fully-foreign owned firms. In other words: competition from the outside in all sectors. Since Chinese firms are for the most part competitive due to price, and that price competitiveness is due to heavy subsidies, remove those subsidies and allow more efficient foreigners to enter China’s home market and mass bankruptcies are the logical outcome.

From the American perspective, this sounds like a decidedly easy problem to fix.
Step one, simply stop massively subsidizing industries and infrastructure that the economy can’t meaningfully absorb. Step two, stop taking intellectual property that isn’t yours. Step three, become a true capitalist society with competition from the outside… ok, that last one sounds like a lot no matter how you say it.
But the point is: sure, maybe that means a recession, but such adjustments are part and parcel of being a modern economy. Cultures as diverse as France and Turkey and Korea and Thailand and South Africa and Brazil have mostly managed such transitions ok. Certainly the “mighty” and “eternal” Chinese can pull it off.
Yet from the Chinese perspective – that is, from Chinese President Xi Jingping’s and the Chinese Communist Party’s perspectives – this is utterly unfathomable. Giving in to any of these demands wouldn’t simply be perceived in China as an unforgivable loss of face, but each and every one would shatter the Chinese economic model, the Chinese political system, and China as a country. Easy money is, after all, the only way the Party can keep up its end of the bargain with its citizenry: a better life than your recent ancestors in exchange for trust in and power to the Party. It does this by offering widescale employment and keeping the doors open at inefficient companies. For the wealthiest, the tradeoff is even more straightforward. Anytime you have a fire hydrant of money blasting, you can expect interests to become entrenched, corruption to spread. Even dictatorial, statist regimes need a political base.

The Party knows this is an unsustainable system and has been racing against the clock, trying to steer an un-steerable, careening behemoth. It aims to transition the Chinese economy from the wobbly foundations of a heavily subsidized economy that relies on other economies buying their goods to something rarified, something more like what the Americans have: a stable, self-sustaining market where goods are produced and consumed domestically. To do so, it needs to cut back overcapacity in a controlled fashion and boost consumption by the Chinese consumer. Until that goal is achieved, the Chinese remain dependent upon imported technology, energy and raw materials, and upon exported goods to more stable markets. China’s real problem is that this entire sequence requires a global system that is open and safe as guaranteed by the Americans.
So far the Party has failed in transitioning the country onto more stable macroeconomic footing, fearing at each step that it will lose one or more of its most important constituencies. Put another way, the Party finds itself unable to transform its economy away from dependence on the Americans. It finds itself at the end of its economy’s ability to take on debt.
Which brings us back to the Phase1 deal:
The trade talks have followed an almost disturbingly predictable pattern: The Americans make demands the Chinese cannot possibly meet. The Chinese promise to comply. A few weeks later Chinese actions make it clear they have no intention of complying. The Americans levy more trade restrictions. Repeat.
All the Phase1 deal is is a bribe to the Trump administration: a promise to purchase a few tens of billions of dollars of American agricultural products and to start implementing protections for intellectual property (some of which were agreed to twenty years ago), in exchange for a slight rollback of the tariffs already in place and a promise to delay a new planned batch for the time being.
The next step in the drama is obvious: sometime in late January or February, the Americans will again say the Chinese are not complying, and that new batch of pre-prepared tariffs will slam into place. And incidentally, geopolitics aside, I can’t think of a better international backdrop for a populist president than to run against China in an election year.
So it’s time to call it. There isn’t going to be a meaningful trade deal with the United States because agreeing to the Americans’ demands would be the end of the Party. The Americans can afford, if they must, to cut China out. It isn’t “easy,” but it’s more akin to a cold than leukemia. In fact, a combination of cheaper resources like natural gas, advanced technology, highly educated labor, and geopolitical disruption all make relocation to North America easier at the same time that East Asia’s costs – from labor to risk – are going up. Some companies and industries have already moved into the NAFTA marketplace and we’re still in the early stages of all these trends. If the world’s largest, most important consumer market, and the physical guarantor of all Chinese supply chains simply walks away, the Chinese are simply out of options.
More likely, it will be (far) worse than that for the Chinese. If the Americans, instead of merely cutting out the Chinese instead get aggressive, things could quickly cascade. Even with a naval deployment policy that’s one-quarter of what it is currently, the Americans could easily – almost lazily – interrupt any trade flow on the planet. In comparison, the Chinese cannot even guarantee their maritime safety within a thousand miles of their own coast, and most of their oil comes from five times that distance along a path littered with threats and rivals. And the size of those oil inflows? Edging up to 12 million barrels a day – greater than what American total imports were at the height of American energy dependency in the early mid-2000s.
China’s crash will be much like its rise. Big, bold, brash, loud, all-consuming, and, in hindsight, completely inevitable.
For more on what the future holds for China, and the entirety of the East Asian rim, take a look at my new project, Disunited Nations: The Struggle for Power in an Ungoverned Worldnow available for pre-order.

Why So Negative?

Bonds are sliding toward negative territory across the developed world.  Among the largest industrialized economies, only the United States is offering over 2% yields on 30-year bonds. And it’s not just the global economic pillars pushing rates down, but even in places like Poland that stretch the definition of “developed” market. Or Italy, which push the boundaries of concepts like “balanced budgets.” And even in Greece, which stretches the definition of… pretty much damn near everything. 

What gives? 

First, the technical answer. 

Part of the shift toward negative territory is quantitative easing (QE). QE is, in essence, the expansion of monetary supply above and beyond what the economy says it needs, and then using the newly “printed” currency to purchase various bonds. This artificially drives down borrowing costs of all kinds and inflates financial markets. The idea behind it is that cheaper borrowing costs and an inflated finance market will boost business and consumer confidence and from that, spending — thereby boosting demand in the real economy. 

Between the American, European and Japanese programs, the equivalent of some $15 trillion has been dumped onto markets through QE since the 2007 financial crisis. One reason for the dollar’s strength under Trump is that the United States’ QE program largely came to an end several years ago and the US has reverted to using more traditional monetary tools. In contrast, Europe has been at near-zero interest rates for a decade (and Japan for twice as long), leaving QE or things like it as their only means of using monetary policy to stimulate economic activity. The Eurozone, after a brief hiatus, just restarted QE again a few weeks ago. Japan never really stopped. 

It all adds up to a lot of money chasing limited investment opportunities. That boosts stock and property markets, while the surge into bonds pushes yields negative. 

Second, we have the traditional answer. 

There is a whiff of instability surrounding everything. Germany is undoubtedly in recession and will drag much of the Eurozone down with it. Japan hasn’t seen reliable, sustained economic growth since the 1980s. The American-Chinese trade war has collapsed global confidence in the Chinese economy while the HK protests have collapsed Beijing’s soft power. Meanwhile, it seems that nearly every country in the Middle East is facing some degree of crisis. Even if you’re an aficionado of my brand of Kool-Aid and believe that the US is largely resistant to global upheaval, “resistant” is not synonymous with “immune.” While I still do not see an American recession on the horizon, the American economy has most certainly slowed. 

Recessions — even fears of recessions — have consequences for capital. Spooked investors tend to push money into assets backed by either long-term income streams, government guarantees, or both. Fewer stocks, more bonds. High bond demand pushes yields down towards, to, and through zero. 

It isn’t so much that either answer is wrong. In fact, they are dead on. But they are not the whole picture. There’s something else going on. Something much bigger than QE and much more structural than the normal ebb and flow of economic cycles. 

It’s demography. 

People act differently depending on their age. There’s aren’t a lot of retirees at spin class, nor do college students frequent buffets that specialize in creamed vegetable products. In a “normal” economy there’s a set balance of roughly four children to three young adults to two mature adults to one revered elder. So long as that proportion holds the economic system has some somewhat straightforward characteristics: young workers spend and borrow, mature workers invest, while retirees shift their financial holdings into decidedly less interesting and volatile holdings. Fewer stocks — more t-bills and cash. 

The problem, if “problem” is the correct word, is that the onset of the Second Industrial Revolution roughly 140 years ago both pushed people off of the farm and into urban environments while vastly, dramatically increasing lifespans. As the decades rolled by our definition of “normal” has shifted. Families became smaller and smaller until most of the developed world slipped below the replacement level of 2.1 children per family. Among the developing world the process started latter, but the downward shift in fertility has been two and three times as fast. The partial exception? The United States. Its wealth of arable land has made it an industrialized country that urbanized slowly. The result? China’s population is already older on average than America’s, while Indonesia and Brazil’s will surpass America’s average ages in about a quarter-century.

The problem (and this time “problem” is certainly the correct word) is that the demographic shift has altered the structure of capital. From roughly 1970 to 2010 the decline in birth rates steadily increased the proportion of mature workers in the population relative to everyone else. It is this block that saves the most both in relative terms and in aggregate. Those savings are the bulk of the world’s working capital. Left unchecked, the growth of the mature worker cohort will eventually oversupply the world with capital.

Well, “eventually” is here. Right now, the population of mature workers as a proportion of global population is at its peak. As this cohort inexorably edges toward retirement, they are shifting their portfolios into less risky assets. Less venture capital, more bonds. The veritable tsunami of capital into the bond space has pushed the safest of those bonds — government debt — firmly into the negative.

Don’t get used to it.

The biggest thing that separates mature works from retirees is time, and in 2022 the majority of the world’s Baby Boomer cadre will have aged into mass retirement. Denied much in the realm of fresh income, the incoming tsunami of government-bond-capital won’t so much recede as evaporate.

Without those inflows, capital costs will — must — rise.

That’s the best-case scenario. It assumes no disruptions. No breaks in global continuity. A rapid climbdown from the trade war. That Italy doesn’t implode. That the Eurozone holds together. That the Brexit debacle calms down. That the Japanese economy can manage its aging and shrinking worker pool via automation and robotics. That the Chinese political center holds. That the broad swathe of the developing world can somehow double their standards of living in under a decade without sacrificing family size. That there’s no shock to energy markets. That the economic contortions of mass aging somehow magically avoid touching banking and finance. That the Americans elect a mild-mannered accountant to be their next president.

Anything that injures either globalization in general or employment and wealth levels specifically immediately imposes burdens, both in terms of raising financing costs directly and preventing capital created in one region from pouring into another. Fragmenting global capital markets will, all by itself, turn regions that have recently become used to ultracheap capital (sub-Saharan Africa, Brazil, and India come to mind) once again into capital deserts.

That’s still a pretty good scenario.

It assumes the global system while beaten and bloodied ultimately holds. Historically speaking, the downturns an instability we’ve experienced to date — and this includes the Great Recession — are pretty minor stuff. The global Order is what has enabled many countries to exist in the first place, and if you cannot exist you cannot issue bonds. A heartily inconvenient fact of economic history is that before the Order (that is, 1946), it was pretty common for markets to not simply fail but go to zero.

The first time that happens the financial markets will come face-to-face with a level of risk and risk pricing that no one alive has any expertise in managing.

My Way or the Huawei

On May 15 the U.S. government put Chinese telecoms giant Huawei and nearly all its affiliates and subsidiaries on an export black list, which prohibits American firms from selling them high-tech products. Much has been made of Huawei’s position in global telecoms and the role it might play in Chinese surveillance of, well, everyone. The American decision largely ends the concern.

To this point I’ve tried to stay out of the Huawei battles for a pair of reasons. First, the people who really know what is going on when it comes to global data surveillance either do not talk publicly about it or have a vested interest in lying. In the former camp sits the United States National Security Agency, the institution responsible for monitoring global electronic communications. In the latter is the Chinese intelligence directorate, who would like to monitor global electronic communications.

Some background:

Back in the 1960s, the American government started collaborating with the U.K. government on a global monitoring system known as Echelon, a sort of semi-public codename for the series of satellites, towers, fiber optic taps, server farms and software backdoors that span the planet. Echelon soon expanded to include the Anglophone allies of Canada, Australia and New Zealand, becoming the core of what is known today as the Five Eyes intelligence alliance. Echelon’s original raison d’etre was to battle the Soviets, and in time it found new life in the Global War on Terror. According to informed scuttlebutt, if a communication is transmitted using electrons, Echelon sees it.

Or at least it used to. Telecoms have evolved radically in the past half century. Even before the recent fascination of all parties with encryption, the simple fact the United States is no longer the middleman in all telecoms traffic means Echelon is more a tool of yesterday than today, much less tomorrow. Regardless, the ability to scan, read or listen for key words remains essential to America’s tech-heavy intelligence gathering networks.

Enter the Chinese, who found themselves behind the Americans by several decades, and that before considering China lacks the alliance system to create anything of Echelon’s depth or scale. Beijing’s bid to catch up is Huawei, a massive telecoms firm which produces everything from the fiber optic cables and telecoms towers of the physical internet to the phones and computers needed to connect.

While the internet is an infamously unorganized mass of connections, the modern network has central exchange points where the tributaries of information coming from all over the world become torrential flows. Such “core” systems are what Huawei is after. Control the cores and a spy is wired into everything that passes through it.

Huawei’s corporate strategy – which is to say, the strategy of China’s intelligence services – is to grant massive discounts on the installation of a network’s less critical bits on the condition that Huawei can also install and maintain the cores.

Beyond the not-so-minor technical fact that there are people beyond China who understand how the internet works and so might object to handing over all their communications on principle, the plan has an amusing political flaw. Like nearly all of China’s tech industry, Huawei is not technologically self-sufficient. It remains heavily dependent upon tech imports from none other than the United States. Which is the second reason why I’ve never taken the Huawei talk all that seriously: The Chinese not only expect the world to pay them to monitor global communications, they expect the Americans to enable the scheme.

At first the Americans didn’t take the Huawei plan all that seriously, mostly because it was a seriously stupid plan. Then Huawei had some success using heavy subsidies to convince some countries to install their gear. That generated a diplomatic reaction in Washington. American bureaucrats started warning countries not simply of the dangers they seemed willingly oblivious to, but that any country who used Huawei in their cores could kiss any intelligence sharing with the Americans good-bye.

That was enough to shut Huawei out of New Zealand and Australia outright. (The Brits got cute and accepted Huawei gear for their system’s edges, but not their cores, a smug near-miss which undoubtedly infuriated the Chinese to no end.)

But three things have changed that have sparked stronger action out of the Americans.

First, the transition from fourth- to fifth-generation cellular technology blurs the line between core and non-core systems. Huawei penetration into any part of a cellular system now generates complications and vulnerabilities.

Second, despite the risk of communications exposure, enough countries have decided to proceed with Chinese equipment that the Americans can no longer just let it roll. In particular, China’s targeting of Five Eyes members – most notably Canada – has snapped the Americans to attention.

Third, after seventy years of expressly keeping economic and strategic issues separate in American foreign policy, a more standard intermingling is now occurring – and that puts everything Chinese in the Americans’ crosshairs.

Bilateral trade talks with China more or less collapsed last week. I can’t say I’m shocked. At the talks’ onset the Americans laid out a series of non-negotiable demands including an end to cybertheft, an end to forced tech transfer, an end to the hyper-subsidization of Chinese industry, an end to functional prohibitions on American firms’ access to the Chinese market, granting the Americans the right to impose any investigation at any time on any issue without any consultation complete with the ability to impose any desired punishment on any Chinese economic sector.

The fact the Chinese even began talks with those swords hanging over them indicates just how weak the Chinese knew their hand was. China exports over four times as many goods to the American market as vice versa and China is completely dependent upon American global security commitments for access to raw materials, energy and end markets. There is no modern China without active American involvement.

Last week it became apparent to the lead American trade negotiator – one Robert Lighthizer – that the Chinese were backing off what commitments he had previously convinced them to make. It was Lighthizer’s recommendation to Donald Trump that American tariffs on China be more than doubled May 10. He then put an even bigger set of tariffs in the pipeline to be applied within a few weeks.

The Americans’ Huawei announcement has the feel of Lighthizer’s work: he likes to throw the odd sharp elbow and knows his boss is particularly fond of bold, direct, splashy actions that cut to the heart of the issue.

That issue is pretty straightforward. The Americans may be done managing the world, but that doesn’t mean they are going to help someone else do it – especially someone who doesn’t have a ghost of a chance of pulling off such a feat without deep and active American collaboration. Better instead to put China in its place.

The Chinese, understandably, have proven less than enthusiastic about accepting that message.

So the Americans decided it is easier to simply end China’s global surveillance ambitions by killing Huawei’s international position outright. It isn’t very subtle, and if it doesn’t generate the desired Chinese cave-in in the trade talks it makes me wonder what Lighthizer will take aim at next. I’ve got lots of ideas.

I’m certain Lighthizer has more.

The Art in the Forest

I woke up Monday morning to find a bit of a debate on my Twitter feed over assessments of my ability (or lack thereof) to pontificate on trends in the energy sector. Specifically, Art Berman — @aeberman12 — noted:

“I told Peter last time we met that I believed he should stick to what he knew–demographics & geopolitics. His view of shale plays & US energy independence/dominance is that of most oil analysts with no experience in O&G business–partly right & dangerously wrong.”

Let me start by saying that while those sound like fightin’ words, Twitter has a way of making us all sound like hot-headed jerks. I’ve met Art a handful of times and I know he is one ultra-polite cat. Art was just pointing out in under 280 characters that he’s a specialist in his field and I am… not.

He’s correct about that, but he is not correct about the rest. I am not a demographics expert, and I’d argue geopolitics is too multi-tentacled of a beast for anyone to truly command.

I also don’t know more about the Chinese DF-26D ballistic missile than the folks in the U.S. Navy who worry about it striking an American carrier, so I’m an avid reader of Aviation Week. Nor do I know the minutiae of demographic trends, so I follow Vikram Mansharamani. Nor can I keep up with the wild insanity of European security policy, so I rely upon the insights of Francois Heisbourg and Ivo Daalder. Nor do have the time, inclination and focus to follow the ins and outs of Chinese finance, so I keep tabs on what Michael Pettis is doing. Rose Gottemoeller for nuclear policy. Liam Denning for global energy markets. Borzou Daragahi for the Middle East. Milo Hamilton for rice. Max Roser for delightfully unexpected data visualizations. Jake Bramante for great backpacking analysis.

I’m not a specialist in any of these things. I mean, come on, I’m from Iowa. How sophisticated do you think I can be?

All these folks I follow are the true experts. The specialists who know all the details and relationships of their respective niches. I think of them as tree people.

I’m more of a forest guy.

Since Art started this little journey, I’ll use him as an example.

Art’s specialty is petroleum economics, in particular he analyzes the relationship among a firm’s finances, its reserves, its production rates, and ultimately its profitability. The bread and butter of his consulting business is to help folks identify which firms will and will not prove financially viable over various time horizons. (Apologies to Art if I didn’t get that quite right. After all, I’m not a specialist.)

If you are interested in the U.S. shale industry from an investment or profitability standpoint, and for some reason you have not spoken to Art, you are doing yourself a disservice. He’s clearly the headliner for his business niche.

But Art is probably not who you would go to discuss the newest technologies in the shale sector, and why would you? He’s not a specialist in that very specific subfield. For that the University of Texas’ Bureau of Economic Geology (BEG) is a better match. I watch what both are doing.

I follow Art both for a reality check on how much the shale sector can grow with current models, as well as to understand what sort of firms might be able to enter the shale patch to displace players less stable. Its about figuring out the future corporate makeup of the shale patch. Without Art I would have never known to even look at the shale sliver of bond markets.

Conversely, I follow the BEG to get an idea of what new techniques might work at what price points in what petroleum basins so that I can grope towards an understanding of what the operational geometry of the shale patch might look like in three to five years. Without the BEG I wouldn’t have even heard of multilateral drilling until it became widespread and could have never projected forward.

I don’t pretend to know more about the specialties of Art or the BEG because I do not, and I never will. But I use the work of both as well as Vikram and Ivo and Rose and Borzou and Milo and many, many others to game out the bigger picture over many sectors on multiple continents over a (much) longer time horizon.

I look at the world. It is a very big forest. It requires me being as well-rounded as possible. I’m certainly not the smartest person on topics oil when in a room of oil operators, but I bet I know more about agriculture. And when I’m in a room of farmers I bet I know more about manufacturing. It isn’t about being the smartest person in the room on any given topic. It’s about being able to draw connections among all topics.

Energy informs electricity informs manufacturing informs trade informs China informs finance informs real estate informs civic development informs educational patterns informs technological advance informs geographic advantage. Not exactly the circle of life, but such interconnections form the context of what I do. I’m a sort of advanced generalist. A professional novice.

So, with that in the proverbial back pocket, let’s talk about shale today.

The biggest point of friction between Art and myself is over output horizons.

I’ve pretty consistently been among the more optimistic forecasters of future shale output, while Art has pretty consistently been among the more pessimistic. We’ve both been wrong. Shale has always done better than the forecasts.

Take a look at this screen grab. This is all data from the U.S. Department of Energy’s Energy Information Agency–EIA is by far the best piece of the U.S. government infrastructure for collecting and understanding the details of any energy question. The dotted lines are the EIA’s annual estimates for what shale output will be in the future. In the legend you can see what year EIA made each estimate.

The solid line at the top is actual output.

Notice that the EIA has never gotten it right. They’ve always under guessed. That’s because they cannot factor in technology that has not yet been invented. There is oil in shale formations, but the EIA–and I daresay, Art–didn’t know how to get it out of the ground. Toss in the profit motive, and BAM! People found a way. Shale boom.

The problem is predicting the impact of new technology. Whenever something comes out that no one has seen before, it is no simple task to predict what it will do once it is applied en masse. As recently as five years ago there were hundreds of producers in the shale space. Each was developing new techs. Even if 90% of those innovations proved unworkable, the rest eventually caught on and transformed what was possible. Things like micro seismic, multilateral drilling, better data and water management are not simply being continually refined and improved but combined into best-practices systems that have steadily–meteorically–increased American oil output to generate that thick line.

That unpredictability is step 1.

Step 2: Enter Art.

Art is absolutely correct: Many of these small companies have not been profitable. Many hemorrhage money. Yet that hasn’t mattered because international instability has funneled ridonkulous volumes of scared, stupid money into the United States. That money seeks investment products that have a hard asset and a revenue stream. A net loss is not considered overly problematic since if the money stayed at home the fear is it would all be lost. Shale bonds, as imperfect as they are, fit the bill. Add in the general swollen nature of the American financial community in the aftermath of the subprime crisis and the availability of financing hasn’t often been a limiting factor. Art doesn’t have to be wrong for the overall sector to grow.

Where I get interested is that the very financial weakness of these barely-profitable or unprofitable firms provides openings for stronger firms.

Enter the super majors. For the first decade of the shale revolution, the supers barely touched the sector at all. Their concern — like Art’s — is profitability. They saw an experimental industry with razor-thin to nonexistent profit margins and they stayed away.

But all those new techs are now combining into a best practices suite, and whenever a piece of the oil patch is determined not by chutzpah and innovation and financial…creativity but instead by brute force and iron-clad internal finance and technical acumen, bet on the supers every time. The supers are now sweeping into the shale patch and buying up financially-stressed independent operators by the dozen.

In a young industry ingenuity is everything. In a mature industry scale is more important. The independents have ingenuity. Ingenuity has made shale ever more efficient, dropping overall production costs from in excess of $100 a barrel to something under $40. But the industry is now maturing, and the supers have scale. The torch is passing.

ExxonMobil has rather boldly opined that some of their newer, larger production schemes for the Permian Basin will be have costs as low as $15 a barrel.

As that’s a figure cheaper than oil production costs in Saudi Arabia, that sort of claim grabs my attention even though we know that the Exxon plan is not an apples-for-apples comparison. Exxon didn’t note whether the $15 figure includes exploration or tax or transport costs or is limited to production and lifting expenses. Much more importantly, the supers operate in a starkly different manner than the smaller mom & pop firms that have dominated the shale sector until now:

In part the supers have the advantage of scale (internally-sourced finance, better data crunching, the best engineers in the world, etc.). A bigger piece of it, however, is the supers won’t drill a well they don’t think will be profitable. Most smaller players — in part because they are experimenting — will drill every possible spot on their leases. That’s what happens when cash-flow is king. The supers think on a longer time horizon and so tend to only drill the really good spots. That generates more output per unit of input, even if it leaves a bunch of crude in the ground. It might generate less production, but it is better optimized. Profitability looks better. (I can hear Art nodding approvingly.)

This evolution in players probably means that the pace of output increases will slow but considering 2018 output gains were the largest single-year gains ever, that really isn’t saying all that much.

Which brings us to point three. Even assuming the pace of increase in 2019 is half that of 2018, the United States still becomes a net crude exporter at the end of this calendar year. Yes, that’s a notable milestone, but it in no way signals the end of the shale story. Even assuming future annual increases are only one-third that of what they were in 2018, the American oil patch will add a new Saudi Arabia of output within a decade.

Now there are a hundred shades of subtlety within that statement, and a thousand events that will unfold before that happens, so I’d not get too enthusiastic with the chick-counting. But most of the things that will go wrong will happen well beyond America’s borders, and there is little to nothing in Art’s world that will change the petroleum switch-over from somewhat financially-stressed small firms to the more stable super majors. This is cooked in.

It is indeed time to start noodling over what it means when the world’s largest supplier of internationally-available crude comes from a country that no longer has much interest in global stability.

That’s my new forest. The trees in this scary forest are not reserves and debt tables and drill bits, but Japanese missile ranges and Swiss insurance brokers and Saudi assassination manuals.

Time to meet some new specialists.

Trade Talk, Part 2 of 2: For Whom the Trump Toll

On Oct 1 the American, Canadian and Mexican governments announced their mutual agreement to a revised treaty text for the North American Free Trade Agreement. As it was at formation, NAFTA remains the most valuable trade block in the world. Donald Trump insists the new deal will be called “the United States – Mexico – Canada Agreement” or USMCA. As something very close to that acronym has already been taken by an organization that excels in high-kinetic situations and getting American citizens abroad out of trouble, I’m still going to call the trade deal “NAFTA.”

Trump got a rough start. He came in with zero experience and a cabinet that was, in a word, messy. Organizationally he spent his first two years dealing with (causing?) personality and organizational conflicts, and during the past year he has fired nearly everyone in his cabinet with expertise.

But in the background this entire time, Trump’s trade team has continued hacking away at rewriting the United States’ entire trade position. During the decades of the global Order, the United States was all about granting the world deference on economic and trade issues so the Americans could gain the allegiance of most of the world on security issues. That’s how the Americans built and maintained their alliance against the Soviets. That Order is now collapsing, and that necessitates a different approach to both security and trade.

Meaningful adjustments to how the Americans treat the world are, generally, broad-scale disasters for most countries. The ability to trade security deference for economic dynamism in a world of global security was a great exchange for most. Under Trump the two issues are now divorced. You want a security deal with the Americans? You need to offer them something security-related. You want a trade deal with the Americans? You need to offer them something trade-related. No more cross-swaps unless you are willing to be embarrassingly deferential. At first everyone resisted. In part because they had a great deal going in – with the Cold War long gone they hadn’t needed to give the Americans much – in part because no one wanted worse terms.

But since the Americans control global finance and the global currency and global trade flows and the global ocean and global energy and the world’s largest market, the White House holds all the cards. Once it became clear Trump’s position wasn’t rhetoric, everyone knew they’d have to find a way to make a deal.

South Korea – fearing the need to stand alone against North Korea and China and Japan – went first, largely giving in to Trump on economic issues in the hope that when the time comes the Americans will be there on security issues. It is unclear if that will work for Seoul, but it was very clear the Koreans didn’t have a choice.

Next came Mexico, a country whose entire meaningful trade portfolio – and its recent rise from mass poverty – is wrapped up in NAFTA. A country whose seen its position in the U.S. market slashed by China. A country who knows it cannot attach itself to any other market.

Trump’s trade team used its agreement with Mexico to force Canada’s hand. And just like that, America’s economic position in the world is guaranteed. NAFTA alone accounts for roughly one-third of America’s entire global trade position. With that secure, the Americans can now get down to some serious bullying with everyone else.

Next up is Japan. Now sandwiched between a South Korea who already has a deal and a slightly redesigned NAFTA, the only markets that really matter to Tokyo are already locked into Trump’s new system. Trump wants a bilateral or nothing at all. And so this week Japan relented and opened negotiations. I doubt they’ll take long to conclude.

Even easier to negotiate will be a pending bilateral with the United Kingdom. In 2019 the Brits will be leaving the European Union without a deal. The pending hard Brexit will trigger a depression in the United Kingdom, forcing London to accept whatever trade terms the Trump administration sets.

Of America’s largest trading partners that only leaves two on the outside.

The first is Germany. There will be no deal here. There are two obstacles. First, Germany is within the European Union, and EU trade deals are negotiated and administered by bureaucrats in Brussels the Germans do not fully control. Those eurocrats tend to be pretty huffy about how special the EU is and – by design – do not factor in geopolitical issues. Even easy deals typically take a decade to negotiate and it is my opinion the EU doesn’t have that much runway left.

Second is the issue of France. If Paris and Berlin were to combine forces to pressure the EU secretariat to cut a quick deal with Trump, it might happen. But the French and German economies are structured differently and interact with the Americans differently. In absolute terms the French export less than one-third as much to the United States as Germany, to say nothing for the thin French industrial position within the United States itself. That leaves the eurocrats to do what they do best – and that doesn’t include a quick deal.

Hong Kong, China

That just leaves China, a country that is loosely tied for first place in the American trade volumes pecking order with the Canadians and Mexicans. With every country that gives in to Donald Trump, the maneuvering room of those on the outside shrinks. With Korea and Mexico and Canada and Japan and the United Kingdom locked in, already representing 40% of all US trade, China has everything moving against it. We’re now beyond the simple issues of the Americans controlling the global system but not needing it, or the Chinese needing the global system but being unable to maintain it, or the Chinese needing the American market far more than the reverse is true. We’ve even moved past the unavoidable fact that the two people most responsible for Trump’s foreign economic and security policies – Trade Representative Robert Lighthizer and National Security Advisor John Bolton, respectively – have taking China down a few dozen pegs as their top goal.

The new bit of info is that America’s entire trade policy is now designed to break China. The Americans wrote into the new NAFTA treaty that if a signatory signs a trade deal with any non-market-based economy (read: China) then the Americans will up and leave. Expect such language to be appended to every deal the Trump administration writes. For all the talk of China stepping into America’s free-trade shoes (which I always found rather silly) everyone now knows exactly the cost of picking what the Americans feel to be the wrong side.

We might even know the date. As part of their efforts to box in Iran, the Americans are prepping secondary sanctions against any entity that continues importing Iranian crude after November 4. Nearly all international trade is not settled directly, but indirectly via the dollar. For example, if Vietnam sells shoes to South Africa, South Africa pays rand to an intermediary which converts them to dollars, and then converts the dollars into dong which are paid to Vietnam (because no one in Vietnam has or wants rand, and no one in South Africa has or wants dong).

Since the U.S. dollar is the intermediary that makes it all work, Washington holds the option of saying “no,” especially if those transactions are routed either through U.S. banks or banks that value their business with U.S. institutions… like the Federal Reserve. Apply that to all transactions of a given entity and the effect is a complete shut-out from not just the American market, but all global trade.

As present, China is the only country that hasn’t at least hinted at cooperation with the United States’ anti-Iranian efforts. That raises the tantalizing, terrifying possibility of a trade-cum-security-cum-finance throwdown between the Chinese and Americans as soon as November 5 that is less the Chinese bringing a knife to a gun fight and more the Chinese bringing a knife to an artillery exchange.

For those thinking that Trump is a spent force because he’s about to face a mid-term wipe out, think again. Even in the event of a Democratic wave that turns the Congress blue, nothing changes. The U.S. Constitution clearly grants the presidency preeminence and autonomy in foreign affairs. When domestic politics hobbled Bill Clinton, George W Bush and Barack Obama, all three put more of their hours into international politics. At its fundamentals, trade policy is part and parcel of such foreign affairs issues. Congress might be required to stamp approval on new deals, but Congress plays no role if the executive wants to scrap old deals. Trump can even choose to cease executive workings for preexisting deals he might legally need Congressional approval to scrap. (You can thank George W Bush and Barack Obama for setting that particular precedent – they are the ones who decided to not enforce laws they disagreed with.)

The fact is that the United States has leverage to spare in every sphere of global significance, and Trump is racking up some significant successes in converting that leverage into real – if fairly minor thus far – changes. Whether or not you care for the Cold War Order or trade deals like NAFTA or more direct action against traditional trouble states, change is less in the wind than barreling down the tracks towards us all. And with each of the old-style allies that finds itself lined up in the new Trump-style system, the speed of onrushing change will only increase.

Now if we only knew something about the destination.

Of China and Oil

The economic conflict between the United States and China continues to ramp up. Earlier this week the Trump administration announced plans for tariffs on another $200 billion in Chinese exports to the United States. Barring (substantial) Chinese concessions the new tariffs will likely come into effect around the end of August. This is now the third volley in what has become a tit-for-tat trade war. I’m starting to think up snazzy names. “Pacific Pong” doesn’t have quite the right je ne sais quoi, but I’m working on it. Suggestions welcome.

The Americans’ imports from China are triple China’s imports from the United States (quadruple if you factor out services). The simple fact is the Chinese are already running out of American imports to penalize. Any effort to shift the dispute to something beyond goods trade will similarly end in colossal failure. The Americans control global trade routes, global energy, global security, and global finance — everything that makes the Chinese system possible. The Chinese simply can’t bring the fight to other fields without suffering immeasurably. (Which isn’t the same thing as me saying I’d like to be an American company operating in China right now.) Chinese holdings of American government debt don’t even give Beijing leverage as such “investments” in reality are capital flight from the Chinese system.

While Chinese state media continues to put on a brave face, the days of tone-deaf chest-beating are gone. Government censorship guidelines now regularly bar terms like “Trump tantrum” and “trade war” and in general discourage the discussing of any angle of the issue whatsoever. One of the problems with stoking nationalism is that it can be hard to turn off. With the Politburo realizing they have little ammo for this sort of fight, political consolidation at home is far more important than scoring points in a media firestorm.

But that’s not what I want to talk about today. I want to talk about one of the funniest things I’ve seen in months. On July 11 the Chinese floated the possibility of a 25% tariff on U.S. oil exports. Several media commentators immediately pounced on the trial balloon as evidence of something that would get Trump’s attention because of his stated interest in “achieving American energy dominance.” Maybe it will. The criteria for what attracts or doesn’t attract the American president’s attention continues to elude me.

But that doesn’t mean a tariff on American oil isn’t a fabulously stupid idea. It has to do with the nature of the oil market, and in particular the role of American crude within it.

First, demand for oil is inelastic. What you need, you need. If it takes ten gallons of gasoline to get your delivery truck from A to B and you only have nine gallons, you cannot make the run. You must have ten. So regardless of what the price of the gasoline is, you’re going to buy it. Applied to this situation, were the Chinese to levy the tariff they will simply have to buy oil from somewhere else, and America’s oil will (easily) fill that gap in that third market. Net effect on U.S. energy exporters: zero.

Second, American oil is different from the rest. Conventional crude percolates through rock formations over time, picking up impurities as it goes (sulfur being the most common). A big part of refining crude oil into finished product is removing those impurities. But American oil exports are not conventional. They come from shale formations. Shale isn’t as porous as most rock, so the oil never percolates. It is trapped. Shale technologies are all about cracking out these pure bits of petroleum out. Shale oil’s lack of exposure to impurities makes it the lightest, purest oil produced in the world, as well as the most valuable and easiest to refine. China likes shale oil because they can blend it with thicker, dirtier crude to make a cocktail that their refineries can use. American exporters will have zero problems finding alternative buyers, but since the United States produces more of this ultralight/ultrasweet crude than the rest of the world combined. China will find alternate supplies difficult to scrounge up.

So either China isn’t going to put this tariff on, or if it does it won’t have any meaningful impact on the American side of the equation. What the tariff trial balloon might do – what discussion of the topic is probably already doing – is pump up oil prices a touch. Markets – especially oil markets – hate anything that might even momentarily restrict oil’s availability. And this little China discussion is only one of four oil-related bits of news that oil markets are stressing about right now.

The second and third issues involve general civilizational breakdown in two major oil exporters: Libya and Venezuela. Ever since Colonel/President/Wacko Muammar Gaddafi was deposed and killed in 2011, Libya has not existed as a state. It is now a shifting series of warlord-run fiefdoms. Unfortunately for the oil markets, not only is Libya’s crude production not in the same area as the oil export facilities, oftentimes the connecting pipeline infrastructure is under a third party’s control. Libya’s larger oil export ports have switched hands twice already this month, with the expected impact upon export volumes – and global prices.

If anything, Venezuela is even worse. Government ineptitude combined with a slow slide towards one-man dictatorship cum anarchy has transformed what was once South America’s richest state to one of its poorest and condemned much of the population of this once-food exporter to famine. The government’s ability to perform basic maintenance on its oil industry is now collapsing. Venezuela’s oil output is already down to a 30-year low and will likely dip below 1.0 million bpd by year’s end… assuming the country doesn’t completely implode.

Needless to say, such civilizational breakdowns can only exert upward pressure on oil prices.

Permian Basin, Texas, US

The fourth hit to the oil markets hasn’t quite landed yet: Iran. The Trump administration is pressuring, well, everyone, to eliminate their imports of Iranian crude by November. The expectation is for a two-thirds reduction in total exports. Countries that resist American pressure will find themselves subject to secondary sanctions that would bar their access to anything that touches the U.S. banking system. Since that is in essence anything that involves nouns it is sort of a big deal. The Indians and Japanese have already signaled they’re going to play ball, and the Europeans are rapidly coming around. That just leaves China.

While the pot-stirrer in me would love to see what would happen to a trade-dependent internationally-wired oil-importing economy like China’s under full financial embargo, I’m fairly sure the Chinese will blink on this one. Financial sanctions of the type the White House is preparing would hit China at least an order of magnitude harder than the tariffs they are staring down, and the Chinese are not suicidal. And while I firmly stand by my claim that no one can really claim to know what Trump is thinking I have to admit things are starting to look more than coincidental: a last-minute cave by the Chinese on Iran just as the third round of tit-for-tat tariffs really start to bite? I see some serious negotiating leverage there, useful in many theaters.

This – all of this – is quite possibly the best-case environment for U.S. shale oil producers. Chronic export outages in multiple countries for multiple reasons, a trade war that is both widening and deepening. All this pushes oil prices up. That helps whichever oil producers can bring new output online fastest. And with today’s shale tech American shale operators can bring on new oil output in half the time the Saudis can bring on their pre-existing spare capacity.

In the first half of 2018, before all this noise erupted, U.S. shale operators were already on course for increasing total U.S. oil output by the largest volume ever – in excess of a fresh 1.5 million bpd. Courtesy of China and Trump and Venezuela and Libya and Iran, that is now the low case estimate.

The concentration of power in the global system continues to gather in the Americans’ favor. Trump is demonstrating he doesn’t need to build an alliance to fight and win a trade war with multiple countries simultaneously. Trump is showing he can wield financial tools simultaneously with trade tools to crushing effect. Trump is showing an enthusiasm for standing up to the business community, something that resonates not just with his base, but also Bernie Sanders’. And in case you missed it, last week the United States became the world’s largest oil producer courtesy of shale, granting Trump even more leverage and autonomy in international relations.

As a guy who makes it his business to integrate context and data in to everything, I find Trump’s brash, details-be-damned approach to… everything a bit annoying. But that doesn’t mean he can’t get results.

This Is How the World Ends, Part III

by Peter ZeihanMelissa Taylor, and Michael N. Nayebi-Oskoui

See Part I and Part II.

Event 3 – The Chinese discover they have no clothes (May 18)

The threat of American secondary sanctions threatens the stability of more than just Iran and Europe, it also is a mortal threat to the world’s largest oil importer: China. And it isn’t like the Chinese were not already under some fairly stupendous pressure.

Two weeks ago U.S. Trade Representative Robert Lighthizer led an all-star team to Beijing to list out the Trump administration’s trade demands. Lighthizer is an old hand when it comes to brutal trade talks. He is the trade lawyer who in essence wrote the legal backbone of what is now the World Trade Organization, and during the Reagan administration he (repeatedly) brought the Japanese to heel on a raft of trade and financial issues that the Japanese blame for many of their subsequent economic troubles.

Lighthizer brought a small army of officials with him: Treasury Secretary Steve Mnuchin, Commerce Secretary Wilbur Ross, White House Economic Adviser Larry Kudlow, and America’s ambassador to China Terry Branstad. Of them, the only face that the Chinese consider even remotely friendly was Branstad – Xi’s first trip to the United States back in 1985 was to Iowa, and he and Branstad have a warm personal relationship. It was a classic bad-cop bad-cop bad-cop bad-cop and-this-guy-will-help-you-to-the-hospital-afterword set up.

Lighthizer and Co didn’t negotiate. They simply delivered some ultimatums.

  • China will unilaterally increase its imports of U.S. goods by at least $100 billion.
  • China will immediately cease protections and subsidies for any sectors related to its Made in China 2025 central economic plan, as well as eliminate tariff and non-tariff barriers on those sectors.
  • China will accept that it is a non-market economy under WTO rules (which would allow the United States to apply protective tariffs against Chinese exports).
  • China will accept American restrictions on Chinese investment-led acquisitions in the United States.
  • China will cease all technological/cyber theft as well as cease any and all policies which aim to force American firms to share technologies with China.
  • China will accept American quarterly reviews on all trade policies, and pre-commit to cooperation with American findings.
  • China will submit rosters of goods shipped to third countries so that China may not do end-runs around American import restrictions.
  • China will abandon all WTO cases it has prosecuted against the United States as regards any of the above issues and preemptively agree to launch no new ones.

The items are notable for their unprecedented nature in the post-WWII order, their depth, how they cut to the core of the Chinese Communists government’s legitimacy, how Beijing hopes to develop the Chinese economic and political space, how China hopes to project economic power internationally, and above of all, by their deadline – July 1.


Hong Kong, China

In “normal” relations such demands would all be non-starters and rejected out of hand. Instead, the Chinese sent their own delegation to the United States for talks a few days ago to see just how much wiggle room there might be with Lighthizer and Co. On May 18 the Chinese discovered that the Americans were actually serious.

As in Europe, local media in China is all aghast with how unreasonable the Americans are being. As in Europe, the real decisionmakers are being far more circumspect. President Xi has been deathly quiet. He and the politburo may have nationalist aspirations, but they fully realize the reality of global power ratios.

  • The Americans are China’s single-biggest end-market and the Americans import more than triple from the Chinese than the other way around. In any tariff v tariff conflict the Chinese just don’t have much ammunition.
  • The Chinese are the world’s largest exporters. Nearly all that trade is dependent upon the US dollar-denominated and SWIFT-managed trading system. Should China befall American financial sanctions the China story would crash pretty quickly.
  • The U.S. Navy has ten times the power of everyone else’s navies combined. Since World War II the Americans have used that imbalance to create a unified global system. Should that commitment fail – and it is – anyone dependent upon global trade is more or less screwed. Like, say, China. Making matters worse, nearly all Chinese trade with the rest of Asia is water-borne and therefore vulnerable.

European bureaucrats don’t get that. American media doesn’t get that. But Merkel does. So does Xi. He has to. Apparently, the U.S. Treasury Secretary has already threatened the Chinese with a SWIFT cutoff.

The biggest outcome of the Lighthizer talks to date? On May 20 the Chinese and Americans indicated they’d stop publicly threatening each other with tariffs. My read is that now that the Chinese realize the Trump administration is serious, there’s no point to beating the trade war drum because that’s a field of combat the Chinese cannot hope to win on. Best to try other methods of persuasion.

(On a side note I’m quite amused that the media is making much hay about how competing agendas in the Trump administration’s senior staff are weakening the team’s negotiating strategy, as if that hasn’t been the norm for American administrations since time began. The person most in tune with Trump’s vision is Lighthizer. You can safely ignore the rest when it comes to comprehending the United States’ bottom line.)

If the Chinese are not going to have their entire economic and political system shattered by American (in)action, they have to bring something big to the table. That something would have to be on the scale of the economic demands the Lighthizer team made. I have no doubt that the talk back in Beijing today is to come up with strategic topics than can be exchanged for continuing American largess. North Korea will certainly make the list. Cooperation with the Americans against Iran – or maybe even Russia – is undoubtedly under consideration.

But time is running short, because the American shifts against Iran and China are only part of a broader pattern.

Bolton in a China Shop

Thursday, March 22 was a big day, but before I get into the meat, there’s a couple of items I need to do a quick update/refresh on.

On March 1st the Trump administration announced tariffs on imported aluminum and steel. In the three weeks since the Americans have granted temporary waivers for a majority of the countries that send America the two metals, most notably Canada, Mexico, and the European Union. In the case of Canada and Mexico, it was so that the tariffs could be used as a cudgel in ongoing NAFTA renegotiation talks – something that has annoyed the Canadians and Mexicans more than a bit.

The European case is a touch more involved. Within hours of Trump announcing the initial tariffs, the European Commission – that’s the EU’s administrative/executive arm – announced a wide-ranging series of counter tariffs targeting firms headquartered in the districts of the entire Congressional leadership. I got a good laugh out of this. Not only did the Commission clearly have that list drawn up well in advance, it also highlighted just how ignorant they were of U.S. politics. Foreigners punishing Nancy Pelosi’s or Mitch McConnel’s districts for something that Trump did isn’t going to earn those foreigners any favors. If anything it might have encouraged the Americans to close ranks a bit.

(What Brussels was likely aiming for here was to copy the tried-and-true American strategy of selectively targeting countries in Europe that are causing problems in trade negotiations, for example putting tariffs on French cheese when France is causing issues in agricultural trade talks. That works well. But going after folks in unrelated industries who are not responsible for trade policy just tends to piss people off.)

All in all it was a traditional bureaucratic kneejerk reaction that can only come from a keyhole view of the situation, and Trump very quickly shattered the myth of European options by tweeting out that should those counter-tariffs come into play, he would simply bar the import of European automobiles into the American market. This would hit the Europeans on two fronts. First, the Americans are at least nominally still Europe’s security guarantor and any real trade war between the two would erase any pretense of alliance at a time when Turkey has become unhinged from NATO and the Russians are on the march (security issues are not a remit of the European Commission so such never entered into their calculus). Second, fully half the German economy is trade-dependent, and some 80% of the vehicles Germany manufactures are sent abroad. Any meaningful trade war would quickly wreck Europe’s core.

One can imagine the Prussian fury that surely flowed across Europe’s phone circuits when German Chancellor Angela Merkel called up the eurocrats to tell them what they were going to do. Those eurocrats have since cooled their jets and sought talks with the Americans on how to get a waiver for the aluminum and steel sanctions. Those talks were completed last week, and the Europeans made a very interesting concession. The EU only received its (temporary) waiver on the condition that they enter into talks with the Americans on presenting a joint position on aluminum and steel versus the Chinese.

China’s steel industry is the most overbuilt and oversubsidized sector in a country that is massively overbuilt and oversubsidized. It alone is now the source of the majority of the world’s excess steel capacity and global steel exports. A TransAtlantic gang-up makes a lot of sense.

Now back to March 22.

On that day President Trump announced tariffs on a mix of $50 billion to $60 billion of Chinese exports to the United States in retaliation for a product dumping, lack of reciprocity on market access, and intellectual property theft. The whiff of a trade war between the world’s two largest economies is in the air, and the American media is apoplectic… as it tends to be whenever it discovers the president did not die in his sleep. This time more serious commentators (i.e. the stock markets) also registered their concerns with most indexes selling off sharply.

The issue is this isn’t about “merely” $60 billion in goods. The Chinese development model is based on overbuilding, subsidization, product dumping, lack of reciprocity and intellectual property theft. Any serious effort by the Americans to pare any of that back cuts to the core of Chinese economic growth, employment, Communist Party dominance and the very political stability of the entire Chinese system.

But the Chinese have little leverage here. Let’s go down the list.

  1. China is a massive exporter to the American market, but the converse is not true. In any trade conflict the Chinese get hosed economically.
  2. The Americans maintaining of the global trade order is what enables the Chinese to export to everyone else. Just as the Germans fully realize that a fight with the US on trade is one in which they have no hope, so too do the Chinese (at least at the top, at least in private).
  3. Even without the trade order, the U.S. Navy controls the oceans to an overwhelming degree. Even with recent expansions the Chinese navy is no more than 3% as powerful as the American Navy on a global basis. If a bilateral trade war were to evolve into something more shooty, the Chinese would lose nearly allexports and all imports – including some three-quarters of their oil needs.
  4. North Korea is no longer a card the Chinese can play. Pyongyang’s recklessness with its nuclear and missile program has now attracted the full attention of President Trump – a man not known for his subtlety. There are only three ways forward for North Korea at this point. The United States nukes it which eliminates China’s only “ally”. The United States rings it with missile defenses which negates China’s own strategic deterrent. Or the United States cuts a deal that both Washington and Pyongyang can live with. Option 3 is by far China’s preferred option and Beijing is (quietly) facilitating a pending summit between Trump and North Korean leader Kim Jong Un.
  5. The T-bill bomb that many have suggested is China’s supposed ace is utter rubbish. The logic is that in a real spat the Chinese, the second-largest foreign holder of U.S. government debt, could just dump some of the U.S. T-bills it holds on the market and crash the U.S. economy. That’s not how things work.
    1. You cannot just walk up to the U.S. Treasury building and demand your money back; it’s a fixed term note.
    2. Any interim sale of a T-bill to another party has to have a buyer. No buyer, no sale.
    3. China could theoretically try and sell its T-bills whenever the U.S. Treasury was trying to sell new debt and that would raise the cost of U.S. financing. But not only is the U.S. T-bill market the largest in the world so it would have to be a big sale, but what would “massive” success bring? It would push down the value of the U.S. dollar. Considering the Chinese regularly intervene in their markets to push the U.S. dollar up so that they can sell more goods into the U.S. market, it would work at cross purposes to the set of Chinese policies that make the Chinese economy possible.
    4. And of course, the U.S. Federal Reserve can simply mop up the T-bill market if it chooses by printing currency. It’s a perk of running the global currency.

It isn’t that the Chinese cannot hurt the Americans on trade, just that they can’t without also causing themselves catastrophic damage. It is an America-sneezes-China-gets-Ebola sorta thing.

Which brings us to the other news of the week. Enter John Bolton.

On March 22 U.S. President Donald Trump fired his national security advisor, General HR McMaster, a man whom many in the national security establishment have profound respect for, and replaced him with John Bolton, a man whom very few hold any respect for.

Many people might rightfully despise Bolton and all that he stands for. Critics say he has never met a country he didn’t want to bomb, a government he hasn’t wanted to overthrow, and an ally he didn’t want to intimidate. And when you look at his public statements on Iran, Iraq, Saudi Arabia, Turkey, France, Germany, the United Kingdom, Russia, China, Japan and the Koreas it is pretty easy to come to the conclusion that the dude holds some fairly strong and mean-spirited opinions. I tend to lean toward the majority view on Mr. Bolton when it comes to his policy preferences. That, and he’s a prick.

But no matter how unlikable he may be, what you can not say about Bolton is that he’s incompetent or inexperienced. If you can put politics and personality aside for a moment, Bolton is one of the most skilled diplomats the United States has ever had. He was a protégé of James Baker, arguably the best Secretary of State in modern times. He knows the ins and outs of how diplomacy – both hard scrabble and polite – works and just where to dot i’s or twist arms, send flowers or send ammunition. His most infamous innovation is that he fully embraces military options as part of the “diplomatic” toolkit, something that many diplomats are too meek or polite to say publicly, but he also excels at building ad hoc international coalitions on the fly to change international law as he did to rein in North Korean missile proliferation in the 2000s. He certainly breaks the mold that claims that diplomats have to be diplomatic.

The worldview of Donald Trump is far closer to Bolton’s heart than any other president, and it is obvious to everyone with a pulse that what Trump has been missing is someone who can translate TrumpTantrums (TM) into actual policy. For those (like me) who are frustrated with the lack of consistency in Trump’s actions, this could be a positive sign. For those terrified (like me) of all the implications of some of Trump’s positions, this could be horrible.

I don’t want to overplay this. The position of the National Security Advisor has exactly as much power as the president chooses to delegate. Some – like Condoleezza Rice and Henry Kissinger – had massive reach, while others – Susan Rice comes to mind – were barely in charge of their own stationery. But whether Bolton is large and in charge or simply tickles the part of Trump’s psyche that loves disorder while holding the door open so the bull can ravage the China shop, John Bolton may be just what Trump needs to translate his foreign policy goals into hard reality.

And the Chinese know it.

Consider the timing of events last Thursday. First, Trump announces his tariffs on China. Second, Chinese media explodes with vitriol and threats of retaliation. Third, the Europeans cut their deal with Trump to avoid the aluminum and steel tariffs should they join Trump’s efforts against China. Fourth, it is confirmed that Bolton will replace McMaster as Trump’s new National Security Advisor. Fifth, the Chinese government forces Chinese financial houses to massively intervene in Chinese stock markets to prevent a rout of epic proportions.

Beijing knows exactly what’s going on here.

If this is real, if Trump means to break the Chinese position (and maybe even the Chinese system’s back), then Bolton is a solid choice and tariffs are a good knife and Bolton will repeatedly use that knife in ways too effective and cruel for me to opine about at present.

Finally, a parting thought:

Trump is not a freshman president anymore. Might he be finding his feet? He seems to be linking issues and personnel and approaches together into a kind-sorta unified theme. If I didn’t know better, I’d say that Trump just might be in the process of getting a handle on this foreign policy thing.

Here We Go

After a particularly… volatile week in the White House of Donald Trump, the administration announced March 1 trade tariffs of 25% on steel and 10% on aluminum. Countries near and far almost immediately announced plans for counter-tariffs on American goods. Many, most notably the American president himself, are now openly talking about a global trade war. Trump went so far as to tweet “trade wars are good, and easy to win.” Anti-Trump reactions among the media, corporate world and global elite has been – in a word – acidic. Similarly, markets haven’t exactly taken news of a potential trade conflict with a ringing endorsement.

I need to start out by correcting what most commentators have been tossing out there: at the core, Trump isn’t wrong. When your country runs massive trade deficits and is functionally energy and agriculturally independent, you have far more options, flexibility and power when prosecuting trade wars. Not to mention the issue of raw exposure. The United States economy is the least internationally linked of the significant powers. The fractions vary widely based on whose data you’re using, but as a rule the American economy is roughly one-third as dependent upon exports as the major Asian or European economies.

And that’s before you consider the global framework. The United States created the free trade order at the end of World War II in order to contain and crush the Soviets. In essence, it used the currency of providing global security and trade access to purchase cooperation from its allies, so it could battle the Soviets the way it wanted (i.e. the Americans bribed up an alliance to fight the Cold War).

But when the Berlin Wall fell, the Americans never bothered to update the system. They kept granting all the security and trade goodies yet neglected to ask for anything in return. Three decades of paying for that lopsided “deal” after the Soviet collapse has generated sufficient blowback on the American Left and Right to push the American population away from valuing a rules-based international order. One result, among other things, is the rise of Donald Trump and Bernie Sanders.

So even if on pure economics the Americans hold the upper hand in a trade war, that drastically understates how much power and flexibility the Americans actually hold because they still are the only power responsible for a system that makes the majority of other countries’ systems – including the European and Chinese systems – even possible. I might not choose the word “easy” when describing how things could go down, but Trump’s theme is certainly on point.

That said, there are a veritable cavalcade of things to keep in mind.

To start off, this isn’t a normal president. This is Trump. As much as it is detrimental for a leader/negotiator to be as thin-skinned, uninterested in context, and offended by detail at any given moment, the most important personality quirk is Trump’s seeming refusal to either be consistent with his own positions or think about what might happen the next day. He tends to make grand statements (often via Twitter) and then expects Congress, the public, and the world to simply do things his way. It’s very Obama, and it tends to generate the same sort of anger and dismissiveness.

That’s a problem for more than just optics.

Competently prosecuting trade wars requires speed to undercut competitors’ positions faster than they can undercut yours, and that speed requires negotiating skill and coordination. Trump may love his executive orders, but he to date has yet to demonstrate a capacity or interest in using the levers of state in an efficient way.

Trade wars require the marshalling of forces government and corporate to know where to hit where it hurts, while also preparing defensive measures to guard domestic interests from likely counters.

The government entities most important to this sort of operation are the Department of Commerce, the Department of State, the Central Intelligence Agency, and the Federal Trade Commission – the institutions with which the Trump administration has the worst working relationships. And Trump’s erratic nature and pathological hostility to immigration has largely sunk his ability to marshal corporate America in any cohesive or reliable manner.

Trade wars – just like real wars – require allies. Most of those allies are at home, but of course some of them are of the more traditional sort: foreign nations.

Donald Trump is not popular, well, anywhere. The Brits think of him as the most uncouth American they’ve ever had to deal with (which after folks like Lyndon Johnson and George W Bush is an exceedingly high bar). The Germans are horrified at Trump’s willing, ongoing and insistent ignorance of European geopolitics. The Russians simply feel he’s a buffoon. The Japanese refer to him as a moronic man-child. (The French actually sort of like him. I think it’s a Jerry Lewis thing.) The average Mexican’s feeling towards the man is sheer hatred. The Chinese, as the ones most dependent upon the American-led order, probably take him the most seriously – but they’ve become increasingly confident of their ability to manipulate him to their ends.

The point is that a trade war isn’t a diktat, it’s a conflict with a lot of moving pieces that must be maneuvered through. How that maneuvering is handled determines how quick and/or “easy” the conflict will be, as well as the economic and strategic collateral damage the United States would need to manage.

  • If you want to target China, the weak points are electronics and finance – not steel and aluminum. But don’t forget to coordinate with the Koreans and Taiwanese who are exposed to Chinese supply chains. You’ll need their help to deflect the blowback.
  • If you want to target Europe, you hit Southern European agriculture and German manufactured exports. (A Trump Twitterstorm over the weekend expressly indicated that European vehicle exports are squarely in his sights.) But you do not levy tariffs against the Europeans in isolation – you make friends of France and Poland and Sweden, leveraging the fact that the European Union is not a single political entity. That way you can pry apart the entire EU negotiating position.
  • Japan has outsourced massive amounts of its manufacturing base during the past generation, making it a powerful ally in any trade war… if you can be sure to not damage the few sectors that are still important at home. Like steel.
  • In any case, it would probably be wise to not pick fights with Eastern Hemispheric powers as well as NAFTA partners simultaneously. After all, the Americans’ North American trade portfolio is nearly as big as everything else put together.
  • But let’s say you want to make Mexico your target anyway: you must go after automotive… but that also means shoring up Texans who are enmeshed into the cross-border supply chains. Otherwise your own political coalition fractures. And don’t forget to deflect Canada so you don’t have a 2-on-1 situation against you within NAFTA.
  • Speaking of Canada, the easiest way to counter America’s northern neighbor is to deliberately and publicly cut direct deals with individual provinces – for example, give concessionary benefits to Albertan energy or Manitoban wheat or Quebecois aerospace. Considering that the Canadian system reserves more power for the provinces than the national government, the result will be a quite undignified screaming match among the provinces that would paralyze the country’s foreign trade policy… as well as be fabulously entertaining. Fun fact: Canada only signed its first comprehensive internal free trade agreement in April 2017.

An “easy” trade war is eminently doable, but without doing the homework or laying the groundwork, the result is a free-for-all of sanctions and countersanctions with should-be allies rapidly degrading into didn’t-have-to-be enemies.

Three specific problems come from this. First, Trump seems pathologically unwilling to even take baby steps in the forging of an international coalition as regards, well, anything. Even low-hanging fruit like Britain and Australia have often been not just ignored, but deliberately repudiated. This whole thing has the feel of a knee-jerk, internal political decision even though most of the outcomes will be felt on the field of global strategic alignments.

Second, because so many people think so little of the American president, when he does act very few take him seriously. Never before in modern history has the most powerful man of the most powerful country with the most global economic and military leverage been thought of as so weak. In part it is because most feel the Americans would never seriously endanger the global order (which is a view as stupid and seeped in wishful thinking as it is widely held). In part it is because Trump never demonstrates follow-through (which is fairly accurate) so no one feels the need to plan for the worst. But all of that ignores the fact that Trump is the most powerful man of the most powerful country with the most global economic and military leverage and if he chooses to use that leverage, however inexpertly, then look out!

Third, considering the global nature of most modern supply chains, any America-First-themed trade war is a trade war with the entire international system: rivals, but also allies, with every action rippling throughout the entire global order. A global recession is absolutely guaranteed and based on how fast and heavy Trump lowers the boom, this could well be the singular action that drops the world into the Disorder that I often speak and write about.

Finally, do not underestimate just how fast this unravelling can happen. One of the few points of Trumpian consistency is his White House’s desire to “get better deals” in trade bodies while systematically undermining those same bodies. For example, the new American steel tariffs will do the most damage to Canada, a country that the Americans are hip-deep in negotiations with on the future of NAFTA. Or there’s the WTO which the Americans are attempting to overhaul, yet they have refused to allow the confirmation of the judges within the body’s appellate courts which hear trade disputes – rendering the entire organization impotent to deal with rising trade tensions.

For those of you who remember, in the Accidental Superpower I expressly noted that the global system was so fragile and counter-intuitive and out-of-date that it was a waste of time to guess what specific action might cause it all to crash apart. An American-initiated trade war is perhaps one of the ways to destroy it most quickly and thoroughly. I believe I referred to it as the “American bad hair scenario.” And so, here we are.

And here we go.