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Cold War II: Why Investors Should Prepare for a Decade of Escalating Political Crises


Over the next 10 years, the value of the G7 currencies, tax rates on investments, solvency of governments, financial repression, and other political parameters will cause more security price movements than changes in real activity or interest rates.

As you have undoubtedly noticed, most of the volatility in the market over the last couple of years comes from uncertainty about the resolution of political crises in major developed countries. Will the US default or shut down its government? Will the euro collapse? Each of these and other political squabbles has repeatedly gone to the brink before some temporary compromise is reached to hold things together for a month or two. The stage is dominated by the shouting of angry radicals on both sides, there is little civility, rationality, or compromise. Nothing gets fixed, we just get complicated patches that start breaking down before they are signed. The resulting market gyrations have dwarfed moves caused by changes in assessments of future real economic activity.

I have gradually come to the conclusion that this is not a temporary state of affairs. These crises are not a result of stubbornness or miscalculation, they are necessary to maintain the social order. Further, I think it will take about a decade of them to achieve any sort of stable result.

This may sound crazy to younger readers, but I lived through the Cold War, or as I am coming to call it, Cold War I. From 1950 to 1980, there was a fundamental struggle in the world between the Soviet Union and the United States. No other country mattered much. It may seem foolish today to think that Communism could have triumphed, but for the 30-year period it was undefeated: No country had ever emerged from Communism into freedom and prosperity, while many countries had lost their freedom after internal crises or external invasions.

This was a Cold War because either side could destroy all life on Earth. We even had a name for it: mutually assured destruction, or MAD. That's not a theory or a joke, that was the system. It meant both sides had a huge stake in avoiding direct armed confrontation. As a result, both sides fomented indirect confrontations all over the world. These crises were essential to the balance. Both sides had to prove their willingness to go to the brink, otherwise the other side would win.

What's important to understand is these were not staged crises, when everyone knew a peaceful resolution would be found. To be credible, leaders on both sides had to be willing to relinquish control, to allow the possibility of things spiraling to disaster. Some historians credit MAD with keeping the peace after World War II. Aside from the fact that the time was not peaceful, I believe we were extremely lucky that no crisis blew up and no accidental or malicious event triggered global thermonuclear war. As formerly secret records are coming to light, we find more and more cases of accident cascades that came within a hairsbreadth of disaster.

Cold War II is less scary, but it's still bad. The basic conflict is the impossible fiscal position of G7 governments. They have promised far more than they can possibly deliver. I want to steer away from the politics here: whom to blame and whether the solution is to shrink government or expand it. I trust we can all agree that G7 governments are spending far more than they raise in taxes, and the reality of the situation is much worse than the official budget projections.

There is some maximum amount of GDP the government can extract from the economy. People disagree about what that amount is, but it's clearly less than 100%. Official tax figures grossly understate the extraction. They do not include all sorts of fees, tolls, and fines. They often omit some levels of government or quasi-government organizations. They do not cover the indirect effect of tax deductions. For example, when the government allows a tax deduction for municipal bond interest, it makes it seem as if it is collecting less in taxes and spending less in interest. But there's no economic difference between a taxable municipal bond paying 6% on which an investor pays half in taxes, versus a municipal bond paying 3% in tax-free interest. Either way the government pays and the investor gets 3%, but if the interest were taxable, both reported taxes and reported expenditures would be higher.

Any time the government gives someone a $100 tax deduction to get them to do something that costs them, say, $50, it lowers reported taxes paid, but economically represents the same thing as the government taxing $100 and overpaying for whatever they got the person to do. Government regulations are also hidden taxes. The government could slap a $1 tax on incandescent light bulbs and use the revenue to subsidize florescent bulbs, or accomplish the same thing by forcing companies to raise the price of incandescent bulbs. It's the same economic effect, but the latter method does not show up in taxes. Any time the government makes people stand in line, fill out a form or do anything else, it uses up economic value that could be harnessed in the private economy.

Future promised expenditures are also grossly understated. They do not include full pension and health-care benefits, sometimes these things are missing altogether, and sometimes they are reported under unrealistic actuarial assumptions. They ignore contingent liabilities like loan guarantees and subsidized flood insurance. Expenditure projections do not include future program growth, either by the natural process of politics or unexpected events like wars and natural disasters.

This problem is exacerbated by huge government debts. If interest rates go up, the precarious fiscal balance becomes obviously unsustainable, which pushes rates up more and leads to fiscal disaster. Political bodies that have never been able to avoid large deficits using honest accounting, are going to have to find ways not only to balance the budget, but to pay down the accumulated debt to sustainable levels, perhaps half current levels.

OK, everyone already knows this, and has known this crisis was coming for years. I had hoped, along with a lot of other people, that some kind of sensible compromise would be reached. There's a lot of pain coming and it would be easier to bear if spread around fairly. In fact, there's not even much doubt about what the compromise will look like. The poor are not going to pay off the debt, they don't have the money. No middle class in a democracy has ever paid more in taxes than it has received in direct government payments and services (I mean things like Medicare and education for children that people would buy out of pocket if the government didn't give them away free, not general public goods like military protection or roads). So the rich are going to have to pay off the debt, and they will because they have the most to lose in a default. But the rich aren't going along with this unless there are caps on middle-class benefits. Medicare payments will be capped and Social Security will be means-tested (that is, only paid to people who need the money to get above the poverty line). Government pensions will be hair-cut and cost-of-living increases will be slashed. Taxes will be simplified, exemptions and deductions eliminated. Unfortunately, the poor, as always, will lose what little they have. I'm speaking in terms of the United States but the general picture is the same in all G7 countries.

There is no alternative to this deal. No one seriously believes you can tax the rich enough to pay for currently-promised middle-class entitlements without destroying the economy. No one seriously believes the rich will allow a debt default, revolution, or anarchy. There is some negotiating room at the margin, but the basic terms are set. To get in the ballpark, the US will need about a 25% increase in taxes (which is harder than it looks because some conservatives believe passionately that current levels of taxation are extortionate) and a 25% cut in spending (and regulation, that is, a true 25% shrinking of government, this is harder than it looks because some liberals have visions of massive expansion of government), sustained over decades. But people will fight hard to make it 30% / 20% or 20% / 30% instead.

So why all the crisis-mongering? Because no politician or political system has the strength to force either the necessary tax increases or the necessary benefit reductions on the population. The reason there is hope, however, is that things are actually pretty good for a solid majority of people in all G7 countries. They are living longer than anyone in human history, with less pain, disease, hunger, crime, injustice, repression, or uncertainty. They live rich cultural lives whether their tastes are high or low. They are surrounded by wonders of technology, which come better and cheaper every year. They are pretty risk-averse, especially the most important group in this struggle: the old. The old have most of the money and consume most of the benefits. Also, especially in the US, people have friends and relatives on the other side. A new college graduate may grumble about paying Social Security taxes for benefits she will never receive, but she doesn't want her grandmother's Medicare cut. A retired policeman won't be happy when cost-of-living increases are eliminated from his pension, but he wants his son's business to be profitable.

When events push things to the brink, a popular consensus will emerge to allow normally unthinkable political actions. People have too much to lose to allow things to fall apart, just as neither the US nor the Soviet Union wanted to destroy the world. So politicians have to manufacture the crises in order to avoid total disaster. But just as with Cold War I, these cannot be staged crises. If either side comes to believe the other side will not let everything collapse, it will ratchet up demands until things do collapse. This is a classic game theory situation, a Cold War II. And since leaders have to relinquish control to be credible, no one can predict the outcome with confidence.

All the people calling for civility and compromise are missing the point. Civil compromisers will be irrelevant. Reckless radicals will rule the day. But they are only shock troops, supported as long as the pendulum swings in their supporters' preferred direction, to be abandoned on the eve of real battle. Unfortunately, we cannot ignore the possibility that things will get pushed too far. A radical may seize power, or civil institutions may break down under the stress of battle.

If I'm right -- and my best friend would call this essay speculative -- it means politically induced volatility will be the rule in the future. Investors will have to worry more about politics than the real economy. The value of the dollar or the euro, tax rates on investments, solvency of governments, financial repression, attacks on rule of law -- all will cause more price movements than changes in real activity or interest rates. On the other hand, we expect each crisis to be resolved. This could lead to extreme range trading, a fair description of what we have seen over the last couple of years. Prices move a lot, but stay within wide limits -- wide but firm limits.

If you think I'm exaggerating in this essay, watch the movie Dr. Strangelove. That may be a better guide to investing in the next decade than anything else.
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