Thinking

Theory of Primary State Formation

A ‘primary state’ or ‘pristine state’ is a first-generation state that evolves without contact with any preexisting states. The evolution of secondary states is strongly influenced by existing states. In particular, nonstate societies are always at risk of being conquered by neighboring states; they can emulate established states; and they can borrow techniques and know-how from preexisting states. All secondary state formation thus takes place in the context of preexisting states. In order to understand how states emerged in the first place, it is therefore important to restrict attention to primary states. We are only certain about six cases of primary state formation: Hierakonpolis in Upper Egypt, Uruk in Mesopotamia, Mohenjodaro in the Indus Valley, the Erlitou state in the Yiluo Basin in China, the Zapotec state in Mesoamerica, and the Moche state in the Andes. The earliest ones—in Mesopotamia and Egypt—emerged in the fourth millennium BCE. But before we examine primary state formation, we have to briefly review what came before.

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Locations where primary state formation took place.

Fifty thousand years ago, behaviorally modern humans burst forth from Africa into Eurasia. By the end of the Pleistocene, they had eliminated archaic humans who had hitherto occupied the Eurasian landmass; and populated Northern Europe, Siberia, Australia and the Western Hemisphere—regions that had hitherto been devoid of people.[1] At this stage in human social evolution, societies were remarkably similar across the globe. Everywhere, people lived together in small, mobile bands—with no more than a few dozen individuals—of unspecialized hunter-gatherers. All practiced shamanism—abstract religious beliefs would have to wait until the Axial Age. There was no political authority to speak of. Leadership was not inherited but acquired. ‘Big men’ sometimes exercised coercion and leadership—but there was no ‘office’ of the chief that would have to be filled if the big man died or fell out of favor with the community. Not only were there no rulers, there was no class structure. For tens of thousands of years, human society was thoroughly egalitarian. Conflict between neighboring bands took the form of raids; there were no wars of conquest and subjugation.

The Neolithic Revolution witnessed the advent of permanent settlements, farming and animal husbandry. With agrarian wealth came social stratification. Social rank became hereditary. Big men increasingly hailed from the ranks of the elite. However, village communities retained their autonomy for a long time. The decisive breakthrough came with supravillage integration—the establishment of chiefdoms.

A chiefdom is defined as a centralized regional polity where authority is permanently centralized in the ‘office’ of the chief, which exists apart from the man who occupies it and is passed down from one generation to the next. Chiefdoms usually have populations in the thousands. There is a lot of variation among chiefdoms. Simple chiefdoms have just two levels of hierarchy (a small number of villages controlled by a center). Complex chiefdoms have three levels (villages clustered around towns controlled by a city.) A paramount chiefdom in an exceptionally powerful chiefdom that has subordinated others.

chiefdoms

A paramount chiefdom is an exceptionally powerful chiefdom that has subordinated others.

While both chiefdoms and states feature centralized coercive authority, chiefly authority is non-bureaucratic—all authority rests in the office of the chief. In contrast, states possess internally specialized administrative organization—authority is partially delegated to administrators, tax collectors, police, judges, military commanders and so on.

While all primary states emerged from chiefdoms, it is wrong to think of the chiefdom as a political form that would naturally evolve into the state if left to its own devices. Indeed, only a few ever made the phase transition; the vast majority of chiefdoms did not.

The central question of primary state formation then is: Why, and under what conditions, did some chiefdoms make the transition to statehood?

The reason that the distinction between chiefdoms and states is important is because chiefdoms cannot be scaled up whereas states can and often did. Why can’t chiefdoms be scaled up? Wright (1977) argued that because authority in a chiefdom is not differentiated, any delegation of authority approaches total delegation; a situation ripe with potential for insubordination, insurrection, or fission. It is in the chief’s vital interest to avoid delegating authority, which means that he has to rule his entire domain from the center. As a consequence, there is an effective spatial limit to the territorial expansion of a chiefdom determined by the distance the chief, or the chief’s representative, could go from the center to the periphery of the domain and back on the same day.

The ruler of a state on the other hand, can dispatch subordinates—whose authority has been defined narrowly enough—to locations far from the capital to manage local affairs with little risk of insurrection. The delegation of partial authority thus allows the state to expand its territory well beyond the spatial limits associated with chiefdoms. Moreover, the optimal strategy for a state ruler is to divide and segment authority as much as possible and delegate wholeheartedly so as to minimize the likelihood of insurrection by subordinates.

The question of primary state formation then boils down to this: Given that it was in the vital interest of the chiefs to avoid delegating authority, why were some compelled to do so anyway and under what conditions did they succeed?

Spencer (1987) suggested that if a chief seeks to implement a new strategy of internal administrative specialization, the chances of success will be enhanced if the shift is made quickly and extensively. Spencer (2010) proposed a ‘territorial-expansion model’ whose basic idea is that territorial expansion is an essential, integral part of the process of primary state formation: Without territorial expansion beyond the spatial limit of a chiefdom there is no incentive for the chief to delegate partial authority and expansion beyond the spatial limit of a chiefdom is impossible without such delegation.

[Simultaneous internal specialization and expansion] will help ensure that the new parcels of authority are defined narrowly enough so that no dispatched administrative assistant in the new order enjoys sufficiently broad authority to foment a successful insurrection. From this perspective, we would expect an evolutionary transition from chiefdom to state to be marked by a qualitative shift in administrative principles and associated optimal regulatory strategies, representing a profoundly transformational process of change.

When we apply the territorial-expansion model to the empirical record of primary state formation, we should expect to find a close correspondence in time between the appearance of state institutions and a dramatic expansion of political-economic territory. This expectation, it should be noted, runs counter to the conventional idea that the territorial expansion of state control is a phenomenon that typically occurs well after the initial formation of the state, during what is sometimes called an “imperial” phase of development.

Spencer (2010) marshals impressive archaeological evidence to show that in all six known cases of primary state formation, the emergence of the primary state was concurrent with territorial expansion beyond the home region.

This is a very promising theory. But it raises important questions: Why did most chiefdoms fail to make this phase transition? Why did primary state formation take place in only densely populated regions? The short answer is that fear is a more important driver of primary state formation than greed. It was the struggle for survival with rival chiefdoms that compelled some chiefs to split the atom of chiefly power.

Redmond and Spencer (2012) argue that high levels of inter-polity competition provided the impetuous to rulers of paramount chiefdoms to develop the internally specialized administration of the state. They examine two paramount chiefdoms on the threshold of state formation of comparable size and complexity. The two chiefdoms differed markedly in one critical aspect of their inception: One was relatively isolated while the other was surrounded by rival chiefdoms.

…inter-polity competition was the key factor accounting for Monte Albán’s successful transition from complex chiefdom to [the Zapotec] state, as opposed to Cahokia’s short-lived attempt to cross that threshold. In Oaxaca, the presence of powerful rivals, less than a day’s travel to the south and east, placed a premium on effective administration and military prowess. Monte Albán was able to vanquish some of its rivals in short order, though others managed to resist Monte Albán’s expansionist designs for a considerable time before they too capitulated. To prevail in such a competitive context, Monte Albán had to develop a powerful military as well as an internally specialized administration that was capable of delegating partial authority to subordinate officials who implemented the strategies and policies of the central leadership. The leadership of Cahokia, by contrast, did not have to contend with such daunting rivals. As a consequence, there was relatively less pressure to experiment with the kinds of military and administrative innovations that might have led to the successful transition to statehood in the American Bottom.

Charles Tilly’s dictum regarding the formation of European national states—war made the state and the state made war—is equally valid for pristine states. The Wright-Spencer-Redmond theory of primary state formation explains precisely how war made the state.

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[1] Characteristic of modern behavior was figurative art such as cave paintings; ornamentation using pigment and jewelry; the practice of burial; fishing; composite tools such as bows and arrows, darts, harpoons and axes; the use of bone, antler and hide; the invention of rope, fish hook and the eyed-needle; and, of course, blades manufactured from flint. This Great Leap Forward in human culture was likely the result of a single genetic mutation that conferred an innate capacity for complex language and abstract thought.

References

Wright, Henry T. “Recent Research on the Origin of the State.” Annual Review of Anthropology 6 (1977): 379-397.

Spencer, Charles S. “A mathematical model of primary state formation.” Cultural Dynamics 10.1 (1998): 5-20.

Spencer, Charles S. “Territorial expansion and primary state formation.” Proceedings of the National Academy of Sciences 107.16 (2010): 7119-7126.

Redmond, Elsa M., and Charles S. Spencer. “Chiefdoms at the threshold: The competitive origins of the primary state.” Journal of Anthropological Archaeology 31.1 (2012): 22-37.

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Thinking

Fed Independence, Trump Reflation, and the Primacy of the Dollar

This is part of an ongoing conversation with Adam Tooze.

There is a tension at the heart of US political economy. President Trump wants to reindustrialize America and create jobs for US workers. To that end, he has promised both big tax cuts and a huge investment program. A big fiscal shock is coming.

He has also attacked US’ trade partners for suppressing their currencies. He wants the dollar to weaken against the euro, the yen and the yuan, so that US manufacturers can compete in global product markets.

The problem is that deficit spending at home is expected to accelerate inflation, which would prompt to the Fed to hike faster, which in turn would strengthen the dollar. As part of the Trump reflation trade, the dollar has already strengthened in anticipation.

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Dollar Index. Source: Bloomberg.

There are only two possible scenarios that could allow the Trump White House to square the circle. The first scenario is one where both the US macroeconomy and the Fed oblige. That is, US inflation could fail to accelerate despite the fiscal shock and the Fed could hold fire waiting to see the whites of inflation’s eyes. The first component wouldn’t be altogether surprising given that US inflation is driven not by domestic slack but by global slack. But given what we know about the Fed’s reaction function, the second—a dovish, patient Fed—is quite unlikely.

The second scenario is one where the Fed’s independence is compromised by Washington. With the resignation of Daniel Tarullo, Trump can now appoint three of the seven governors of the Fed immediately. (Monetary policy is decided not by the Board but by the FOMC which consists of the seven on the Board and five regional Fed presidents, always including the president of the New York Fed.) Yellen’s term also ends on Feb 3, 2018; at which point Trump could replace her with a lackey. In short, it is not inconceivable to see the Fed revert back to control by political masters.

The second scenario is not as likely as it appears either—despite the clear interest of the Trump White House and the opportunity to pack the Fed with Trump appointees. This is because the Senate has to confirm the appointments. While the Senate Republicans are not as crazy about Ayn Rand as those in the House, it is hard to see them falling behind a policy of packing the Fed with doves. In other words, the balance of power in Congress points in the opposite direction as the White House. If Trump succeeds in this endeavor, it would likely be with the support of Democrats in the Senate. And they would demand their own pound of flesh.

There is another reason to doubt the reflationary scenario. The Fed’s independence—secured by Volcker’s coup in 1979—has served the interests of  Wall Street well. Since the Trump administration is packed with Goldmanites, it is difficult to see them supporting an attack on the Fed’s independence. To be more precise, it is not clear that the big banking firms would pursue their long-term interests (and resist attacks on the Fed’s independence) or their short term interests (which would be well served by the steep yield curve attending a Trump reflation).

A related issue is that of financial deregulation. It is amply clear that the Trump White House and the Republican Congress are going to unshackle Wall Street. This solves at least one problem while risking another. The former is the global shortage of safe assets. Deregulation of Wall Street banks would allow them to expand balance sheet capacity and intermediate dollars to lend offshore via FX swaps. The latter is the risk of financial stability. As Tooze notes, unshackling dealer balance sheets may unleash a new, unsustainable credit boom.

There is of course an entirely different possibility suggested by McHenry’s letter to Yellen and more generally, the strength of the Ayn Rand fanatics in Congress. Namely: Congressional hawks could prevail in the battle for political control over the Fed and make it even more hawkish and its reaction function more formulaic by law (by demanding say that the Fed justify deviations from the Taylor Rule). That would doom any possibility of a great boom in real activity.

Tooze’s original discussion centered not on the political economy of the Federal Reserve per se but the impact of Trump’s economic nationalism on the dollar’s role as the hard currency of choice globally. Tooze mentions three areas of conflict:

 (1) [T]he tension between the dollar’s reserve role and the desire of the Trump administration to boost exports by increasing American “competitiveness” and talking down the dollar; (2) tensions around global bank regulation; (3) nationalist backlash from Trumpites in Congress against the role of the Fed as a global liquidity supplier, by way principally of the swap lines.

As for (1), it is not clear that dollar strength is a required to sustain the dollar’s role as the reserve currency. The dollar has been both stronger and weaker than it is now (or is expected to be) without compromising the willingness of other central banks to hold US dollars.

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It is even less clear how (2) could work against the dollar’s preeminence. If US banking firms are subjected to less onerous regulations then the dollar’s share of international funding—already at 75 percent—would tend to increase with the balance sheet capacity of US banking firms.

A nationalist backlash against the Fed’s international activities as envisioned by (3) could potentially backfire on the dollar. In particular, if the Fed is forced to close down it’s swap lines the other hard currency issuing central banks would look for alternatives, which could result in solutions that undermine the dollar’s position. For instance, they could denominate their settlements in euros—a scenario that would be consistent with a major unraveling of the transatlantic alliance.

The Policy Tensor contends that the real threat to the dollar’s hegemony is the possibility of a global trade war which would usher in a more nationalized and a more regionalized world. A global trade war between the United States and China, not the victory of Marine Le Pen, is the most important political risk to financial markets of 2017.

The dollar’s role is due to a mutually-reinforcing combination of America’s command of the global maritime commons, the liquidity of US dollar funding markets, the depth of US capital markets, the network externalities of currency denomination (for invoicing and payments), the stability and predictability of US institutions, and the sheer weight of the United States in the world economy. It is mighty hard, even for an administration led by Donald Trump, to undermine the dollar’s role in the global monetary, financial and economic system. The closest competitor is the euro. And for the euro to merely bid for the dollar’s role in the world economy would take dramatic changes in the political economy of Europe and an outright breakdown of the Western alliance. We may possibly be headed in that direction but we are nowhere close to that scenario.

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Thinking

Can the Liberal International Order Survive President Donald J. Trump?

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Weeks into his first term, President Donald J. Trump has already insulted Prime Minister Turnbull of Australia—a longstanding US ally; humiliated President Nieto—going as far as to suggest that he would to send troops to Mexico; issued a thinly-veiled military threat against Iran; banned nationals from seven Muslim-majority countries from stepping foot on US soil; and berated the EU and Nato enough to prompt the President of the European Council to issue a public letter warning against the threat posed by the new American president to the stability of Europe. He is, of course, just getting started.

In what follows I will argue that President Trump has turned the United States into a rogue state that poses an existential threat to the liberal international order. We begin by making these terms more precise.

Liberal international order

The liberal international order is the superstructure of global cooperation, integration and rules-based arbitration that sits atop the substructure of US hegemony. The foundation of this substructure is US military primacy. But just as the substructure contains more than the foundation, hegemony is more than primacy.

Whereas primacy is a statement about the asymmetry of global military power, hegemony is a statement about the foreign policy orientation of other powers. Primacy describes the fact that no state can expect to prevail against the dominant state in a war or an extended rivalry, whereas hegemony describes the willingness of other states to follow the lead of the dominant state. In other words, hegemony describes the politics of a near-unipolar world when relations between major powers are largely cooperative.

A liberal international order need not be based on a near-unipolar configuration of hard power. Indeed, the liberal international order of the late-nineteenth century was based on a stable balance of power. But underlying the contemporary liberal international order is a near-unipolar distribution of military strength. The important thing to keep in mind is that the politics of a near-unipolar world looks very different in the absence of hegemony.

US hegemony

US hegemony manifests itself first and foremost in the stability of the transatlantic and transpacific alliances. The Europeans and Japanese follow the US lead not only because they need US protection—if that were the case, these military alliances would’ve disbanded in 1991—but also because US preeminence is congruent with their core interests. The United States acts as a guarantor not only of US capitalism but also of global capitalism—this has been the job of the “excess capacity” of US power since the second world war. The United States has allowed its major power protectorates full access to the US market. And the US has largely refrained from leveraging its hard power advantage to secure its parochial geoeconomic interests. It is these accommodations by the United States that have held the transatlantic and transpacific alliances together even after the capitulation of the Soviet Union.

Japan and Europe are not the only protectorates of the United States. US security guarantees cover most of maritime Asia including South Korea, Taiwan, the Philippines, Singapore, Thailand, Australia and New Zealand. All the oil monarchies of the gulf are likewise US protectorates; as are Israel and Turkey.

The US allows these states to pursue their national interests unless they conflict with vital interests of the United States. In particular, the US allows them to compete against US firms in global markets. In return, US protectorates largely follow the US lead on major politico-military issues.

Maritime primacy allows the United States to secure the world’s sea lanes. The US has generally allowed all states in the international system to have unimpeded commercial access to the maritime commons. Minor powers can, of course, do little about this dependence. But the cooperation of other major powers is contingent on the continued provision of unimpeded access to the maritime commons.

Open Door

The most important feature of the liberal international order is the openness of national markets to foreign penetration. The core of the world economy—US, Europe and Japan—was largely open to trade in the early postwar period. In the course of the late twentieth century, other nations were persuaded—by the US above all—to open up their economies. The process culminated with the accession of China to the World Trade Organization at the turn of the century. Tariffs have never been lower, and more generally, the global trading system has never been more open.

Global trade integration over the past twenty years has gone considerably beyond the opening of national product markets to global competition. What we have witnessed has been described as the ‘second unbundling’ of global production characterized by ‘vertical trade’ in intermediate goods and services. Multinational firms have supply chains which spill over vast cross-border regional networks. More generally, global value chains—including both intra-firm supply chains and arms-length, subcontracting vertical chains—criss-cross borders largely within the three main networks of global production: Factory North America, Factory Europe and Factory Asia.

These vast regional value chains look like hub-and-spoke networks connecting headquarter economies—US, Germany and Japan—to factory economies within a day’s travel distance around them. (Headquarter economies reimport—i.e., offshore processes—a lot more than they reexport while factory economies reexport a lot more than they reimport. Also, headquarter economies have a large number of partners while factory economies are heavily dependent on their nearest advanced technology manufacturing giant.) Among the four giant manufacturers, only the United States and China are important suppliers globally. China’s export pattern is the most globalized of the G4.

Deep integration—the harmonization of commercial rules, standards, taxes, intellectual property rights and policies between states—and global value chains are mutually reinforcing. The main purpose and result of the so-called regional trade agreements such as Nafta has been to enhance deep integration. A roll-back of deep integration would undermine global value chains.

Another pillar of the liberal international order is the highly-integrated global banking and financial system. International finance is critical for the provision of working capital for international trade. The global periphery relies on FDI from the center countries for access to technology and know-how and on core funding markets for hard currency credit. Global banks are the key conduits through which hard currency credit is transmitted internationally. Global banks fund themselves largely in dollar-denominated wholesale funding markets and intermediate these funds to regional banks, who in turn lend to local firms. Global and regional nonfinancial firms also tap capital markets directly. The entire architecture of international finance depends on a high degree of cooperation on unimpeded capital flows and investor rights.

International cooperation

The liberal international order extends to global and regional cooperation on a slew of issues beyond security, economics and finance: law enforcement, aid, health, food safety, science, education, conservation, arms control, fishing, nuclear energy, climate change, civil aviation and so on and so forth.

Much has been gained by institutionalized international cooperation since the second world war. The thing to keep in mind is that it took a great deal of time and effort to persuade countries to sign up for these institutional mechanisms of international cooperation, as anyone who followed the WTO negotiations can recall. Even though most nations had little leverage, many could and did bargain, resist and drag their feet. Most countries may not be truly sovereign, but they do have autonomy—this is especially true of other major powers. The United States did try to bully other states many times and generally failed in the endeavor. Military power proved to be no substitute for persuasion.

Notice that I have not included liberal democracy in pinning down the liberal international order. This is a conscious departure from contemporary usage on my part. I would like to focus on concrete issues rather than ideological agendas or fall prey to liberal triumphalism.

Regular readers may be surprised to see a realist like the Policy Tensor waxing lyrical about the liberal international order. The incongruity is only apparent. The realist claim is not that liberal international orders don’t exist or that they are not beneficial. It is that they cannot override the underlying logic of geopolitical competition. Whereas liberal internationalists believe that liberal international orders can secure great power peace, realists have no such illusions. International orders are epiphenomena—they can and do fall prey to harsher logics underneath; logics that they cannot alter.

The Trump shock

President Donald J. Trump is a hard realist. He sees international relations as fundamentally a zero-sum game. As opposed to hard realist scholars, Trump’s worldview is decentered: He has strong views on the US national interest which he firmly believes that the president should try his mightiest to secure, but he is only dimly aware that there are other states in the international system with their own interests and agendas. Moreover, he believes that in order to secure the US national interest, all he has to do is intimidate everyone else into submission. In other words, he overestimates the efficacy of US hard power and seems to be entirely unaware of the value of speaking softly. In short, Trump is a bully.

Laderman and Simms’ timely Donald Trump: The Making of a Worldview documents the core beliefs of the President. He has consistently believed since the 1980s that the world is “laughing at us”; that the US doesn’t get the “respect” that it deserves; that adversaries and allies alike are “ripping us off”; that the US is “losing” because its leaders are “idiots.” Trump is an unabashed economic nationalist. His main beef against the liberal international order is that China and other economic rivals steal American jobs by outcompeting US firms by unfair means—currency manipulation and “sharp practice” (presumably dumping and export subsidies). If you became president, asked O’Reilly on Fox News in 2011, whose butt would you kick? Trump answered:

I would say China “number one.”

… We have all of the power. All of the chips are on our side. The trillion, it’s actually $1.1 trillion that they have, forget it, that’s peanuts compared to the overall economy. Now, what I would say very strongly, you don’t start behaving, 25 percent tax on every item you sell in this country. Twenty-five percent right now. By the way, based on what you are doing, it should be 41 percent….

It will put China out of business. We have all the cards and chips. If that ever happened, they would have a depression the likes of which you have never seen. They cannot play the game. We can. 

Laderman and Simms show that this is not a theme Trump picked up recently. He has repeatedly emphasized it since the 1980s. This is a bedrock belief of the man. There is no reason to believe that in his moment of vindication he would suddenly change his core beliefs. The upshot is that Trump is likely to fire the first shot in a trade war against China.

A potential trade war between the world’s two largest and most globally-integrated economies is the most significant threat to the liberal international order posed by President Trump. Not only because of China’s systemic importance—it is practically everyone’s largest trade partner—but also because the potential for geopolitical, and indeed, military confrontation. In extant military power the world may be near-unipolar but in potential warmaking capabilities the world is already near-bipolar.

Trump’s bullying is particularly unsuitable for dealing with Chinese leaders who cannot allow domestic audiences to watch China’s national honor trampled on by the US President. In other words, China is near-certain to respond aggressively both to Trump’s bullying and to US policies that harm its national economic interest.

More generally, all statesman face a ‘double security dilemma.’ In order to maintain themselves in power at home, they must keep domestic audiences in mind when dealing with the statesman of other nations. Put another way, statesman face domestic political constraints on their ability to conduct diplomacy and strike deals with foreign powers—something that Trump seems entirely unaware of. Indeed, the leaders of Britain, Australia and Mexico have already had to bear a backlash at home for their interactions with Trump.

Trump has declared his intention to slap a 20 per cent tariff on imports from Mexico. Because the bulk of Mexican exports to the United States are essentially reexports, this will hurt a substantial number of US manufacturing firms, especially in the auto industry. Deep integration in Factory North America is dead in the water.

An important point to note is that tariffs are much more disruptive for global value chains than for trade in final goods because the former often involve crossing multiple borders and even the same border multiple times. Beyond the disruption induced by the snapping of value chains, the protectionist measures would make US manufacturers less competitive in tradable product markets. The net effect on American jobs could possibly be negative. What is certain is that US consumers would end up paying higher prices for tradable goods.

Most macroeconomists understand that global imbalances are the result of differential rates of savings and investment among nations. In other words, the US current account deficit (which is mathematically equal to the capital account surplus) is the result of Asian and European underconsumption not the natural or artificial competitiveness of their firms against their US rivals. According to the proponents of the savings glut hypothesis, the main culprit for the US current account deficit is not Mexico but Germany. I used to subscribe to the savings glut hypothesis but since then I have come to realize its limitations. An alternate explanation of the US current account deficit is the shortage of safe assets hypothesis, which also explains the asset mix on both sides of the US balance sheet. US external liabilities are mostly low yield safe instruments such as Tbills while US external assets are high-yield risk assets such as FDI and equity. This means that the United States provides insurance to the rest of the world while earning greater returns on its external assets than it pays on its liabilities. Does that sound like “losing”?

It is entirely conceivable that Trump will try to bully the Europeans on their trade surplus as well. That’s not going to go down particularly well in Berlin. The Europeans do have as many “cards and chips” as the United States when it come to trade. The European market is after all a bigger prize than the US market. Contentious transatlantic trade relations will also interact with the Brexit negotiations. So one way for the EU to get back against the Anglo-Americans is for it to undermine the City of London’s position as the dominant financial center in Europe. More generally, it is not difficult to see the Europeans push the euro as the hard currency of choice for global investors—especially in light of Trump’s threat to the independence of the Fed.

Such measures are especially likely if Trump keeps encouraging the breakup of the European Union. Vocal support by the US President of eurosceptics such as France’s Le Pen will further undermine the transatlantic alliance. In fact, a breakup of the Western alliance is no longer beyond the realm of possibility. The EU could very well respond to the breakdown of the transatlantic security alliance by finally pulling together and emerging as unitary security actor—which would automatically make it a peer of the United States. Before we get to that point however, transatlantic relations will have to deteriorate significantly.

More immediately, if Trump tries to intimidate the Europeans into reneging on the nuclear deal with Iran, the Europeans will not simply submit.  Meaningful sanctions against Iran can be ruled out without European participation. If the United States goes to war against Iran—which is not hard to envision in light of the sharp worsening of relations between the two republics—the Europeans are likely to be loudly against the adventure. In turn, that may very well prompt the Trump White House to take a harsher line against the EU. There are very many ways in which things can go south for the Western alliance.

An even bigger threat to the liberal international order is a potential breakup of the eurozone. The most direct route to such a scenario is the rise to power of Marine Le Pen in France. The breakup of the eurozone would create significant instability and increase Russian influence on the continent. It may very well herald the return of history to Europe and with it an immediate end of the liberal international order.

The core of my argument is that even in a near-unipolar world, there are other powers who have their own interests and agendas. Trump’s unrestrained pursuit of his geoeconomic agenda directly undermines the implicit agreement between the United States and its major power allies whereby the other powers accept US preeminence and follow the US lead in exchange for accommodation of their core interests and US restraint on using its preponderance of military power as leverage against them. The unrestrained pursuit of economic nationalism by the United States will therefore undermine US hegemony. Dominance without hegemony in turn poses an existential risk to the Open Door and international cooperation, that is, to the liberal international order.

It is possible to imagine others taking up the baton of the Open Door and international cooperation. Indeed, in an astonishing speech at the World Economic Forum, President Xi Jinping effectively suggested that China is ready to take up the baton of the open global economy. One cannot rule out a joint EU-China bid to sustain the Open Door while the United States goes though this unprecedented bout of insanity—a more proactive version of hunkering down so to speak. However, this rosy scenario is mighty hard to entertain for long since such a bid would be a direct challenge to US preeminence. President Trump is likely to respond by lashing out in unpredictable ways.

A near-unipolar world where the dominant power is a rogue state is a highly unpredictable world. In such a world, all bets are off.

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Thinking

How I Learned to Stop Worrying and Love the Bomb

The President-Elect promised on Twitter to “greatly strengthen and expand” America’s nuclear capability, generating predictable opprobrium from the usual suspects. The arena of nuclear weapons is especially prone to myths and fallacies. Even the greatest of minds, starting from Noam Chomsky down, have deeply misunderstood the role that nuclear weapons have played since their discovery. In this essay I will try to dispel some of these myths and argue that nuclear weapons are in fact weapons of peace and a force for stability in the modern world.

The first myth is that the number of nuclear warheads is a meaningful metric of nuclear capabilities. So you have this infographic from the grey lady which suggests that US and Russian nuclear capabilities have vastly reduced since the height of the Cold War. Nothing could be further from the truth.

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Nuclear warfighting capabilities depend first and foremost on the range and accuracy of delivery platforms (ICBMs, long-range cruise missiles, long-range bombers, field artillery and so on) and intelligence, reconnaissance and surveillance (ISR) capabilities required for detection and targeting of the adversary’s nuclear forces. For the principal goal of nuclear warfighting is to disarm the adversary; not attack his population centers. This is because once the adversary is disarmed attacking his cities is unnecessary to obtain political obedience, and destroying all his cities while failing to destroy his nuclear forces guarantees nuclear annihilation.

Imagine the United States circa 2016 with its 7,000 nukes squaring off against the United States circa 1966 with its 32,000 warheads. It would not be a fair fight. US-2016’s reconnaissance-strike complex would allow it disarm US-1966 in a splendid first-strike well before the latter could mobilize its bombers and ICBMs. US-2016 would not, of course, consider initiating a first-strike except under the gravest of circumstances. This is because US-2016 could never be absolutely certain of destroying all of US-1966’s nuclear forces. In fact, that is the point of US-1966’s vast nuclear arsenal. The thirty thousand warheads are not meant to be used but are meant to enhance the survivability of the deterrent against a surprise overwhelming counterforce strike by the adversary.

That also brings us to a much more important question: Is mutual strategic nuclear deterrence stable? The question is more precise than it may seem at first sight. We are not talking about situations where a nuclear-armed state seeks to deter a conventional attack by a non-nuclear weapons state (which would not be mutual). We are not talking about the tactical use of field nuclear weapons in a limited nuclear war (which would not be strategic); nor are we talking about the question of extended deterrence where one seeks to deter the adversary from attacking a protectorate (also not strategic).

There is indeed only one scenario under which mutual strategic nuclear deterrence can be said to fail: An all-out thermonuclear war. In other words, if strategic nuclear deterrence is extraordinarily stable then the existential threat posed by nuclear weapons is minor; if it is not, then advanced human civilization has so far survived the discovery of nuclear weapons by sheer dumb luck. The stability of strategic nuclear deterrence is therefore the most important question of them all.

The question is more interesting than it looks at first sight. Strategic nuclear deterrence is extraordinarily stable when both parties have a secure second-strike capability. As long as neither party can expect to destroy the adversary’s deterrent by launching a surprise first-strike with near-certainty, the stability of strategic nuclear deterrence is not in doubt. The bar for a second-strike capability is extremely low. There need only be an iota of a doubt that a splendid first-strike will fail to eliminate all of the inferior party’s nuclear forces for the superior party to be deterred from ever attempting a first-strike.

Only with highly asymmetric capabilities can one begin to conceive of scenarios where deterrence is not stable. This would happen in a crisis scenario where the weaker party may face a “use it or lose it” situation in the face of the adversary’s overwhelming counterforce capabilities. For instance, in an armed confrontation over Taiwan, China may fear that the United States is about to launch a (perhaps purely conventional) disarming first-strike on its command, control and launch capabilities (as the US war strategy called AirSea Battle calls for). Although even in this most extreme of scenarios it is hard see why China would commit suicide for fear of death.

The most interesting implication of these observations is that nuclear arms races, in fact, enhance the stability of strategic nuclear deterrence. Conversely, increasing asymmetry in nuclear warfighting capabilities is destabilizing. The idea that nuclear arms races between great powers increase the risk of thermonuclear war is as wrongheaded as it is pervasive. The increasing asymmetry in the nuclear capabilities between the unipole and the lesser great powers is a more serious cause of concern. Lieber and Press have argued that the United States has sought, and more controversially still, attained nuclear primacy: The US can destroy Russia’s entire nuclear arsenal with near-certainty. (Although Russia has since modernized its nuclear forces.)

This brings us to the final delusion concerning nuclear weapons: Global Zero. Even if all nuclear stockpiles could be eliminated in their entirety, that would not remove the existential threat posed by nuclear weapons since states would retain nuclear weapons know-how and the silos would get refilled in the event of a major confrontation. In fact, it would surely undermine strategic nuclear deterrence since great powers would face a strong incentive to be the first to reacquire a nuclear arsenal and in fact threaten its use to blackmail their adversaries into capitulation. Global Zero is an extremely unstable configuration—the most likely path to a nuclear holocaust. It is hard to think of a more counterproductive idea.

I am not saying that the risk of nuclear accidents or inadvertent nuclear use or “broken arrow” or jihadi-general scenarios are not a cause of worry. They are indeed. I’m all for tighter control over nuclear weapons. But these questions of safety and control tend to overshadow the overwhelming benefit of nuclear weapons. By effectively ruling out all-out war between the most powerful states, nuclear weapons have ushered in an unprecedented and open-ended era of great power peace. Only those ignorant of the extraordinary toll of hegemonic war can see nuclear weapons as anything other than an overwhelming force for stability in the modern world.

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Thinking

Global Slack, US Inflation and the Fed’s Policy Error

After signaling four rate rises in 2016 this time last year, the Fed finally managed to deliver a quarter-point hike in a unanimous decision. It also signaled that it would raise rates thrice in 2017. Markets promptly responded by selling off bonds and EM assets, and strengthening the US dollar. Meanwhile, core inflation remains well below target. The Fed has, in effect, made clear that it regards the 2 percent inflation target as a ceiling; not a symmetric target.

The Fed is eager to hike because it thinks inflation is just around the corner. The FOMC has consistently predicted higher inflation than has obtained in this recovery. How can the Fed be making a systematic error of this magnitude? The answer is surprisingly simple: The Fed, along with most other central banks and international macroeconomics institutions (IMF, OECD, World Bank), relies on the standard Phillips curve theory that relates the rate of change of inflation to national measures of slack such as the output gap or the unemployment rate. In particular, labor market tightness is expected to generate wage pressures, which in turn would cause inflation to accelerate.

The problem is that the standard, domestic, accelerationist Phillips curve no longer captures the inflation process. Figure 1 shows the US output gap vs. change in core PCE inflation over four periods: 1960-1973, 1973-1990, 1990s, 2000-2016. We have used quarterly data from the CBO and FRED. We see that the model worked from 1960 through 1990, weakened in the 1990s, and then disappeared after 2000.

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Figure 1. The Phillips curve weakened in the 1990s and broke down after 2000.

There are two competing explanations for the demise of the standard, domestic, accelerationist Phillips curve. The first is that because inflation expectations have become firmly anchored at the target (no one doubts the Fed’s willingness or ability to keep inflation in check), the inflation process has mutated so that the relationship that works now is between domestic slack and the level of inflation rather than changes in inflation. There is some evidence to support this hypothesis. See Figure 2.

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Figure 2. The return of levels?

The competing explanation is the Global Slack Hypothesis which says that due to the integration of global markets, what now drives inflation is not domestic slack but rather global slack. Due to competition from global rivals, domestic producers in the tradable sector cannot raise prices when the domestic labor market tightens and wage pressures build. Instead, they either rebalance their global supply chains and off-shore production; or they lose business to their foreign rivals. In either case, domestic inflation is determined as much by global slack as by domestic slack.

The evidence is mounting that the second explanation is the right one. What is especially compelling is the evidence that global slack is statistically significant in ALL countries for which data is available while domestic slack is significant is NONE since 2000. See Figure 3. The last column corresponds to global slack (“foreign gap”); no stars means the variable is not significant; three means it is significant at the 1 percent level.

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Figure 3. From Manopimoke (2015).

I wanted to check for myself so I did a straightforward exercise. I took output gap data for twenty countries (not including China) from the IMF and constructed a global slack measure for the United States defined by the average output gap of US trade partners weighted by trade intensity (exports+imports of state i to the US/ sum of exports+imports of all 20 states to the US). I use these weights not because inflation propagates through trade but because global integration tracks trade intensity. I use annual data from 1985-2016. Figure 4 displays the simple linear relationships between domestic and global slack vs. change in US inflation. We see that global slack is a stronger predictor of US inflation than domestic slack.

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Figure 4. Domestic vs. global slack as predictors of changes in US inflation.

US output gaps are, of course, contemporaneously correlated with global slack. Figure 5 shows the relationship.

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Figure 4. US output gap vs. global slack.

In order to examine the independent influence of the two variables we (1) project the US output gap onto global slack, and then, we (2) project changes in inflation onto the fitted values from (1) (which represent global slack) and the residuals (which capture variations in the US output gap orthogonal to global slack). The results are extraordinarily revealing. See Table 1 below.

Table 1. What explains changes in US inflation?

Estimate SE tStat pValue
const -0.053 0.058 -0.915 0.367
global slack 0.129*** 0.038 3.363 0.002
domestic gap -0.006 0.046 -0.129 0.898

We see that global slack is significant at the 1 percent level, while variation in domestic output gap orthogonal to global slack is completely insignificant (and bears the wrong sign). Meanwhile, the inclusion of domestic slack in the model reduces the adjusted-R^2 from 0.256 to 0.231. In other words, the weak relationship between domestic slack and changes in US inflation depicted by the lower chart in Figure 4 is entirely due to the fact US domestic slack is contemporaneously correlated with global slack.

Returning to the return of the levels model, we can do the same exercise we did above. See Table 2.

Table 2. What about return of the levels model?

Estimate SE tStat pValue
const 2.274*** 0.152 14.962 0.000
global slack 0.193* 0.100 1.933 0.063
domestic slack -0.246** 0.120 -2.046 0.050

The levels model is even more of a disaster for the standard model. The coefficient for domestic slack is significant but bears the wrong sign after we control for global slack! (Note that we are using annual data here while Figure 2 uses quarterly data. Figure 6 at the bottom shows the annual data. There again, we see that global slack is a significant predictor of the rate of inflation but domestic slack is not. Also, Figure 7 shows that the output gap is strongly correlated with unemployment. One can use either in a Phillips curve. Figure 8 shows the time-variation in the measures for domestic and global slack for the United States. Figure 9 and Table 3 revisit the levels model and document the absurdity that the Canadian output gap is a better predictor of the level of US inflation than the US output gap!)

We have not included any slack measures from China and other emerging markets. There is good reason to believe that their inclusion would make global slack an even stronger predictor of US inflation.

I hope to have at least sown some doubt in your mind about the standard model of the inflation process. The Fed’s model error is a significant risk for the economy and markets. The Fed will likely fail to deliver the three promised hikes. But if it does, it would be running a significant risk of plunging the US economy into recession. Ironically, it might be Trump’s Keynesian shock that kills the recovery by bringing out the hawks at the Fed.

***

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Figure 6. Levels, annual.

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Figure 7. US output gap and headline unemployment.

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Figure 8. Domestic and global slack for the United States (1985-2016).

***

P.S. More on the return of the levels model.

Quarterly output gap data seem to be unavailable for other countries besides Canada, Japan and Sweden. Among these the US’ most important trading partner is Canada. Turns out, the Canadian gap is strongly correlated with the US’ global slack metric at the annual frequency. What this means is that we have the following absurdity. The Canadian gap is a slightly better predictor of the level of US inflation than the American gap! See Figure 9. The data is for Q2’2001 to Q2’2016.

absurdity

Figure 9. Absurdity (levels model): The Canadian output gap is a better predictor of US inflation than the US output gap!

And just to really rub in the point, we repeat the decomposition exercise we tried above for the US and Canada. We project the US output gap onto the Canadian output gap and then project US inflation on the fitted values (representing Canadian/global) and residuals (American orthogonal to Canadian/global). Table 3 displays the estimates. Note that the constant is more or less equal to the Fed’s target, which is a good sign because this is a period of anchored inflation expectations. The Canadian/global gap coefficient is more statistically significant and more than twice as large as the coefficient of US gap orthogonal to the Canadian/global gap. Fun stuff!

Table 3. Absurdity continued: Canadian gap is a superior predictor of US inflation than the US gap.

Estimate SE tStat pValue
const 2.066*** 0.048 43.455 0.000
Canadian gap 0.167*** 0.018 9.248 0.000
US gap 0.064** 0.027 2.318 0.024
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Thinking

The Sudden Death of the Neoliberal Consensus

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We wake up. It’s the day after. Fear and anxiety mixed with bile rises up from the pit of the stomach to the throat. How? We ask ourselves. How could this be? How could a con man bluff his way to the White House? How could Americans elect a television huckster to the highest office of the land? How could hopeful dreams of breaking the glass ceiling be shattered by—of all people—a sexual predator? Are a majority of Americans really nativist and xenophobic?

Is the American republic under threat? Is it 1933 all over again? Is this how fascism comes to America?? What will happen when the man takes office? Do brown people need to fear for their life and limb? Will Homeland Security turn into an intrusive state police kicking down doors and intimidating nonwhites? How resilient are the institutions of the constitutional republic? And what lies in store for the liberal international order that Trump has threatened with a bludgeon?

I don’t have an answer to any of these questions. Trump is an absolute wild card. The next four years could be a farce. Or they could be the late 1930s. We just don’t know.

A friend of mine asked me if there is a genuinely insightful narrative to explain what is happening in the West. Here is what I wrote:

Over the next few days, we’re going to be bombarded by a million explanations. I want to suggest a rule of thumb as we sift through them. Any good explanation must explain the geographic, temporal and class distribution of the turn to populism in the West; including and especially, dogs that did not bark. (For instance, American race relations cannot explain the developments in Europe.) With that in mind, I’d like to put forward an explanation that builds on the insights of Karl Polanyi, Dumenil and Levy, Case and Deaton, and Eric Hoffer.

Polanyi argued that society responds to the whiplash of the global market economy by clamoring for protection. This works largely through the labor market whose disruptions threaten to annihilate the body social. In his reading, the connection between the political and the economic goes through the labor market which is where society lives.

Dumenil and Levy have shown that the neoliberal counterrevolution was a political project to resurrect the liberal international economic order. The rise of neoliberalism can be traced to the stagflation crisis of the seventies which opened the way to a revolution from above. The counterrevolution was consummated in the nineties as the center-left largely abandoned pro-labor policies and in the process established the neoliberal consensus wherein there were no centrist alternatives to the rigidly pro-wealth, pro-finance, pro-globalization, anti-welfare, anti-inflation policy mix.

The neoliberal consensus held as long as the world economy was in the up-cycle; that is, until the outbreak of the Western financial crises. During the up-cycle the unshackling of the global economy had amplified the medium-term (8-30 yr) financial cycle in wealth, credit, and asset prices. The down-cycle that followed, whose amplitude was equally large, led to especially deep and long-lasting balance-sheet recessions that decimated the labor market; that is to say, the body social. (The unemployment rate in many Continental nations is still in double digits.)

All was not hunky-dory during the up-cycle either. The addition of Asian workers, especially the Chinese, to the effective global labor market, suppressed wages and employment in the West. The result was redistribution of income from the rich world lower and middle classes up to the rich and the highly-skilled and out to the low-income working class (captured in the so-called elephant curve of global income gains, see chart).

branko-milanovice-global-inequality-elephant-curve

That these twin developments hurt the great white beast is an understatement. Case and Deaton uncovered evidence showing an epidemic of self-destruction in precariat white communities in fly-over country. They documented that there have been an astonishing half-a-million excess deaths in this demographic as a result of suicide and drug overdose since 2000.

Eric Hoffer argued that decaying political orders swell the ranks of the frustrated who are ready to demolish the political center and start over. What happens in a mass-movement is that differentiated individuals are marshaled by a demagogue into an undifferentiated, solid mass of identical particles, that is then deployed as a bludgeon to demolish a decaying political order.

I believe what we have witnessed is the sudden death of the neoliberal consensus in the precise manner expected by Hoffer. The West has seen two previous periods of extended economic crises: 1930s and 1970s. The present crisis has much more in common with the general crisis of the 1930s than the 1970s. And that is very, very scary.

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Was the Release of the Lewd Trump Tape Timed to Coincide with the Wikileaks Clinton Dump?

Sexual predator. The phrase popped into my head while listening to Donald Trump and Billy Bush’s so-called locker room banter. Except this wasn’t harmless locker room banter. This was a textbook illustration of rape culture.

Trump: You know I’m automatically attracted to beautiful — I just start kissing them. It’s like a magnet. Just kiss. I don’t even wait. And when you’re a star, they let you do it. You can do anything. 

Bush: Whatever you want.

Trump: Grab them by the pussy. You can do anything.

Note that Trump is literally bragging about sexual assault: Non-consensual kissing and grabbing of women’s genitals.

The revelation has gravely injured the Trump campaign. Numerous Republicans have withdrawn their support. Trump’s numbers with women were already appalling. We can now expect them to collapse. This may well turn out to be the arrow that slayed the monster.

Was the Clinton campaign behind the story?

Whosoever had this tape must’ve been sharply aware of its explosive potential once Trump started dominating the Republican contest. But they sat on it even as Trump secured the GOP nomination. This means that the original source’s sympathies did not rest with Trump’s Republican adversaries. That they released it at all means that their sympathies did not rest with Trump either.

Even after the general election campaign started in earnest, the source sat on the tape. What were they waiting for? Why release it on Friday, October 7?

Modern presidential campaigns have extensive operations to dig up dirt on their adversaries. Since they have the greatest stake in the matter they hire armies of sleuths and devote considerable resources to the effort. If there are skeletons to be found in the closet of their adversary, there is a good chance a priori that their black ops team would find them.

Assume that the Clinton campaign had discovered the tape. What would be the ideal time to surface it? If I were a strategic advisor to the Clinton campaign, I would advise them to hold it in reserve and use it as a defensive weapon when the campaign was at a serious risk of being harmed. In particular, I would hold it in reserve to use against any “October surprise.”

Now, Assange had been promising a game-changer for a while and more recently dropping hints of a major dump this week that would hurt the Clinton campaign. Here was the “October surprise” that Clinton strategists had been waiting for.

The unnamed source who had the tape called Washington Post reporter David Fahrenthold around 11am on Friday, October 7. The Post published the story at 5pm on the same dayAt 6pm, Wikileaks dumped a treasure trove of Clinton campaign emails online.

It seems that the Clinton campaign timed the release of the Trump tape absolutely perfectly. The operation ensured that the sordid Trump story would drown out the Wikileaks dump. It was straight out of The Art of War. I can almost hear the champagne popping in Brooklyn.

This may sound like a criticism of the Clinton campaign’s machinations. Far from it: The affair demonstrates the strategic superiority of the Clinton campaign. Not only do they have a bigger war chest and a superior ground operation, even their strategists are more cunning. The Policy Tensor is impressed.

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