Anglo-Saxon Population History and World Power

The German Empire would not be proclaimed until next January, but it was forged in Bismarck’s splendid war against France in 1870. That was also the last year in which Germany would be more populous than the United States. Germany was born in relative demographic decline as a result of the settlement of the American West. In 1870, Greater Britain (Britain, Canada, and Australia—we don’t have data for New Zealand and South Africa)’s population was 37.0m, France’s population was 38.4m, America’s 40.2m, and Germany’s 40.8m. 1870 is really the crossover point of the population scissors. The populations of all four were roughly around 40m in 1870. Over the next forty years, while France’s grew by a mere 7 percent, Greater Britain’s grew by 53 percent, Germany’s by 58 percent. But both were dwarfed by America’s 131 percent. By 1910, France, Greater Britain, Germany, and the US weighed in at 41.2m, 56.5m, 64.6m, and 92.8m respectively.

The stagnation of the French population, the fact that Greater Britain expanded demographically nearly as much as Germany, and German demographic decline relative to the United States, all came to weigh heavily on the world question at the turn of the century. This was especially so because all four great powers were roughly at the technological frontier by the turn of the century. Although the United States had clear leadership, the secondary industrial revolution occurred in all four poles (and beyond). Germany in particular was a major center of innovation in the mechanical arts, leading in many sectors, eg industrial chemistry, heavy industry, and catching up in many where the Americans had led, eg automobiles.

Population in millions
Greater Britain United States Germany France
1870 37.0 40.2 40.8 38.4
1880 41.2 50.5 45.1 39.0
1890 45.5 63.3 49.2 40.0
1900 50.4 76.4 56.0 40.6
1910 56.5 92.8 64.6 41.2


Life expectancy is a good measure of everyday living standards. The next figure shows that by this measure, improvement in German living standards accelerated around 1890. But there was no relative improvement in Germany’s position because the Atlantic powers themselves hit the toe of the hockey-stick at the same time. The Anglo-Saxons opened up a gap with France as well. No one was as rich as them or lived as long.


The evidence from stature is even more daunting from the perspective of an aspiring world power. Americans still towered over Germans. Greater Britain and Germany remain close throughout, although with a British edge. France, which was closer to the Anglo-Saxons in life expectancy, lagged behind even though it too participated in the onset of the hockey stick.


Note that we have defined the average stature of Greater Britain as the population weighted average of British, Canadian, and Australian means. If you unpack Greater Britain, it turns out that Canadians and especially Australians enjoyed a definite settler premium. See next figure. American supremacy in stature is therefore not surprising. Britons would finally become taller than Americans for the first time in 1930. But that is a story for another day. Instead of unpacking Greater Britain, the challenge is to expand it to encompass not just New Zealand and White British subjects in southern Africa, but Greater Britain in a thick sense: as the predominance of the British diaspora in the offshore world. Proximately what was required was to monopolize prime temperate land in Anglo-Saxon hands; in order to do that, what was required was the take-off of self-reproducing settler colonies; preferably junior geopolitical allies of Belich’s Anglo oldlands (see the schematic map) that could thus anchor the world position of the two Anglo-Saxon great powers.


Screen Shot 2018-10-31 at 3.24.26 AM

From Belich, Replenishing the Earth.

I still haven’t finished reading Belich’s Replenishing the Earth: the Settler Revolution and the Rise of the Anglo-World, 1783-1939, so I will hold my judgement of the first three-fourths of the book. I will say that his description of the wildcat banking and asset price bubbles of the Anglo-Saxon frontier is excellent. I also agree with him that explosive colonization was a bubble by construction. One went all in when one went to settle a fledgling colony. Things worked themselves out once enough talent showed up. Speculators abounded. Increasingly massive boom-bust cycles whipsawed the frontier. Boom towns expanded at prodigious rates; driven by investment booms, unregulated bank lending, furious speculation, and attendant asset price bubbles amid extraordinarily elevated rates of settler arrivals. At the heart of Settlerism itself was a Ponzi scheme; the Anglo-Saxon folie a famille in two senses. As the Anglo-Saxon madness of course. But also the self-accelerating aspect of settler success itself. The booms were in a fundamental sense self-igniting. They solved the problem of coordination through faith. Not just faith in God. But faith in the colony. The frontier attracted the believer like a magnet.

In the American West, there were three major medium term cycles that peaked in 1837, 1857, and 1873. (The last of the great booms peaked in 1893 and 1907.) After each of these busts, Belich argues, the West was re-colonized, reoriented to point towards to metropole; peripheralized via a vertical division of labor—Cincinnati would no longer produce books and periodicals (88,000 books were published in the town in the three months of 1831, Belich reports) but pork and grain; New York would supply the books and periodicals. Fair trade or not, this was the construction process of the Weltwirtschaft.

The topology of the world had been transformed by Anglo-Saxon settlement. Britain’s decline relative to Germany has been overestimated. If we consider the product of life expectancy and population as the measure of war potential instead of GDP which is a product of per capita GDP and population, Britain kept pace with Germany all the way. (We know the picture that emerges from income: Britain’s per capita GDP was 25 percent larger than Germany’s in 1900).


France was guaranteed to be a member of any balancing coalition against Germany. The real question was Anglo-German relations. Given the Anglo-Saxon stranglehold on the maritime world-economy, their naval mastery, and their settlement of all available prime temperate land, there was no solution to the problem of wrestling world control away from Anglo-Saxon hands. Fisher’s ‘five keys that lock up the world’ were Anglo-Saxon property by the time the German Empire was proclaimed. So the German bid to be one of the four world policeman was thwarted by the difficulty of dethroning Great Britain, the Franco-Russian alliance and the problem of two-front war, and above all, the settlement of the American West and the rise of the United States.

Population history is crucial to the Franco-German story, the Anglo-German balance, the rise of the United States to global mastery, and the cul-de-sac of German navalism. But was there no viable path for Germany to become a world power? The missed opportunity of 1905 points in the right direction. Above all, Germany needed to achieve military hegemony on the continent. Russia was out of business and France lay exposed. Navalism came to bite not only in 1914 but also in 1905 when the Kaiser decided to wait for a more favorable naval balance.


How was the German question resolved?

Sovereignty is always shaped from below, and by those who are afraid  — Michel Foucault

Marc Trachtenberg’s A Constructed Peace: The Making of the European Settlement, 1945-1963, won the George Louis Beer Prize as well as the Paul Birdsall Prize.[1] It remains highly regarded in the field. Trachtenberg argues convincingly that the German question was at the heart of postwar international politics and its resolution was the key to the establishment of a stable international system. Since the great powers disagreed so profoundly on what was to be done with Germany and put a great deal of importance on that question, a stable pattern of East-West relations could not obtain until the German question had been settled one way or the other. As long as the German question remained unresolved, the specter of general nuclear war hung over East-West relations. Once it was resolved, the basic parameters of the bipolar world fell into place, East-West relations were stabilized, and the Cold War in effect came to an end.[2]

The entire future of Germany was open for reconsideration when postwar planning began during the war.[3] Was Germany to pay reparations? Was it to be deindustrialized and turned into an agrarian country to reduce its power as envisioned in the Morgenthau Plan? Was Germany to be broken up into smaller statelets? Into two, three, or four pieces? Under whose sphere of influence were these pieces to fall? Who was going to control the Ruhr? Even after they had been agreed upon, were the occupation zones to be run separately by each occupying power as it wished? What was to be their socio-economic system? Were all non-fascist political parties to be tolerated in all zones? Or were the zones merely temporary and a unified German state was to be resurrected? And if so, was the Germany army to be reconstituted? And if German power was to be restored, was Germany going to be neutral or an ally of one of the three great powers?

Given the centrality of the German question to his account of the European postwar settlement, it is perplexing to find Trachtenberg begin his narrative at war’s end, some two years after official three-power negotiations began. A number of important decisions on the German question were in fact hashed out during the war; above all, the territorial division of Germany into occupation zones. The first steps in that direction were taken at the Moscow Conference in October 1943.[4] The British circulated a draft agreement on the zones of occupation on January 15, 1944.[5] On February 18, 1944, the Soviets accepted the British proposal for the eastern zone apparently without bargaining.[6] Why Stalin would accept a division that gave him control of the agrarian third of Germany is not clear.

So Trachtenberg is not interested in how the German question was resolved per se. What Trachtenberg does instead is mobilize it to explain why East-West relations took so long to stabilize. Secretary of State James Byrnes, ‘the real maker of American foreign policy during the early Truman period,’ we are told, pressed for ‘a spheres of influence settlement in Europe’ that the Soviets could get behind, whereby ‘each side would have a free hand in the area it dominated, and on that basis the two sides would be able to get along with each other in the future.’[7]

But a settlement of this sort did not come into being, not until 1963 at any rate. Why was it so long in the coming? Why did the division of Europe not lead directly to a stable international order?[8]

Trachtenberg’s answer is that profound disagreements on the German question prevented the emergence of a stable order. The Soviets were implacably opposed to the resurrection of German power, especially a nuclear-armed Germany, particularly one allied to the West. The US did not want an independent Germany. But the defense of Western Europe ultimately required the reconstitution of the German army. In the end, despite the fact that the Soviet Union had almost single-handedly defeated Hitler, the US was able to get its way on the German question. In effect, the US managed to impose its preferred outcome on the Soviet Union. Why?

Although Trachtenberg does not come right out and say it, the short answer is that the US leveraged its nuclear superiority to get its way on the German question. The first great confrontation was triggered by the introduction of a common currency into the three Western zones in 1948. It meant in effect the creation of a West German state. It is this that triggered the Berlin Crisis. At the time the United States enjoyed a nuclear monopoly, and according to Trachtenberg, ‘as long as it was a question of purely one-sided air-atomic war’ the US was ‘sure to win in the end’.[9] The West could thus afford to stand firm in the face of Soviet pressure. And the Soviets backed down once it became clear that the United States was prepared to go all the way to general nuclear war in order to defend the West’s position in West Berlin.

America responded to the loss of nuclear monopoly in 1949 with an enormous buildup of air-atomic forces. By 1952 the Strategic Air Command had emerged as a war-winning first-strike weapon. It was in this context that the resurrection of the German army was put on the table. Stalin responded by sending the famous March 1952 Note suggesting that the Soviets would be willing to accept a unified Germany with free elections and even a capitalist economic system as long as it was guaranteed to be neutral. The West dismissed the offer as a mere ploy. Trachtenberg, following Gaddis, concurs.[10] But many serious scholars of Soviet foreign policy have argued that the offer was in earnest.[11]

A series of increasingly hostile confrontations occurred in 1958-1962 culminating in the Cuban Missile Crisis, when Khrushchev, emboldened by the Soviet acquisition of ICBMs capable of reaching US cities, decided to force a showdown on the question of the introduction of tactical nuclear weapons into the German army. Astonishingly, Trachtenberg devotes less than three pages to this final confrontation over the German question, concluding that the US ‘laid down an ultimatum’ and the USSR ‘acceded’ without explaining why.[12] As Trachtenberg himself had argued elsewhere,

It really does seem that “we had a gun to their head and they didn’t move a muscle”—that their failure to make any preparations for general war was linked to a fear of provoking American preemptive action. … The effect therefore was to tie their hands, to limit their freedom of maneuver, and thus to increase their incentive to settle the crisis quickly.[13]

The picture that emerges thus calls for a major revision of the account presented in the monograph, one that pays attention to the balance of strategic power as it came to weigh on international politics at crucial moments in the resolution of the German question, 1942-1963.


[1] Trachtenberg, Marc. A Constructed Peace: The Making of the European Settlement, 1945-1963. Princeton University Press, 1999.

[2] Except for a brief revival under Reagan in the early 1980s. See Stephanson, Anders. “Cold War Degree Zero.” Uncertain Empire: American History and the Idea of the Cold War (2012): 19-50.

[3] This paragraph is adapted from an earlier essay that appeared on my blog.

[4] Mosely, Philip E. “The occupation of Germany: New light on how the zones were drawn.” Foreign Affairs 28, no. 4 (1950): 580-604, p. 580.

[5] Ibid, p. 589. Of course, the British awarded the Ruhr to themselves.

[6] Ibid, p. 591.

[7] Trachtenberg, p. 4.

[8] Ibid.

[9] Trachtenberg, p. 89.

[10] Ibid, p. 129.

[11] See Willging, Paul Raymond. “Soviet foreign policy in the German question: 1950-1955.” (1975): 1199-1199, and references therein.

[12] Trachtenberg, p. 352-355.

[13] Trachtenberg, Marc. History and strategy. Princeton University Press, 1991, p. 259.


Testing Krugman’s It Theory of Global Polarization

Krugman’s paying attention to global polarization again. His It theory is a sort of zero-one law of modernization:

One thing is clear: at any given time, not all countries have that mysterious “it” that lets them make effective use of the backlog of advanced technology developed since the Industrial Revolution. … Once a country acquires It, growth can be rapid, precisely because best practice is so far ahead of where the country starts. And because the frontier keeps moving out, countries that get It keep growing faster. … The It theory also, I’d argue, explains the U-shaped relationship Subramanian et al find between GDP per capita and growth, in which middle-income countries grow faster than either poor or rich countries. Countries that are still very poor are countries that haven’t got It; countries that are already rich are already at the technological frontier, limiting the space for rapid growth. In between are countries that acquired It not too long ago, which has vaulted them into middle-income status, but are able to grow very fast by moving toward the frontier.… and rising inequality within Western countries means that if you look at the global distribution of household incomes, you get Branko’s elephant chart.

The It theory implies that the rate of growth of per capita income is a quadratic function of per capita income since middle income countries who have It ought to grow faster than low income nations who don’t have It, as well as high income nations who, although they do have It, are too close to the technological frontier to grow rapidly. This has a certain plausibility since middle income countries seem to be the fastest growers while advanced economies and the least developed nations tend to grow slowly. Let’s test it to see if it accords with empirical reality.

If the It theory holds then the coefficients in the linear regression of growth rates as a quadratic function of log per capita income should be significant and bear the right signs. More precisely, the quadratic function has to be concave down (a hump shape), so that the linear coefficient ought to be positive and the coefficient of the quadratic term ought to be negative. Is it true?

We test this prediction against the Maddison dataset. We begin by running rolling regressions of the 5-year moving average of the rate of growth of per capita income as a quadratic function of log per capita income. Figure 1 displays the t-Stats (the ratio of the coefficient and its standard error) over time. Interestingly, Krugman’s It theory seems to hold for two periods, 1973-1986 and 2003-2012. But it seems to reverse in the 1990s. Is this because of the Soviet collapse?


To check this, we exclude the countries of the former Soviet Union and rerun our regressions. Figure 2 displays the estimates. That attenuates the problem. The nineties reversal is no longer statistically significant. Yet the overall pattern is unchanged. Why were middle income countries growing significantly faster than low and high income nations in these two periods but not otherwise?

It_test_exUSSR.pngThe next figure displays the R^2 of the regressions. We see that the relationship really breaks down in 1986-2002. Why? We must dig deeper.


In order to get to the bottom of this we fit a linear mixed effects model. We restrict the sample to the past 50 years and fit the model,


where we allow for random effects for country (u_i) and year (v_t). The results are pretty robust. With t-stats close to 10, both fixed-effect coefficients are extremely significant and bear the right sign.


Do the results continue to hold if we introduce fixed-effects for income group (“class”), ie dummies for low, middle, and high income groups? For if the coefficients remain significant and continue bearing the right sign despite the inclusion of dummies for income group, that would imply that the pattern extends within income groups.


The results are very interesting. Instead of attenuating, the quadratic coefficients increase slightly in magnitude. But the fixed-effect coefficients for low income group (“class_3”) and especially, middle income group (“class_2”) bear the wrong sign. This could be because we are controlling for income (and squared income). But that is not the case. Even dropping the income variables, and with and without random effects, the coefficients of the low and middle income group dummies remain resolutely negative and significant. Indeed, high income nations averaged a growth rate of 2.15% over the past fifty years, compared to 1.71% for the middle income group and only 0.72% for the low income group. So it seems that our intuition was wrong.

Krugman appears to be right on average if we stick to the past half century. There is indeed a statistically significant cross-sectional relationship between income and growth whereby growth rates are a quadratic (and concave upwards) function of per capita income. But the reality is far more complex than that simple picture would suggest. The next graph shows the time-variation in the quadratic relationship since 1800. There is substantial systematic time-variation in the relationship since it emerged. Moreover, we can see how truly novel this catch-up business is. The series looks stationary around zero all the way until the 1970s. In English, there was hardly any catch-up—more precisely, excess middle income growth—before the last quarter of the twentieth century. Even the two brief periods of relative convergence bookend a decade of major divergence. The graph thus testifies to both the late arrival of convergence and the failure of the mid-century dream of Modernization.


The figure incorrectly states that the sample is restricted to the low income group. It is not. This is the full sample. 

The big question thrown up by the present investigation is the dramatic pattern of convergence, divergence, and convergence over the past two generations. What explains this pattern? Could it have something to do with the global financial cycle? The next figure displays the global financial cycle from Farooqui (2016).  It is also double-humped like the graphs above (also reproduced below), but the two seem to be out of sync with each other. While the financial boom of the late-1980s was gathering pace, the middle income premium in growth was collapsing. The second cycle is more congruent. So the evidence for a connection to the global financial cycle is mixed.


This requires more work. But we have the basic picture for now.

Postscript. I like scatterplots. It lets you quickly examine the strength of any hypothesized relationship. So I looked at actual average growth rates in the modern period versus that predicted by the fitted model. The fitted model is,

\text{growth}=-0.3028+0.0710\times log(PCGDP)_{i,t}-0.0039\times log(PCGDP)_{i,t}^2.

We do a sleight of hand and compare the predicted growth rate not with the actual growth rates by country-year. Instead we look at average growth rates in the modern era. The evidence that emerges is very strong. The quadratic model does a good job of predicting average rates of growth. Here we compare the predictions with the average rates of growth achieved since 1960. The estimated correlation coefficient is very significant (r=0.308, p<0.001). The picture is similar if we start the clock in 1950, 1970, 1980, 1990, or 2000. Krugman is really onto something.


Post-postscript. Actually, it is not so simple. The even simpler Biblical model does even better. [Matthew 13:12. For whosoever hath, to him shall be given, and he shall have more abundance: but whosoever hath not, from him shall be taken away even that he hath.]



An Irredeemable Miscalculation?


The grim details of the extrajudicial torture-execution of the Post columnist are now clear. The most astonishing fact to emerge is that MBS did not even bother to cover his tracks. Instead of sending expendable killers-for-hire to maintain plausible deniability, the standard operating procedure for kinetic intelligence operations, MBS sent men from his own personal security detail to assassinate the journalist.

2017 imprisoned

Journalists imprisoned. Source: CPJ.

Killing journalists is not a new trick for mafia states. On average a journalist is killed every week, according to the Committee to Protect Journalists. Some 44 have already been killed this year, although that number does not include Khashoggi.


Of the 1,323 journalists reported killed since 1992, 912 have been killed since the Iraq War began in 2003; including 159 Iraqi journalists and 110 Syrians. Outside these two warzones, the greatest rate of scribe killing is in the Philippines, followed by Algeria, Pakistan, Russia, Somalia, Colombia, India, Mexico, and Brazil. The next graph shows the notorious double-digits scorers in the CPJ database.


We can think of the number of scribes killed as measuring to what degree the state formation approximates a mafia state. This is not exactly right because the 1,323 total scribe killings since 1992 include some 131 involving criminal gangs, as when the Chicago mafia gets rid of a pesky reporter with the understanding of the local judge and politician. More generally, only 1,083 killings can be attributed to specific actors. The next table shows the breakdown. It’s clear that the vast bulk of the killings are ordered by political or military authorities.

Attributed killings of journalists.
Killer Number Share
Government 194 18%
Military 242 22%
Political 436 40%
Paramilitary 62 6%
Mob 14 1%
Criminal 135 12%
Total 1,083 100%
Source: CPJ.

So it cannot possibly be the case that the prestige media is up in arms about the mere killing of a journalist. Why then does it look like MBS has his feet to the fire? And why does it look like his days are numbered? Are they? What precisely can be done about MBS? and more generally, the Saudis?

What the extraordinary opprobrium in the Western press reflects, I think, is Said’s Orientalism in reverse. What was so egregious about the Khashoggi business was not that he was a scribe. It was that he was a columnist at the Washington Post. Indeed, he probably thought that his association with a prestige paper in the United States made him bulletproof. Put bluntly, the implicit norm said: You can kill a journalist in your backyard, especially one writing in the vernacular. And if you’re going to kill a prominent critic who is known internationally, you better have plausible deniability. But you can’t kill a card-carrying member of the Western Press, especially not without even a fig leaf of deniability. So MBS miscalculated badly. It may be because he has always lived in the Kingdom and has no first-hand experience of the rigidity of the liberal-democratic discourse in Western civil society.

Now what? What is the West to do with MBS? Must he go? Oh it can be arranged. And if you are thinking of European dependence on gulf crude, there are operational solutions to the problem of stabilizing oil prices. There is no need to occupy Saudi cities and the vast bulk of Saudi territory. All you need is to secure a small portion of the eastern province. US forces can secure the oil fields in the gulf with a light force, as a joint Anglo-Saxon plan had it in the 1970s, and as someone, probably Kissinger (Grey Anderson tells me that Edward Luttwak admitted to having authored the article in 2004) wrote about anonymously in Harper’s at the time of the Arab embargo. Since all of Saudi oil sits under a zone of Shiite predominance, the political problem can be solved by working with Iran just as the United States has to already in the arc of weakness that stretches from the gulf to the Levant. The micro-oil monarchies of the gulf are already under US protection. They would have to move closer. We cannot allow the Saudis to mediate between the United States and the Trucial States.


But knowing that the United States can secure the oil fields without putting many boots on the ground is an insurance policy, not the proposed strategy. The Policy Tensor has been suggesting for a long time that the United States ought to follow a more even handed policy in the gulf. Indeed, it would not hurt to ditch Saudi Arabia for Iran. To put it bluntly, Iran dwarfs the gulf region in warmaking potential. The United States shot itself in the foot by destroying the garrison state built by Saddam. The result of US debacle is that Iran is now the most influential power in southwest Asia. Iran understands that the US is capable and willing to confront Iranian foreign policy in the gulf region and in southwest Asia as a whole. But it is also true that the United States has little choice but to work with Iran on regional questions. I think it is obvious that rolling back Iranian influence in Syria and Iraq is a fool’s errand.Iran is a natural ally of the West in the fight against salafi jihadism. The US needs a working relationship with Iran; better still, would be a genuine partnership with Iran.

I think there has been increasing cooperation in US-Iranian relations, each has gained an increased appreciation of the other’s strength by fighting side-by-side against Isis. What needs to be recognized now is the congruence of interests between Iran and the West. Because Iran is the potential region hegemon of gulf region, it is best to have good working relations. It makes for stable relations to have potential regional hegemons invested in the status quo.  As Huntington observed, the world is uni-multipolar. The United States is the only state in the world that can project power system wide. But geopolitics is regional. In order to run the different regions of the world, at the minimum, the United States has to reach an understanding with China in east Asia, India in south Asia, Iran in southwest Asia, Russia across Eurasia, and Germany in Europe. This is particularly true under conditions of mutually-assured destruction.


What requires particular attention is gulf terror finance. Whether or not we contain Saudi Arabia more generally, terror finance from the gulf has to stop. Frankly, this requires eyeballs and interdiction by law enforcement in international financial flows from and to the gulf. Congress should fund this right quick and subject enforcement to oversight. But the real problem with Saudi Arabia is not restricted to terror finance even in the narrow sense of the war on terror. For Saudi Arabia is the world capital of salafism. Thousands of little religious schools run by the Saudis dot the Old World from Kosovo to Indonesia, where every attendant is at risk of recruitment by salafi jihadists. These schools are the breeding ground in which salafi jihadism grows. More generally, the propagation of salafism is the principal driver of jihadism. If we are serious about the fight against salafi jihadism, we must arm-twist the Saudis to roll-back their global network of salafi madrasas.

These are all matters of elementary security policy for the United States. But should Saudi Arabia be contained? What exactly would containment entail? Sanctions? Air strikes? I do not believe any of that is required. A simple threat of US abandonment would be enough to concentrate minds in the Kingdom. For if abandoned by the United States, the Kingdom would be faced with a vastly stronger power across the gulf without any security solutions. My proposal is not to jump to containment yet.

If the West were to act jointly, it would inform the Saudi authorities—once the intelligence is verified—that MBS has to go. He would be persona non grata. If the Saudis want to hold on to him even though there are thousands of princes waiting in line for the throne, it will be awkward for a while. But the West could very well stand firm on this. MBS just cut it too close to the bone.

Whether or not the Saudis ought to be subjected to sanctions depends on whether or not they are willing to cooperate in a major reorientation of Saudi policy (on terror finance, the madarsa network, and MBS). It would be best if the Saudis marginalized MBS without US intrigue. Although even intrigue would be better than having to deal with Saudi Arabia without talking to its de facto leader for whatever time it takes for the Saudis to come around.

Here’s how the unipolar world works. If there is a Nash equilibrium in international politics that the United States lays down and insists on, eg Washington Naval Conference of 1922, then a stable order can be secured. But this does not mean that Europe does not have a say. Indeed, the Europeans could unilaterally contain MBS. By declaring him persona non grata and opposing this administration on gulf policy, Europe can prepare the ground for when adults are back in Washington. This is already underway in the sense that the Europeans are working with the Iranians to pushback against the US reneging on the nuclear deal. Merkel would be wise to take this opportunity to extend the pushback to MBS.

When adults are back in Washington, one could move ahead in leaning harder on Saudi Arabia. But two things must be recognized. This is not just about Khashoggi and not just about MBS. This is above all an opportunity to reconsider Western gulf policy tout court. Why is the West containing Iran and arming the Saudis when core Western interests are closer to the former than the latter?



Musings on the Microstructure of the Market for Risk


Margin Call (2011)

In closing the previous dispatch I offered that we may be missing a theoretical piece of the puzzle. Here I offer some musings on what sort of structure I think we need to get an even better handle on asset prices.

My understanding of the microstructure of the dealer ecosystem suggests to me that we have three kinds of market players in the market for risk: sell-side, buy-side, and noise traders. US securities broker-dealers on the sell-side make markets by trading at quoted prices. They also provide funding for the trades which consumes balance sheet capacity (the risk-bearing capacity of the sell-side relative to the scale of the buy-side which I have argued is the right pricing kernel in intermediary asset pricing). Noise traders are needed to close the model. More on them later.

Balance sheet capacity is a joint function of the relative ease of funding in the wholesale funding market on the one hand and the market clearing price of risk in the over-the-counter derivatives market on the other. When the price of risk is low (ie when asset valuations are high) more funding can be secured against the same collateral than when the price of risk is high (ie asset valuations are low). This generates a dangerous feedback loop between the market price of risk and the ease of funding.

To be sure, default-remote bonds serve as collateral in the rapidly spinning rehypothecation flywheel because the stability of the flywheel requires the absence of default risk. The proximate cause of the GFC was the fateful introduction of private-label RMBS into the flywheel. And it was the great sucking sound of the wholesale funding market that generated the housing finance boom. Once debt burdens triggered a massive wave of defaults and credit risk reached the flywheel it tottered and shrank, but continued to spin rapidly in its shrunken state on public collateral. But the crunch of the wholesale funding market generated a massive seizure in the machine of global credit creation, sending a massive shockwave that propagated worldwide. Only those with autonomous financial systems insulated by thick regulatory firewalls and those too remote to have been penetrated by global finance managed to come out in one piece.

In the aftermath of the GFC, an intrusive enforcement regime of limits on bank leverage, balance sheet surveillance, risk-assessment, and other regs have reduced the elasticity of dealer balance sheets. The sharply reduced risk-bearing capacity of the system is reflected in breakdown of the iron law of covered interest-rate parity, volatility spikes, and the risk on-risk off behavior of asset prices. Due to the upper bound on the leverage of global banks, the ease of funding has become a function of US monetary policy with the result that the strength of the dollar has emerged as a barometer of the price of balance sheets. Indeed, the strength of the dollar is now priced in the cross-section of US stock returns.

With the dealers pinned down, fluctuations in the market price of risk can be expected to driven by developments on the buy side. Investment strategies of large asset managers are variations on a small number of themes. Big institutional investors like pension funds and insurance companies (‘real money investors’ in the finance jargon) are bound by regulation and governed by similar investment philosophies to maintain asset allocations in certain definite proportions, which requires periodic and tactical rebalancing of their portfolios. When strategists speak of rotation in and out of asset classes, it is these real money investors that they usually have in mind. Also on the buy side are less constrained hedge funds who make up for their smaller size ($3 trillion AUM in the aggregate) by their tactical agility and willingness to make lots of leveraged bets funded by the dealers. Somewhat between the two are leveraged bond portfolios like Pimco who are interested in holding positions with ‘equity like returns with bond like volatility’ (Bill Gross:”Holy Cow Batman, these bonds can outperform stocks!“). That’s your buyside.

Then we have the noise traders. We can think of them as low information small retail investors, or plainly speaking, the small fry whose herd behavior is driven by sentiment. They kick asset prices away from fundamentals by randomly bidding asset prices too far up or down, thereby generating positive risk premia that are then harvested by the big fish. More generally, the game is subtly rigged towards the house by structural advantages of the dealers. In particular, privileged access to order flow information puts dealers is a position of tactical advantage. Apart from trading for the house, traders at dealer firms share order flow information (and therefore the information premium) with their networks on the buy side in exchange for a larger volume of trades with their attendant commissions. Moreover, since exposure to fluctuations in balance sheet capacity comes with a juicy risk premium, dealers and their counterparties in the market for risk enjoy higher risk-adjusted returns than the small fry even without exploiting order flow information. Furthermore, traders on the sell-side are not beyond generating handsome profits by pumping asset prices up and down or otherwise loading the dice. Although the real scandal is what is perfectly legal.



Stock Market Fluctuations Are Driven by Investor Herd Behavior

FT AlphaVille linked to an interesting blog post by Nick Maggiulli on Dollars and Data that examined the long-run stock return predictability in terms of equity allocations. Nick shows that high allocations predict lower ten-year returns. Here’s a replication of the main result.


The result must be taken with a pinch of salt. Is it a feature or a bug? The cause for concern is that overlapping regressions generate spurious correlations. There is good reason to be skeptical of the extremely high coefficient estimate (r=-0.897, p<0.001). It likely reflects the medium-term cycle in Equity Allocation. (We use the same metric as Nick and in the original blog post at PhilosophicalEconomics.) Econometrically, regression estimates rely on the assumption that the series is stationary (no detectable temporal patterns like trends and cycles) which is manifestly violated here. See next figure.


What is required for kosher statistical inference is to transform the series so that it is at least roughly stationary. The best way to do that is to difference the series. Here we look at changes in the natural logarithm (ie, compounded rate of return) of the SP500 Index and Equity Allocation. The two series are manifestly stationary and appear to be strongly contemporaneously correlated.


Indeed, contemporaneous percentage changes in Equity Allocation strongly predict quarterly returns on the SP500. Our gradient estimate (b=1.25, t-Stat=30.7) implies that 1 percent higher allocation to equities predicts a 1.25 percent quarterly return on the SP500 over and above the unconditional mean of 1.79 percent per quarter. Equity Allocation explains 78 percent of the variation in stock market returns. See next figure.


The empirical evidence is rather consistent with the idea that fluctuations in the stock market reflect investor herd behavior. Specifically, the stock market goes up when investors rebalance to equities and goes down when investors rotate out of equities to bonds and cash. This is not only an important amplifier of dealer risk appetite and monetary policy shocks but also an important source of fluctuations in its own right. So stocks are getting culled across the board as we speak precisely due to investor rebalancing prompted by higher yields. (In turn, higher yields reflect either the expectation that the Fed will hike faster, a higher term risk premium, or both. The two can be disentangled using the ACM term-structure model as I illustrated not too long ago. [P.S. It’s risk premium; although Matt Klein doesn’t seem to buy the ACM decomposition.)

Tying market fluctuations empirically to investor herd behavior goes some way towards explaining the excess volatility of the stock market that has long puzzled economists. My wager is that stock markets fluctuate dramatically more than reassessments of underlying fundamentals could possibly warrant because of fluctuations driven by investor rebalancing.

The question is whether this is due to the herd behavior of small investors, or whether it is due to the inadvertently-coordinated rebalancing among large asset managers because they face similar mandates. If the former, that leads us to questions of investor sentiment. If the latter, it leads us straight back to market structure. In particular, it draws our attention to the buy side. Instead of paying exclusive attention to dealers and wholesale funding markets, perhaps we should also interrogate the investor behavior of large asset managers as an independent source of fluctuations in the price of risk.

In either case, knowing that rebalancing investor herds drive stock market fluctuations is not very useful since data on equity allocation is only available at the end of the quarter. Or is it not? Can we not think of Equity Allocation (hence implicitly investor herd behavior) as a risk factor for pricing the cross-section of stock excess returns? Indeed we can. Turns out, percentage changes in Equity Allocation are priced in the cross-section of expected excess returns. We illustrate this with 100 Size-Value portfolios from Kenneth French’s library.


What we find is that instead of a linear pricing relationship whereby higher betas imply monotonically higher expected returns in excess of the risk-free rate, the relationship is quadratic. Portfolios whose equity allocation betas is moderately high outperform portfolios with extreme betas in both directions. So an easy way to make money is to hold portfolios that are, depending on your risk appetite, long or overweight moderate beta stocks, and short or underweight extreme beta stocks.

Note that stock portfolios that are more sensitive to tidal investor flows are generally more volatile. See next figure.


The big puzzle that thus emerges is why these frontier assets (stock portfolios that are highly sensitive to investor rebalancing) don’t sport high expected returns. For the fundamental insight of modern asset pricing is that risk premia (expected returns in excess of the risk-free rate) exist because investors require compensation to hold systematic risk (but not idiosyncratic risk since that can be easily diversified away). In other words, assets that pose a greater risk to investors’ balance sheets ought to sport higher returns. We have shown that the tidal effect of inadvertently-coordinated investor rebalancing is a significant and systematic risk factor for all investors. So why isn’t there a monotonic relationship between the sensitivity of portfolio returns to investor rebalancing and the risk premium embedded in the cross-section? Why is the price of risk quadratic and not linear in beta? Clearly, we are missing a theoretical piece of the puzzle.



Wage Growth Predicts Productivity Growth

Tip of the hat to Ted Fertik for bringing Servaas Storm’s unpacking of total-factor-productivity growth (TFP) to my attention. Storm shows that TFP can be regarded mechanically as a weighted sum of the growth rates of labor and capital productivity, roughly in a 3:1 ratio in that order. TFP, of course, is a measure of our ignorance. It nudges us to look inside firms, ie the supply side. This leads down the path to situated communities of skilled practice, ie Crawford’s ‘ecologies of attention.’ But perhaps it is better to work directly with labor productivity, certainly if Storm is right. Some say that high wages incentivize firms to invest in labor-saving innovations thereby increasing labor productivity. This is certainly consistent with the standard microeconomics view of firm behavior in that they are expected to do whatever it takes to get a competitive advantage in the market. A straightforward implication of this hypothesis is that real wage growth ought to predict productivity growth. We’ll see what the evidence has to say about this presently. But let us first note the policy implications of the theory.

The fundamental challenge of contemporary Western political economy is how to restore economic dynamism. The first-best solution to the rise to China is for the West to maintain its technical and economic lead. Similarly, the first-best solution to political instability and the crisis of legitimacy is a revival in the underlying pace of economic growth. So far no one has offered a credible solution; Trump’s tariffs, nationalist socialism á la Streeck, restoration of high neoliberalism á la Macron, are all small bore. But if the hypothesis that a significant causal vector points from real wage growth to productivity growth holds, then a bold new Social Democratic solution to the fundamental challenge of Western political economy immediately becomes available.

What I have in mind is a new mandate for central bankers. To wit, Congress should mandate the Federal Reserve to maximize real median wage growth subject to monetary and labor market stability. Until now central banks have targeted labor market slack as understood in terms of employment and inflation. But the real price of labor (more precisely, productivity-adjusted real median wage) is also an excellent measure of labor market slack. The hypothesis implies that targeting productivity-adjusted real median wage growth could restore productivity growth; perhaps dramatically. My suggestion is consistent with social democracy’s concern with distributional questions as well as with standard central banking practice. So if the result holds, it’s very useful indeed.

We start of by checking that real wage growth predicts productivity growth in the United States. The correlation is large and significant (r=0.531, p<0.001). This is suggestive. Wages_productivity.png

In order to systematically investigate this question we interrogate the data from the International Labor Organization (ILO). The ILO provides estimates of real output per worker, unemployment rate, and the growth rate of real wages. We restrict our sample to N=30 industrial countries since wage growth has diverged so significantly between the slow-growing advanced economies and fast-growing developing countries. We estimate a number of linear models and collect our gradient estimates in Table 1.

We begin in the first column that reports estimates for the simple linear model that explains productivity growth by 1-year lagged real wage growth. In the second column, we introduce controls for a temporal trend and lagged productivity growth. This sharply reduces our estimate for the gradient suggesting that the estimate reported in column 1 was inflated due to autocorrelation. We introduce country-fixed effects (ie country dummies) in column 3, which modestly reduces our estimate of the gradient. Instead of country fixed-effects, in the fourth column, we control for the unemployment rate, which turns out to be significant and which very modestly increases our gradient estimate. In the last two columns we introduce random effects for country and year. What this means is that instead of dummies for each country and year which is equivalent to having fixed intercepts by country and year, we admit the possibility that the intercept for a given country and year is random.

Table 1. Linear mixed-effect model estimates.
Intercept Yes Yes Yes Yes No No
Trend No Yes Yes Yes Yes Yes
AR(1) No Yes Yes Yes Yes Yes
Country fixed-effect No No Yes No No Yes
Unemployment Rate (lagged) No No No Yes Yes Yes
Real wage growth (lagged) 0.233 0.136 0.104 0.140 0.108 0.100
standard error 0.037 0.042 0.046 0.042 0.037 0.044
Country random effect No No No No Yes Yes
Year random effect No No No No Yes Yes
Source: ILO. Estimates in bold are significant at the 5 percent level. Dependent variable is real output per worker at market exchange rates. The number of observations is 480. 

We note that the gradient for lagged real wage growth remains significant across our linear models even after controlling for a temporal trend, lagged term for the dependent variable, lagged unemployment rate, country fixed-effects, and random effects for country and year. We can thus be fairly confident that real wage growth predicts productivity growth across the industrial world. The next step would be to embed this in a macro model to interrogate the viability of real median wage growth targeting by central banks.