Weaponizing Global Depression

Today, I’m going to talk about weaponizing global depression. That’s right, global depression can be weaponized. The key to this dynamic is the asymmetries built into the global economy.

One important asymmetry is energy, with exporting (producer) nations on one end and importing (consumer) nations on the other. A very small number of nations/regions occupy the middle: they export or import relatively little energy, as they are largely self-sufficient and can make do with what they produce themselves. They aren’t reliant on exports for income or imports to keep their economy from collapsing.

Another key asymmetry is currencies and bond markets which are one integrated system: currencies are valued by the liquidity, depth, risk premium and yield of the bonds denominated in the currency.

A lot of people have a lot of opinions about currencies, and unfortunately many of these opinions are detached from the basic reality that currencies and bond markets are one system.

If a currency and its bonds don’t trade freely on the global market, i.e. they’re pegged to another currency (RMB to the USD for example) or capital controls limit the liquidity and depth of the market for the bonds, this places intrinsic constraints on the risk characteristics and thus the value of the currency and the bonds.

If the risk is high (or difficult to measure), demand for the bonds and currency will be limited. The issuing nation/central bank will be constrained in how much new currency/bonds it can issue without pushing the value off a cliff.

In other words, currencies and the bonds backing them have asymmetric risk premiums, liquidity and valuations. For players in size, for example sovereign investment funds, illiquid bonds are risky because when it comes time to dump their $10 billion stake, the market is bidless: there are no buyers in that size at any price.

Risk is tricky. It tends to become visible only after it’s too late. Yes, there are hedges, blah-blah-blah, but at size there are no hedges.

Asymmetries 

A range of asymmetries arise between exporters of energy and consumers of energy in a global depression. Once demand for goods and services falls off a cliff, demand for the energy to generate those goods and services also falls off a cliff. As marginal demand is swept away, marginal enterprises, loans and employment are also swept away.

Far fewer people can afford to jet around the world and frequent restaurants, so demand for jet fuel, etc. also plummets.

Energy consumers aren’t concerned with the cost of producing energy: that’s your problem. As the price of oil/natural gas drops below production costs, consumers are cheering. (Recall that price is set on the margins: if demand falls faster than production, price collapses.)

Producers care very deeply about the cost of production and the price of the energy they export. Energy exporters are still bound by the commodity curse: it’s so easy to make money selling energy, and so hard to compete in the global economy for other means of production, and so the producers depend on selling energy for a consequential share of the national income.

The exporters have no substitute for the share of their national income derived from exporting energy.

Currencies and Bonds

The asymmetry in currencies and bonds plays out in the consumer nations. The few nations that can issue new currency and bonds without destroying the purchasing power of the currency can issue whatever currency they need to fund social welfare for those who lost their jobs.

Yes, fewer people can afford pricy air travel, vacations and eating out, but they’ll make do with preparing food at home and much cheaper forms of amusement.

Those nations that can’t print more currency without destroying its purchasing power don’t have this luxury. Belt-tightening is all well and good until a “nothing left to lose” revolution sweeps away the ruling elite.

The producer nations dependent on energy exports have an equally difficult set of constraints. They can try to cut production to match plummeting demand, but game theory strongly favors cheaters who announce production cuts but pump as much as they can to maximize revenues as the price of energy drops.

Most energy exporters have built up savings in the form of central bank reserves and sovereign wealth funds, but they now discover another asymmetry in global depressions: the value of their stocks and bonds has plummeted, and even precious metal prices are dropping as everyone is forced to liquidate savings to fund the exporters’ insanely high social welfare / military expenditures.

Why would bonds lose value? As the demand for buyers of newly issued bonds explodes higher (to fund deficit spending), bond yields rise globally as nations compete for the dwindling pool of capital willing to buy potentially risky bonds. As bond yields rise, the value of all existing bonds tumbles off the cliff.

So not only could energy revenues fall by half or more, the value of reserves could also fall dramatically. Nations dependent on energy exports will face a one-two punch with no viable Plan B to replace energy revenues with revenues from some other source.

It Works Until It Doesn’t

Energy producers can cut production but they’ll still be selling fewer units for far less money. Energy prices below production costs are “impossible” until there’s competition for declining consumer demand. The frictionless pathway is to slash prices to maintain national income, and sell off the reserves and sovereign wealth fund assets to fund social welfare and military budgets.

This works for a while, but not for long. A global depression isn’t just deeper than a recession, it’s longer. Depressions occur when all the policy gimmicks reach diminishing returns and they fail to restore “growth” in credit and consumption. Eventually the energy exporters have to cut their government spending, and that will inevitably trigger social and political disorder.

Their difficulties are painfully visible to all, and the demand for any bonds they issue will be low due to the risk that the national enterprise is spending far more than it’s bringing in and therefore could go bankrupt.

Add up these asymmetries and we find a very few winners and many losers. The winners are limited to those nations with these five capacities:

1. Self-sufficiency in energy, or close enough to manage with modest imports from friendly neighbors or allies.

2. Not dependent on energy revenues for the bulk of national income.

3. The capacity to sell newly issued bonds without reducing the purchasing power of the currency, i.e. the risk premium and yield are more attractive than competing issuances of bonds.

4. Maintain a freely traded (i.e. price and risk discovered by the market), liquid market in size for its bonds.

5. A diverse, adaptable economy that maintains deep, liquid, transparent markets for goods, services, risk, credit, bonds and other financial assets.

Weaponize Global Depression 

Systems are defined by their constraints. Should oil fall to $40/barrel and stay there due to declining demand, various constraints start limiting policy options. If savings are depleted to maintain the illusion of solvency,’ various constraints start limiting policy options. If there’s no demand for newly issued currencies / bonds, various constraints start limiting policy options.

Messy realities tend to generate the illusion that an array of policy options still exist, but eventually these will be pared away by the systemic asymmetries and constraints. Dancing the humba-humba around the campfire (such fun!) and spewing propaganda (if you’d just agree with me, everything will be fine!) won’t change anything.

The most diverse, adaptive economies with the largest and most transparent markets and the most balanced energy production and consumption will be the winners, and every other nation will struggle due to the constraints and asymmetries described above. It’s just the way systems function.

All this suggests a strategy that’s only available to those few nations with all five capacities: weaponize global depression by jacking up bond yields and tightening credit so the increasingly fragile global economy slips off the cliff into a recession that quickly becomes entrenched in depression by decades of policy extremes that are finally generating unintended consequences that cannot be reversed.

The ensuing global depression will be bearable for those with the five capacities, and a system-breaker for everyone else.

It’s nothing personal, it’s just business. Systemic asymmetries and constraints present opportunities for the few and risks for the many.

I’m not claiming weaponize global depression is inevitable or even likely. What I am exploring is the potential for global depression to be weaponized as a policy option or as an unintended consequence of actions that stretch asymmetries and constraints to the breaking point.

Where does that leave us as individuals and households? It’s best to take the long, emotionally detached view and and devote ourselves to maximizing our own self-reliance.

The less we depend on high debt, high consumption and fragile global systems, the better off we’ll be.