Friedman: Why there is no such thing as black swans
Coverage of the 2013 Global Investment Conference
BY Scot Blythe | May 9, 2013
In the world of finance, black swans are supposed to be rare events, but in world politics, they are far more frequent, says George Friedman, founder of the global intelligence firm Stratfor. However, that doesn’t mean they can’t also be predicted, he told delegates at the 2013 Global Investment Conference which was held in Whistler, B.C. in April.
“We live in a very strange period,” Friedman said. “Between 1991 and 2008, we all thought that geopolitics had been abolished, that the only thing that mattered was the market — and that the truth will set you free and make you rich. That was a complete aberration.”
During the 20th century, Friedman noted that the U.S. spent 17% of its time fighting full-scale wars, not counting such things as the Cold War or the Cuban missile crisis. In the new century, however, the U.S. has spent just under 10% of its time fighting other wars.
What does that mean for investors? “The financial markets seemed to take this two ways,” he told delegates. “First, there’s the error of thinking that these things don’t happen all the time. War has been the fabric of human existence: the other side of economics. Second is that it’s not unpredictable. There’s a belief in financial markets that if it’s not quantifiable, it not predictable.” If geopolitics is not quantifiable, it is understandable, if you have a theory on the constraints of what’s going to happen.
Misunderstanding North Korea
Take North Korea for example. “If we were to watch market commentators, we’re on the edge of destruction,” he said. In reality, Friedman says North Korea has limited options. To guarantee regime survival, it has to appear fearsome, and it does so by “exploding weapons underground.” But it does not have a missile capable of delivering a nuclear warhead. The second issue is that Korea is facing a massive food crisis that will, given time, cause the country to collapse. So the North Koreans act as if they are crazy, said Friedman: “ if you’ve played poker you know that you want to be the one no one can predict.” In that way, they’ve managed to get the U.S., Japan, Russia and South Korea to the negotiating table.
For investors, however, misunderstanding the Korean situation, Friedman argues, is akin to making an investment based on a press release. You understand fully that in the financial markets, a press release is just a press release,” he says. “Yet, when a politician makes a crazed announcement, you take it seriously.” Investors’ reactions to those announcements moves markets, even though the actual threat is not all that dire.
North Korea is not an outlier event, Friedman notes – in fact, it happens all the time. “There’s constantly something like this going on … financial markets are part of a system. They are a subsystem that includes political, military, financial and economic considerations.” But markets often fail to notice that and when they do, “it results in a massive, and in my view, humorous, overreaction.”
Europe perhaps illustrates this best.”[T]he Europeans announce that we have solved the problem of Europe. We had a meeting and we all shook hands and the deputy assistant minister of something assures it. The markets see that and say it’s over. Things don’t happen that easily.”
In fact, the European Union was built on two considerations: binding France and Germany together to ensure peace after two catastrophic wars, and ensuring prosperity. For almost 20 years, the Maastricht Treaty made Europe tremendously prosperous. Until the 2008 mortgage defaults in the U.S..
The U.S., having been through financial crises before – New York City’s financial crisis in the 1970s, the third-world debt crisis of the early 1980s, the Savings and Loans crisis of the late 1990s and the subprime crisis of 2008 – acted like an 800-pound gorilla, Friedman says, wincing after being whacked by a 2 X 4, but moved on. Europe, by contrast, was “smashed.” In this, Friedman concludes that size matters, although it is little acknowledged. “The Federal government bails out [the banks] the banks take the money and then condemns the Federal government for irresponsible behaviour. I love it. It’s an American opera.”
But not so in Europe. That’s because the European project, peace and prosperity aside, was based on a fundamental irrationality: Germany. It’s economy depends on exports, mostly to Europe. But there’s also the geopolitical background. Germans fear a return to the 1920s: “recession, which leads to unemployment and social instability.”
The trouble with Germany
In the process, however, what Germany has done is export unemployment to the rest of Europe, maintaining a low 5.6% rate of joblessness itself against a European average of 11%. Germany has an industrial base that is far higher than its consumption base, Friedman says.
That sets up a clash between France and Germany, over stimulus measures. France wants less unemployment. Germany fears inflation. And smaller nations, such as Cyprus, are sacrificed.
But in this is the seed of the Maastricht Agreement’s undoing, and in two ways. First, although the headline news was about Russian deposits in Cyprus, the majority were from Cypriot corporations. With banks deposits above $100,000 taxed or frozen,, the tourism industry suffers, since the hotels can’t pay their employees full salary and the employees may default on their mortgages, many owned by Italian banks. But Germany can’t bail out Italy.
So a second consequence is the rise of social movements, as in the 1920s, garbed in nationalism. “When you move into a room talking about Europe, you are no longer a European anymore. You are the French talking to the Germans, you are the Greeks talking to the Italians. The nation-state is very much back,” says Friedman.
And could become stronger, as states rebel against European Central Bank directives that essentially decimate the middle classes.
China in decline
So among the three pillars of the post-Cold War global architecture, one is bloodied but surviving and a second is on the ropes. The third pillar of the post-Cold War era, China, is facing a Japan-like decline. Like Japan, it was a low-wage, high-growth economy. “Japan had been the low-wage, high growth economy in the 1980s, but as it matured the costs of labour rose and the profit margins on exports declined. The government came in to make loans to subsidize the banks to make loans to companies that really weren’t making much money.”
So the banks had lots of non-performing loans, but needed to keep lending to keep the economy alive. Why? “Unemployment around the word is now more important than sovereign debt, rates of return on capital or anything else because unemployment can bring regimes crashing down,” says Friedman.
But there’s another parallel between Japan and China. Many thought it “stupid” for Japanese firms to buy New York City’s Rockefeller Center in the late 1980s. But some Japanese outsiders wanted out of the Japanese economy in order to protect their wealth. Now the Chinese are doing the same. “They’re looking for apartments, condos, houses, companies and dirt – whatever you have – just so long as it’s not where it was,” Friedman explained.
That’s one reason why U.S. stock markets have perked up. Europeans are moving money out of Europe, at least in part thanks to the Cyprus precedent – a country “too small to worry about,” according to Friedman. The Chinese are moving money out of China and into to the next growth hot spots, countries in Latin America, Africa and Southeast Asia where low-wage, low-technology garment work seems to offer a path that could emulate China’s own growth.
In the meantime, Friedman looked to the future and asked the audience, “What happens next? The United States, big, dumb and ugly, comes through again, not because it should, but because ‘what the hell here we go again.’” As it nears energy independence, factories are moving back. And it’s regarded as a safe haven for investments,” he said.
As for explosive, Chinese-style growth? Well, there could be a budding textile factory in Uganda.