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Ancient Greece’s Red Flags for Modern China

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Ancient Greece holds lesson for the trade wars today. Photographer: Paris Papaioannou/AFP


Ancient Greece’s Red Flags for Modern China

The current conflict between the U.S. and China is not unlike when Athens challenged Sparta’s dominance. Also, a book club update and Boris Johnson…


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Ancient Greek historians bearing gifts.

Where is the ever-more-fraught relationship between China and the U.S. headed? That is perhaps the central question in this month’s Authers’ Notes Bloomberg book club selection, “Red Flags” by George Magnus, which we will be discussing live on the Bloomberg terminal with the author on Thursday. More on that later. But for now, I want to address one of the biggest problems in analyzing the clash, which is that there aren’t many historical precedents, and none that are perfect.

As people look for clues about how the conflict between the world’s dominant power and a second power on course to overtake it will be resolved, all periods of history become relevant. And that, in turn, explains renewed interest in the ancient Greeks. Not just academics but even Wall Street strategists are churning out research based on the war between Athens and Sparta, and the lessons of Herodotus, Thucydides and the rest.

First, we had the invocation of the Thucydides trap by Graham Allison, a professor at Harvard, in his 2017 book “Destined for War: Can China and America Escape Thucydides’ Trap?.” The trap in question is that when an established hegemonic power is threatened by a rising power, war is almost impossible to avoid, with disastrous results for both. This is what happened when Sparta’s dominance of Greece was threatened by the rise of Athens, leading to the war which Thucydides chronicled.

It certainly looks like we have a Thucydides situation now. U.S. takes on the part of Sparta and China the part of Athens. The following chart is from BCA Research, and shows China fast gaining on the U.S. in geopolitical power, in military expenditures, and in spending on research and development:

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In case this shows up too small on your screen, here is the first chart, covering the geopolitical power index, which BCA measured by taking a country’s population, the size of its economy and its imports, military expenditures, arms exports and primary energy consumption. China may still be a long way behind the U.S. and Western Europe in terms of GDP per capita, but in terms of raw power this calculation shows it rapidly closing the gap:

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So a Thucydides trap leads to war, ceteris paribus (all else equal). But — and this bedevils economists in all their endeavors — not all things are equal. In a fascinating paper, BCA geopolitical analyst Matt Gertken points out that nations change when they fall into the trap in that they become more united. As an example, look at this measure of bipartisanship in U.S. Congress. Polarization virtually disappeared during World War II and the Cold War as everyone stayed focused on a common enemy. Since the end of the Cold War, though, partisanship has shot to unprecedented levels:

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Provoking a war to unite an otherwise fractious people behind you, or to distract attention from other problems, is a well-established Machiavellian move. Just watch the classic 1998 movie “Wag the Dog.” But polarization in the U.S. is not just about the absence of war. It is also about growing inequality. When people feel others are unfairly doing better than they are, political anger and polarization will rise. And as we can see, polarization and inequality have risen hand in hand:

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This raises the worrying possibility to me that if you are a leader sitting on an inequality problem, which you cannot see a way to solve in a hurry, then going to war becomes far more attractive. Further, if we take a look at China’s record on inequality we can see that both the nations in the Thucydides trap have an inequality issue that is pushing them toward war. In this chart from BCA, inequality on the horizontal scale is mapped against social mobility, or the chance of moving up in income, on the other scale. The two are naturally linked — the more equal a country, the easier it is for any increase in wealth to raise you up a level. But the performance of the U.S. and China is extraordinary:

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The U.S. is a more unequal country than China, but only just. It is far more unequal than either Italy or the U.K., but it does have slightly greater social mobility than either of those class-ridden societies, which is not surprising. Extraordinarily, China’s social mobility is far worse. An avowedly communist country has somehow enshrined a lack of social mobility. So this implies that Xi Jinping, possibly even more than Donald Trump, has something to gain at home from amping up the conflict against an agreed-upon common enemy. The U.S. can now become a convenient villain to blame, because of its iniquitous trade policies — a tactic taken straight out of the successful Fidel Castro playbook in Cuba.

Partisan furies in the U.S. are strong, as this graphic by Gertken makes clear. Pushing them higher is tempting. As amping up tensions with China would both inflame the president’s core constituency while also tending to increase the chance that all will band behind him, this has to be a very attractive option for Xi:

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Gertken suggests that there may be something positive to be drawn from this for the American polity:

If the White House, any White House, were to pursue a consistent strategy to contain China, the result would be a major escalation of the trade conflict that would bring Americans together in the face of a common enemy. It would also encourage the U.S. to form alliances in pursuit of this objective.

All of this would be a natural corollary of the Thucydides trap. Meanwhile, if China is caught in the trap, then:

[W]estern pressure on China’s economy will force China into a destabilizing economic transition. China could lie low and avoid conflict in order to undertake reforms, or it could amplify its aggressive foreign policy.

This, BCA warns, is where the risk of armed conflict rises.

More interestingly still, BCA invokes another Greek historian who came after Herodotus and Thucydides: Polybius. Lesser known these days than his predecessors, Polybius was around to witness another great power dynamic work itself out, as Rome came to supplant Athens. And his explanation for how this happened had everything to do with internal politics, which should in turn have great interest for both Trump and Xi. You can read an interesting summary of his work here. As far as we know, he looked like this:

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Polybius’ big idea was that it was countries’ internal modes of organization that determined their success in power competitions. He divided a nation into the One (the monarch), the Few (the nobles), and the Many (the commons), and anticipated that these would take over in turns as “A dictator would die; a group of elites would take over; this oligarchy would devolve into democracy or mob-rule; and from the chaos would spring a new dictator.” His big idea was that it should be possible to maintain a mixture or balance between the three powers. The Roman republic did this in the era during which it rose to preeminence. With such a system, “The natural cycle of growth and decay could be short-circuited, enabling a regime to live much longer than its peers.” This is the process as graphed by BCA:

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The relevance of these ideas for the philosophy that was adopted by the founders of the U.S. is obvious. Polybius thought that countries could be far more powerful in the long run if they had effective institutional checks and balances. Arguably the apparatus of the postwar Pax Americana — the U.N., the Bretton Woods institutions, the European Union and so on — is another attempt to embody some kind of balance and fairness in institutions, and allow for a long period without damaging conflicts.

As for the long-term cause of governments’ downfall, Polybius blamed “wealth, inequality, and corruption,” which he said naturally followed from good times. That sounds a little reminiscent to the modern ears of Hyman Minsky. As the masses watch the rich grow richer, we move into a vicious cycle of conflict. This is BCA’s parallel with present-day America:

Just as Rome grew fat with its winnings from the Punic Wars and decayed from a virtuous republic into a luxurious empire, as Polybius foresaw, so the United States lurched from victory over the Soviet Union to internal division and unforced errors. For instance, the budget surplus of 2% of GDP in the year 2000 became a budget deficit of 9% of GDP after a decade of gratuitous wars, profligate social spending and tax cuts, and financial excesses. It is on track to balloon again when the next recession hits — and this is true even without any historic crisis event to justify it.

Meanwhile, Xi’s China, as George Magnus’s book makes clear, is also having great difficulty maintaining a very different but effective form of constitutional balance that has worked for several decades. Polybius in short, I think it is fair to say, builds on his Greek predecessors to suggest that the current situation is even more perilous than it at first appears. There may be a way out, but it requires leaders to take exactly the opposite path in their domestic affairs than the one on which both Xi and Trump are currently embarked. And for an investment read-through from all of this, BCA suggests that we should be interested in “risk-off” assets such as gold. That seems logical, if not terrifying.

“Red Flags” review: Diana Choyleva.

Let us do more to prepare for the “Red Flags” discussion on Thursday. I asked some China experts to submit their own reviews. What follows are some thoughts by Diana Choyleva, a veteran of Lombard Street Research in London, who now runs her own consultancy, Enodo Economics. It specializes in making deep dives on the Chinese economy. She has made some fascinating points that I suspect will come up on Thursday.

Choyleva argues that Magnus is right that China needs to change its economic model, and that the leadership knows this. She also points out that China has shown itself to be very resilient in the face of shocks:

China has experienced many periods of extreme economic turbulence in the 40 years since Deng Xiaoping ushered in the era of reform and opening up. To name a few: the layoff of tens of millions of workers in the mid-1990s when swathes of state-owned enterprises were shut down; the Asian Financial Crisis; the recapitalisation of a bankrupt banking system; SARS; and the fallout of the Global Financial Crisis. Overcoming any of these episodes would have defeated lesser policymakers. Yet in each case not only did China survive, it continued to thrive.

However, she now considers herself more pessimistic about China that at any point in the 20 years she has been analyzing the country. Her reasons cover the problems raised by Greek history; Xi is trying to harden ideology just as it comes into a conflict with the U.S. That, in turn, will make it far harder for the usual Chinese solution of credit-fueled, investment-led stimulus to work.

In the chapter on rebalancing and reform, George is right to focus on the need for China to consume more and save and invest less. Indeed, the trend is well-established: China’s current account surplus has all but disappeared over the past decade.

George writes, “The main reason for the fall in China’s current account surplus, therefore, was the surge in domestic investment that started in 2007 and 2008, coinciding with the Western financial crisis.”

True, despite an already exorbitant investment rate during the financial crisis, Beijing’s knee-jerk response at the time was an investment-led spending spree that pushed the rate to even more stratospheric heights.

But by 2011 the story had changed, as I argued in the book I co-authored that year, “The American Phoenix: Why China and Europe Will Struggle After the Coming Slump.” The financial crisis had dealt a mortal blow to China’s export- and investment-led model.

I made the case that the workout of the global financial imbalances was going to be prolonged and weigh on global growth for years. As for China, its ability to grab export market share was impaired by an increase in its real exchange rate. Because much less export income was flooding in, Beijing could no longer throw money at unproductive investment without debt as a share of GDP rising fast.

With the external demand shock undermining the sustainability of its development model, I argued that China’s potential growth rate could well halve to 5% during this decade. Sure enough, the nominal investment rate peaked in 2011 and fell continuously until 2017.

Thus, Choyleva argues for putting more weight on China’s domestic savings rate than Magnus does. Savings have long been excessive, but are now declining due to two forces, one good and one bad:

Let’s start with the corporate sector. In the aftermath of the crisis, the business savings rate plunged as China’s export sector flagged, hitting company revenues. The rate rebounded in 2012-2014 but has since stopped in its tracks as China’s firms struggle to find their footing.

Unfortunately, data in China on sectoral financial balances are published with a long lag — the latest available figures are for 2016. But the close correlation between EBITDA, as gleaned from industrial profits data, and the gross operating surplus of non-financial firms implies that corporate savings are likely to have tumbled again in the past couple of years.

Dwindling margins and a worsening external environment are likely to keep depressing corporate earnings, suggesting a continued decline in the business savings rate.

Meanwhile, the decline in China’s household savings rate that started in 2010 has been a positive force. With Beijing intent on rebalancing the economy towards consumer spending, a range of structural policy changes have led to a continuous fall in the household savings rate.

These reforms include strengthening the social security safety net; expanded medical care and pension provision; and, more recently and importantly, unlocking untapped spending potential in rural areas. I would have put more stress on what Beijing has already achieved in these areas than George does. Also, while Beijing may not have necessarily followed Western reform prescriptions, it’s nonetheless important to note its success in bringing down the household savings rate.

However, the outlook is not clear-cut. Well-off urban households are likely to have ramped up their saving in 2018 and are set to do so again this year. Xi’s economic policies are sapping their wealth and income — not to mention their confidence — with no respite in sight, while fiscal support is aimed at lower-income urban and rural households. Rural dissaving should offset some of the increase, but the overall household savings rate is more likely to have risen last year and to continue to climb in 2019.

Meanwhile, the government’s savings rate has, of course, fallen as officials have done their best to offset problems elsewhere in the economy. It is hard to see how this can change — so the domestic savings rate will likely fall, as the investment rate begins to creep higher.

Weaker output growth is likely to trump the leadership’s desire to stick to the major supply-side transformation they started in earnest in 2015. They will most likely continue to pursue structural change but undo some of the good work reining in the relentless increase in debt to GDP by resorting to more sizable stimulus through credit-fueled investment spending as 2019 unfolds.

Beijing is unlikely to be able to achieve, or want to achieve for that matter, a repeat of the massive monetary injection of 2009-’10. Even so, the gap between what China saves domestically and what it needs for its investment is likely to widen.

As George notes, China’s rebalancing is complex and difficult to pull off. If China does indeed turn into an international borrower, despite its still vast domestic savings rate, attracting capital could be a tall order.

That leads to the kind of outcome that we have all been thinking about, or what Choyleva describes as the “ultimate red flag.” A current-account deficit that drags on amid economic weakness as the economy painfully de-levers could at last be the catalyst for upending the current order. To avert this, Xi will need to boost productivity somehow, and he will not be greatly interested in Western liberal thinking as he goes about doing so.

Fundamentally, it seems to me, Choyleva’s view is similar to that of Magnus — or possibly even to those of the ancient Greek historians. China is facing something like a trap. Escaping it is not impossible, but will be difficult. She, like Magnus, is right to wave red flags.

All further thoughts over the next 24 hours would be greatly welcomed as we prepare for the chat on the Bloomberg terminal.

Reading assignments.

Now for some details. We will be holding the discussion on the live blog (just go to TLIV on the Bloomberg terminal) starting at 3 p.m. in London and 10 a.m. in New York. All terminal users can ask questions via the IB chat room that we have set up for Authers’ Notes, for which many of you now have access. If you do not have access to the terminal, you can still send in questions to the book club email address: [email protected]. A transcript will be available later. I will try to spend as much time as I can in the IB room Wednesday to build up the discussion.

This will be our first tri-continental terminal chat. I will be taking part from my bedroom in New York. (To all those who have asked, thank you for your concern; my recovery from hip surgery last week is going well but it still keeps me away from the office.) George Magnus will be in our London office, and Shuli Ren, Bloomberg Opinion’s brilliant columnist on Asian markets, will be sitting at a terminal in Hong Kong. We will be chatting for 90 minutes. The more questions you fire at us, the better it should be.

Finally, there is the issue of what book to read during the month of August. I asked for easy reading suggestions last week, before I went into hospital, and the most interesting idea for a financial novel was “Lake Success” by Gary Shteyngart, a novel about a hedge fund manager who has a midlife crisis and sets off across the country in a bus. I have started on “A Conspiracy of Paper” by David Liss, about murder and stock fraud in the City of London at the time of the South Sea Bubble, and I am enjoying it so far. Also worthy of discussion is “The Fear Index,” Robert Harris’s suspension-of-disbelief thriller about a hedge fund manager whose algorithm takes on a life of its own and starts plotting murders.

As for readable nonfiction, “When Genius Failed,” Roger Lowenstein’s brilliant, novelistic account of the Long-Term Capital Management disaster, is hugely popular. It might even have overtaken “Barbarians at the Gate” as the most popular financial narrative yet written.

It is a great book, but I had not thought in terms of offering it as a book club selection because so many people have read it already. That said, it frames our perceptions of an event that was in many ways a dry run for the Lehman Brothers disaster a decade later. Maybe it is time to revise our opinion on whether Lowenstein really got it right. If you feel like rereading “When Genius Failed” for the end of summer, let me know. Otherwise, I’ll recommend one of the novels. I still have quite a while off my feet to catch up on my reading.

Le Carré on Johnson.

Finally, a note on the change of power in the U.K. We now know that the next U.K. prime minister will be Boris Johnson, a college contemporary of mine, and a bizarre figure who presents himself like a character out of P.G. Wodehouse. But he could he be like a character from the great spy novelist John Le Carré, who is presenting a fake facade to the world? That is possible.

Educated at Eton and then Oxford, Johnson represents a return to Britain’s classic ruling class. And in the novel I just finished reading, “The Secret Pilgrim,” Le Carré’s great spymaster George Smiley tells recruits about such people:

The privately educated Englishman — and Englishwoman, if you will allow me — is the greatest dissembler on earth. Was, is now and ever shall be for as long as our disgraceful school system remains intact. Nobody will charm you so glibly, disguise his feelings from you better, cover his tracks more skillfully or find it harder to confess to you that he’s been a damned fool. Nobody acts braver when he’s frightened stiff, or happier when he’s miserable; nobody can flatter you better when he hates you than your extrovert Englishman or woman of the supposedly privileged classes. He can have a Force Twelve nervous breakdown while he stands next to you in the bus queue, and you may be his best friend, but you’ll never be the wiser.

The Johnson premiership will be a fascinating one, and frustrating to analyze as the U.K. will be led by “the greatest dissembler on earth.” I am looking forward to his challenge in due course, but I need to get a bit better first. For the time being I will continue preparing for the task by reading spy novels by the likes of John Le Carré.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.


To contact the author of this story:
John Authers at [email protected]

To contact the editor responsible for this story:
Robert Burgess at [email protected]

https://www.bloomberg.com/opinion/articles/2019-07-24/ancient-greece-s-red-flags-for-modern-china-jygq0jk6

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