There is one great positive-sum game in all of human economic history -- trade. But there are periods of time in human history when this core engine of growth and prosperity falters, when it becomes, at best, a zero-sum game of equal winners and equal losers. We are entering one of those times.
Why? Because this is what ALWAYS happens as independent nations struggle with the domestic political consequences of massive debt. Debt begets wealth inequality. Wealth inequality begets political polarization. Political polarization begets shocking electoral outcomes as the median voter theorem fails and shocking market outcomes as the central tendency fails. So go ahead ... ask Nate Silver how well his electoral models are working. Ask any Fed staffer how well their econometric models are working. Democracy is hacked, not in the sense of some Mr. Robot f-society conspiracy, but in the sense of what Sen. Lindsey Graham appropriately calls “bats**t crazy” domestic political behavior, behavior that ALWAYS emerges under these circumstances. It happened in the 1870s. It happened in the 1930s. It's happening today. As George Soros would say, I'm not expecting it. I'm observing it.
Under the strain of domestic policy errors and domestic policy uncertainty (uncertainty in the technical sense of the word, where neither outcomes nor probability distributions can be known), global trade volumes and global trade prices ALWAYS roll over. Again, this happened in the 1870s, it happened in the 1930s, and it's happening today. And when this global economic pie begins to shrink, the strategic interaction between nations inexorably changes from a Cooperative game to a Competitive game (read "The Silver Age of the Central Banker" for more). This is the moment where trade activity -- in goods, services, and capital -- shifts from a positive-sum game to a zero-sum game, where domestic political institutions ALWAYS shift towards protectionist policies. In the modern context, this political shift takes place primarily in monetary policy, specifically monetary policy that impacts currency exchange rates. Why? Because currencies are the linchpin for both trade in goods and trade in capital. Currency intervention is the quickest and most direct way to protect your slice of a smaller and smaller pie, even though it's exactly this currency intervention, when done by everyone, that is making the pie shrink.
I can't emphasize strongly enough how this politically-driven shift in the equilibrium payoffs of global trade and capital flows -- and its expression in monetary policy focused on currency exchange rates -- changes everything for investors.
But I also can't tell you how this all ends up. I know this is a really disappointing statement I'm about to make, but the outcome of most Competitive Games is not predictable. And by "not predictable" I don't mean that there's an equal chance of this or that outcome. I mean that any attachment of any probability distribution to any set of potential outcomes just doesn't work in a predictive sense. Or if it does work, then it worked by pure luck. For example, there are two equilibrium outcomes in a game of Chicken, but that doesn't mean that each equilibrium is equally likely. It means that the entire concept of likelihood or probability functions has no meaning here (read "Inherent Vice" for more). It means that the entire econometric toolkit is about as useful as a socket wrench kit is useful in baking a cake. Again, I know how hard it is to wrap one's head around this fact, and I know that many readers will just reject it out of hand. But it's still true.
So I can't tell you what the ultimate outcome of this Competitive Game between nations will be. But I can tell you what the process of this game will be. I can tell you what the dynamic of this game will be. I can give you a perspective that works for the times we're in, and I can identify specific asymmetric risk/reward set-ups (but call them by their proper name -- trades -- not "investments"). That's the most that is possible here, and I think anyone who says otherwise is mistaking luck for skill.
What is the dynamic of the Competitive Game of nations here in 2016? Specifically, what's next? I think I can sum up my views in two pictures.
First, here's a group shot from the G-20 meeting that just concluded in Shanghai. There's Christine Lagarde of the IMF on the left, the belle of the ball ... and then there's Janet Yellen on the right, looking about as uncomfortable as it's possible for a human to look.
Frankly, as an American ... and as someone who recognizes that the nature of the international game has changed from Cooperation to Competition ... I'm pleased that Yellen isn't all buddy-buddy with her fellow conferees. That's no slight on Lagarde -- her institution is intentionally designed to promote the Cooperation game, she offers carrots rather than swings a big stick, and it makes perfect sense that anyone who runs the IMF would be highly charismatic and the life of the party (true for her predecessor, DSK, too, although maybe he was too much the life of the party ... just sayin'). Yellen, on the other hand, has no institutional mandate for international cooperation and swings the meanest stick, by far, in the global economy. Yellen is the big stack, to use a poker playing analogy (poker being a zero-sum game, of course), and short of wearing a hoodie and mirrored shades to convey intimidation and an intentional separation from the crowd -- an effective big stack strategy, by the way -- I can't think of more effective game-playing body language than Yellen displays here.
So what's next for this high-stakes poker game? A series of raises (in the poker sense!) from Europe and Japan, with the US calling and checking down every step of the way, until ultimately China goes all-in by floating the yuan or otherwise sharply devaluing their currency. Less metaphorically, that means I expect the ECB to lower its negative interest rates significantly this week, and the Bank of Japan will do ... something ... of similar or greater magnitude later in March. The US will be dragged from its current tightening bias to a neutral bias (maybe as early as the March meeting, but probably not), and then to an easing bias, and then to actual easing. But the US won't be initiating any of these moves, they will be responding to the actions of the ECB and the BOJ.