Interest Rates, The Queen, The Dark Empire and the Rise of the Eastern Alliance
2022 is like 1989. Why are the interest rates rising?
There Is Something Strange About 2022
Historic moves are like tectonic plates cracking under pressure. Everything in between these events are just life moving along interrupted by intermittent crises that come and go without causing too much trouble to the status quo.
This year, however, we are witnessing historic changes in real time. We usually don’t read well where these changes lead to. Here are two quotes from Peter Ackroyd’s “The History of England, Vol VI” describing the public mood and the expectations when WWI started:
On 3 August 1914, Germany declared war on France. […] The [British] government now believed it had little choice but to confront the country that Britain had identified as the greatest threat of her security and prosperity. Germany had to be stoped.
The government’s declaration was made in the confidence the war would be over in a matter of weeks, an optimism shared by the belligerents.
And:
When the newspaper boys announced that ware had been declared, people rushed out of shops and houses to cheer.
You could replace “Britain” with “Russia” in the first paragraph to describe the euphoric optimism that Putin and his entourage must have had when he invaded Ukraine. In both cases a hellish reality followed.
The overall idea is though, that big transformations manifest in conflicts that do not reveal immediately the actual underlying problems or the ultimate outcome of those conflicts. But when they happen, you start seeing signs of long term changes reflected in measures of risk, allocation of capital, trade relations and alliances.
Rising Interest Rates
Interest rates are rising and falling mainly because of two reasons: economic and historic. Economic cycles are marked by changes in credit conditions. When economic expansion becomes unsustainable capital cost raises to reflect the increased risk. Left to its own devices, the lending market can crash spectacularly as it did in 1929. The lesson learned then was that the Fed must see the risk and raise interest rates early enough to prevent risky lending which develops in overly optimistic markets. 2008 is a good example where excessive lending in a hot housing market led to crisis that unraveled faster than the Fed was able to raise interest rates.
The other main cause of interest rate change is of a historical nature driven by geopolitics and world trade system. By geopolitics, I don’t mean regional conflicts, but changes in the world order, the interruption of the prevalence of well established rules, which in turn affects the world trade patterns. These changes occur continuously, but they have short periods of acceleration which causes large imbalances which are always accompanied by economic instability. These rapid currents have an impact on the interest rates that need to change to reflect the heightened (or lowered) level of risk.
A recent example of such change is the transformation that followed the fall of the Berlin Wall which led to a long expansionary globalisation trend. The end of the Cold War allowed countries to establish different relationships and gradually increase the trade volume on the basis of new, open rules. This translated into a long economic boom and overtime to a reduce risk, as opportunities to conduct productive business were abundant.
We are now on the cusp of a new world order. It is not clear yet how that order will eventually look like, but it is clear that globalisation as we know it has ended. 2022 looks a lot like 1989 in reverse. This change is reflected in the way interest rates have risen around the world: fast and furious. The US02Y rate has increased from under 1% to over 4% in less than a year and it isn’t likely it will return to that low level anytime soon. The technical chart (logarithmic scale) shows clearly the magnitude of that change:
The chart shows that a significant change is underway, a change that is more than just part of a normal economic cycle. What we are seeing is a symptom, a consequence of historic processes that have been triggered by the breaking of diplomatic and trading rules that they are no longer satisfactory for the current status quo.
This does not necessarily mean that the world enters a period of stagnation. It just means that new industries will arise driven by an accelerated pace of innovation needed to overcame these challenges. New leaders will emerge taking the baton from Apple, Microsoft, Google and Facebook to build a new economy suited for the new world order.
Higher interest rates reflect a higher risk caused by uncertainty in a historic transformation. The current ultra-hawkish Fed tone, the “keep at it”, is a bit concerning. Aiming for a low interest rate of 2% within a short time frame may risk causing a deep recession because structural changes of supply cannot be fixed by rising interest rates. I am looking for key strategic initiatives that are designed to stimulate the truly new 21st century industries because that is where the opportunities are and this is where the solutions come from.
Queen Elizabeth II’s passing
Even in our time of distractions and division, Queen Elizabeth II’s passing moved many people around the world. I know it sounds cliche, but many feel this is an end of an era, that the British Monarchy will never be the same. There is sadness and respect, but political actors already use resentment seeded in the past to enact changes today.
The queen managed to transcend turbulent times unscathed, with an extraordinary sense of her role as guardian of the British constitution, and because she ascended to the throne almost a century ago, the monarchy has survived as an institution by benefiting from tradition and a carefully crafted continuity. “Keep calm and carry on” phrase evoking the Victorian era of stability is a fitting description of her reign.
Now, the monarchy is getting a hard reset. Suddenly, the king will be judged using the contemporary norms, or lack of. He will no be sailing on a calm sea, but driving a boat down the river, shaken by furious rapids. Hopefully, he will make it to the calm waters in the plains, to the lake or to the sea. King Charles III is also facing the challenge of holding UK together. So much has changed!
It would be a mistake to overlook the role of UK plays in the world, despite its smaller size when compared with EU, US or China. UK is very influential and it can have a strong and positive influence on how the new world order will shape up.
The Dark Empire
After the stunning advance of Ukraine that resulted in the liberation of most of the Kharkiv Oblast, Russian TV had an abrupt change of tone. Initially, for the first time in a long time critics were allowed to express opinions that normally would attract immediate punishment. Alas, that was just one short moment of “softness”. The aggressive pro-war supporters came back to the fore demanding the destruction of civilian infrastructure, oblivious to the fact that these actions are war crimes.
Among these endless cries for war, I was surprised to see one person raising the prospect of a real, existential threat for Russia. Karen Shakhnazarov (see the tweet below) said that if Russians do not learn from this episode, Russia can suffer defeat and “for us, this defeat may prove fatal”.
This comment may prove to have been prophetic. In the following days, the major powers of Central Asian head of states gathered in Samarkand, Uzbekistan, for the summit of the Shanghai Cooperation Organisation. Tellingly, the body language of those who met Putin as part of a diplomatic display of “friendship” signalled a sharp downgrade of his power of influence.
Moreover, events that occurred in that week put in evidence the loss of power of Russia among the ex-Soviet Union states: the conflict between Azerbaijan and Armenia (Russia would normally send troops to intervene, it didn’t do that now), exchange of fire between Kyrgyzstan and Tajikistan.
The most distressing development for Russia, apart for the disastrous war in Ukraine, must be the obvious expansion of Chinese influence in Central Asia at the cost of the traditional Russian influence. The diplomatic rapprochement between Kazakstan and China (Tokayev, the president of Kazakstan, speaks Chinese and studied in China in his youth) must be unnerving for the Russians.
Accelerating Downfall
The problem with Russia has been the long term accumulation of power in the hands of one person who is surrounded by a tight circle of beneficiaries and “trusted” lieutenants. This power is “too big to fail”, too many are involved in it to let go. Putin will have to escalate his bets to protect that power because he has no alternative.
His dreams, however misconstrued, are ambitious, as he sees himself as a modern Peter the Great, a leader who built a large military power and expanded Russia by annexing territories by force. He is seeing his dream collapsing in slow motion. The loss of Kupyanks and most of the Kharkiv Oblast must have shocked him. Putin responded by rising the ante: start partial mobilisation to recruit and extra 300,000 soldiers. Reports that he actually wants to recruit 1 million, show he will do anything to protect his dream, and ultimately his life.
It is hard to see how escalation can go any further, unless he decides to use tactical nuclear strikes. Now, everyone is touched by this war in Russia and the number of Putin’s enemies are multiplying with each new recruit, with each meter of territory lost to Ukrainian army. Everything moves very fast now and prospect of Russia having to face the consequences of war crimes will make him a too large liability to hold on the country’s moral balance sheet.
Russian’s history of expansion through territorial annexation may enter a reverse cycle, bringing the dark empire (as viewed by its East European neighbours) to its end, the same way the Mongol empire did, as parts of the empire will seek to establish new alliances and economic treaties either with Europe or China. Think Belarus, as an example of a potential candidate.
The Rise of the Eastern Alliance
Why did Xi Jinping go to Kazakstan and Uzbekistan amidst a strict zero covid policy that locked millions of Chinese in their own homes?
The answer lies in the immense strategic opportunity that Russia’s war in Ukraine presented itself to China. This was no a normal state visit, not a Belt and Road Initiative business trip either.
This trip aimed to accomplish two objectives: bring Central Asian countries under the Chinese sphere of influence and strengthen the power of the Shanghai Cooperation Organisation.
The first one has a historical significance that cannot be underestimated. It is not a fluke, not an opportunistic “trade”, although it is an opportunity. The expansion of China’s influence in Central Asia is a continuation of a process that started over a thousand of years ago, and Xi Jinping wants to be the leader who made that happen.
The Emerging SCO vs NATO Rivalry
The Shanghai Cooperation Organisation (SCO) is the response to NATO. Currently, a “cooperation” agreement, the organisation is binding together all continental Asian states that either want to move away from Russia or are against the West, especially US. The participation of Iran is a strong indicator of the direction of this organisation.
The summit in Samarkand, which concludes on Friday, will include Iran as the ninth member of the regional security bloc founded by China, Russia and Central Asian countries in 2001. The leaders are also expected to issue a declaration on its position on international and economic issues. Such announcements are likely to further fuel U.S. concern about an anti-American axis between the two powers that could threaten Washington’s security and economic interests.
Both Chinese and Russian leaders see U.S. foreign policy as being part of a grand strategy to contain the rise and influence of the two major powers through America’s economic heft and its global network of alliances. They have challenged the U.S.-led international order, saying that America’s democratic system isn’t superior to other forms of governance and that Washington is losing authority in the world.
WSJ - Russia’s Vladimir Putin Says China’s Xi Jinping Raised Concerns on Ukraine War, 15 September, 2022
The next step is the offering of mutual protection against aggression of other parties, followed by an evolution toward a structure similar with NATO, meaning standardisation of military industrial production, which will naturally be set by the Chinese.
This will not be smooth sailing, as its members do not have a history of trust, only a common interest at the moment. India, for example might have second thoughts, although the fact that it joined this organisation, while being a reluctant member of the Quad, is proof that it seeks to master its own destiny free from western dominance.
As a NATO member, Turkey is perhaps the most puzzling candidate. Turkey is like a military Swiss country: with an incredible valuable strategic geographical position, Turkey has been a negotiation facilitator between Russia and Ukraine, while simultaneously sold weapons to Ukraine, and did business with Russia often bypassing the sanction rules, took active position against Sweden’s and Finland’s ascension to NATO to obtain concessions regarding Kurdish militants, took a clear position against Russia stating that it must return all occupied territories from Ukraine, including Crimea, having an open conflict with Syria, supporting Azerbaijan against Armenia, etc. Turkey, historically a big power, holds many keys to many regions, trade and conflicts. This is a dynamic in need of equilibrium and it is not clear yet, how that might look like.
China must envy, and probably fear at the same time, the way NATO and other western countries came to Ukraine’s help. SCO could be the instrument that would protect China from broad sanctions imposed by the West if it comes to a dispute around Taiwan.
Watch this space.