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07 December 2022

Karlsruhe - the good, the bad and the ugly

In our public story we write about the Karlsruhe ruling on the recovery fund - and why it is not what it seems; we also have stories on Victor Orbán's veto of the aid package to Ukraine, and the horse trading that will now set in; on how Spain's divided left is hurting Pedro Sánchez; on the possible agreement on a gas price cap; on EU member states moving towards windfall taxes; and, below, on how and why western sanctions are less effective than hoped for.

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Today's free story

Crypto enters the war

German TV reports that Russia is planning to legalise cryptocurrencies, obviously to circumvent sanctions. Citing the head of the financial committee of the Duma, Russia's parliament, Tagesschau reports that the new rules should be implemented from next year onwards. Anatoli Aksakov is quoted as saying that the goal would be to use cryptocurrencies for international trade and finance to fund so-called parallel imports: grey market imports of essential goods for use by Russian manufacturing companies. The cryptocurrencies will thus become official transaction currencies with foreign countries. The government had already hinted at a new regulation, but this is now happening.

Parallel imports relate to goods subject to western sanctions, procured through third countries. These are mostly semiconductors, plant and machinery. We agree with the Tagesschau's conclusion that the western alliance's ability to limit these grey imports are ultimately limited, as a result of which there is booming flow of goods. It quotes intelligence from the Kiel institute of the world economy, according to which the numbers of goods offloaded in Russian ports was rising again, mainly coming from China and Turkey. 

Economic sanctions are a blunt tool, to be used with extreme care. They tend to give rise to externalities that are often not considered by the state departments and foreign offices that wield those instruments like a toy. The privilege that comes with the dollar, and to a lesser extent the euro, as global transaction currencies evaporates quickly once you use this privilege in your foreign policy. It is a depleting resource.

Cryptocurrencies cannot replace the dollar as the world's leading currency, but they reduce the ability of the US administration to control international financial flows. If these flows are conducted in dollars, the US has ultimate control as the clearance of the dollar balances taking place under US jurisdiction. If cryptocurrencies are pinned to the dollar, as was the case in crypto 1.0, the situation will not change because the dollar is involved in some node of the transactions. But cryptocurrencies can be highly effective in Russia's case. Russia is a net exporter of commodities. Russia and a third country could engage in an oil-for-machinery barter type deal, with the cryptocurrency serving as the transaction currency. As long as both trading partners are confident that the value of the cryptocurrency is maintained - not necessarily the dollar value but the ability to use it in future transactions between each other - an effective decoupling from the dollar is taking place.

While the western sanctions failed to have the desired impact, western weapons deliveries to Ukraine have been successful. Russia still has a good stock of missiles and drones, as even the Ukrainians are now admitting. The Russian stock is not infinite. What we would like to know is whether the parallel imports allow Russia to produce the weapons it needs in sufficient quantity to continue fighting the war. Our sense is that the west has been underestimating this factor.

6 December 2022

Labour's big idea: A better deal with the EU

Muddled thinking has been the main quality of the Brexit debate, by most participants, on both sides. Sir Keir Starmer is now back to the "let's get a better deal" phase. We can state flat-out that a better deal is not going to happen. It is worth reading his comment in response to a question from a BBC journalist:

"I think trade has gone down because the deal that we’ve got is not a very good deal. I think we can move from getting Brexit done, which is all that we’ve managed at the moment, to making Brexit work and I do think there’s a better deal."

Trade has not gone down because the deal is bad, but because the UK left the customs union and the single market. If you want trade to increase, you have to rejoin one or the other, or both. It's really quite simple. The EU will be open to UK membership of the single market or the customs union. But Sir Keir has ruled that out, for political reasons. 

We understand why, but we are not sure whether this will work politically for him. He has made that promise before: in the 2017 elections, when he said the referendum result should be respected. A year later, he emerged as the leader of the ill-fated second referendum campaign. The best deal the UK was ever offered was Theresa May's deal, which Sir Keir rejected. A read-my-lips commitment on Brexit is not credible coming from him. But it gets worse. If your Brexit strategy consists of the hope of gaining a better deal, you don't have a strategy. It will not be hard for the Conservatives to expose Labour's position as dishonest and ineffectual. 

The reality is that there is no substantially different deal on offer, especially now that an agreement on the Northern Irish protocol is on the cards. We have been writing about a long-term process for the UK to rejoin the EU, but Sir Keir's narrative is probably the worst starting point. It is the very notion of a deal that lies at the heart of the failed pro-EU advocacy in the UK. They, Sir Keir included, never made a case for the EU itself, only for a transactional arrangement with the EU, whether through opt-outs when they were inside, or through deals now. 

We have seen the UK failing in the EU, and failing outside out of the EU, which is why we are happy to sit on the fence in this particular debate. 

If you are outside, the task is to make Brexit work and compensate for the loss in trade with the EU through new types of business. This requires a new economic model. Neither of the big parties offer this. The alternative is rejoining the EU, or the single market and the customs union. 

It is quite possible that the only politicians able to offer realistic alternatives are the Liberal Democrats on the pro-EU side, and a Nigel Farage-style party on the right. 

5 December 2022

Do we care about Russia's security interests?

Emmanuel Macron triggered a lot of angry responses with his comment that an eventual peace agreement will have to include security guarantees for Russia. Of course it will. It will also have to include security guarantees for Ukraine and everybody on the Russian border as well. It will also have to deal with sanctions, and many other things. 

The importance of Macron's message is to shift an increasingly hysterical public opinion, with its fantasies of regime change war crimes tribunals, towards a more realistic set of outcomes. Peace treaties are not drawn up in a vacuum. They always reflect the reality of the military situation on the ground. A treaty will, of course, have to reflect the fact that Russia is not going to win this war. But even that would at present not square with public expectations in the west right now. There will be stuff in this treaty we don't like. There will be a lot in it that Russia won't like either. And of course there can be no peace treaty without Ukraine. 

Macron's error is not what he said, but the way he said it:

"... one of the essential points we must address - as President Putin has always said - is the fear that NATO comes right up to its doors, and the deployment of weapons that could threaten Russia."

We noted a comment from Johann Wadephul, deputy leader of CDU/CSU Bundestag group, who interpreted Macron's statement as giving an ex-post justification to Vladimir Putin's originally stated reason to invade Ukraine when he blamed Nato's expansion. We don't think this is so, but we can see how Wadephul and others drew that conclusion. It should be possible to reject Putin's fake pretence for an invasion, and yet accept that his country has legitimate security interests. Macron's error lies in the clumsy way he conflated the two issues.

The strategic goals for western Europe should be clearly defined: respect for the territorial integrity of Ukraine, respect for international borders, the country's post-war reconstruction, and robust structures that provide security guarantees for both sides. It is also interesting that Macron made his comments, in a TV interview, after his return from his US trip. We think that Macron and Joe Biden are on this together. We also know that Olaf Scholz holds the same views. You would be silly to dismiss this. 

2 December 2022

What happened to the cordon sanitaire?

The far-right is a political reality in several EU member states. They are in power either as leaders or partners in a coalition government, or via confidence and supply agreements. When coalitions are formed between centre-right, liberal and far right parties, the traditional fault lines in EU politics are blurred. This has repercussions for the European Parliament.

The once-heralded cordon sanitaire, where traditional parties refused to cooperate with the far right, is no more. Italy now has a coalition government that includes two far-right parties. In Sweden, the new centre-right government relies on the far-right to get laws through parliament.

For the French MEP Pascal Durand, Sweden’s case was reason enough to quit the Renew Europe Group. Its 109 members include Karin Karlsbro, MEP from Sweden’s Liberals, a party that joined the new government coalition and thus is seen as benefitting from far-right support. The Renew Europe group had several tumultuous behind-closed-door meetings in October to define its response. MEPs from France, Belgium and even Romania called for excluding the Liberals, but the Nordic countries blocked that decision on the grounds that exclusion is too violent, writes Le Monde. Several amongst them also no longer hold firm on their cordon sanitaire, refusing to rule out future government cooperation with the far-right. After long debates, the members of the Renew group settled for a compromise. The Liberals are allowed to remain a member, but they have been excluded from all activities within Renew. Renew will also monitor the party's behaviour in Sweden.

This is not enough for Durand, whose conviction, and departure from Renew to join the Social Democrats, is raising some fundamental questions. If the far-right is getting to power throughout Europe, what happens to those from the centre-right who still believe in the cordon sanitaire? They may no longer find their place in the EP’s political groupings. Messy coalitions at home are a good reason for transnational lists, where political pan-European platforms can be formed without the muddled positions from national policy making.

1 December 2022

Sticks and carrots for Hungary

The European Commission made good on its decision to recommend to freeze Hungary’s share of the EU budget worth €13bn, as Hungary did not do enough to fulfil the rule of law conditions the Commission had stipulated. It is the first time they have applied the so-called conditionality mechanism. There is a carrot too, as the Commission has offered to approve €5.8bn Hungary is set to receive from the EU recovery fund, contingent on Hungary implementing 27 key reforms. The two procedures have the same goal for Hungary over its law and order violations. But they were negotiated with different EU teams and have different conditionalities in mind. Why have they been so strict on one set and lenient on the other?

The Ecofin council will have to make sense of the two different recommendations next week. And it only takes a qualified majority to adopt the Commission’s proposal. But there is politics at play here too. The Ecofin’s agenda for December 6 opens with the case on Hungary and closes with a vote on Hungary and whether to back up the Commission’s recommendation. In between are two other items on the agenda, a €18bn aid package for Ukraine and minimum tax rates for multinational companies. These are two subjects Hungary vetoed in the past.

The Czechs are currently holding the EU presidency and are working to convince Viktor Orbán to relent on his vetoes. Will this be enough as a quid pro quo for a softer Commission response? Even if they were to go soft in tone, or change conditionality by introducing milestones in return for funds, Hungary still has to deliver those milestones to actually get the money, as the Verfassungsblog reminded us. This is what they did with Poland before, and it is similar to the way the bailout programmes worked in the past. It is about making member states take responsibility for solving the problem. But if this vote is simply about setting an example over rules enforcement or punishment in the EU, it won’t work as long as Orbán is in power. It would only strengthen his case nationally.

30 November 2022

Industry is really worried about IRA

Whether you talk to European industrialists in Brussels or German industrialists in Berlin, you get the same message these days. They are really worried about the US inflation reduction act. At the BDI conference in Berlin, it was the dominant subject. FAZ quotes the president of the German federation of industry as saying that more than a fifth of German medium-sized companies they had polled were considering packing up and leaving the country. We cannot recall ever seeing such a figure. The main reason he cites are the high energy costs. Despite recent market moves, end user energy prices will not revert to the pre-war times on a sustained level. Many privately-owned industrial companies are operating at the limits of their pain thresholds with low profit margins. But it is one thing for a company to pull through a recession, with their owners forgoing income for a year, or for the owners to conclude that the business model is no longer viable in its current form. The German government's gas price break is not going to make the difference between viability and non-viability. It will help struggling, but viable businesses to tide themselves over. The time horizon when cheap renewable energies will shift the viability calculations for companies is still outside all planning horizons, even for long-term oriented private company owners.

Robert Habeck said he was considering stricter local content rules, as the US has been doing, and a series of other measures. One of them are contracts for difference, where companies that invest in low-carbon technologies get subsidised by the state. There are national and European schemes, but they are much less effective than comparable US schemes. Habeck said that what takes two years in Germany takes two months in the US. Agility is the real threat of inflation reduction act. Europeans, too, are no strangers to subsidies. But the Americans deploy them faster.

What we expect to see in Germany is not so much large de-industrialisation but a shift in production technologies. We think that the headline number of a share in manufacturing in GDP of 20% exaggerates the underlying picture. Many manufacturing companies offer services that are not accounted for separately. We would therefore not use the officially recorded manufacturing share as a reliable metric. What we expect to see instead is a shift away from energy-intensive production, like bulk chemicals and steel, towards lower energy-intensive industrial segments, and a shift towards low carbon technologies in particular, a process that will be accompanied with friction and possibly lower GDP growth. What we do not expect is a complete overhaul of the industrial model as such. You are not going to transform hundreds of thousands workers in the car component industry into bankers. Nor would that be necessarily desirable if that were possible.

One of the big problems all manufacturers are struggling with right now is a shortage of skilled labour. This, too, is affected by bureaucracy. As FAZ reports, the German government is considering an overhaul of its immigration regime for skilled workers, by adopting a Canadian-style point system, which allows immigration for qualified workers even without concrete job offer.

29 November 2022

Could Syriza come back to power?

Greece is holding elections next summer. Unsurprisingly, today’s politics is done with elections in mind, buying favours to be rewarded at the polling stations. Current polls show that New Democracy could get between 35-36.5% of the vote if elections were held today, which will not be enough for an outright majority. Syriza comes second in the polls, though numbers vary between 20-29% depending on the poll. Macropolis notes that they did not capitalise on the difficulties the government faced over the summer with inflation and a scandal about wiretapping journalists and opposition politicians by the National Intelligence Service, which is under Kyriakos Mitsoutakis' direct control. Mitsoutakis assured that he did not know anything about it and would have objected to it had he known. The question various democratic committees are now trying to answer is how widespread the scandal was and how much the prime minister knew.

The cost-of-living crisis is straightforward by comparison. For New Democracy, pensioners are key voters. A recent bill that raises pensions for 1.7m retirees next year and offers a €250 inflation cheque to 2.5m pensioners will most certainly feature on the campaign trail. Whether this will be enough depends on how the cost-of-living crisis unfolds over the next six months and how the party emerges from the wiretapping scandal. The party has had chronic issues with corruption cases in the past. This is one of the reasons why Syriza, a new party from the far-left, rose to power in times of economic hardship during the Greek sovereign debt crisis. Today, the cost-of-living crisis is a priority, and on this front New Democracy is faring well. But new revelations from the scandal could awaken the ghosts of the past.

For an outright majority a party needs to win 37-38%. This is within reach for New Democracy. But so it is too for Alexis Tsipras, the Syriza leader and former prime minister. He could win if a sudden shift in public perception emerges over the coming months.

28 November 2022

Could Turkey lose it over the Kurds?

Turkey is rolling out its operation Claw Sword against the Kurds in Syria. Drone attacks on the headquarters of the Syrian Democratic Forces (SDF) last week were just the beginning. Ground troops could follow soon. It is payback time, as the Turkish Defence minister put it on Twitter. Is this the one mad move from Recep Tayip Erdogan that could lose him his political capital with the West and Russia?

The US has been backing the Syrian Democratic Forces (SDF) in the fight against Islamic State, the jihadist group that swept over Iraq and Syria during the last decade. The Kurds were the ones who fought IS. They now keep the group's members locked up in prisons. There is concern that if Turkish troops face the SDF on the ground, it could allow the terrorists to escape.

The US is also worried about the safety of its own troops stationed in the Kurdish region of Syria. So far they only issued a warning to their Nato-partner, Turkey. But from the sound bites we are hearing this probably won’t stop the Turkish military in its pursuit of the Kurds.

Recep Tayyip Erdogan blamed the recent bombing in Istanbul, which killed six and wounded 80 people, on the PKK, a terrorist group for the Turkish, recognised as such by all western nations. But Turkey went one step further, viewing the SDF as part of the PKK. This is the rubicon the West has not crossed. Sweden and Finland too had used this distinction in their bid to convince Turkey to back their accession to Nato. But Turkey's patience has run out. Erdogan said last week that he is having no more of the West’s efforts to differentiate the SDF ad the PYD and YPG, its subdivisions, from the PKK, writes Al Monitor.

What should we look out for at the political level? Erdogan is signalling that a meeting with Bashar al-Assad is likely. If Syria and Turkey were to come to an agreement, the Kurds will be at the centre of those discussion and risk being the ones who will lose out in such a deal. Turkey is also likely to seek some form of clearance from the US and Russia.

How much leverage are the US and Russia ready to use against Erdogan, given that the Kurds are no longer a priority? Russia could play it over al-Assad, who is indebted to Vladimir Putin for helping him to win the civil war. This leaves the US. If the US does not step up its response against Turkey’s operation in the Kurdish region, it could force them to give up their support for the SDF and their troops there. After Afghanistan, would be another highly symbolic retreat from the US in the region. If the US were to step up its response against Turkey, the conflict would come into Nato. And Sweden may have to wait even longer to get the green light from Ankara for its accession.

25 November 2022

Erdogan, the Kurds and the economy

Turkey is testing the West with its military operations against the US-backed Kurds in Syria while its economic experiment at home is defying economic orthodoxy and market expectations. Both military and economic narratives are framed by Recep Tayyip Erdogan as battles, against Kurdish terrorists and for economic independence. Both are tools of Turkey’s foreign policy, to define a space somewhere between the US, the EU, China and Russia and to defend its position in the region.

Turkey’s latest military attack against the Kurds came after they blamed Syrian Kurds for the bomb attack in Istanbul. The drone strike on Sunday hit Kurdish headquarters in their region of Syria, only 130m away from where US troops are. Even if it is not the full-blown operation on the ground, the increased likelihood of further attacks raises serious concerns over Syria’s security situation for US troops, Kurds and ISIS prisoners. Clearly, the two Nato partners, the US and Turkey, are not on the same page here. We also do not know what it means for Sweden and Finland’s accession process as it is pending on the two Nordic countries cutting ties with Syrian Kurds.

In economic terms, the difference with the West is most visible in monetary policy. Western economies raise interest rates when inflation rates gets to 9%. The Turkish central bank lowered its interest rate for the third time since August to 9%, and this is despite an inflation rate of over 85% in CPI terms and 150% in producer prices. The Turkish Lira is at an all-time low, losing 50% of its value against the dollar compared to last year, but it has been stable over the past couple of months.

The dynamics of a devaluing currency combined with high-cost imports push up inflation while exports are soaring, the main reason behind high GDP growth rates of 5.7%. But despite those high growth rates, export revenues and tourism still do not bring in enough foreign currency to balance the current account. Friendly central banks from China, Qatar, South Korea, UAE and Azerbaijan have had to help with swap loans. Saudi Arabia opened up a $5bn credit line this week, according to the FAZ. Russia is said to have transferred a similar amount in the summer. Domestically, the government also scraped foreign exchange and gold from private individuals and companies with the promise that they would compensate them for the exchange rate loss. The currency risk is thus shifted to the state budget. According to Reuters, the central bank netted $100bn this way and was thus able to stabilise the Turkish lira over recent months.

Can this continue? Rating agencies, market observers and the IMF are warning that this is unsustainable. The Turkish government does not relent on its narrative and prefers to focus on the bright side of soaring exports and high numbers of tourists this year. Market observers expect things to turn sour next year, and for GDP growth to fall to 3.5%, but what if Erdogan keeps the show going with some of his creative tricks? For how long?

It seems unlikely that Erdogan will change his tune before the elections and the Turkish republic's centennial celebrations next year. He wants to demonstrate that the Turkish economy runs under his rules, not the ones dictated by the West or the markets. And he wants to win the elections. So his model has to last at least for another seven months.

His economic agenda clearly has foreign policy implications. Given their need for cash to stabilise the exchange rate, Turkey’s economic connection with Russia and China is likely to deepen further, creating new dependencies. Can Turkey continue to be relied upon as a neutral broker for peace? This depends on how far Erdogan wants to take his operation against the Kurds and how the economy will cope with these price shocks. A high-wire act that requires none of these big bets go wrong, be it militarily or economically.

24 November 2022

23 birthdays

This is the decade of the supply chain: complex global networks of the flow of goods between companies. Twitter is a network, of course. And so is the crypto blockchain. And global financial markets. Many of our biggest misjudgements this century relate to a generalised failure to understand network dynamics. 

The simplest example we can think of mistaken network maths is an old problem from probability theory - though most people don't think of it this way: on average, how many people do you need in a room for two to share the same birthday? The counter-intuitive result is that it takes only 23 people. The reason our brains get this wrong is that we cannot intuitively compute simultaneous probabilities. We are prone to the fallacy of composition, which is ultimately a failure to understand networks. The chance of our own birthday falling on a given day in the year is 1 in 365. So we extrapolate, mistakenly, that it takes some 180 people for any two to share the same birthday. The mistake we are making is massive. 

Supply chain dynamics shares some characteristics of the birthday problem. Your output may be my input. It might only take 23 individual disruptions to disrupt a large chain.

Pollsters misjudged network dynamics when non-voters turned up at the polling both in the US presidential elections in 2016 and in the Brexit referendum. The failure to predict the global financial crisis was a failure to grasp financial networks. A minor fiscal crisis in Greece ended up being a life-threatening financial crisis for the entire euro area because of network effects. EU member states all imposed synchronous austerity.

Macroeconomists, whose reasoning is often based on linear logic, are particularly prone to misjudgements when they leave their reservation. The other day, we heard a well-known economist gloating about the collapse of the FTX crypto exchange, and concluding that crypto itself would be doomed. That's your classic fallacy of composition - making a macro judgement based, in this case, on a single case. There was, without a doubt, a bubble in the crypto markets that has now largely deflated. But crypto itself is rock-solid. The bitcoin blockchain, for example, did not have a moment of disruption since its start in 2008. The same goes for the other big blockchain, Ethereum. 

A technical expert, meanwhile, was quoted in newspapers last weekend saying that twitter's demise was imminent because Elon Musk had fired essential staff. But there has not been a single moment of disruption. That judgement was not so much a fallacy of composition, but simple wishful thinking. The experts were not so much afraid that Twitter would fail, but afraid that it would survive. Without them.

Many fearful Twitter users turned to Mastodon, a decentralised, open-source, social network, with Twitter-like features, and projected all their hopes into it. We think Mastodon has its uses, for scientific communities for example.  But it cannot replace Twitter because of network effects.

Just consider this: Many Twitter users have often spent more than a decade building up a large following. If you leave and join another network, you are starting from scratch. We, too, set up an account at Mastodon, and were shocked to find that we had a single follower after one week.

All of these examples stem from only two sources: globalisation and the internet. Both have had a tremendous impact on our lives this century. Neither will go away. What they both have in common is that they are networks, something we humans are not well equipped to understand intuitively.