Having lived through the LDC debt crisis in the 1980s, I’ve never forgotten one of the best books from that time: “The Debt Threat”, by Tim Congdon, published in 1989. He made a simple point: That if the real rate of interest on a nation’s debt (“r”) was greater than its real rate of growth (“g”), outstanding debt would explode, and eventually trigger a crisis, as it did in Latin America. It took more than a decade to clean up the mess it left behind.

Fast forward 32 years. Debt is exploding again, and “r” and “g” are back in the headlines. This time around, it is Stanford’s John Cochrane who is providing some very timely insights about an important dynamic that will, along with other factors, cause the emergence of different macro regimes in the years ahead.

Cochrane begins his new paper, “r < g” (that's really the title) with a statement of what should be obvious, but for too many still is not: “Fiscal sustainability is the most important macroeconomic issue of our time. The US is embarked on a historically unprecedented peacetime fiscal expansion. The debt to GDP ratio, passing 100%, is already higher than it has ever been. And current deficits, spending plans, and looming entitlements mean we are only halfway done.”

He then notes the siren song of “r minus g” (i.e., when the interest rate on government debt is less than the rate of GDP growth), which “seems to offer a delicious opportunity. Briefly, suppose the government borrows a huge amount, and simply rolls over the debt, borrowing new money to pay principal and interest on the old. Then debt grows at the rate of return on government debt, r. But if GDP grows at a greater rate r < g, then the ratio of debt to GDP slowly declines. The borrowing need never be repaid by higher later tax revenues or lower spending. Public debt, apparently, has no fiscal cost.”

[Moreover], “The federal government is more and more just borrowing and sending checks to people, businesses, and other levels of government. Indeed, since the Fed is buying most treasury debt, the government is basically printing money and sending it to people. The sense that such government spending, must eventually come from taxation has totally disappeared from policy discourse.”

After setting the stage, Cochrane asks out loud what many people are wondering these days: “Will this work?”

He begins by identifying a central but mostly unacknowledged assumption behind the argument that if the interest rate on government debt is less than the economic growth rate, then over time the government debt/GDP ratio will decline: the government will not run a deficit; all spending will be paid for with tax revenue.

Unfortunately, the US last had a federal budget surplus in 2001. Since then, the average annual deficit has equaled (4.6%) of GDP; the median was (3.9%).

Cochrane then asks, if, rather than a declining debt/GDP ratio, we just want to keep it constant, what is the maximum deficit the government can run, as a percentage of GDP? It is the difference between the cost of its borrowing and the growth rate of GDP.

Let’s take a closer look at that. Today, the real yield on ten year, inflation protected US Treasury securities (TIPS) is negative (0.67%).

As we show in our monthly valuation analysis (our assumptions in parentheses), in theory, the real yield is a function of the future annual rate of labor force growth (0.5%), the future rate of total factor productivity growth (0.5%), the standard deviation of real annual GDP growth (1.5%), investors’ time preference (.75) and their relative risk aversion (.38). Note that for the latter two parameters, we use research findings on their values for long-term, institutional investors. These parameters produce a required real yield (“r”) of 0.97% today.

What about the prospects for long-term future GDP growth? The US Bureau of Labor Statistics projects the labor force will grow by only 0.5% per year in the future.

What about long term US productivity growth (known as either total factor productivity – TFP – or multifactor productivity – MFP)? Between 1990 and 2005, TFP grew by an average of 1.20% per year. But between 2006 and 2019 this shrunk to just 0.51% (OECD data).

If they remain unchanged, these rates of annual labor force and productivity growth imply the potential long term real growth rate of the US economy is only about 1.0% per year.

If this is the case, it presents a very troubling picture of the likely future state of “r-g”.

Today, the real cost of government debt (the yield on the 10 year TIP) is 1.67% below the forecast long-term real growth rate of the economy. If the federal government ran a balanced budget from today forward, debt/GDP would decline by just 1.67% per year (in real terms, assuming zero inflation).

Alternatively, if the US doesn’t want to reduce debt/GDP, but instead just wants to keep this ratio constant, it could run annual budget deficits equal to 1.67% of GDP. US nominal GDP is currently about $22 trillion; 1.67% equals annual deficits of up to $367 billion. The last year the federal deficit was below that was 2007.

But if the real cost of government debt returns to 0.97%, and labor force and productivity growth remain unchanged, then “r-g”, will be about equal, and just keeping the debt/GDP ratio constant would require running balanced federal budgets – something the United States has been unable to do for the past twenty years.

As Cochrane euphemistically says, “If the r < g opportunity vanishes while we are still at a high debt to GDP ratio, a sudden fiscal reckoning awaits.”

Whether and when the United States will face this “sudden fiscal reckoning” depends on two critical uncertainties: the future real interest rate on government debt and the nation’s future real GDP growth rate. Let’s look at how they could evolve in the future.

Future Real Interest Rates

In recent years, two popular theories have been offered to explain the decline of real interest rates not just on US sovereign debt, but on the sovereign debt of many other countries as well.

The “Savings Glut” hypothesis claims that falling real rates have been caused by a higher than normal level of desired savings relative to capital investment demand. High level of savings are attributed to a number of causes, including weak government pension plans in many developing nations, and the baby boom generation in developed countries reaching their peak saving years.

In contrast, the “Secular Stagnation” hypothesis claims that low rates are caused by weak investment demand, which in term is attributed to various factors including rising inequality, high debt levels, an increasingly short-term focus by company management teams, legalization of share buybacks, and reduction in government infrastructure investment as social safety net spending has risen.

On balance, the evidence suggests that the Savings Glut hypothesis may have exerted a stronger effect, while Secular Stagnation played a smaller role (see, “Secular Stagnation and Returns on Capital”, by Gomme et al, “Focus on Low Rea Interest Rate Might Be Misplaced” by Crews et al, and “Low for Long? Causes and Consequences of Persistently Low Interest Rates” by Bean et al).

However, two other analyses that use longer data sets cast doubt on both the Savings Glut and Secular Stagnation hypotheses as explanations for the long-term decline in real yields on sovereign debt.

In “Why So Low For So Long? A Long-Term View Of Real Interest Rates” Borio et al analyze a data set for 19 countries that begins in 1870. They conclude that the relative impact of monetary factors in the determination of the real interest rate may have been underestimated.

A much longer data set is used by Paul Schmelzing in his paper, “Eight Centuries Of Global Real Interest Rates, R-G, and the ‘Suprasecular’ Decline, 1311–2018.”

He observes that, “global real rates have shown a persistent downward trend over the past five centuries, declining within a corridor of between -0.9 (safe asset provider basis) and -1.59 basis points (global basis) per annum, with the former displaying a continuous decline since the deep monetary crises of the late medieval “Bullion Famine”. This downward trend has persisted throughout the historical gold, silver, mixed bullion, and fiat monetary regimes, is visible across various asset classes, and long preceded the emergence of modern central banks. It appears not directly related to growth or demographic drivers, though capital accumulation trends may go some way in explaining the phenomenon. But whoever posits particular recent savings-investment dislocations in the context of an alleged “secular stagnation” needs to face the likelihood that such “imbalances” may have been a continuous key driver for five centuries.”

This obviously begs the question of what causal drivers produced this decline in real interest rates across the centuries. Other research offers one hypothesis.

A number of authors have noted the steady increase in the complexity of economic, social, and political organization across the centuries (e.g., “Complexity Rising: From Human Beings to Human Civilization, a Complexity Profile”, by Yaneer Bar-Yam, and “Quantitative Historical Analysis Uncovers A Single Dimension Of Complexity That Structures Global Variation In Human Social Organization”, by Turchin et al).

We also know that increased complexity typically increases uncertainty, which induces predicable effects in humans, including greater social copying and conformity. It is therefore not unreasonable to conjecture that the same increases in complexity that drove faster economic growth (e.g., the “great takeoff” in the growth of GDP/Capita in England after 1750) also increased uncertainty. If the resulting precautionary savings consistently grew faster than investment, that could account for the observed centuries long decline in real rates.

Schmelzing continues, “Similarly, negative long-term real rates have steadily become more frequent since the 14th century, and I show that they affected around 20% of advanced economy GDP over time, a share that has historically risen by 1.2 basis points every year: once more, this suggests that deeply-entrenched trends are at work – the recent years are a mere “catch-up period” in this and a number of related aspects” …

“Whatever the precise dominant driver –simply extrapolating such long-term historical trends suggests that negative real rates will not just soon constitute a “new normal” – they will continue to fall constantly. By the late 2020s, global short-term real rates will have reached permanently negative territory. By the second half of this century, global long-term real rates will have followed.

“The standard deviation of the real rate – its “volatility” – meanwhile, has shown similar properties over the last 500 years: fluctuations in benchmark real rates are steadily declining, implying that rate levels are set to become both lower, and stickier.”

However, other analysts have argued that the steady decline in real interest rates may reverse in the future.

In his paper, Cochrane claims that as the gap between “r” and “g” narrows, and the US gets closer to an explosive debt trap, investors will likely demand higher risk premiums on US Treasury debt, which will increase real rates.

An argument base on the economic impact of aging societies in set forth in the Bank for International Settlements paper “Demographics Will Reverse Three Multi-Decade Global Trends”, by Goodhart and Pradham. The authors claim that, “aging will lower both desired savings and desired investment, but desired savings will fall by more. The resulting imbalance will require the real interest rate to rise for the market to clear.”

They acknowledge that, “This is clearly our most controversial proposition, and much of the pushback we receive is based on the argument that demographics will lower potential output growth, and hence real interest rates. We agree wholeheartedly with the first argument regarding output growth. But we disagree that it will also lower real interest rates. Indeed, there is much less reason to believe the two are connected than many believe…

“Rather than looking for explanations of falling real rates in any one country at a time, the focus needs to be on global factors. Ex post, savings have to equal investment in a closed economy, ie the world. So, if one points to a particular country, say China, where savings have exceeded investment and there is a current account surplus, then by definition there is another country (or countries such as the United Kingdom or United States) where savings have been below investment and there is a current account deficit. What we need to look at is the ex ante desired savings versus investment dynamics on a global scale, and think of the equilibrating price as a global
price.

“Most of the demographics studies that we have seen take one of two routes. One set of studies looks only at national demographic trends and tries to explain wages and consumer price changes through local dynamics. Studies about Japan are the classic example here. The other set includes a model of two or more countries with differing demographic trends that determine local prices, which then impact the domestic and foreign economies. We think both could go a step further and consider truly global labour force dynamics that set global prices. And nothing we have seen pays more than lip service to what we believe is the crucial factor – China…

“Everything about China is enormous; its demographic dynamics have been and remain remarkable, and the consequential movements in its savings and investment ratios have been extraordinary. As China’s labour force dynamics change direction, the savings-investment balance within and even outside China will change as a result.

“Demographics will ensure that China’s extraordinary savings will fall. Prior to modern times, the (relatively few) old in China were cared for in the extended family. But the one-child policy, extended for too long, has meant that support has gotten more and more scarce for the aged. With an insufficient social safety net, personal savings rose to plan for retirement. Add to this the incentive on the managers of state-owned enterprises to retain, rather than pay out, profits, and the explanation of these extraordinary savings ratios becomes clearer.

“What will happen in the future? Although a higher proportion of the old work in Asia than in Europe or North America, increasing longevity will increase the dependency ratio, in China and elsewhere. The result will be a decline in the personal sector savings…

The authors then argue why investment will fall by less than savings, thus driving up real interest rates: “A smaller population naturally requires less investment, but we argue that the reluctance of the old to relocate and corporate behaviour will help explain why investment will remain supported…

“Many expect that as population growth slows down, the demand for housing will decline sharply. However, that does not take into account the elderly’s preferences. As nations become richer, the old stay in their existing homes rather than relocate to their adult children’s homes. Moving is stressful, and those among the old who are homeowners have little incentive to relocate. As the young come of age and gain financial independence, they will not move into existing housing vacated by the elderly, but will move into new homes that have to be built. In our view, a shift in the balance of the population of a given size towards more old and fewer workers will raise, not lower, the desired stock of housing. That will support residential and housing-related investment…

“One aspect of the demographic impact that doesn’t suggest a ready answer is the behaviour of the corporate sector. There are two polar arguments. The popular argument is that the corporate sector will respond to demographic headwinds by slowing down the rate at which it accumulates capital so that the capital/labour ratio falls. Our view is that the corporate sector is likely to respond by raising the capital/labour ratio, i.e., by adding capital to compensate for labour, which is the factor of production that is getting scarcer and more expensive.”

Future Real GDP Growth

Broadly speaking, potential GDP growth is a function of two factors: growth in the labor force, and growth in productivity.

Growth in the labor force is a function of two main variables: (1) The rate at which the civilian labor force is grows, and (2) the “participation rate”, or the percent of the total labor force that is either working or searching for work.

As you can see in the following table, the growth rate of the labor force has been declining:

In recent years, the constraint on growth caused by the slowdown in the rate at which the civilian labor force has been growing has been further compounded by a decline in the percent of working age people who are in the labor force (known as the participation rate), as shown in the following charts:

Note that since the mid-1990s, the decline in the labor force participation has affected people with all levels of education, including those with college degrees:

Taken together, the slowing growth in the size of the civilian labor force, along with the falling participation rate, have been putting downward pressure on the potential rate at which the US economy can grow in the future. For example, the Congressional Budget Office forecasts that in the future total work hours in the economy will only grow by 0.50% per year. Their low estimate is 0.40% and their high estimate is 0.80%.

However, the CBO report doesn’t explicitly take into account the impact of improving automation and artificial intelligence technologies, and their increasing deployment in the economy. In the absence of a substantial improvement in human capital quality, this will likely be a two-edged sword – potentially further reducing labor force participation rates while increasing the rate of productivity growth.

In sum, achieving significantly higher rates of productivity growth will be critical to keeping “r” below “g”.

What are the chances that will happen?

Productivity growth measures the increase in output per unit of input over time. It is typically broken down into growth in labor and capital productivity, as well as a residual known as total or multifactor productivity (TFP or MFP), which essentially captures improvements in a range of other factors, including technology, human capital quality, and improvements in the management of organizations.

TFP/MFP growth is critical, because the labor and capital inputs into productivity calculations are based on what can be easily quantified (e.g., hours worked or the value of capital services provided – such as machine hours -- which is assumed to be fixed proportion of the capital stock). As a result, many of the improvements to labor and capital quality are captured in TFP/MFP (e.g., see, “Total Factor Productivity Growth in Historical Perspective”, by Robert Shackleton from the CBO).

Unfortunately, in the United States, and indeed across most OECD countries, TFP/MFP growth has been declining in recent years. OECD data shows that between 1990 and 2005, TFP grew by an average of 1.20% per year. Between 2006 and 2019 this declined to 0.51%.

Data from the US Bureau of Labor Statistics helps explain one of the important causal factors that have been at work: The declining share of US employment in relatively high productivity manufacturing, and the increasing share of employment in sectors where MFP was initially growing much more slowly, and where in recent years it has been negative.

The BLS finds that between 1990 and 2005, the average rate of annual MFP growth in the production of industrial equipment and consumer durables was 3.92%. In other sectors it 0.43%. Between 2006 and 2019, the corresponding MFP growth rates were 2.74% and negative (0.32%).

Whether the US can generate a substantial and sustained increase in TFP/MFP is one of the most critical uncertainties facing the nation. Unfortunately, you wouldn’t know that by looking at what has been happening in many sectors where productivity growth has been minimal or negative.

Two of the largest are healthcare and education. In both of these you see well-organized interest groups defending current business models, regardless of the drag them impose on productivity growth in the US economy. It is a classic case of large negative externalities whose heavy costs are mostly unrecognized, much less priced.

A second hypothesized cause of the slowdown in TFP growth has been talent scarcity due to stagnant education results at a time when technology has been growing more sophisticated. Effectively using that technology requires employees with more knowledge and skill. Unfortunately, neither the education system nor initiatives to “reskill” existing employees has been meeting demand. This has limited the diffusion of the most advanced (and productivity boosting) technologies, and widened the competitive advantage of companies that can attract employees with scarce knowledge and skills.

A third possible cause for the slowdown in TFP growth has been identified by Stanford’s Erik Brynjolfsson. He argues that some of the delay in TFP has been due to the same type of “J-Curve” phenomenon we saw in the 1990s during the last big wave of new technology adoption. Back then the full productivity benefits of new technologies didn’t appear until companies made very difficult organizational changes to their structures, processes, and staff – a difficult process that typically takes longer than most people expect. To some extent, that is also true today.

A fourth hypothesized cause of slow TFP growth has been a relatively weak level of business investment (e.g., in advanced capital goods and digital technologies) due to continuing high levels of uncertainty about future demand growth (e.g., due to rising inequality and high levels of outstanding debt in the private sector). Instead of investing in expanding and upgrading production capacity, companies have instead given substantial amounts of money back to their shareholders, especially via stock buybacks.

Conclusion

For people too young to remember Tim Congdon’s 1989 warning about “The Debt Threat”, John Cochrane has provided a very timely new reminder about the critical relationship between the real interest rate on a government’s debt, and the real rate at which its economy grows.

The following table shows different scenarios that are driven by the average 10 Year TIP yield (i.e., the real rate of interest on government debt) and the growth of total factor productivity over the next five years.

Each scenario also shows the maximum deficit the federal government could run while keeping the debt/GDP ratio constant. Finally, we note our current subjective probability estimate that each scenario will develop over the next five years.
 

If real rates stay low while productivity growth regains the heights it reached in the 60s and 90s, there is a high probability that the Normal regime will emerge and be sustained. But if the opposite happens (the real rate increases while productivity continues to stagnate), the probability of the Persistent Deflation and, at some point (assuming a more attractive alternative to the US dollar is available) High Inflation regimes increase.

Finally, we’ll leave you with some parting words of wisdom from John Cochrane: “If our fiscal situation is so dire, why do bond investors still lend money to the government at astonishingly low rates?

“First, recall that bond markets have never seen trouble coming, or waning. They did not see inflation in the 1970s, they did not see disinflation in the 1980s, they did not see Lehman or Greece coming… Surely the USA will not borrow and spend itself into a debt crisis.

“Fixing our structural budget problems is not hard as a matter of economics, or, really, once everyone recognizes it has to be done, as a matter of politics. I hazard bond markets assume the US will, as usual, get around to doing the right thing after we try everything else. Let us hope so.”

This Month’s Regime Forecasts

Our 12-month regime forecast probabilities remain unchanged from last month.

In light of the size and composition of the Biden stimulus package, and the progress of COVID vaccination programs, we forecast that the probability of being in the Normal Regime 12 months from now is 40%. Based on the assumption that COVID’s negative impact on supply capacity will not recover quickly, there is a 25% probability that 12 months from now we could be in the High Inflation Regime.

However, that high inflation is almost certain to have a negative impact on equity and debt valuations, which could slow spending and increase business insolvencies. The speed at which this could happen, and uncertainty about the depth and breadth of its cascading impact across a complex global economy leads to our forecasts of a 20% probability of being in the High Uncertainty Regime 12 months from now, and a 15% probability of being in the Persistent Deflation Regime (which assumes faster and deeper negative effects).

Our 36-month forecast reflects two main analytical results. The first is last month’s assessment of the 30% probability that over the next three years, the Biden Administration will avoid seven possible crises (a feat which would result in the Normal Regime):

(1) An increase in inflation, and the popping credit and equity market bubbles rising rates would very likely trigger;
(2) A US sovereign debt and/or dollar crisis (though the latter would also require a more attractive new currency home for investors fleeing the dollar, which at this point seems unlikely);
(3) An LDC debt crisis, due to heavy corporate borrowing in foreign currency;
(4) A Eurozone sovereign debt crisis, most likely triggered by Italy;
(5) A severe private sector solvency crisis, as the government support that enabled many companies to survive during the pandemic is withdrawn but the economy remains weak;
(6) SARS-CoV-2 mutations that significantly reduce vaccine efficacy, forcing another return to lockdowns (as we have recently seen in the UK and EU);
(7) A violent conflict between the US and China (most likely over Taiwan), or between the US and/or Israel and Iran

The second is the result of this month’s feature article, which uses new evidence to update last October’s assessment of the likelihood that war between the US and China could break out over Taiwan at some point over the next 36 months, and the potential results if it does. We estimate that the probability has risen to 50% (as the Financial Times’ John Dizard recently observed, “War risk is consistently underestimated by money people”).

Combining the two assessments yields the following probabilities for our four global macro regimes:

Finally, we reiterate that uncertainty in the global macro system remains very high. Under these conditions, people rely more heavily on social learning and copying what others are doing than they do on their own private information and views.

This not only slows the diffusion of new information throughout social systems like economies and financial markets, but also causes these systems to coalesce around a small number of narratives. However, as tension increases on various fault lines in the global macro system, the dominant narrative or narrative grows increasingly fragile.

Under these conditions, rapid, non-linear changes are very likely to occur, that are out of proportion to the apparent trigger that sets them off.

Implications of the Most Recent Three Month Asset Class Returns

Our forecasting methodology also includes quantitative analyses of asset class valuations, market stress indicators, and the level and change in three-month returns, over the most recent and previous three-month periods, for those asset classes, which should perform best under different regimes (in this sense, our regimes can be regarded as macro factors).

We assume that that the rolling three month returns reflect investors’ views regarding the relative probability that a given macro regime will develop in the future.

Note: The language we use to describe our estimated likelihood of asset class over or undervaluation is based on US Intelligence Community Directive 203 on Analytic Standards, which includes the following table:

Market Stress Indicators (@28Feb21)

Portfolio Allocation Implications of Our Forecast

We take two approaches to deriving the tactical asset allocation implications from our analyses (i.e., deviations from our "neutral" or base case model portfolio).

The first takes a systematic approach, and is based on relative asset class valuations. Our starting point is our neutral model portfolio, which is equally weighted across nine broad asset classes, and also includes 5% allocations to alpha strategies (equity market neutral and global macro) that are designed to have a low correlation to returns on broad asset classes.

Based on asset class valuations, we systematically vary the asset class weights (but not the active strategy weight), increasing from 10% to 15% when an asset class is likely undervalued, and 15% when it is very likely undervalued. In the case of overvaluations, we go to 5% and then into cash, if there are no undervalued asset classes with room for an increase. In effect, this replicates the systematic rebalancing strategy we used for 15 years in our previous model portfolios.Based on subscriber requests, this month we are re-introducing a feature from the previous version of The Index Investor: Tactical Asset Allocation Implications from our analyses.

The second tactical approach is based on our subjective view not only of current asset class valuations, but also of the implications of the broader macro trends and uncertainties that we analyze each month. Importantly, this subjective view reflects our primary goal of avoiding large downside losses, rather than seeking large upside gains.

Three final notes: First, with respect to US fixed income, we include credit products (investment grade and high yield) in the same asset class as government debt, and will shift into the former when their valuations become attractive.

Second, we regard gold not as a separate asset class to be held long-term, but rather as a complement to cash, into which we shift in periods of substantial overvaluation across multiple asset classes.

Third, we continue to be deeply concerned by the distortion in asset class valuations that have been created by negative real interest rates on sovereign bonds, which are the foundation of most asset pricing models. In August, we decided to address this distortion by using in our asset class valuation models our estimate of the economically logical real yield on inflation protected US government bonds (TIPs). This brings our quantitative valuation conclusions much closer to those based on our qualitative analysis.

More information about our investment beliefs, including our core philosophy, approach to asset allocation (including our model portfolios and their long-term track record), and views on various approaches to active and passive management can all be found here.

Here is our latest asset allocation view:

Pre-Mortem Analysis

One of the most important forecasting disciplines is to ask yourself why your forecast could be wrong. Dr. Gary Klein’s research has shown that a very powerful and insightful way to do this is via a “pre-mortem analysis.” This method asks you to assume that it is a point in the future, and your forecast has been proven wrong (or your strategy or company has failed). You are then asked to look backward from this imagined point in the future, to explain why you failed, what you missed, and what you could have done differently to avoid your fate.

The pre-mortem method takes advantage of the fact that humans reason much more concretely and in more detail when explaining the past than they do when trying to forecast the future.

So let us assume that it is one year from now, and our current forecast has turned out to be wrong.

How did this happen? What developments did we fail to anticipate?

• Following the election of Joe Biden, the removal from office Xi Jinping could lead to a reduction in the dangerously growing conflict between the US and China. The impact of this surprise seems uncertain. To the extent that reduced external threat reduces the perceived urgency of implementing structural reforms in the US, it would increase the probability of the High Inflation Regime. Yet at the same time, it could accelerate economic and political reforms in China, which would increase economic growth there, creating a more dangerous medium term situation for the United States.

• A supply side shock of some type – beyond the disruption of global supply chains caused by COVID-19 -- could produce a sudden increase in inflation. The most likely scenario is a reduction in oil supplies due to a prolonged kinetic conflict between Iran and the US. An unlikely scenario could be major crop failures associated with the next solar cycle, which NASA forecasts will be the weakest in 200 years. McKinsey recently concluded that the probability of such a failure has increased due to changes in the environment, and now stands at about 10% over the next five years ("Will the World’s Breadbaskets Become Less Reliable?”).

Feature Article: The Probability of a US-China War Over Taiwan Is Increasing

The Financial Times’ John Dizard recently observed that, “War risk is consistently underestimated by money people” (“The Battle Ahead: War Is Coming For Your Money”). Of course, this doesn’t only apply to people in the financial sector. Strategic surprise is a common theme throughout history.

One of my favorite quotes about its root cause comes from Thomas Schelling: “There is a tendency in our planning to confuse the unfamiliar with the improbable. The contingency we have not considered seriously looks strange; what looks strange is thought improbable; what is improbable need not be considered seriously.”

At the turn of the 20th century, the world economy had reached unprecedented levels of integration, with international trade at an all-time high. This led many to believe that war was unthinkable, because its economic costs would be so high. Yet World War One still occurred.

In 2019, the value of goods and services trade between the US and China was over $600 billion; between the EU and China it was closer to $700 billion. Once again, many people believe that China would not go to war over Taiwan because the potential economic costs would be too high. Unfortunately, accumulating evidence suggests a rising probability that they are wrong.

Specifically, four developments have caused us to change the forecast we made last October (“Will Xi Jinping Launch a Surprise Attack on Taiwan Before the 20th Party Congress of the CCP in November 2022? And What Happens if He Does?”):


1. The surprise declassification in January (shortly before the Trump administration left office) of the “US Strategic Framework for the Indo-Pacific Region.”

2. Publication of “Xi Jinping’s Conception of Socialism” by Charlie Lyons Jones of the Australian Strategic Policy Institute (ASPI).

3. January changes to China’s National Defense Law.

4. Testimony given at the US China Economic and Security Review Commission’s February hearing on “Deterring PRC Aggression Towards Taiwan.”

US Strategic Framework for the Indo-Pacific Region

This document contains the following points about China:

• Under “National Security Challenges” – “How to maintain US strategic primacy in the Indo-Pacific region and promote a liberal economic order while preventing China from establishing new, illiberal spheres of influence...

• Under “Assumptions”:

• “Loss of US preeminence in the Indo-Pacific would weaken our ability to achieve US interests globally.”
• “Strategic competition between the United States and China will persist, owing to the divergent nature and goals of our political and economic systems. China will circumvent international rules and norms to gain an advantage.”
• “China aims to dissolve US alliances and partnerships in the region. China will exploit vacuums and opportunities created by these diminished bonds.”
• “Chinese economic, diplomatic, and military influence will continue to increase in the near-term and challenge the US ability to achieve its national interests in the Indo-Pacific region.”
• “China seeks to dominate cutting-edge technologies, including artificial intelligence and bio-genetics, and harness them in the service of authoritarianism. Chinese dominance in these technologies would pose profound challenges to free societies.”
• “China’s proliferation of its digital surveillance, information controls, and influence operations will damage US efforts to promote our values and national interests in the Indo-Pacific region and, increasingly, in the Western Hemisphere and at home.”
• “China will take increasingly assertive steps to compel unification with Taiwan.”

Xi Jinping’s Conception of Socialism

“Is Xi Jinping more Hitlerian or Stalinist in his view of Chinese socialism? The answer to that question is important because it bears on the policy choices China’s adversaries will need to make.

“George Kennan, the godfather of America’s policy of ‘containment’ of the Soviet Union, made clear in his 1946 ‘long telegram’ that Adolf Hitler’s vision of ‘national socialist’ modernity wasn’t a force that could be contained; the reason was that Hitler had a timetable according to which the Third Reich was to achieve global domination and his strategy could be thwarted only by annihilating Nazism by means of total war. The Soviet Union, in contrast, could be contained through Western domestic resilience and a resolve to counter territorial revanchism. That was because Joseph Stalin had in mind no specific time by which the world would need to reach the communist phase of development.”

“Precisely where Xi Jinping sits on the spectrum of totalitarianism is a matter of dispute. Elements of Xi’s ideology are notably Hitlerian. His ambition to achieve ‘the great rejuvenation of the Chinese nation’ introduces a nationalist character to the Chinese Communist Party’s understanding of socialism. Unifying China and Taiwan is one revanchist mission driving Xi’s ‘great rejuvenation’, but revanchism is only one part of the nationalism Xi has begun to emphasise in CCP ideology—militarism and capitalism are the others…

“The party has allowed China to undergo capitalist industrialisation since Deng Xiaoping, having repudiated Maoist collectivisation, but remained committed to a strong supervisory state. The political economy Xi has inherited is thus similar to the economic structure Hitler presided over in the Third Reich. The problem for the CCP, however, is that China’s state-supervised yet market-oriented economy necessarily repudiates any notion of socialism being driven by Marxism. To a political party that supposedly follows traditional Marxism-Leninism, that contradiction constitutes an existential threat. The way to negate it, for Xi, is to unify ‘state and race’ by integrating nationalist notions of China’s ‘great rejuvenation’ into CCP ideology. China’s economic model has forced Xi to take a leaf out of Hitler’s book…

“Xi views leadership in terms of a sacred bloodline and believes nationalism to be essentially ethnic. He probably sees the nationalisation of socialism as his personal mission on behalf of the Chinese nation.

“National socialist images of a sacred bloodline have now become a feature of CCP ideology … The national socialist mission of unifying race, party, nation and state seems to have taken on singular import for the CCP, while its Leninist role of securing a path to communism has been subordinated. Nationalism is no longer a necessary step on the road to communism, but the driving force behind Chinese socialism…

“The CCP’s role in securing China’s path to communism is being subordinated to Xi’s vision for China’s nationalist resurgence. The likeliest result of this phenomenon is a less patient, more erratic and risk-hungry foreign policy. Indeed, the prominence of Beijing’s ‘wolf warrior’ diplomats and the CCP’s track record of economic coercion are good indicators that Chinese foreign policy is already taking on that distinctly Hitlerian quality.”

January Changes to China’s National Defense Law

• Changes to the National Defense Law have transferred important powers from civilian officials (the State Council) to the military (the Central Military Commission).

• The CMC is led by Xi Jinping. After the changes, it now has full power to mobilize military and civilian assets to defend national interests both within China and abroad. The Chinese military is now completely under Xi.

• For more discussion on these changes, see “China’s Updated National Defense Law: Going for Broke”, by Ben Lowsen of the Jamestown Foundation

Hearing on Deterring PRC Aggression Towards Taiwan

Testimony by Lonnie Henley, retired Defense Intelligence Officer for East Asia at the Defense Intelligence Agency

• “The PLA has systematically built the capabilities they believe they need for a war with the United States over Taiwan. They probably have achieved initial capability.
• “A failed Taiwan landing would not end the war. The Communist Party (CCP) leadership could not afford to accept defeat. The passions aroused by the war itself and by the propaganda effort in support of the war would not allow the Party to stop short of a political outcome they could credibly sell as a victory. China would continue the conflict by whatever means available, primarily blockade. The PLA would have the advantage in that extended phase of the conflict even after severe losses.

• “Most of the operational approaches available to US forces would not serve to end the war.

• Defeating the amphibious landing
• Destroying the PLA Navy and Air Force
• Cutting off China’s international trade
• Trying to spark internal unrest or crises on China’s periphery
• Other “cost imposition” strategies

• “Penetrating a Chinese blockade of Taiwan would be a slow, grinding battle stretching over many months… If we cannot defeat the blockade, we will not prevail.

• “Taiwan’s will to resist is vital but unknowable. Equally vital, and knowable but inexcusably not known, is their ability to endure a long-term blockade and what they would need to survive.

• “The military center of gravity of this conflict is the PLA integrated air defense system in southeast China. If we can disable that, we can win militarily. If not, we probably cannot…

• “Over many years of participating in Taiwan Strait war games and tabletop exercises, I observe that Taiwan’s air defenses are almost always disabled within the first few days of the conflict, but China’s integrated air defense system (IADS) along the Taiwan Strait remains effective for as far into the conflict as the exercise examines. This in turn limits the United States to long-range stand-off weapons or precision-strike incursions by stealth platforms. I assume I am not the only person to have observed this and that US forces are working on the issue.

• “Success in this area would have the greatest impact on the overall conflict, more even than finding a way to defend US air bases from Chinese missile strikes. Poorly defended bases will still generate some combat sorties, particularly as the conflict drags on and the Chinese expend their inventory of theater-range missiles. But a functioning air defense network greatly reduces the impact those sorties can have. Conversely, defeating the Chinese IADS would open the door to the kind of air campaign that has proven decisive against less capable opponents.

• “More specifically, enabling US air operations over the Strait would be our best hope for getting cargo into Taiwan’s western ports. The PLA’s short-range anti-ship assets can be extremely effective under a tight air defense umbrella, but much less so in the glare of US air power. The PLA air blockade, meanwhile, simply ceases to exist without the IADS.

Testimony by Oriana Skylar Mastro, Center Fellow, Freeman Spogli Institute for International Studies, Stanford University. She also serves in the Air Force Reserve, as a strategic planner for the US Indo-Pacific Command

• “Cross-strait deterrence is arguably weaker today than at any point since the Korean War. Impressive Chinese military modernization, U.S. failure to build robust coalitions to counter Chinese regional aggression, and Xi Jinping’s personal ambition, all coalesce to create a situation in which Chinese leaders may see some aggregate benefit to using force. I support this assessment.

• “The most realistic pathway to conflict used to be that Taipei or Washington crosses a redline that precipitates conflict. For example, if Taiwan were to declare independence, China would undoubtedly use force to reverse the decision, potentially even using the opportunity to push for ‘reunification.’ In case we needed reminding, the Chinese Ministry of Defense clearly stated on January 28, 2021 that “Taiwan independence means war.”

• “But the basic argument in my testimony is that the situation has changed. The greatest threat now is that Beijing will launch a military operation to force ‘reunification,’ irrespective of Washington’s or Taipei’s policies or actions. Specifically, I believe Xi Jinping will use force to compel Taiwan to unite with the mainland once he is confident in the Chinese military’s ability to succeed in relevant joint operations, like an amphibious attack…

• “Because of [organizational] reforms [focused on improving the ability to conduct joint operations] and the modernization of Chinese equipment, platforms, and weapons, China may now be able to prevail in cross-strait contingencies even if the US intervenes in Taiwan’s defense. China’s improved anti-access/area denial capabilities and its strides in cyber and artificial intelligence also contribute to the weakening of cross-strait deterrence. In the words of Michèle Flournoy, ‘In the event that conflict starts, the United States can no longer expect to quickly achieve air, space, or maritime superiority.’ As Beijing hones its spoofing and jamming technologies, it may be able to interfere with US early warning systems and thereby keep US forces in the dark. Worryingly, other analysts have concluded that Chinese interference with satellite signals is only likely to grow more frequent and sophisticated.

• “China also possesses offensive weaponry, including ballistic and cruise missiles, which if deployed, could destroy US bases in Western Pacific in days. Finally, the US intelligence community warns that, “China has the ability to launch cyber attacks that cause localized, temporary disruptive effects on critical infrastructure—such as disruption of a natural gas pipeline for days to weeks—in the United States.”

• “Because of these aforementioned capabilities, many US experts are concerned with a fait accompli, a scenario in which China takes Taiwan before even the most resolved United States could act decisively. Recent war games jointly conducted by the Pentagon and RAND Corporation have shown that a military clash between the United States and China over Taiwan would likely result in a US defeat, with China completing an all-out invasion in a matter of days.

• “In the end, Chinese perceptions of their likelihood of victory are more important than the reality in determining if they use force. It is not a good sign that Chinese sources express an increasing confidence that the PLA is well prepared for potential military confrontation with the United States over the Taiwan issue. The multiple large-scale military exercises (at least nine) conducted simultaneously in the Yellow Sea, the South China Sea, and the Bohai Gulf by the PLA in August 2020 are considered a credible demonstration of its ability to conduct complex, intense joint operations. While Chinese strategists acknowledge US military superiority generally, the conventional wisdom is that China’s proximity to Taiwan, corresponding access to operational resources and resolute stance, makes the local balance of power favorable to Beijing.

• “The bottom line is that for the first time in Chinese history, Xi will believe that he has at his disposal a military capable of forcing unification. While many Western observers think China will be able to do so in the next five to eight years, Chinese military leaders have told me that they will be ready within a year. It is telling that, in Xi’s first order to China’s armed forces in 2021, he emphasized the importance of “full-time combat readiness” and said the PLA must be ready to “act at any second”…

• If Beijing thinks the US will intervene on Taiwan’s behalf, then time becomes crucial. Chinese military strategists believe that if you let the United States fight the way it is used to, which includes time to mobilize and amass firepower in theater, then victory is unlikely.

• “Thus, if Chinese leaders believe the US is likely to intervene, they are more likely to move quickly to the highest level of violence that the scenario requires to force Taiwan’s capitulation to Beijing’s demands before the US can intervene. If China’s objective in the scenario is unification (versus punishing Taiwan or compelling a reversion to the status quo) and it expects US intervention, then it could even preemptively hit US basing in the region to cripple Washington’s ability to respond.

• “In other words, US deterrence and defense are working at cross purposes. The more credible our resolve to fight, the more likely Chinese leaders are to escalate rapidly and hit US forces in the region in their opening salvo – thus making a US victory less likely. But if there is a possibility that the United States will stay out, Chinese strategists would avoid such a move, as it would inevitably bring the United States into the war. In this scenario, as China focuses on compelling Taiwan’s capitulation at lower levels of violence, the United States would have time to mount an adequate defense” …

• In response to Commission members’ questions about Mastro’s testimony, she acknowledged that since the United States’ place in the world would be at stake if China invades Taiwan, Chinese leaders almost certainly assume that the United States will intervene. While on one hand this would argue for a very strong “first strike” attack by China on the United States, Mastro also noted that Chinese leaders are well aware of the reactions that followed similar surprise attacks on Pearl Harbor and 9/11.

• Elsewhere, Mastro has written about the challenges China would likely face in trying to limit the escalation of violence once a war with the United States had begun (e.g., “Can China Stop Wars Once They Start?”).

• “The United States does not usually accept a return to the status quo antebellum after blood has been spilled. If China uses force against Taiwan, US leaders may want a war termination settlement that sufficiently punishes Beijing for this action—likely by demanding concessions on Taiwan’s political status that Beijing will not make. In this scenario, Beijing will turn to its tendency for disproportionate escalation to bring about an end to the war on its terms. China will start by increasing the costs on US military forces in the region; if that does not work, they will consider civilian targets in the United States. However, due to range limitations (China has limited conventional options25 for hitting the US homeland), this is more likely through nontraditional means like cyber or counterspace attacks. This is one of the few scenarios in which the leadership may consider using nuclear weapons, though I do not believe they would use nuclear weapons first.

• “Maintenance of the status quo is no longer desirable for Chinese leaders. Xi has publicly called for concrete movement toward ‘reunification,’ an explicit demand that stakes his legitimacy on progress in that direction. By doing so, he moved the goalpost from preventing Taiwan independence, which means living with the 40-yearlong status quo, to an actual change in the nature of the cross-strait relationship, which is substantially less achievable without the use of force. Xi Jinping has stated multiple times his position that his program of national rejuvenation cannot be complete without ‘reunification.’ His ambition to “resolve the Taiwan issue” during his tenure is common knowledge among the Chinese people. Xi has also expressed in various ways that he is more willing than his predecessor, Hu Jintao, to use force. Additionally, in a major speech, Xi articulated that “the long-existing political discrepancy is the root cause of cross-Strait instability, it cannot go on generation to generation.”

• “Xi also seems to be ruling over an increasingly impatient Chinese population. A recent Global Times poll revealed that around 70 percent of mainlanders support war to unify Taiwan, and 37 percent of them think it best if war occurs in three to five years. (The next most popular answer is one to two years, with only approximately 10 percent saying unification can wait for more than 10 years.) Furthermore, 64 percent of mainlanders anticipate a full-scale war to unify Taiwan, and 72 percent of them think China would definitely win. Luo Yuan, a major general in the Chinese military, recently said that China’s leaders “can only follow the will of all Chinese nationals [and] realize reunification by force,” should Taiwan refuse to cede to Beijing’s leadership.

• In response to Commission members’ question about her testimony, Mastro made a critical point: “Military success is not the criteria for success in the Chinese view of the world. The key question for them is can the application of military force achieve our strategic objectives?” From this perspective, and given his personal ambitions, Mastro noted that Xi Jinping might see significant military losses as being worth the political benefits of conquering Taiwan by force (not to mention the very substantial negative impact this would have on limiting the United States’ access to advanced semiconductor chips produced by in Taiwan Semiconductor Manufacturing Company’s (TSMC) fabs on the island. Xi is also very likely to be tempted by the potential benefits of imposing a military defeat on the United States, which would make China the de facto hegemon of Asia.

• Mastro concluded that, “When Xi Jinping is confident that his military can win a war across the strait, I think he’s going to go for it… The key is reducing his confidence that he can win… Our number one concern today is not deterring China; it’s deterring Xi.”

Testimony of Mark Cozad from The RAND Corporation

• Cozad argues that, “even though Beijing’s confidence in all elements of PRC national power has increased significantly over the past two decades and continues to grow, Chinese political leaders probably remain cautious about the PLA’s ability to execute high-intensity operations, most notably a major campaign to force unification with Taiwan. Even though the PLA has made great strides over the past two decades, military publications, official statements, and reform programs suggest that its modernization has not progressed as rapidly as Beijing thinks necessary in several areas critical to fighting modern wars.”

• In particular, while the PLA has made substantial progress in upgrading its doctrine and equipment, “Beijing remains concerned about the PLA’s overall level of experience and proficiency [particularly in conducting joint and amphibious operations]… PLA self-evaluations often address qualitative concerns, such as personnel quality, decision making, reliability, and command. These evaluations deal heavily with internal PRC and PLA issues of demographics, organizational culture, and differing cognitive styles… PLA modernization imperatives—such as informatization, jointness, and systems warfare—cannot be realized without qualitative intangibles, such as capable personnel and efficient, effective command.”

• “Based on the nature of PLA weaknesses, a key question in our understanding of China’s calculations regarding the use of force against Taiwan is how Beijing’s views of the PLA’s weaknesses might shape or constrain its decision to take military action against the island.”

• In their discussion of Cozad’s testimony, Commission members agreed that a critical indicator would be any successful small-scale “real world” demonstration by China of its amphibious and joint operational capabilities, which would serve as a test run for a much larger invasion of Taiwan. A likely candidate would be a Chinese amphibious attack to retake small islands that Vietnam claims and has fortified in the South China Sea.

Conclusion

In our October 2020 feature article, we asked, “What Is The Probability That China Will Launch A Surprise Attack On Taiwan Before The 20th Congress Of The CCP In 2022?”

We concluded then that there was a 25% probability that China would attack Taiwan before the 20th CCP Congress, which is scheduled for November 2022.

Based on the latest evidence, we now estimate that the probability has significantly increased to 50% (+/- 10%) between now and March 2024.

It is almost certain that the increasing risk of war between the United States and China is not fully reflected in asset class prices today. For example, Chinese equities account for almost 40% of the MSCI Emerging Markets Index today.

In terms of our macro regime probabilities and their implications for portfolio asset allocation, an increasing likelihood of a Chinese attack on Taiwan should initially lead to a relative increase in the probability of being in the High Uncertainty regime.

Once the war begins, and assuming it results in severe disruption of supply chains and capital flows, there would likely be an initial burst of shortages and inflation in some product categories (the largest US imports from China are electronics, such as computers, cellphones, and related products). However, this would also be accompanied by a sharp reduction in private consumption and investment spending.

What comes next likely depends on the nature of the war. If the war begins with a surprise Chinese attack on broad range of US assets, including civilian assets located in the United States (e.g., pipeline and power grids), causing significant loss of life, it would, like Pearl Harbor and 9/11, almost certainly trigger a sustained national mobilization. If the US defeats China, this would very likely lead to an eventual transition from the High Uncertainty to the Normal regime.

However, if the US suffers a defeat in the Western Pacific, a global crisis of confidence in the United States would ensure, and the slump in private consumption and investment spending would almost certainly deepen, leading to increased insolvency problems, and likely a transition to the Persistent Deflation regime. Whether the very substantial increase in national anger, will, and defense spending and the accelerated replacement of foreign supply chains following a defeat would be sufficient to escape this deflation is a toss-up.

In sum, we are almost certainly entering a period of substantially higher uncertainty that has not yet been recognized by investors and reflected in asset class valuations.