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An Intended Vacuum?

We have discussed the Balkanization process we see unfolding, over the last five years. It is a reaction to globalization reaching its limits of penetration, and a partial retreat to regional political-economic concentration.

Today’s focus is on the planning, and perhaps instigation of this trend. Regulatory and financial restrictions have increased, as the US government made it increasingly difficult to have overseas businesses run from the US. In fact, this administration seems to have taken the position that the US is a giant island and the rest of the world revolves around it. This is not a domestic policy observation, but foreign policy one. The benign neglect of the Middle East/North African situation in Egypt and Libya was astonishing, given that the State Department was both aware and concerned about these two countries for a decade earlier. Let’s consider, for argument’s sake, this was an intended direction.

What if the administration agreed with our observation, that global politics would drive the six regional hegemony that would be essentially “super countries.” These would be the North Americas (US, Canada, Mexico) the South Americas (Central and South Americas), Europe, Russia, India, Non-Islamic Asia (China and surrounding contiguous areas). All other areas would be either under economic control, as the output from Australia to China demonstrates, or unclaimed.

This Balkanization has important financial consequences, as regions are less interested in financially supporting their competitors. Thus, self financing is important. Those countries that rely on financial support from others are inherently weaker politically, militarily, and financially.

It is not in anyone’s interest to have capital flows stop and reverse suddenly. Yet how can a country quickly go from external financing to internal self-sufficiency? For today’s note, let’s consider the United States.

The US is a powerful dispenser of financial and military support to their allies and business partners around the world. It has spent huge sums, not just in the recent war on terror efforts. Direct financial aid to countries is also quite large. Were the US to begin wider reductions in military and financial aid, it would create a local political vacuum in that country. That is Phase One. Phase Two would be the withdrawal of funds by the business and the well-informed population from the country’s banks and domestic bond market. Phase Three would be a political and economic realignment, usually accompanied by protests and other disturbances. Phase Four – if it gets ugly enough – is a civil war.

Phase Two is the element is most important to other countries. Capital flight will have to go somewhere, and capital usually goes where it is safest and best treated. In the existing global structure, that mostly leaves the US for capital of size. Temporary capital would flow into US Treasury securities. Permanent capital would likely choose real estate, both commercial and residential. Unlike US real estate buyers, these investors are not using banks to finance their purchases. A buyer who is not using a mortgage is not influenced much by interest rates. This is important, and will be discussed in another piece.

This dynamic also allows the US budget deficit and debt structure to develop. Baring an energy shock, inflation in the US would also stay low as the dollar would stay firm from greater inbound and small outbound capital flows. This would increase the perceived financial strength of the US too.

A global environment, where the US gradually withdraws aid, can create a self-reinforcing cycle. As more assistance is withdrawn, more money flows to the US, which then further weakens those countries. Further, the non-rate sensitive investors give the US an advantage other countries do not have – disproportionately cheap capital. This makes US-based businesses more competitive than overseas ones, thus attracting more capital. This cycle goes on until the other areas reach a point of stabilization in the new environment or they default/restructure their debt.

While we cannot know the US intends directly, we can see the actions and draw conclusions from them. Rhetorical statements aside, the US does not seem interested in getting involved overseas. Recent actions involving Syria, Iran, Russia/Ukraine are exceedingly modest. There are public press accounts questioning how strong our support is of different long-term allies, such as Saudi Arabia. Based on these and other observations, a policy of gradual aid withdrawal already appears to have started.

The scenario we have laid out above has investment implications. However they are quite involved enough, and these pieces are too concise to discuss them.

In our next piece, we will discuss the flows we have observed from Russia and China and what they imply about this framework.

As always, we would like to hear your thoughts and observations on our thinking. Do you see it differently? In what way?