[00:00:00] Viktor Shvets: If you go back to 2008, there was only one asset class that went bad. In dot com, there was only one asset class that went bad. Today, the mines are everywhere. They're everywhere. And so one of the things I discussed is that, if risk is everywhere, risk is basically nowhere. Ah, it has to be by definition, and therefore, none of those mines will truly go off. Now that doesn't mean you as an individual cannot lose money. That, you can. It doesn't necessarily mean that certain asset classes cannot go down so long as another asset class goes up. But nothing systemic of those fearful headlines that you see will ever really truly come to pass.
[00:00:53] Adam Butler: Okay, welcome everyone and welcome Victor Shvets. For those who don't know, Victor is Managing Director and Global Strategist at Macquarie Capital and more importantly for this conversation he is also the author of two books, the first one, which came out in 2020 was The Great Rupture, Three Empires, Four Turning Points and the Future of Humanity. Do We Need to be Free? We had Victor on actually to talk about that, which was one of my absolute favorite all time conversations. And today we've got him back to talk about his new book, which is called The Twilight Before the Storm: From the 1930s Fractures to Today's Crisis Culture. How to Avoid a World on Fire.
Victor, I have to say you definitely take the cake for exciting titles, so this, I think I actually liked this book even better than the first book. As we'll probably come to see, it hits on a few of my own personal biases and frameworks as well. So I'm sure that's part of it, but I really enjoyed it and, I'm looking forward to getting into it before we do. I mean, obviously you spent a lot of time researching and writing and then talking through the concepts in The Great Rupture. What motivated you to write this new book so soon after the grand tour of your first book?
[00:02:30] Viktor Shvets: Well, thank you very much for inviting me. Essentially, so many things have changed, as you know, over those four years. Quite a part from pre COVID 19. COVID. We had a massive flare ups of geopolitical pressures. There was a significantly greater and deeper societal polarization occurring at the local level across various countries, and economically, if you think of changes, both from a monetary policy perspective from our inflationary perspective, fiscal policies, just so much had changed over those four years that I thought I need to revisit some of the concepts that we've developed in the first book, and develop it in light of what happened in those four years.
I also felt that everybody was comparing our times to 1970s, and to me, that's a wrong comparison. I think 1930s is far more appropriate. So those were the major reasons why I sort of wrote it as quickly, or as frequently, I guess, after the first book. Just too many things have changed, and I think people are focusing on the wrong parallels.
Changing Perspectives
[00:03:45] Richard Laterman: And did these events over the last few years, did they reinforce the hypotheses that you put forward in the first book or were some of them shaken? Did you have to revisit some of them? How has your thinking evolved as the policies that governments put forth since COVID, how has that changed your perspective on everything?
[00:04:07] Viktor Shvets: Well, the fantastic thing from my perspective was that the major thrust of my first book, actually has not changed. The major thrust was really Fujiwhara Effect, or a merger of highly disruptive information age, and deeply disruptive financialization. That's something that started all the way back into 1980s-90s, but really accelerated all the way to my first book, and even more so over the last four years. So the major reason why we are experiencing polarization, why geopolitical pressures are greater, why we have economic volatility, why the role of the state is continuing to increase, are still the same. It is a Fujiwhara Effect.
But one of the things I try to address is a question of subjecting economic cycles to even more pressure than what we had, you know, four or five years ago. So in other words, the government's tentacles have spread even wider and faster than I would have anticipated back in 2019, when I was writing my first book.
So the thrust is the same, but there is more urgency, I think, in this book, compared to my previous publications, and that's very much colored by the experience of COVID and our response through fiscal and monetary means to what happened to us.
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[00:05:33] Richard Laterman: Can you maybe…
[00:05:33] Adam Butler: Sorry Richard, go ahead.
The Fujiwhara Effect
[00:05:35] Richard Laterman: Yeah, no, I just wanted to maybe connect some of the dots. I think the information age and the financialization, which I think we did discuss in our first conversation, they are somewhat intuitive, and they have been the zeitgeist for some time. So we understand them to some degree, but how would you connect the dots with the geopolitical strain that we see in the world today, and things have been flaring up quite a bit in the last few weeks. So maybe connect those dots for us, if you would.
[00:06:03] Viktor Shvets: Yeah, sure. Well, the essence of Fujiwhara Effect, which is self-reinforcing information age and financialization, is that it disrupts the functioning of capital, it disrupts the functioning of labor, it also disrupts social relations. So in other words within the countries, people start moving in different direction at different speeds. That applies to the population as a whole, but also applies to different racial groups or ethnic groups of people of different backgrounds.
Now that’s basically a recipe for polarization rising within societies. But what is also happening is that countries start moving in different directions, different speeds, depending on their position, geographic position, structure of the economies, the importance of tangible versus intangible capital in those countries, the importance of know-how, the importance of financialization and how much of that they experienced.
Countries that moving in different direction, different speed. When that happens, what actually occurs is that it flares up historical grievances, and all the other things that people were hoping are in the past. Yeah. But they still sort of continue to exist and linger in our memory and what we do. And so that's really the areas.
The other thing I keep highlighting that eventually what happens is that people stop agreeing on the right economic, social or political model. So if you think from late 1970s, early 1980s until the global financial crisis, it didn't really matter whether you were Republican or Democrat, whether you were George Bush or Bill Clinton, whether you were Tony Blair or whether you're John Major, whether you're a Social Democrat or Christian Democrat in Europe. All of them were singing from pretty much the same hymn book.
And the hymn book was neoliberalism. In other words, the government is an efficient, inefficient, quite often is unjust, does not have enough market signals in order to make appropriate decisions, private sectors, on the other hand, offer a much more efficient solution. At the same time, this neoliberalism was basically highlighting desire to be free. I want to be free to marry or divorce anybody I like. I want to be free to move the countries. I want to be free to change my jobs. Now, all of these freedoms have the price, and sort of, the check arrived around 2010. And so what started to happen around the global financial crisis is that people stop agreeing what is the right political, social, and economic model.
And so what we started to see certainly over the last decade, and one can even trace it all the way to 2010, when the Chinese were telling the Americans and Hank Paulson that we no longer have anything to learn from you. We are now in our teacher's domain. So what started to happen is that people started to disagree.
And as they start to disagree, what you end up is alternative proliferating. There are, there's Chinese alternative. There is Russian alternative. Europe is looking for the right model. U.S. is trying to figure out what's the right model. Whenever there is this disagreement on the basic concept, what is the right business model, what is the right economic model? What is the right social model that aggravates massively post polarization and geopolitical issues? And my argument is that COVID aggravated it even more. So the last four or five years have become much more extreme compared what it used to be, back in 2019, 2020.
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China and the WTO
[00:09:58] Adam Butler: They were granted access to the World Trade Organization. Would you say that the Western powers just assumed that by granting China access to the WTO, that by virtue of them embracing the capitalist dimensions of that access, that Democracy and sort of free society would inevitably follow, and do you think that Western societies were surprised when Chinese leadership maintained their more autocratic preferences? And how do you think that may have shaped the 2010s and the change in postures between the West and China?
[00:10:41] Viktor Shvets: Yeah, absolutely. You're totally right. The whole idea of integrating China, and remember, that was a consistent philosophy of at least five or six U.S. administrations, all the way from George Bush Sr. to the very end of the Obama administration in 2015, 2016, and so it was a very consistent policy.
And the view was exactly what you've just described. As we grow, as we integrate, as income levels increase, what's going to happen, that gradually you'll become a stakeholder in the Western design, economic, and political system, and we'll welcome you to be one of those stakeholders. One of the things Chinese seem to misunderstand, they seem to believe that Americans are preoccupied, that they want to be number one.
The reality is, as Coolidge once said, the business of America is business, and so this sort of view that Americans are so preoccupied with being number one, is incorrect. So long as there are opportunities to grow, so long as there is a fair playing field between the countries, so long as there is opportunity to enter your country and benefit from that growth, the business lobby in the United States, as you know, is so strong that, irrespective of anything, politics could not overrule the business considerations. It was really the change, the way China perceived itself.
Now, one could argue it even goes to the early 2000s, but certainly around 2010, you saw a major shift in Chinese government policy, and that's what, very much motivated by the shock of global financial crisis and a perception that clearly liberal model is not going to be the right one for China going forward. You can even track it through things like ownership of national wealth. A very hard number to compute, but most people believe that if you go back to sort of 1980s, government was controlling well over 80 percent of national wealth. By 2008, it was down to below 40 percent.
At that point in time, it stopped declining, and in fact, several years, at least three, four years before Xi Jinping was elevated to become a General Secretary of the Communist Party, China already started to recombine state owned enterprises. They already largely extinguished local democratic initiatives at the local level. They already started to broaden the mandate of what state owned enterprises were responsible for, not just for delivering goods, not just for delivering efficiency. but also a variety of social and political outcomes. And of course, Xi Jinping took it to the next level.
So, for example, back in the pre global financial crisis, party cells in China were really social clubs and retirement clubs. Today they are not, and the head of the party cell is, actually has the highest standing. They're the CEOs of the companies that they run, and so this perception that liberalism is not the way forward, it creates too much volatility. It undermines the power of the states. It potentially could create unimaginable problems.
That this sort of view become ingrained after global financial crisis. And it was just a question, and at the time, of course, I was based in Hong Kong. It was just a matter of time to see and how far China is going to take it, and I think if you go back to 2010, nobody would have expected that it'll go as far as it did, but everybody should have expected that China had already made a decision that they would rather change the world to be much more accommodative towards the way China prefers to run its economy and society, rather than changing China in order to integrate or accommodate the rest of the world.
So I said that decision actually predates Xi Jinping and predates the current leadership, and to me, we can debate exactly where change occurred, but it's really become visible at least in the way the government treated state and state owned enterprises and the importance of state owned enterprises. That's really started around 2010.
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Tangible and Intangible Capital
[00:15:11] Adam Butler: One of the consequences of China's change in stance toward global trade may have been a disproportionate impact on global trade. The economy of Western Europe, right? One of the things that we have seen over the last 15 years or so, in a much more pronounced way, I think you'll agree, is a change in the rate of growth. We've seen a continuation of very rapid growth and innovation in the United States.
We've seen a retrenchment in China for a variety of reasons, including the ones that you mentioned, but as a function of that retrenchment in China, because of the previous potentially more hardwired integration of Europe with the Chinese trade engine. And for other reasons, Europe has really slowed down in its growth, right? You can, you can observe that in GDP, in debt levels, and in terms of the performance of European equity markets, for example, right? How has this economic desynchronization impacted the frictions that we're now seeing emerge around the world?
[00:16:58] Viktor Shvets: So European monetary union is mercantilist block, but it's also true to say that Europe has missed the software trade. So if you go back to around 2000 when I was a technology analyst, back then the software companies, the first mobile software company was actually Nokia. If you think of operational management company, it was SAP in Germany. But from 2000, they really missed the entire train. Now, having missed the software train, they're now lagging in intangible capital. So, one of the sayings I've discussed in my book, that it's very important to have a right balance of tangible and intangible capital.
When a lot of people were suggesting after COVID that we over-invested in intangible and under-invested in tangible capital, I've disagreed, and if you think of what ChatGPT alone has done for the world and as quickly, you appreciate the value and importance of intangibles. And so what started to happen is that Europe started to lag in intangible capital. Most of their patents, most of their goodwill are very much industrial age. They have a lot of niches, which are very interesting, things like luxury, for example, they have one or two niches in technology, in capital goods, but essentially, initially it's industrial age. It goes back to middle of 20th century to 1950s, 80s, 90s. They've missed a lot of the other intangible assets relating to software and how you use software. Now the question is whether it's possible to catch up. Right now, going forward, the answer is, it's going to be very, very hard.
And that's the problem facing Europe. That on the one hand you're a mercantilist bloc and therefore you rely on the global cyclicality. You're relying on China. You're relying on demand to come to you and that demand is no longer there. China will never again support global growth rates. China will never again support global commodity complex.
And globally generally we're stuck at a much lower GDP trajectory. You know, closer to two and a half percent in market terms rather than three or three and a half. So number one, Europe doesn't give the same degree of cyclicality. And number two, they haven't really built the future. Now the only thing to argue against that is that, is to say that, look, an average European only works 1,300 hours a year.
Average American works 1,900 hours a year. So if you just, for the strength of U.S. dollar, in other words, look at a PPP basis, and if you just per hour work, Europeans are not actually less productive than Americans are per hour basis. It's just, they make a different decision how to lead their life, what lifestyle to have.
So for example, U.S., average American lives five, six years less than an average European. If you think of, if you think of deaths in maternity wards, or infant deaths, they have two, Americans have three to four times higher deaths occurring, than it is in Europe. If you think of healthcare expenditure, they're spending only 10 percent of GDP compared to 19 percent in Europe.
If you think of inequalities in European Monetary Union, the bottom 50 percent of households own about 6, 7 percent of national wealth in Europe. In the U.S., it's like 2 percent. If you think of the top 10, in the U.S., it's 70. In Europe, it's more like 50. So, in other words, it's more egalitarian society. If you think of violence and incarceration rates, in the U.S., it's 5-10 times the level that's what you're experiencing in Europe.
So I totally agree with what you're saying. And that's part of the reason Europe is falling behind, and part of the reason Europe is only half the size of the United States, where back in 2000, they were almost the same size. But at the same token, one has to take social characteristics into account, that Europeans have a different view of what is important in life, and in some ways on a lot of those parameters, they're leading a better life on average than an average American does.
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Demographics
[00:21:18] Richard Laterman: And what about the role of demographics here, because the aging of the European population is such, in combination with the inability of most Western European countries to function, properly integrate a lot of the migrant populations that have come to Europe over the last several decades, that would maybe suggest that this is less so a choice that European economies make, but rather they're dealing with something that's kind of inexorable in a way, whereas the U.S. has much more dynamic demographic variable, as well as a more dynamic labor market, right? The ability to hire and fire much quicker, which Europe does not have. So how do you contemplate demographics in this scenario here for Europe?
[00:22:10] Viktor Shvets: Well, demographics, not just in Europe, but globally, have kind of two sides to it right now. Number one, humans are becoming less important, and humans are far less important driver of productivity than they used to be, and as we progress forward, we already have gone through the first stage of information revolution. That was 1980s, 90s.
We've gone through the second stage, which is digital, which is 2000-2010. We now going to the third stage, we're starting to disintermediate hard elements. In other words, instead of digits, we're going into atoms, and a classic example is anything to do with AI, artificial intelligence, which is the general purpose technology, which is starting to permeate robotics, automation, biotech. As we go over the next five, six, seven years white collar employment will be decimated. Not necessarily that people would lose jobs. They'll just becoming less relevant and you will employ less of them. So if you were a bank and employing 500 graduates in order to end up with 50 next year, you'll be doing 250 to end up with 25, then be doing a hundred in order to end up with 10. And then you'll be doing 50 in order to end up with one. So potentially, it could have a dramatic impact on white collar employment, but because it's general purpose technology and it continues to accelerate, if you start thinking five, 10, 15 years from now, that's your dark factories. That's your elimination of supply and value chains.
That's your changes in logistics. How you deliver products or services, and so the question is in that world I've just described, do you really want to have a lot of people? Do you really want to have a lot of young people? Well, the answer is no. So in an industrial age, the whole idea was progressively train younger people to a high and high level of productivity so they can look after the older people, the country as a whole, and drive the productivity forward.
Increasingly productivity is not driven out of labor. It's driven out of intangible capital and how that intangible capital actually changes the functioning of money, capital and labour. So that's the first point. So yes, you're right. They have a terrible demographic. But it's actually not a bad time to have terrible demographics. It's actually much worse to have a lot of younger people. And that's my second issue. that Europe is facing because Europe is really a cauldron of all geopolitical and immigration and social tensions that you can possibly envisage.
You know, Americans worry about Central America, you know. For Christ's sake, there's only 55 million people in the whole of Central America. Now, if you think of Europe, on the other hand, one of the things my book highlights that we could have migratory waves on the scale of Barbarian invasions of the third and fifth century against Rome, and Turkish and Mongol invasions of the 13th and 15th century against the Russians, the Greeks, the Persians, and the rest of it. So, and that's primarily because if you think of Africa, Middle East, and Central Asia, they're on the course of doubling the population to three billion people. Now, 3 billion people to put in perspective, that was an entire population of the world back in 1960s.
So you're going to have 3 billion, half of them are younger generation. So in other words, a lot of youngsters are coming through. And if you don't find a job, if you don't find attractive lifestyle, and if climate change is going to accelerate, in other words, the drying up of Sahel, much more unpredictable monsoons and monsoon rains, if you're going to have that, a lot of those people will be on the move.
And as I have described in the book, if just 10 to 20 percent of this younger generation decides to move, you're going to have hundreds of millions of people on the move and Europe is completely exposed to that. Now that explains anti-immigration feeling in Europe, because one of the things I described in the book is that look, Romans couldn't keep the Barbarians out, you know, Greeks and Russians could never do it. Walls never work. People always find a way around it. Because what drives people is not the desire to leave home. Nobody wants to leave home. It's just, I have to. And that was true of the Turks and Mongols. That was true of Franks and Burgundians and Vandals. That was true of all of them. And it is true today.
And so the question is, how would Europe in particular, handle it, and there is really only three answers. Either you open your borders, and you change racial, ethnic, religious composition of your societies - ultimately, that's what Romans, had to do, but that's where they settled the Barbarians on the border. The second alternative is that you somehow recolonize those countries and keep people there, but that involves armed forces and all sorts of terrible choices that you need to make. The third alternative is much better and that's enlightened Marshall Plan. So in other words, you dedicate 10 to 20 percent of your GDP to developing those countries.
So people actually don't move, and, and decide to stay at home. Now, again, if you mentioned that to Europeans, they will say, well, number one, we don't want to open borders. Okay. Number two, we don't want recolonization, and number three, we don't want to spend the money. We have poverty at home. Why should we spend trillions of dollars somewhere else? But there is no other choices that they have. So when people discuss European impact, by the way, that will impact U.S. as well, but all I'm saying it's surrounded by the oceans, just like Australia is. And so there is some impact, but it's nothing like what Europe is likely to face.
Say, if you think of demographics, two things to say. Number one, I think as we progress forward, humans are not as relevant as productivity drivers, and therefore you can actually grow productivity with much more limited number of humans and even older humans rather than younger people. And number two, I think Europe is really facing a very different, difficult dilemma, over the next decade or two. What do you do with Africa, Middle East, Central Asia, and even South Asia?
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Burn Down the House
[00:28:52] Adam Butler: So I want to steer us a little bit more directly onto the trajectory of the book, and I think it's a good segue because we've discussed the asynchronization or desynchronization of global economies in terms of social dimensions, economic dimensions, ideological, political, and demographic. In the book, you make a strong case for why the current period, for these and other reasons, mirrors the 1930s and not the 1970s. Why don't you walk us through that thesis?
[00:29:32] Viktor Shvets: In 1930s was the last time when all sorts of ideologies and competing systems were directly competing against each other. If you think of 1970s, for example, Communism was already discredited largely. There was really no other alternatives. All we were doing is fine tuning our own system, rather than doing anything else. 1930s was the last time when you had that. One of the books I keep referring to is a 1937 book that was called Planned Societies and Economies: Yesterday, Today and Tomorrow. The book never been republished again, so you can't actually get a digital copy. I actually had to call it physical copy.
But what it was, it was actually a book which discussed the following. It said, look, the liberal free market ideology turned out to be a religion, not a science. It led to devastating, catastrophic consequences. Remember that's 1937. And therefore the question that we are facing is not whether we should be planning our societies, but the extent to which we should be planning, how much free space should relieve to individuals, to businesses, as we go forward.
And that book had a contribution from Benito Mussolini and one of his ministers, from Joseph Stalin and one of his ministers as well, who was shot by the way, in 1938, 12 months later. It has contribution from Nazi Germany. It had a contribution from New Deal economists in the U.S., from sociologists, anthropologists across from Europe, as well as the U.S., and all of them agreed that liberal free market ideology is defunct. It caused major problems. We can't go back to that. And therefore, how far should we go forward?
And there were three answers. Answer number one provided by Joseph Stalin and communists was to say, you're absolutely right. We always said capitalism will lead to this. What we can promise you is a brighter, equal future. But you lose your property rights and we're going to put professional people to run the economy as a vanguard of the proletariat. How are we going to build our societies and economies?
Somebody like Benito Mussolini would have said, I said something like, we also agree that free market democratic liberalism is defunct. We will allow you to have your property, but your property is really your steward of national wealth. You're a steward of what we try to do as a country. And by the way, we also get rid of all this democratic nonsense. There will be professional people making professional judgment, what needs to be done. And then of course there were people on the New Deal who were basically saying, well actually what we need is Security and Exchange Commissions. Actually what we need is a bit of social welfare and infrastructure. And so the way my book describes it, we're in a pretty similar position today.
We basically all agree that the government has already extended their tentacles massively over the last couple of decades. We all agree that societies are extremely polarized. We can discuss why it is so, but just like they were polarized in 1930s, we all agree geopolitical tensions are rising just like they were in 1930s. And so the question is, how we're going to reduce the extremes, define them as much as possible, and keep as much freedom as we possibly can. And again, today, whether you're Republican or Democrat, whether you're Labor, Conservative, whether you're a Social Democrat or Christian Democrat, everybody agrees government will play a larger role.
Industrial policies, monetary policies, educational policies, R&D policies, they're proliferating. If you think of it five years ago, when I wrote my first book, we were discussing it, but very little of it actually was around. Today, there is plenty of examples of those policies. So that's one similarity.
In 1970s, it was the opposite. It was a government that was far too proactive through 50s and 60s. It was a desire to get rid of it. Some of the government function and liberate the economies, which is the opposite of what we have. The other similarity, of course, was 1930s, is that it was a period of significant financialization and also significant technological change occurring.
Environment of extreme inequalities, it was almost like Gilded Age. Now today we have something similar, we have extreme financialization, we have a technological progression, we have extreme inequalities. If you look at 1970s, it was actually one of the most equal eras in terms of wealth and income inequality ever in the Western world.
A degree of financialization was very much more limited. Technology was not as disruptive. So again, that shows you 1930s are closer. You also have polarization between the countries and within the countries, which much was much more pronounced in 1930s, where people were reaching out to extremes.
So this was a time of Benito Mussolini and Adolf Hitler and Franco and Mao with his long march. This was a period of Stalin. This was a period in the U.S. of Upton Sinclair and Father Coughlin and Hugh Long. This was a time when KKK really become an invisible government of the United States. This was the time of the first reported, or recorded attempt of fascist takeover in the United States. This was a time the time when the Communist Party was growing rapidly in the U.S. So it's not just what was happening in Germany or Italy. France was almost completely ungovernable. So today we're not quite as extreme, but people again want alternatives.
They don't want what they used to have, and so the result is, existing parties either dissolve themselves… so that's what happened in Europe. None of the parties that ruled Netherlands or Italy or France actually exist anymore. So you have different parties, with the parties survive under the first past the post electoral system like U.K. or U.S. Some of them become unrecognizable, just like a Conservative party in the U.K. is totally unrecognizable compared what it used to be, or Republican party in the U.S., that recognizable. So either you change yourself or you completely go extinct. Very similar what used to happen in 1930s, in 1970s, you didn't really have that sort of extreme reactions, compared to today. So, there's a whole range. Things like complete distrust of international institutions. In 1967, the trust in international institutions, World Bank, IMF, UN was actually quite high. Today, it's extremely low, very similar to the way people started to mistrust League of Nations in 1930s. So to me, nothing is perfect. There is never a complete similarity because there are also differences, but I think there are so many areas that are so similar that it would seem to suggest we're going through something very akin to what happened in 1930s. And the key is really, is that for a number of reasons, to me, it's all to do with experiences of generations. So in other words, technology, financialization, how much volatility of experience in your life, that determines how you look at life.
And there are times when people say, look, I don't agree with this anymore. And if I don't agree with this anymore, I'm looking for alternatives. Some of those alternatives are an extreme right, some of those alternatives are an extreme left. The question is, I keep coming back to in my book, is to say, at this stage it looks like populace is not yet mad enough to burn down the house.
In other words, we want something else, but we're not yet willing to burn down the house. In 1930s, they were, they were willing to burn down the house. So the question is, can we find policies so that we don't get to a stage that they did go to in the 1930s, where they magnified the extremes. Today at this stage, if you're extreme right or extreme left, if you want to be allowed an opportunity to govern, electorate is forcing you to eject the worst instincts that you have, or the worst policies that you have.
So for Republicans, it's agenda 2025, it's not a Project 2025. They're trying to disclaim it's not part of what they try to do. If you think of Obamacare, nobody talks about healthcare. If you think of entitlements, nobody talks about it. If you think of Kamala Harris, she is apparently for fracking. Who would have thought so, that she actually likes oil and gas industry. The same applies to Italy. If you think of Brussels, of Italy, they no longer want to exit Europe. They no longer want to tax the banks, they no longer want to cut welfare payments. If you think of R.N. in France and the journey that R.N. has done over the last 10 or 15 years, even A.F.D. in Germany is becoming more normalized than what it was previously to that. So in other words, increasingly, they emerging as a social conservatives, but from an economic perspective, economic policy, they're gravitating towards the center, and the reason they're gravitating towards the center is because the electorate is not yet mad enough to burn, as I said, to burn down the house.
And so the question is, what sort of policies do we need in order to ensure that this polarization geopolitically and within the countries just don't keep escalating up and up and up, that people will really at that point settle for very extreme answers, as they did in 1930s.
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Replacing Capitalism
[00:39:50] Richard Laterman: It seems like this exhaustion of the capitalist system has been growing since the great financial crisis in 08. This has been a conversation that seems to be growing in many corners and now has really entered the Overton window, and your book, just to start with, makes that much clearer.
I think a lot of people would point to maybe China as being this example potentially of capitalist with Chinese characteristics, or this idea of state led capitalism, but they are really, by all accounts, trying to write a generational wrong., right, that this grievance that they have with the West, where they have the center of humiliation subjugation.
So it seems like they have been adapting to tactics in order to emerge as they would want their role in the world. But we are now seeing a real issue with their bubble bursting and property prices making new lows. So, we might say that they have started to show the real consequences of state led intervention and misallocation of resources.
So, I guess my question to you is, what are the models or what systems are going to, how do you envision these systems? Capitalism may really be, as we know, it may be coming to an end because of too much debt, because of demographics, because of the, the information and digital age, as you put it, but what’s going to take its place? What do you think are the likeliest models to replace it?
[00:41:33] Viktor Shvets: Yeah, that's a great question. Again, if you go back, as I said, to 1930s, there were choices, there were menus, all of them emphasize stronger role of the state. All of them, nobody was arguing state is bad. Nobody was arguing state should stay away from economy. Nobody was arguing, you know, let's keep a small state just for police, defense, borders, law and order, and let private enterprise flourish. That idea is dead and was buried, as I said, around the time of global financial crisis. And it's not coming back. So the question is, in that spectrum, how far do you want to go? So China is facing, or is trying to handle some of the very similar problems we have.
Unaffordable housing, unaffordable education, healthcare, role of the digital media, extreme wealth and income inequalities, inequities. So a lot of problems China and Chinese leadership is facing, not dissimilar what U.S. is facing in many other countries. The question is, as you decide on the solutions to those problems, how far down this curve do you go? Remember I said 1937, so you had Stalin on one side, you had your Benito Mussolini and the fascists somewhere here, and you have FDR somewhere on this side. And so the question is, do you want to go towards Benito Mussolini angle? Do you want to go to Stalin angle? Do you want to go to FDR? And I personally think FDR was absolute genius, finding this middle ground that actually reduced the tensions, defined the extremes, kept as much freedom as you could, and created a new consensus that then really took hold in late 1940s, and continued all the way for two decades, all the way to the end of 1960s, early 1970s.
And so China is facing, as I said, the same 2,000 year history, by a century of shame, by other sayings that other countries don't have to deal with, and also China is confronted with a history just like Russia, that you don't really have a history of civil rights. You don't really have a history of democratic rights. You don't, you always had a strong central government and whenever central government falling apart, it was always disaster. It was always civil wars. And out of those civil wars come out another centrist government.
And so, and so the way Russians are looking at it and the way Chinese are looking at. There are times we live under good emperors, there are times we live under bad emperors, there are times we live under good Czars, and there are times we live under bad Czars, but nobody questioning the underlying system. That's why neither Russia nor China ever had military coups, because nobody would even think of that that will be the answer.
And similarly, elites in those countries believe the country belongs to them, and therefore they are the leading force, or they're leading what's going to happen in the country rather than building institutions of state, institutional bureaucracy, rather than building impartial judgments within the countries.
And so in China, it's complicated by all of those other things, and to me, China was moving in the right direction all the way to global financial crisis. One could argue that the first two stimuli that China would put in, in 08, 09, 10, were appropriately done, and in fact, capitalism might not have even survived if China didn't do what they did back, back in those years. And so that was appropriately done, but eventually it become very excessive. And if you think, one of the numbers I really like is the IMF numbers of depreciated assets. So in other words, it's your gross fixed capital formation minus assumed amortization and depreciation. And if you think of China, according to IMF, pre global financial crisis, depreciated assets were like 4 trillion.
India had like 1 trillion, U.S. had like almost 30 trillion. Today, China is knocking on 100 trillion. India gone from one to six, so China from four to over a hundred, India from one to six, U.S. gone from 30 to like 70. And so China absorbed in less than two decades, something like 100 percent of global GDP in depreciated form in capital.
When you absorb so much capital so quickly, almost inevitably inefficiency of capital utilization arise. Now, do you see those inefficiencies? The answer is yes. One of the easiest way to look at it is to look at the leverage. If you don't utilize the capital efficiently, what happens? You never generate high enough return to repay back the debt.
So your leverage tend to rise. So if you go back pre global financial crisis, China had leverage of about one and a half times GDP. Today, they're knocking up four times. Think of Japan through 70s, 80s and into 90s. They used to have one and a half. By early 90s it was four. Exactly the same process. If you think of other areas you can look at, you can look at a return on equity for a broader sample of corporates in China, pre global financial crisis, return on equity was quite high.
It was 18, 20 percent. Today, they're about eight or nine. If you go to Japan in the 1970s, it was 12, 13. At the bottom of the cycle, in the early 2000s, it was only two or three. You can look at I-rate incremental capital output ratio. How much do you need to invest to generate incremental GDP? China's gone from three to 10, so you need $10 of investment for every dollar of GDP you generate.
You can look at nominal GDP gross rates. Again, Japan used to grow at 10 percent, then suddenly by early 90s it was zero. And they never nominally grew again, until fairly recently. China's gone from double digit nominal GDP to around 4 percent. Everybody focusing on real GDP, but the important is nominal GDP, because disinflation gets stronger the more you put capacity.
So China's problem, as the book discusses, is a very high national saving rates, maintained for too long, for well over two decades. And China never put policies in place to consume those savings and therefore reduce the saving rates. So if you don't have the policies to consume, then you're, the only answer is you must invest and you must export.
Now, remember China is investing nine, ten trillion dollars every year. That's a double of GDP, of the entire GDP of Japan invested every single year. So if you're forced to invest in export, you immediately create excess capacity almost in everything you do. And so China has multiple problems, but if one were to distill it to one thing, and that is keeping national saving rates too high for too long and embarking on a very aggressive stimulus, four stimulus waves that they have done since the global financial crisis.
So even if China puts the right policies in place today, you would still need to absorb or digest about a hundred trillion dollars of capital. But if you put policies in place to tackle excess capacity, you've mentioned real estate, but that's only one area of the economy that actually has excess capacities. It's the most important one, but the only one of several. If you put policies in place to absorb or shut down some of that excess capacity, reduce the credit risk, if you put policies in place to increase universal basic income, which China already has, universal basic income, you just need to level it across the entire country at a high level.
If you're putting policies in place to change the taxation system, and put local governments on the viable revenue footing, if you were to do a number of those things, for example, debt level, most of the debt belongs to local government and SOEs, not the central government. Can you relocate the debt around much more efficiently? So there's a variety of things China can do. And the good news is that they operate behind the Chinese walls. So in other words, capital account is closed, and currency is not convertible. So they actually have greater flexibility than Japan did in 1990s because Japan had an open capital account and fully convertible currency, so they actually have more flexibility. The good news since I published the book, they're actually starting to do at least one or two of those things right now. But, it's a long way to go for China.
And that's why I've argued that don't think China will ever again, support global growth. I don't think they will ever support the global commodity complex. There is no other country, currently, or even 10 years from now with, that can step into China's shoes.
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Tariffs and China
[00:51:06] Adam Butler: Victor, are there any policies that China could introduce that would allow them to absorb so much excess capacity using only domestic means, or are they going to need to rely, at least partially, or perhaps materially on their traditional mercantilist or export driven model, and if the latter, then just how scary is some of the rhetoric coming out of some, different parties in the U.S., and some European governments about introducing huge tariffs. I heard Trump articulate that if he's elected, he's going to introduce tariffs between 50 and 200 percent, on many foreign goods. How does this play into this, the state of the union in China and bind China's options?
[00:52:07] Viktor Shvets: Yeah, I mean, the best outcome is ability to gradually introduce consumption related policies while continuing to export excess capacity to other countries. The problem is I just mentioned you the size of the investment is so large. So the only places you can realistically export meaningful amount is U.S., Japan, Europe, and U.K. maybe, but that's about it.
Laos or Cambodia cannot take much. Neither can Kazakhstan or Central Asia. And so the problem China is facing, something that Japan did not face in 1990s, 2000, is that Japan was a fully paid up member of a global community, and at the same time, Japan was very lucky because, if you remember, maybe I'm older than you guys, but 1989, 1990 were not good years, and anybody who lived and worked in those years did not know that we are facing 20 years of global growth, financialization of the United States, reemergence of China. Nobody knew it back then. But Japan was lucky. They were actually facing two decades of rapid globalization and growth. And so all Japan did, they settled for a declining share of rapidly expanding markets.
China, unfortunately, is not facing it because I say the world will have a circular stagnation for years, for decades to come. Global growth rates will be hanging around two and a half percent, maybe less as we go forward. So like Japan, 1990s, 2000, China is not facing that sort of climate. When you have such a rapidly growing world, you find tariff protection or protectionary measures are not as critical because everybody's growing. Everybody's doing things. Whenever you start growing at only two and a half percent, which is only a hundred basis points above global recession, if you actually start growing at that level, then almost inevitably protectionism becomes incredibly, incredibly important.
The other thing, of course, in 1990s, 2000, people didn't realize that all this globalization, which is benefiting the entire world, is actually disintermediating labor in developed countries, is destroying communities, destroying factories, destroying middle class.
Today, both people and politicians fully recognize that that is a price you pay. Now, theoretically, if we live in a global community, then it doesn't matter because one benefits, the other transfer the benefit. But we don't, we live in tribes, we live in nation states, we don't live in the world, and so even though everybody as a world benefits, individuals in those countries are not. And that's why Danni Rodrik called it political trilemma of a global economy, that you can't maintain local politics and democracy and globalization at the same time. You have to choose two out of the three, but you can't choose all three at the same time, because it's incompatible with the interest of citizens of a specific country. And so again, Japan was lucky in that respect. China is not.
And a final point, Japan did not try to change the global world, the world. They didn't try to change internet rules, communication rules, human rights, trade rules. They didn't try to build spheres of influence.
And so for China, The most obvious and the best thing to do is to say we're going to continue to export whilst we gradually rebuild our economy. But as you correctly said, that's going to be hard. They will not be able to export to the U.S. I think Japan is going to be a no-go area. That's why they're spending so much time in Europe as the only bloc which is not coherent or speaking with one voice, that you might be able to do that.
And so you do need to introduce other policies, other than just export oriented policies. But most of them are hard. Things like agricultural productivity, for example. There is over 200 million people in China producing about the same output as 10 million farmers in the U.S..
So if you were to change the rules of engagement on land, what do you do with land? Can you create bigger farms? Should you invest in farms? What's going to happen to 200 million people? And at the same time, you would need to change the taxation policies because local government rely on land speculation and sale of land in order to fund themselves. Now that no longer will be possible. So you need to introduce some kind of property taxation, value added taxes, or something else to finance the local governments as you go forward.
You can also try to allow greater freedom for households and private businesses to make decisions. But then, if you do that, then the degree of control that the state and the party exercises over economy and society will almost inevitably diminish, and that also conflicts with a more global agenda that is not just stabilizing China itself, but its neighborhood. So in other words, the perception that the Sinosphere is a protective blanket around China, and again, a lot of countries would not agree with that, either definitions of spheres of influence or how you do this.
So it becomes incredibly difficult economic, social and geopolitical I guess, triangle that you need to somehow square for China to go forward. Are there policies? Yes. Uh, I just mentioned some, the UBI policy, changes taxation policy, reshuffling the debt from local to central government, things like real estate.
Remember, so far China has spent less than 1 percent of GDP in support of real estate. If you think of TARP and ARR in the United States, that was 5 to 10 percent of GDP, so it's just a fraction of what needs to be done. So there are policies. There are policies on specific industries. There are policies on consumption. There are policies on geopolitics, on politics. But all of them are hard, and all of them involve compromises.
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China Hesitates
[00:58:49] Richard Laterman: So to what do you, just quickly, to what do you attribute this hesitation or apparent hesitation of China to deploy a fiscal policy that would be commensurate with the hole that the economy finds itself in. But I was reading a recent estimate that there's about a negative 10 trillion effect on this property slump in China. And then after announcing some monetary interventions, they announced a fiscal policy intervention that's still a little bit murky. They haven't given too many details. And then the estimate is now somewhere in the order of 300 billion, which is, you know, a drop in the bucket to the size of the issue. So why are they hesitating? Are they hampered by non-economic circumstances? How do you see this hesitation and then to what you attribute it?
[00:59:52] Viktor Shvets: We've just discussed, whatever you do is in conflict with whatever else you're trying to do. So, if you think of China, China has a lot of problems. They cannot add labor anymore. They've added too much capital as we discussed over the last two decades and a multi factor productivity is not growing. So they say, okay, we need to grow multi-factor productivity. Very true. How do you grow multi-factor productivity? Well, you grow through technology. And so whether it's a EVs, whether it's batteries, whether it's solar panels, whether it's robotics, a lot of investment goes into this area and that's appropriate.
But because it's a relatively small areas, when you invest trillions of dollars, you create three, four, five times global demand almost overnight, in all of those industries, remembering the size of China. So you need to pull back. But if you pull back, you don't grow multi-factor productivity, or at least it takes you longer to actually reposition your economy much more towards higher productivity end.
Also, when you build your higher productivity end, you have to remember that bulk of manufacturing in China is still very primitive. It's still toys, it's still plastics, it's still bulk chemicals, it's still steel. It's all of that stuff. So you have to be careful how much you actually withdraw from those areas and how quickly. Because, again, you have to have the labor force moving from one side to the other. And then you have state control, or in other words, directives, that come out from Beijing, what to do. Now those directives are not always consistent in what they're trying to do. And so it's really trying to square this box, that you have, on the one hand, you have political objectives, you have social objectives, you have economic objectives, and you have geopolitical objectives.
And you try to fulfill all of them as much as you possibly can. The other thing is, and that's quite interesting, is that I think China is probably one of the last truly capitalist societies in a sense that they, nobody in the West any longer believes there is such thing as a sound money. Nobody believes that. Nobody believes that you can bring down this cloud of finance to anything meaningful without at the same time undermining property prices, pensions and everything else that people rely on, and therefore we gave up on any meaning of liquidations, clearing of excesses, recessions, and everything else.
China in some ways have not fully given up on that, uh, and therefore there is an undertone that we can't just bail out the companies, even though in the U.S., or most other countries, it's done incredibly frequently, or we have to be careful, moral hazards and what degree of moral hazard we introduced. So in some ways, China is also, in my view, sort of a throwback to more conventional, interestingly enough, to more conventional capitalism, the way it's supposed to function, but in the modern world, that is not possible. That's why the ultimate destination that you were asking me, the ultimate destination my book discusses is that it's clearly not a conventional capitalism.
Even China recognizes, gradually, that is not the case. So you're not going to liberal capitalism, you're not doing that. So the question is, through the combination of technology and finance, changing the functioning of labor market, capital markets, money, central banks, what the government does, are we going to end up with a system that a few technocratic guys control everything and everybody else has no rights and just do side hustles and gig jobs?
Are we going to end up with1984? Are we going to end up with Mad Max? Are we going to end up, what sort of a feudalism, a modern version of feudalism? My preferred one, and I must say, my editor was telling me to get rid of it is that, because people might misinterpret it, it's an enlightened version of communism. And what I meant by that is basically a society of such high productivity that people no longer need to toil, for to earn the living. That jobs will disintegrate, professions will disintegrate, and humans will find another way to compete. It could be on likes or dislikes or what you do personally, but professions and jobs are not going to be the primary purpose or identification of your life.
How other people look at you will be different. And so to me, I hope that's the right answer, which by the way, not that far away from what John Maynard Keynes used to say back in 1930s, when he was saying within four or five generations, we need to figure out how are we going to live a good life, when the productivity is going to be so high.
It's not that the similar to Peter Drucker or Ray Kurzweil or any of those other guys, they've been discussing it for decades, centuries, in the case of Karl Marx, what it ultimately would look like. And so to me, that's the answer. And that's why the positive note in the book is to say that ultimately, and I think it's maybe two decades from now, but ultimately, productivity will jump from 1 percent to maybe 5 percent or more. But the reason it's going to jump because most of us will not be working, but nevertheless, productivity will be incredibly high. And then society will find a way of sharing the benefits of it. So in other words, who owns a technology? Who owns means of production, as Karl Marx used to say? Who owns it?
How is it distributed? And to me that is likely to be the future, rather than a more conventional liberal capitalism, or rather than more traditional industrial capitalism, as we have been describing. As I said, most people will get petrified. Oh my God, he's talking about communism, but it is not the communism of North Korea. It's not a communism of Cuba. It's not a communism of a Soviet Union. It's designed in its original sense as a society of very high productivity. And the book asks the question, I think that's going to be the future. But that's several decades from now. So what happens between now and then, because that's a problem.
That's going to be an incredibly violent decade or two. And so the question is not between, the choice is not between freedom or slavery. The choice is how much of our freedom needs to be sacrificed in some form in order to reduce the tensions in societies and defund the extremes as much as possible.
And that's where you start thinking of policies like universal basic income. How do you fund the government? What is the role of MMT or central banks? What is the role of industrial policies? How we should change educational and scaling institutions. Who should be owning what assets and how they should be owned? Who benefits from the flow of that higher productivity.
And that's not to forget, as I said, my pet project, which is a Marshall Plan for less and least developed countries in order to contain as much as possible immigration waves, but also healthcare waves, because if another pandemic is going to come, more likely than not, it's going to come from those places. And so think of it as a survival, cost of survival, rather than a DCF. So instead of saying, if I pay, I need to get a return. Well, your return could be in lower immigration, lower pressures, and less pandemics. Maybe that going to be the return.
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[01:07:51] Rodrigo Gordillo: Sorry to interrupt, but I did want to take a quick second to remind listeners that while we do absolutely love providing our audience with world class guests and weekly investment insights, we wanted to remind you that we actually do our best work outside of this podcast, and we try to do this by providing cutting edge, globally diversified, and systematic investment strategies that are designed to be broadly non-correlated to traditional equity and bond portfolios. So we actually manage private and public funds, as well as bespoke, separately managed accounts for investors that seek the potential to smooth out portfolio returns in the long run. So if you do want to see that theory that we've been talking about put into practice, please do go ahead and check us out at www.investresolve.com. Now back to the podcast.
Embracing the Changes
[01:08:33] Adam Butler: Yeah, we've long sort of been on a path where we've discovered how we can employ financialization to moderate the economic cycles that we were used to in previous decades, and that actually is a, more of a binding constraint. In other words, we cannot go through the normal cycles that we had in previous decades because of the leverage in the system and our reliance on high asset prices in order to facilitate the creation of more credit. So you've got this, on the one hand, a binding constraint from financialization. On the other hand, you've got this, what I consider a binding constraint from technology. And that arises because, you know, apart from all of the different demagoguery that's taking place around, you know, everyone being fearful of the impact of AI and what have you, and new rules that are being proposed.
The fact is that there is an arms race, right? And in a world where you've got multipolar actors with individual agencies that are not cooperating all the time, that every day, every major agent needs to assume that the other is actively working on innovation that's going to undermine the other players, right?
So there is no stopping the financialization wave, and there is no stopping the technology wave. These are binding constraints, right? So the externalities need to be resolved outside of tech and outside of finance, which means politics and, you know, the social contract, right? So, do you agree that's kind of where we're going to see the major changes?
[01:10:29] Viktor Shvets: That's right. One of the things the book discusses is that we no longer have economic cycles, as you correctly said. We no longer have capital market cycles, which means people, when you look at the screen, if you manage money, you're just playing computer games.
None of those numbers are real. And so the question is, when does your computer screen collide with the reality? And the answer is, risks don't go away, they just migrate. So, you expelled it out of economic system, you expelled it out of capital markets. So, where did it go? Well, it got into politics, it's gone into polarization, inequalities, into geopolitics, into climate, into healthcare, and all of this outside the system. And so, if you're a policymaker, if you're a Federal Reserve, for example, you have no chance of either estimating or predicting when this real life will intrude into your screen. And you have no clue how we as people are going to respond to that, either to politics or pandemics.
How are we going to respond for fiscal and monetary means? Nobody knows. And so that creates a huge swipes up and down, whether it's inflation, gross rates, and the rest of it, or to put it in economic terms, we can no longer estimate neutral rates. And one of the things Jay Powell keep highlighting, and he must be a sailor because he always uses nautical sort of comparisons, but he is saying, look, we've been sailing out of the cloudy sky and he'd been saying that lately, or certainly for quite a number of years, we could not identify the location of the stars. And what he means by that, he doesn't know where A star is, he doesn't know where U star, Pi star, he doesn't know neutral rate of interest rates or inflation or unemployment.
Now, if you don't see the stars, then you don't really know whether you're in the middle of Atlantic Ocean or whether you're on Lake Michigan. You have no clue. Now, if that is the case, then you have to be data dependent because you can't look forward. Now, if you become data dependent, does it mean that you create even more waves because of that? Yes, because essentially you're saying that I can't see the stars. I don't know the future. I'll be just data dependent. So I could be hawkish one day, and I can change from one to the other in the space of three or four months. That is not a reflection of me wanting to be inconsistent. It's a reflection of the fact that neutral rates are very volatile.
Now, what creates this volatility is those risks that we expelled outside the system. Now, what that basically means, if you invest, that means neutral rates could be 2 percent or could be, there could be one, it could be three, it could be from Monday to Thursday that could actually change as quickly as that. Now that means your risk free rates also has to be very volatile. And because the risk you're assessing outside the system, your ability to assess risk premia, whether it's equity risk premia or debt risk premia, is also gone. In other words, 1 percent is just as likely as 5 percent. That means you have no weighted average cost of capital, you have no DCF and you have no reliable way of valuing.
So as a corporate or a fund manager, not only you're not clear where demand is, because neutral rates are volatile, but you also have no weighted average cost of capital to estimate whether opening a factory or closing the factory will increase the value or reduce the value of your company. The interesting thing I keep highlighting is that even as we eliminated economic cycles, they largely do not exist. Even if, as we eliminated capital market cycles, once again, they largely don't exist. Even as we expelled all the risk outside the system, the business cycles are accelerated. Not economic cycle, business cycles. So, in the past, it could have taken you a decade or longer to build a big company. These days, you know, four quarters is good enough.
It could be anybody. How they utilize technology and how they utilize finance. In other words, what I described as a Fujiwhara Effect. How did they use Fujiwhara effect in order to differentiate themselves?
So what's happening, industries and sectors are colliding. You thought you had three competitors. Suddenly you have 12, 15, god knows who it is competing against you anymore. And so the result is that you need to deploy it in a way that raises your productivity faster than a frontier in that market or in that industry or whatever happens to be. If you manage to do that, you have almost infinite values. On the other hand, as soon as you miss the turn, you no longer have that value. Somebody else will have it. And so, this is a recipe for mega caps becoming micro caps and micro caps becoming mega caps in a very quick succession. Very quick. It's also a recipe for very concentrated returns.
So when people say, oh my god, the market looks terrible because concentrated returns well, get used to it. And by the way, they're not the same companies. If you're saying a FAANG, the old FAANG, today's composition of FAANG index is very different to what it was five or six years ago. Now, you look at Magnificent 7, well, it's no longer 7, it's 4. And if you look at the Granola's in Europe. So, in other words, we will invent phrases to describe the degree of concentration. Constituents of those indexes will be very, very different. So one of the examples I highlight is that clearly NVIDIA has gone from a hundred billion dollar company to multi trillion dollar company in five years.
It took other companies decades to get anything like that. But as their products become more powerful and as a marginal cost continues to decline, eventually somebody will use that power at very low cost to build a brand new business. And you find media will go down in market cap, but that company that needs high power and low cost, suddenly will prosper. How long would that company prosper? Who knows? Maybe a year or two, maybe somebody else will overtake them. The same applied to, if you think of Microsoft versus IBM, and different fortunes of those companies. If you think of luxury companies, you know, your Hermes versus LVMH. So you can go on, you can look at the car companies and how they're changing.
And so to me, the interesting thing is that it's such a multifaceted game. If you are either a corporation or an investor, in a sense that you no longer have reliable, economic signals, or any signals you can use, you no longer really have capital market signals. As I said, you're playing computer games when you look at a screen.
None of it is real. The risks are completely outside the system. You have a highly volatile, as a result, neutral rate, risk free rate, as well as risk premia. But business cycles are being accelerated at a massive space, which means winning goes to the winner and loser gets nothing, which would imply, interestingly enough, that if you're an equity investor, you ought to become a stock picker again, because it's really understanding the management teams, the products, the positioning, how can they grow productivity faster than a frontier.
But then also recognizing that as soon as that's not the case, they will be punished severely. And the losers will have to rely on self-liquidations, share buybacks, dividends, and stuff like that in order to try to maintain the market capitalization. So it's an interesting world. That world basically tells you that everything is changing, economic cycles changing, the capital market cycles changing, role of money changing, role of capital changing, role of humans and their role in driving productivity is changing, the role of the jobs, role of education and scaling and what's the importance of that, role of the government, all of that.
Theoretically, that creates monumental opportunities in various forms, but also monumental problems, and how you actually navigate from A to B.
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Managing External Risks
[01:19:17] Adam Butler: So I just, let me just pull on this one string here because I think, I'm curious whether you agree with me on this point. So you've got a runaway train technologically, you've got a runaway train, in terms of financialization. The Fed, in concert with other central banks and other primary governments who are cooperative in terms of their fiscal response and the way they manage the duration of the sovereign balance sheets, etc. Everybody seems to have figured out what their role is and be comfortable with the fact that they can steer the ship without the ship tipping over to one side or the other. But as a function of that, and as you said, the risks are no longer in the business cycle. They're no longer in the financial markets, but that also means that the risk is that the instruments that those actors use to keep everything on a firm footing can be pulled away from them, which would be like a political action or, you know, some sort of political, geopolitical conflict, what have you, right?
So, are the tails just that, so you've got this really narrow distribution of outcomes, but then if they bulge out at the side, like it's very, we call it in, it's leptokurtic, right? They'll come, the risks are to come from outside of the financial system, and therefore those operating the financial system are unlikely to do a very good job anticipating it and managing it when it when it arises.
[01:21:04] Viktor Shvets: That's very true. What you've just described is high kurtosis or skewness of the outcomes, that you have, and there is no way of avoiding it. I mean, theoretically, there is only two ways of avoiding it. Having a World War III and destroying capital, and labor and rebuilding economies from scratch. And I don't think anybody wants to see that. The other alternative is just muddling along, as we do and trying to put enough safeguards in place in order to avoid the worst outcomes. And that is why the governments are becoming the guardrails. Just like people who grew up in 1920s and 1930s and 40s felt very strongly that the government is a guardrail.
It's the only thing that keeps abyss away. It's the only thing that keeps chaos that those people experience first hand, away from us, and they were prepared to trade rights. If you think of 1956 as I describe in the book, it was not a liberal era by any stretch of imagination, socially, culturally, politically, or any other way. But they were prepared to trade it in and say, look, I'm willing to trade those rights in order to keep the ship afloat. Now, one of the things I discussed in the book is the younger generation. If you think of millennials and if you think of Z, basically anybody born after early 1980s, that survey after survey is highlighting that they have a very different view of the world compared to their parents and grandparents and much closer to the great grandparents, much closer to those people who were mature adults in the 1950s.
And they want community, they want government, they want the guardrails, they want sharing, they're willing to sacrifice some of their rights, they're willing to have greater social conventions established around them. So, one of the things in the book, I just summarized the qualities, and if you can see those qualities, it's almost replica of GI and silent generations and completely the opposite of baby boomers and X, completely the opposite. And so the good news is that all of them are now reaching the stage of maturity. So if you think of the United States, they already, more than 50 percent of the population, but they're only around 40 percent of the adults and they're only about 30 percent of voting because in the U.S. as you know, voting is not compulsory.
But give it another five years, there will be an absolute majority of adults in a voting public. And so they'll be steering the agenda. Every developed country, you can look at it year by year, sometime in late 2020s, early 2030s, those born from the early 1980s until, call it around 2010 or so, there will be absolute majority of adults, of voting public. So the interesting thing is that just like the generations that grew up in 20s, 30s, and 40s, demanded those guardrails. These guys are increasingly demanding the same thing. Right now, they're still minority. They still don't have the power. They're still fighting against prevalent views. In other words, public sector is inefficient.
You should have freedom. This ridiculous ideas of absolute, absolutist free speech and the rest of it. They're still fighting against that. But it won't be long, because at the end of the day, they are bound to be a majority, and so the question is the next 5, 10, 15 years, as all of this progresses, can we put enough guardrails to minimize this damage? Can we put enough guardrails to minimize this volatility? Because as you correctly said, what keeps whiplashing us is polarization, political, electoral outcomes. Think of geopolitics, climate, healthcare, pandemics.
So think of the United States. If Democrats sweep Congress, Senate, and a presidency. Democrats, as you know, running on economic agenda. They're trying not to talk about it, but essentially they're running on economic agenda. If they do come to power and they do have control of the levers, whether it's a chips policy, infrastructure policy, education policy, healthcare policies, you know, student forgiveness policy, they have, they don't agree on everything, but they are in that, in that mould. Now, that basically would imply that primary deficits in the U.S., which are currently running three, three and a half percent of GDP, probably will go up a hundred basis points at least. Now, it won't be reflected until 26, 27, but Federal Reserve would need to react in 25 against it, because the market will reprice it.
If Republicans come to the party, Republicans don't have economic agenda. They run on the social and cultural issues. The only economic agenda is taking down taxes on the rich people, withdrawing subsidies from the poor people, doing some deregulation, and a bit of tariff policy and stuff like that. But they don't really have a coherent in any form economic agenda. It's very much trickle down economics all the way back to 1980s, their running ways. But if they control everything, again, there is a problem. Primary deficits might go up because maybe they're not collecting enough money, rather than spending more money.
Now, what impact will that have on the neutral rates and the monetary policies? If you have a divided government, i.e.: one party does not control all the levers, you probably will have a problem changing neutral rates, but you could attack institutional pillars. That's where Project 2025 comes in.
Whether it's a role of Department of Justice, FBI, whether it's a role of Federal Reserve, Department of Education. A lot of people say, well, if it's divided government run by Republicans, uh, you will have lower taxes, higher EPS, less regulation. That's true. But what about risk premia? U.S. assets have a very low risk premia right now. If they come anywhere near trying to attack institutional pillars, what will happen to risk premia? So all of that just to highlight, just one election and how much it can alter the outcomes, and I said, the only good news I find in this, and I keep coming back to that, that people are not yet mad enough to burn down the house.
And that's good news. And that's why people are gravitating towards a more neutral territory, which means hopefully the degree of volatility will not be as high. But as we go down this path of the next 3, 4, 5, 10 years, will they become angry enough? They might.
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Degradation and Positioning
[01:28:18] Richard Laterman: Automation and robotization and all these technological trends that we see could be the catalyst for a lot of this discontent. I think it's probably one of the reasons why we see the folks from Silicon Valley, and most billionaires out there advocating or having been advocating for the better part of a decade now for UBI, because I think they envision pitchforks at their doorsteps once the mass unemployment that a lot of people speculate would come from all these technologies. So how…
[01:28:56] Viktor Shvets: But, but it's not just, if I say, it's not just unemployment, it's lack of self confidence in a sense. It's how you feel about yourself and about your life. You don't actually need to become unemployed. You need to just be degraded in what you do. Either the functions you do, how you compensate it, it's every day you sit in your chair and you feel less valuable. If you feel less valuable, and if other members of community feel you become less valuable, you immediately become angry. Even though unemployment might not increase at all, you're just not happy with your life. And then you think about your son or your daughter, what will happen to them, and they, and you become even more depressed. And so that's the only correction. It's not so much unemployment as your own perception of your own worths. Your own, how societies view you.
[01:29:49] Richard Laterman: The prospects for your kids. Yeah, that's a great point. So, which countries in the West, or I guess globally, which countries do you see better positioned to deal with what's coming? Which ones do you see already maybe further down the path and taking some of the policies that you would consider the right policies to prepare for this? And which are some of the laggards? Like how do you see, did you see any potential reshuffling of global order? I guess putting aside geopolitics, which is already a large and important variable in this question, but putting that aside, staying on the economic model problem?
[01:30:32] Viktor Shvets: Yeah. I mean, as a 1930s, nobody knew what to do. So Britain had its own way. U.S. had its own way. France was ungovernable, you know, Spain, Italy, Germany, Japan got fascist. You know, liberal experiments in China evaporated. The Soviet Union gone from new economic policy in late 1920s to collectivization in the early 1930s, and industrialization, which was devastating in human terms, whether some countries which were better positioned, yes, but they were usually out of the way places and they were not as impacted.
And I think today there are some, there's some of those out of the way places, but they don't really matter in a global context. They might be great safety harbors. They might be great places to park in a context of what's happening, but they don't actually alter the global equilibrium. If you think of the key powers, if you think of the United States, U.K., European Monetary Union or EU, if you think of Japan, if you think of China, if you think of the United States, I can't say that any of them actually have the right policies.
One can debate a little bit about parts of Scandinavia, but as I said, I'm not, I don't think they matter. It was, all due respect for Scandinavians, I don't think they're going to swing the thing one way or the other. But, so the way I look at it, in bigger entities, I just don't see coherent policies. I don't see a realistic discussion of UBI. I don't see a realistic discussion of how governments are going to be funded. I don't see a realistic discussion of what is meant by public debt. Is it real? Is it not real? How are we going to handle it? I don't see a realistic discussion of taxes, what the tax rates should be.
Should we go back to 50s and 60s tax rates, for example, either in terms of income, capital gains, estate taxes? Do you, you know, desk duties, corporate taxes? I don't see any of that. I don't see any meaningful discussion of restructuring educational and scaling institutions, which are still designed to create very narrow skills, which are becoming less and less relevant and will be even less relevant 10 years from now, compared to today, globally. In terms of migration, we're still talking about walls and building walls all over the place.
As my book said, go and ask Emperor Hadrian or Byzantines, how well those walls work. They will tell you if they were still alive, that it doesn't work. But, so nobody is discussing that. Everybody is looking much more, much more shorter term and politicizing all of those issues enormously.
There are some discussions on technology and who should own technology, and how the benefits should be shared. But in my view, that's a very early stages of discussion. It’s not progressing anywhere near as enough. There are discussions on the role of the government. That's why the government is coming through with various policies, whether it is, if you think of, you know, chips policies, whether you think of infrastructure policies, but again, it's haphazard.
Some of it is geopolitically driven rather than economically driven. Some of it is driven by needs of certain communities, but there is so, I find just like in 1930s, nobody, nobody knew, and that is why I have a great deal of respect for FDR and what FDR has done. He didn't know either, but one way or the other, he managed to find that middle ground. Now he was a bit lucky. Who knows? If Hugh Long was not assassinated in 1935, who knows? If Second World War did not happen, who knows what might have happened, but certainly tensions by late 1930s in the U.S. and extremes in the U.S. by late 1930s were far less pronounced than what they were in earlier to mid 1930s.
And so right now, if you were to ask, do you see anybody out there, either politically, geopolitically, economically, the answer is no. Do we need it? Yes, we do, but it's hard to find people like that, very hard, and ultimately politics reflects societies. When people say, you know, disorganized or disconnected Washington or London or whatever, it's really people who are disoriented, and that's reflected in politics when people finally connect and finally understand what is needed, and when they finally coalesce, politics will coalesce almost immediately, and will become consenting institutions, trying to solve problems. While people are disoriented, politics just reflects it and so you get into this problem of what do people want, how do politics reflect it, when would people coalesce? When a generational change will actually lead you to a decision, like if you think of Woodstock, if you think of late 1960s, clearly there was a desire of baby boomers to do something, whether it was drugs, whether it was sex, whether it was a flower culture, but essentially it was about freedom.
In many ways, there was a desire to do it, but Richard Nixon was right to say that there was a silent majority back then that disagreed with a lot of that stuff. But by late 1970s, that was not the case anymore, and so on the baby boomer shoulders, you had Ronald Reagan, you had Maggie Thatcher, you had Milton Friedman. You have Ronald Coase, you have all of those guys coming through, and they were regarded as geniuses, but the reality is consensus already formed, and they basically exemplified that consensus. And so I'm hoping that by the time we get to late 2020s, or earlier 2030s, something like that will happen, and then we'll find our men or women.
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Positioning for Growth and Resilience
[01:36:59] Adam Butler: Victor, you've been incredibly generous with your time, and I want to make sure that we're able to touch on a question that I'm sure is going to be on the minds of many of our listeners, and that is, given the scope of issues that we are, that we've talked about and the ambiguity of the right kinds of policies, when they might be enacted, where, how is an investor supposed to position over the next five or 10 years to be, both be able to move forward with their financial plans and trajectories, but also be resilient to the types of changes that might come about.
[01:37:48] Viktor Shvets: Well, to my mind the first thing is don't worry about recessions, stop worrying about absolute blowouts, don't worry about, oh my God, this time it's different, it's never different, it is different, so stop worrying about that. The way I look at it is, assume that most of the time the system will be intact. The only thing what's going to happen, I describe it as a twilight. The sun will be shining less brightly every day as you go forward, but there will be no lightning, there will be no thunder, there will be no floods, and regularly your screen will go off. That's when the real life collided with your screen.
And then a couple of people will knock on a screen and the picture will come back. Now, people who will knock on the screen will be the central banks and the policymakers, and you look around, oh, okay. The screen is good enough again. So don't get this idea that, suddenly there will be like 40 percent, 30 percent drawdown in the marketplace, high yield market is going to explode, private capital is a mine waiting to explode, basis and parity trade will destroy the market, and all those headlines you're getting.
Now, I'm not suggesting that they're not real mines, they are. If you go back to 2008, there was only one asset class that went bad. In dot com, there was only one asset class that went bad. Today, the mines are everywhere. They're everywhere. And so one of the things I discussed is that, if risk is everywhere, risk is basically nowhere. It has to be, by definition. And therefore, none of those mines will truly go off. Now that doesn't mean you as an individual cannot lose money. That you can. It doesn't necessarily mean that certain asset classes cannot go down so long as another asset class goes up, but nothing systemic of those fearful headlines that you see will ever really truly come to pass. And so my view, as soon as you build this sort of utopian macro roof over your heart, and I've just described you sort of not utopian, a dystopian, probably the right word, dystopian roof, no economic cycle, no capital market cycle, nothing blowing up, as long as you build it over your head. Then you should try to reconcile your macro assumptions with your micro assumptions.
Now, what's your macro assumptions? Which countries do you want to be in? Which markets do I want to be in? Now, none of them are good, but some look better than others. We've just discussed Europe, for example. European Monetary Union doesn't tick any of the boxes, almost. That means if you've chosen the right place or the right stocks in Europe, that means you can perform, but you will always be a negative macro roof over your head.
Now, which countries look better? Well, U.S. is one of them. India is another one of them. So you'd say, okay, if I discuss it as checking in at the Hotel California and really not checking out. So you're kind of checking in and there will never be enough good reasons to check out because remember, bad stuff will not happen.
So why would you buy defensive? There is nothing to defend against and high cyclicality will not happen. So why would I buy cyclicals? So you sort of end up in this middle ground between the defensive and cyclicals and try to figure out what stocks, if you're an equity investor, in what markets would I prefer to have. And then you build those portfolios and then you monitor it. Now, is there a trading opportunity in between? There are, but they are very sharp and short. So, for example, in emerging markets frequently the real rates get very, very high, and so even though emerging markets in the world I've described are not really winners, there could be a significant re-rating very quickly occurring.
That re-rating only lasts maybe a few months, maybe a quarter or two at most. But you can try to take account of those trading opportunities. Otherwise, it's all about productivity growth rates. That's what we've discussed. It doesn't matter what sector it is. Can you find companies where productivity can increase faster?
Then a frontier in that market and stay there at least for a period of time. That will provide you resilience in your portfolio. Now, those sorts of portfolios are relatively expensive. In most cases you will find on the stock basis, you will be looking at around 25 times forward. But they usually have ROEs, which are at least 30-40 percent. They usually have pretty good balance sheets. And so to me, that's sort of a middle ground with some trading opportunities on the side, is the only way I can think of handling it. And so in the U.S., if you agree with my view in the U.S., in the U.S., there is a wide waterfront of assets to choose. In emerging markets, for example, India has a wide waterfront of assets.
In Europe, you can only select certain niches that actually do look interesting. Occasionally you can have emerging markets, as I said, being reproduced, being priced totally out of the whack with what's likely to happen. And one of the classic examples that are real rates. That's one of the classic examples you can look at, how you can benefit from it, and that's the only way I can think of how you can build that sort of resilience, considering the whiplashes that you're likely to experience.
End miniriff here
Preparing for Risk
[01:43:44] Adam Butler: But Victor, I guess just coming back to what we talked about in terms of like the kurtosis of the return distribution, I guess I'm thinking forward to a point where the people might get mad enough, right? And so the U.S. government decides to withdraw some of the autonomy of the Federal Reserve. Something similar happens in the U.K. or the EMU, and therefore the technocrats don't have access to the tools that they would otherwise use in order to continue to perpetuate this perpetual motion machine. So, do you see that as being a material risk and is there a way to prepare for it?
[01:44:36] Viktor Shvets: I do. One of the things I discussed in the book that it's almost inevitable that the role of Federal Reserve or central banks will come under spotlight. It doesn't necessarily have to be inflationary by the way, because you're dealing with a lot of disinflationary backdrop, which has discussed how even media will not be able to price its products, properly as you go forward.
So it doesn't necessarily mean inflationary, but we would need to discuss how the government gets funded. What does the government do? What is the role of MMT? What is the role of, for governments that have sovereignty? In other words, they have a monetary sovereignty. They issue, use, and borrow exclusively in their own currency and mostly from their own citizens. Now, if that is the case what is public debt? It basically, we are, we are basically borrowing from each other and lending to each other. So this is where your MMT policy comes in and says, okay, how do you measure, how do you manage it through taxation policies, for example? So all of these debates we’ll have to go through.
Now, knowing how we work, none of it will be consistent, None of it will come at the same time. All of that will occur in emergencies. So, for example, with central bank digital coins proliferate. Right now, a lot of Republicans want to ban central bank digital coins. But the reality is that China does it, Russia does it, Europe does it. I mean, it's inescapable. You're going to have that. As you have central bank digital coins, then there is a question of what commercial banks are going to do. Because the role of commercial banks historically was propagating monetary signals through the economy. Central bank digital coins largely will negate that.
There is no need for that. You find central banks essentially will become banks. So what do commercial banks do? And if central banks or central bank digital coins can directly manage demand rather than indirectly via the markets as they already have done during Covid, for example, or during GFC. So how do you manage it? How well, what are the rules of that? How are you going to use it? And so to me, every time we're going to have an emergency, which we will over the next 10 years, so we'll be multiples of them. Those tools will be rolled out and then gradually a patchwork of rules will emerge.
Every country will be a bit different. Not all of them will be the same, but the philosophy will be the same. The government will be determining most of the rules. So they will determine probably margins that the banks will be allowed to make. They will determine where capital is going to go and how it's going to go on behalf of society, so to speak, because we have 5 to 10 times more capital than we need, but it's not allocated where people would like it to be allocated.
Now, will the government go too far? Of course they would. That's what happened in 1970s. Of course they would, and so the question is, would you have a backlash at some point in time? Yes. You will have a backlash, but at that point, perhaps, jobs won't exist anyway, and professions won't exist anyway, and labor will not be functioning the same way anyhow, and portfolio managers probably won't exist anyway.
So there will be, because capital will not look the same as it is now. And so maybe at that point it becomes something else. So when people say, how does it end? The answer, it doesn't. It just carries on eventually until you get to singularity, whatever that is, and then people will figure out what is meant by capital? What is meant by money? What is meant by labor? What is meant by education? What is meant by skilling? What is meant by productivity, and as I said, the danger is really the next decade or two as you transit there, and could we have World War Three? And that's why my subtitle of the book is hard to avoid, the world on fire, because could we have that? Yes, because people in 1930s didn't make good judgments, really. Most of them.
To believe that today's people are any better than what the people in 1930s were, and so could we make the wrong judgment? Yes, we could. Yes, we could. And that way you can't rule out a world on fire, of 1940s, n which case your portfolio could be the least of your problems, and how you're going to manage your portfolio could be the least of your problems at that point.
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Different Directions
[01:49:12] Adam Butler: I guess where I was also going with that, and I mean, that's a perfectly good answer, but there are policies that governments could enact that will be slightly less favorable to the corporate sector, or in general to the financial sector, and that would, I think, cause a potential reshuffling of the deck and warrant a very different type of asset allocation. And we could go through a multi-year or potentially multi-decade period where for profit margins shrink relative to other areas of the economy, which will then accrue a larger proportion of the pie, right? And then we could choose to externalize some of our financial risks through the currency markets. And so what might that imply to global portfolios versus domestic, or a global devaluation, relative to commodities or gold, that sort of thing. Like, do you see the potential for many of these different directions as well?
[01:50:28] Viktor Shvets: All of that, all of that is true, and by the way, in 1950s and 60s, you actually have high enough productivity that profit margins were high, REIs were high and there was enough money left to reposition the money towards the middle class, and that's why the middle class was growing through the 1950s and 60s.
Now the question is how much of it is due to reconstruction, and that's why I tend to start in 1955, because by that stage most countries were already rebuilt. And therefore you go from 1955 onwards, because the basic idea that you're coming back to is the idea that public sector will be more hostile to corporate sector.
They will take some of the profits. They will reallocate the money. And that's not always true. As I said, in 1950s and 60s, it was not true, and both corporate sector and the middle class managed to grow at the same time. Also, the government will be directing more, they already are, but they're not going to nationalize the industry.
You're not going to have British Leyland or British Steel or something like that. They are going to create a system of carrots and sticks to guide the capital to go into the areas where they would like the capital to go. Now, a lot of people say, but that will be inefficient politicized. Well, the private sector did not actually allocate capital terribly efficiently in the last couple of decades. And certainly in 1920s and 1930s, they did not allocate capital efficiently. So one thing I expressed in the book, I just don't buy the argument, the private sector is always automatically efficient. I don't buy the argument that we have fully equilibrating system. I don't buy the argument that we have perfect information.
We have competitive markets. None of those things are true. And so private sector is almost just as poor to inefficiencies as a public sector is, and in many areas, public sector could actually deploy it more efficiently, from social and other perspective. Now, what that does, of course, there are certain winners than losers.
One of the things I've been advocating for a while is what I call localization portfolios. In other words, portfolios that are designed to benefit from localized policies directed to localized corporates, okay, to implement those policies. It could be infrastructure, it could be chips, it could be education, it could be laboratories like Bell Labs and stuff like that.
The other thing you can argue is that different countries will prioritize different things, so the impact will be different. That ought to be translated into currencies. But I don't believe currencies will be allowed, and they haven't been allowed to move the way they should be moving anyway. That was a whole problem with Paul Walker. He was assuming that financialization he is spawning will be corrected by currencies moving and therefore excess deficits and surpluses will get normalized. They never did because currencies never cleared it. So I'm not even totally sure that a currency market will provide you with that.
Now the intangible versus tangible assets. As you know, I've been in a camp of intangible assets being much more powerful, but there are elements of tangible assets also valuable. These are the tangible assets needed for the new world, and so whether it's copper, nickel, cobalt, lithium, rare earths, I'm not, generally speaking, a great commodity believer. If I go a penny every time somebody told me that we're going to run out of commodities, I would be very well cemented by now, because none of it was true. We either find it somewhere, or if we don't find it, we use technology somehow, or we change industrial process, or we use less of that commodity.
But nevertheless, if you think of commodity space, there is your old industrial commodities, and there are newer commodities. So I tend to prefer newer commodities. So can you express all of that through localization portfolios? Can you express all of that through intangible assets and commodity space? Yes, you can, but the way I look at it, for most people, I think it will be easier to just go and say, whatever happens, there are companies and countries that have a wind behind their back. And there are companies that are facing the wind and the countries, if you find countries that have some wind behind their back and the companies are benefiting from that, either through localization or tangible, intangible aspects, then you are more resilient, no matter what happens as you go forward. But you're right, it could express itself in local politics. It could express itself in commodities It could express itself in currencies.
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[01:55:33] Adam Butler: Phenomenal. Well, we're sneaking up on two hours and maybe the horse is already out of the barn, but do you want to respect your time? Like I said, I was really looking forward to this conversation because I just absolutely love your books. I love The Great Rupture. I really love the new one. Again, for everybody, it's The Twilight Before the Storm: How to Avoid a World on Fire by none other than Victor Shvets. Victor, where can people find you other than on Amazon?
[01:56:12] Viktor Shvets: Well, my book’s on Amazon will be the easiest thing to do. I'm also, um, reasonably active in LinkedIn, so occasionally I post. Otherwise, I guess, all the shows like yours, and thank you very much for inviting me ,and I really enjoyed our conversation.
[01:56:37] Richard Laterman: Thanks for being here. This was phenomenal.
[01:56:39] Adam Butler: Yeah. Thanks very much, Victor.
[01:56:41] Viktor Shvets: Thank you.
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