Doubled-Down

Doug Nolan


The real trouble with this world of ours in not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not an illogicality; yet it is a trap for logicians. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait.”

G.K Chesterton

The S&P500 rose to a record 2,490.87 during Tuesday’s session at about the same time the VIX was trading down to 9.52. The DJIA reached a record 22,179 during Tuesday trading. At 5,973, the Nasdaq100 (NDX) was on track mid-day Tuesday for a record close. Tuesday saw the bank index (BKX) trade to a five-month high, with the broker/dealers (XBD) just shy of all-time highs.

"North Korea best not make any more threats to the United States. They will be met with fire and fury like the world has never seen. He has been very threatening ... and as I said they will be met with fire, fury and, frankly, power, the likes of which this world has never seen before."

The initial market reaction to President Trump’s Tuesday afternoon “fire and fury” comment was anything but dramatic. Market players have grown accustomed to bombast – apparently even when it concerns potential nuclear war. The S&P500 ended the session down about one-quarter of a percent. The VIX rose but only to 11.5. The bond market barely budged, though the already jittery currencies showed some instability.

Instead of dialing back his comments, the President Doubled-Down. The markets took notice. 

By Thursday the VIX had surged about 70% to trade above 17 (“Biggest weekly gain since December 2015”). U.S. and global stocks were under pressure. Junk bonds were getting hit (worst two-day decline of 2017), and even investment-grade corporates were under some pressure. In a rather unbullish development, U.S. bank stocks (BKX) sank 3.6% for the week. Broader U.S. equities indices were under pressure, with the mid-caps down 2.3% and the small-caps 2.7% lower.

All in all, it was an interesting – perhaps enlightening – week in the markets. At least this week, the U.S. dollar was notable for weakness in the face geopolitical uncertainty. The yen (up 1.4%) and Swiss franc (up 1.1%) enjoyed some of their traditional safe haven appeal. Speaking of safe havens, Gold surged $31, or 2.4%. European equities trade poorly. German stocks dropped 2.3%, with previous highflyers Spain (down 3.5%) and Italy (down 2.7%) under significant pressure. Italian 10-year sovereign spreads (to bunds) widened 10 bps.

August 9 – Wall Street Journal (Colin Barr): “Ten years ago this Wednesday, the first glimpses of the global financial crisis came into view. The French bank BNP Paribas froze three investment funds, saying a lack of trading in subprime securities made valuing them impossible. The bond market seized up, rattling investors and central bankers who previously soft-pedaled the notion that the U.S. housing bust would hit the economy. Aug. 9, 2007, marked the beginning of the most far-reaching economic disruption since World War II. The events that Thursday made clear that subprime-lending excesses wouldn’t be ‘contained,’ as Ben Bernanke, then Federal Reserve chairman, had predicted just months earlier. Yet few people appreciated the scope of the disaster that would unfold over the next 18 months.”

It’s simply difficult to believe 10 years have passed since the beginning of the so-called “worst financial crisis since the Great Depression.” It’s not beyond imagination to believe historians might look back to this week’s “fire and fury” as the start of the worst crisis in generations.

August 7 – Financial Times (John Authers and Alan Smith): “After the credit crisis began to unfold in the summer of 2007, many on Wall Street and in the City of London complained it was unprecedented and had been impossible to see coming. They were wrong. Speculative bubbles are rooted deep in human nature, and have been widely studied. History’s most famous bubble took root in the Netherlands almost four centuries ago — for tulips. The common elements to speculative bubbles are: An exciting and new ‘disruptive’ technology that is difficult to value in the short term, and whose long-term value is uncertain. Easy liquidity of markets so that shares or other securities can change hands quickly. The provision of cheap credit to pay for it. These classic elements were visible in, for example, canals and railroads, which both enjoyed speculative bubbles in the 19th century: In the 20th century, economic history was marked by a series of huge bubbles in critical markets. All followed almost identical patterns, and had a serious economic impact.”

The opening quote above – one of my old favorites – comes from Richard Bernstein’s classic “Against the Gods – The Remarkable Story of Risk.” The view that financial innovation and enlightened policymaking had tamed risk grew stronger throughout the nineties and mortgage finance Bubble periods. Each crisis surmounted only emboldened New Age thinking. Monetary stimulus coupled with derivatives and sophisticated financial engineering ensured that virtually any type of risk could supposedly be hedged away. And as the mortgage Bubble began inflating precariously, a powerful view took hold that “Washington would never allow a national housing bust.” GSEs, MBS, ABS, repo, CDOs and derivatives, Credit insurance – all things mortgage finance Bubble - enjoyed implicit government backing.

The 2008/09 financial crisis should have concluded an incredible era of dangerous risk misperceptions and flawed calculations. But the Federal Reserve and global central bankers Doubled-Down. Instead of the markets reverting back to more traditional (stable) views of risk, massive QE liquidity injections, zero rates and aggressive market liquidity backstops pushed risk analysis and perceptions only deeper into New Age Fallacy.

These days there’s virtually little in the way of risk that central bankers and government policymakers can’t address. Central banks became willing to fight risk aversion by directly inflating risk market prices, while simultaneously devaluing safe haven assets (with zero rates and inflationary policies). They could eradicate liquidity risk with promises of open-ended QE and the willingness to “push back against a tightening of financial conditions.” Policymakers also learned the value of concerted efforts to manage liquidity, manipulate prices, backstop markets and stabilize currency markets on a global basis.

Over time, markets began to appreciate the even political and geopolitical risks had been tamed. The 2012 “European” crisis demonstrated the new post-crisis reality that financial, economic and political risks would be met first and foremost by “whatever it takes” from central bankers and their electronic printing presses. Essentially any potential risk would ensure lower rates and more “money” printing for longer. It became clear that there was only one way to bet in the markets: with central bankers.

Yet one festering risk remained seemingly outside the purview of our inflationist central bankers: geopolitical uncertainty. But even here things became clouded by a world inundated with “money” and surging securities markets. The global Bubble championed cooperation. 

With economic and financial fragility a global phenomenon, it was basically in each country’s interest to act in ways supportive of the global recovery. Of course, promote the securities markets! And it was also not the time to embark on geopolitically risky endeavors. Indeed, a global consensus developed to use economic/financial sanctions to dissuade countries from unconstructive behavior (i.e. Russia and Iran).

A relatively benign geopolitical backdrop unfolded – with economic expansion the focal point for most leading developed and developing nations. The focus on investment, trade and attracting global flows spurred a generally cooperative post-crisis backdrop, with nations seeking active participation within the global community. Of course, the major central banks were dominating the New Global Order. And with the monetary bonanza train having left the station, it was imperative to not be left behind. In their efforts to inflate securities markets and economies, global central bankers as well fostered a relatively quiescent period geopolitically. 


There were small countries that refused to participate, but they were irrelevant to the new global financial and geopolitical backdrop.

With finance, the markets, economies and geopolitics so well-controlled, there should be little mystery surrounding meager risk premiums, record global stock prices and a VIX index below 10. It was certainly not sustainable, yet central bankers had succeeded in almost fully harnessing risk.

Let me try to explain why North Korea is potentially a huge market issue. It’s a small and irrelevant country financially and economically. Not only does it choose not to cooperate in the New Global Order, it would take great pride in being disruptive. And, most importantly, it has nukes as well as having made major strides recently in ICBM technologies.

Risks associated with North Korea are well outside the comfortable purview of central bank monetary management/manipulation – and they’re potentially catastrophic. The big problem is that market perceptions, behaviors, structures and prices have for going on a decade now been distorted by central bank’s dominance over all things risk. Disregarding risk has been consistently rewarded to the point where markets have been forced to disregard potentially catastrophic risks, including a nuclear confrontation with North Korea. Moreover, years of market risk distortions have deeply impacted the structure of the marketplace (i.e. the ETF complex, derivatives and speculating directly on risk metrics).

Going into the Presidential election, I believed markets would face significant selling pressure in the event of a surprising Donald Trump victory. It was clear from the campaign that a President Trump would be unconventional and not bound by traditional mores and behavior. 


He would be unpredictable like no President in modern times. And Trump was going to be tough, and likely bombastic and impulsive. No matter what, he would take great pains in doing things his way. For an already divided nation and a world of festering geopolitical instability, a Trump presidency came with extraordinary uncertainty and risk. As it turned out, over-liquefied and speculative markets were in the mood to disregard risk.

Let’s pray there’s a very low probability of a nuclear confrontation with North Korea. 


Hopefully, over time some diplomatic solution will be found where North Korea halts development of nuclear and ICBM technologies. But I would argue that even this best-case scenario is problematic for the markets.

Key market vulnerabilities are being exposed. There’s a major problem for highly inflated and speculative markets when it comes to hedging against risk – especially this type of undefinable risk. Indeed, this week provided a wake-up call for those that have been making a fortune writing variations of risk (“flood”) insurance during a period of over-liquefied financial markets (a risk “drought”). And the upshot of this mania in the “insurance” market has created a seemingly endless supply of cheap risk protection – readily available hedging vehicles that have kept players aggressively speculating in the markets. 

I appreciated a Friday article by Gillian Tett of the Financial Times: “The Next Crash Risk is Hiding in Plain Sight.”

Sometimes, market shocks occur because investors have taken obviously risky bets — just look at the tech bubble in 2001. But other crises do not involve risk-seeking hedge funds, or products that are evidently dangerous. Instead, there is a ticking time bomb that is hidden in plain sight, in corners of the financial system that seem so dull, safe or technically complex that we tend not to focus attention on them. In the 1987 stock market crash, for example, the time bomb was the proliferation of so-called portfolio insurance strategies — a product that was supposed to be boring because it appeared to protect investors against losses. In the 1994 bond market shock, the shocks were caused by interest rate swaps, which had previously been ignored because they were (then) considered geeky.”

Tett doesn’t believe the “financial system faces an imminent threat of another ‘boring’ time bomb causing havoc.” Her article did, however, mention the $4.0 TN ETF industry. And Marko Kolanovic, a senior JPMorgan strategist, estimates that “passive and quantitative investors now account for about 60% of the US equity asset management industry, up from under 30% a decade ago.”

When it comes to today’s global government finance Bubble, I would argue that “ticking time bombs” are more associated with risk misperceptions and “moneyness” (on an unprecedented global scale) than exotic debt instruments and egregious leverage. The collapse in the mortgage finance Bubble was not about subprime – but with the unappreciated risks embedded within Trillions of perceived pristine “AAA” mortgage securities and derivatives. The subprime crisis was in full bloom ten years ago today. Yet the S&P500 went on to all-time highs, with the systemic crisis not unfolding until about a year later.

Importantly, subprime tumult was the upshot of initial de-risking and de-leveraging behavior. 
 
The more sophisticated market operators began responding to a deteriorating macro backdrop and escalating risk. Their moves to de-risk altered the market liquidity and pricing backdrops that led eventually to systemic crisis. As is typically the case, full-fledged systemic crisis erupted where price and liquidity risks were perceived to be miniscule – with a crisis of confidence in the money markets. In the case of 2008, panic unfolded in (the belly of the beast) the “repo” market.

Hopefully the North Korean situation will be resolved relatively quickly – perhaps mediated by the Russians and Chinese. A quick resolution would allow the markets to remain in this phenomenal backdrop of risk ignorance. But the longer this drags out the more problematic it becomes for the markets. This unfolding geopolitical crisis illuminates a major type of risk that’s been disregarded in the marketplace. If this illumination initiates de-risking/de-leveraging dynamics, this could mark an important inflection point for the risk markets. 
 
Rather than just waiting to see how this plays out, I would expect the more sophisticated players to take some risk off the table.

It’s worth noting that safe haven Treasury bonds rallied little in the face of a bout of “Risk Off” behavior. Not much “hedging” value left there. And in the event of a major military escalation, I’m not convinced that derivatives markets will function effectively. Reducing risk may (for a change) require liquidating holdings - stocks and corporate debt. And losses in equities and corporates would test the unprecedented trend-following flows that have chased inflating securities markets.

For a number of years now, I’ve referred to the “Moneyness of Risk Assets” issue – the perception of central bank-ensured safety and liquidity - that has been instrumental in Trillions of flows into ETFs and other “passive” strategies. It is Here Where the Wildness Lies in Wait. I wouldn’t bet on a continuation of low market volatility.


Demography

The rise of childlessness

More adults are not having children. That is much less worrying than it appears
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POCKET LIVING has been building and selling small flats in London since 2005. The flats have many of the things that young, single people want, such as bicycle storage, and lack the things they do not, such as large kitchens and lots of bookshelves. At first, Pocket expected that most buyers would be in their late 20s, says Marc Vlessing, the firm’s boss. Instead the average age is 32, and rising. It is not that many buyers are yet to have children, speculates Mr Vlessing; rather, they probably will never have them.

A growing number of city-dwelling Europeans are in the same situation. Just 9% of English and Welsh women born in 1946 had no children. For the cohort born in 1970—who, barring a few late surprises, can be assumed to be done with babies—the proportion is 17%. In Germany 22% of women reach their early 40s without children; in Hamburg 32% do.

All of which might seem to suggest that Europe is bent on self-erasure. Childlessness is “a symptom of a feeble and terminally ill culture” that has lost touch with its heritage, according to Iben Thranholm, a conservative Danish journalist. The suggestion is misleading, however. Mass childlessness is not a sign of demographic collapse, nor is it remotely novel. It would be more accurate to say that rich countries are updating a long tradition.
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In some European countries, such as Germany and Italy, the overall birth rate is low and childlessness is common. But other countries, such as Britain and Ireland, combine a high birth rate (by European standards) with a high rate of childlessness. And in still other countries, especially formerly communist ones in eastern Europe, childlessness is rare but birth rates are low, because many women have one child. Overall, there is surprisingly little correlation between childlessness and fertility (see chart 1).
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Many countries that have lots of childless women today had even higher rates in the early 20th century. Indeed, the baby-filled late 20th century looks like a blip (see chart 2). That reflects deep-rooted social norms. In pre-industrial western Europe, men and women did not marry while they were maids or apprentices, but only when they could set up households of their own.

To stay unmarried and childless was a sign of economic failure. But it was not shameful in itself. “It is poverty only which makes celibacy contemptible,” explained the heroine of Jane Austen’s novel, “Emma”.

The attitude lingers. In western Germany, people without children tend to feel only mild social stigma. “It’s something that requires an explanation, but not a lengthy one,” says Tanja Kinkel, a successful novelist who did not have children because she did not find a suitable partner. And western Germany combines a forgiving attitude to childlessness with a harsh view of working mothers. Until recently, nurseries were rare; a woman who put her child in one might be abused as a “Rabenmutter” (raven mother). Many happily working women simply opt out.

Childlessness is becoming more common in countries like Italy and Spain, which also squeeze working mothers. But perhaps the best example is Japan. Even if Japanese mothers were not pressed to stop working (which they are) they would be pushed into it by a brutal office culture.

In a Japanese firm everybody is responsible for everything, complains one woman, an architect who lives in Tokyo.

As a result, nobody dares to leave work early, which makes parenthood almost impossible. She delayed having children and is undergoing fertility treatment at the age of 41. Japan’s childless rate has shot up from 11% for women born in 1953 to 27% for women born in 1970.

The reasons why people do not have children are varied, complex and often overlapping. A few (but, pollsters find, not many) never wanted them. Others do not meet the right person. Some fall in love with people who already have children, and feel satisfied. Others suffer from medical problems. A great many fall into a group that Ann Berrington, a demographer at the University of Southampton, calls “perpetual postponers”. Waiting to start a family until they are finished with education, until they have a stable job and a house, they find it is too late.

Almost everywhere, the most educated women are least likely to have children. And the highest rates of childlessness are found among women who pursue degrees in non-vocational subjects.

Researchers at Stockholm University have found that 33% of Swedish women born in the late 1950s who studied the social sciences did not have children, compared with 10% of primary-school teachers and just 6% of midwives. It may be that teaching and midwifery attract women who strongly desire children, or that these jobs offer more parent-friendly hours and conditions. But the difference is probably also down to job security. A trained teacher can expect to find a stable job at a younger age than a trained anthropologist can.

The charitable childless
Although childlessness makes some people utterly miserable, that is not the case for most. One multi-country study by two demographers, Rachel Margolis and Mikko Myrskyla, suggests that childless people aged 40 and over in formerly communist eastern Europe are a little unhappier than people with children, once you control for things like wealth and marital status. That might reflect the stigma against childlessness in those countries. In liberal Anglo-Saxon countries, though, middle-aged childless people appear to be slightly happier than parents. The same demographers find that young parents are gloomier than childless youngsters.

Amazing as it may seem to parents who spend their evenings and weekends traipsing to football training and piano lessons, childless people find plenty of things to do with their time. Among these are good works. One German study found that 42% of charitable foundations were created by childless people. Ms Kinkel started a charity called Bread and Books, which operates mostly in Africa. She describes it as her way of nurturing the next generation.

People without children are far more likely to bequeath money to charity, points out Russell James, an expert on philanthropy at Texas Tech University. In 2014 fully 48% of married childless people aged at least 55 who had written wills or will-like documents committed to giving something to charity. That was true of only 12% of parents and a mere 8% of grandparents. Knowing this, American universities have become acutely interested in whether their alumni have offspring, says Mr James.

That question is easier to answer for women than for men. Men’s fertility declines with age, but less predictably than women’s fertility. So, whereas demographers and fundraisers can reasonably assume that a 45-year-old woman will have no more children, they cannot assume the same for a man.

Worse, men sometimes forget their children when filling in census forms—and may have fathered children they do not know about. Still, two things are clear. Childless men are numerous, and quite different from childless women.

Men are erratic. Some are reproductive prodigies, having many children with more than one partner. Others—more than is the case for women—have none at all. Ms Berrington finds that 22% of British men born in 1958 were childless at the age of 46, compared with 16% of women. And in many countries childless men are disproportionately working class. French men who have never worked are about twice as likely to have no children as men who hold good white-collar jobs. Michaela Kreyenfeld, a demographer at the Hertie School of Governance in Berlin, finds that 36% of west German men without university degrees born in the early 1970s were childless in their early 40s. Among men with degrees, the rate was 28%.

That suggests men and women end up childless for quite different reasons. Women often have no children because they have prioritised education or work in their 20s and 30s. Men are more likely to remain childless because women do not view them as good boyfriend material—let alone good husband or father material. “They have a problem finding partners,” suggests Ms Kreyenfeld.

The distinction might be disappearing, however. In western Germany, childlessness is rising among less educated women, who are converging with their highly educated peers. In Finland, a switch has already occurred: women with only a basic education are the most likely to remain childless. It may be that, as two-earner households become more common, men have taken to judging women as women have long judged men. Those who fail to land dependable jobs might not be given a good opportunity to have children.

Nobody knows whether childlessness will rise further. It has been going up in most European countries, but not all: the rate has fallen in Switzerland, for example. One possibility is that childlessness will veer up and down, mirroring the economic cycle. As the average age of marriage rises and couples push childbearing into their mid- or even late 30s, they become increasingly vulnerable to shocks. A bad recession or a mortgage-lending squeeze will encourage couples to pause—and, because many now give themselves only a narrow window before their fertility drops, some will be knocked out of childbearing altogether.
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That seems to be happening in America, points out Tomas Sobotka, of the Vienna Institute of Demography. The proportion of 45-year-old American women without children has fallen steadily since the turn of the century. Following the financial crisis of 2007, though, childlessness among 30- and 35-year-old women shot up (see chart 3). No matter what their intentions, many of these women are likely to remain childless.

That will not be such a terrible fate. Childlessness is often undesired, but in rich Western countries it is hardly calamitous. As the peculiarly procreative generation born around the middle of the 20th century passes away, it will come to seem ever more normal.


The electric car revolution will leave many behind

In the future, the auto industry will need far fewer people to make vehicles

by: Pilita Clark
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The death of the internal combustion engine could imperil more than 20m jobs in the US and Europe © PA


This has been another big week for electric cars, which means it has been a frantic week for people who loathe the things. First they had to deal with the UK banning new petrol and diesel car sales from 2040 — just three weeks after France announced a similar plan.

Then they have had to gird themselves for the frenzy due later today when Elon Musk presides over the live-streamed first deliveries of the Model 3, his Tesla company’s electric car for the masses. All this in the same month that Volvo said all its new models would have an electric motor from 2019.

“Crazy” was the word that jumped out from the email that arrived in my inbox on Wednesday from the Global Warming Policy Foundation, a UK think-tank that rarely sees a climate change policy it likes.

When it comes to electric cars, there is no end to what the foundation’s followers think is crazy: the high price tags, the lavish subsidies, the swelling mounds of used battery waste.

This time they had a newer worry: the power stations that may have to be built to “cope with the electric revolution”. They have a point.

There were only 2m electric cars on the world’s roads last year, well below 1 per cent of the global total. But with annual sales soaring and most top carmakers planning new electric models, no one expects those numbers to stay still. The International Energy Agency thinks there could be up to 20m electric cars by 2020 and maybe 70m by 2025. That’s brilliant news for anyone worried about climate change and air pollution. But it does require more thought about matters such as safely mining raw materials for batteries and possibly extra power plants, though not the vast numbers electric-car critics like to cite.

Climate change sceptics typically exaggerate these issues. They can also be fantastic hypocrites, coming over all tree-huggerish about toxic battery waste when no other environmental threat ever bothers them.

Curiously, they don’t spend so much time on one of the great economic and political risks posed by the rise of the electric car: its potential to be a jobs killer.

The auto industry is fond of saying that if it were a country, it would be one of the world’s largest economies. Its figures show it supports around 7m jobs in the US alone and close to 13m in Europe.

Robots may have encroached on the assembly line already, but wait until the beguilingly deceptive electric car takes off. It might look like any other car from the outside but inside, it is more like a computer on wheels, a very different beast to the internal combustion engine vehicles we drive today.

You can get a sense of the disparity from a recent report by some enterprising UBS financial analysts, who tore apart one of GM’s $37,000 Chevrolet Bolt electric cars to see what it cost to make. They found it was $4,600 cheaper to produce than expected and concluded that, with further cost falls likely, electric cars would probably disrupt the industry faster than widely understood.

The report did not dwell on jobs but for an auto worker, its findings are frightening. It said the Bolt had just 24 moving parts compared with 149 in a VW Golf, mainly because electric motors are so much simpler than combustion engines.

That suggests the car industry of the future will need far fewer people to make not just vehicles, but the components that go into them.

There is also the auto repair and service market. Combustion engines have spark plugs and oil that need changing. Electric motors do not require anything like the same amount of maintenance.

It is hard to know exactly what this will mean for the world’s car workers, not all of whom will switch easily from doing an oil change to rebooting a car computer.

Obviously a growing electric car industry should create new jobs in companies that make, say, batteries or software. But an awful lot of people may be left behind. If you talk to people who spend time looking at this, you hear alarming figures. One analyst I spoke to this year said he thought the reason some executives in older car companies were initially reluctant to embrace electric cars was because they understood the implications for their huge workforces. More than 420,000 auto jobs in Germany could be imperilled by a 2030 ban on combustion engine cars being debated there, a study commissioned by the country’s car industry said last week.

All this speaks to a problem about the shift to a greener energy system that is well understood by those who study it closely but yet to attract nearly enough attention from politicians: the need to retrain and possibly compensate workers at the face of rapid industrial change.

There is no point blaming green campaigners who lobby for lower carbon emissions or warn about the risk of stranded financial assets in oil and coal companies.

Those are real dangers. But as the political ructions in Donald Trump’s America have shown, much more needs to be done to address stranded human assets as well.


South America: Divided, not Conquered


Nations are products of their environments, and not the other way around. They simply have to behave in certain ways if they want to remain nations, and more often than not their behavior is expressed not by what they can do but what they can’t do. Nations can’t move mountains or rivers. They can’t create farmland from scratch. They can’t produce more resources than what the ground allows.

Particularly bound by these kinds of constraints is South America. The geography of this often overlooked continent is oddly egalitarian: Some nations are stronger and richer than others, of course, but the preponderance is less pronounced than it is in other regions of the world. For this reason, South America may seem inconsequential, so uninvolved is it in the wars of the Middle East, U.S.-Russia sanctions, Islamic terrorism and the South China Sea. But its apparent complacency elides more pressing geopolitical imperatives. The following report explains why.
 
Confinement
The defining characteristic of South America is that its geography will not allow any nation to project power across the continent. Those that have come to power have been confined to either the Pacific Coast or the Atlantic Coast. Some were even able to hold power on both coasts, but none were able to form a seamless political entity.
 
 
Their separation is largely due to the Andes Mountains, which span the entire length of South America near the continent’s western edge. Other geographic features, however, accentuate the east-west divide. In the north, the vast Amazon rainforest prevents the movement of people from one population center to another and stunts urban development. The Amazon River and its tributaries, which flow from the west to the east, enable ventures farther inland, but upstream waters quickly become unnavigable to large ships.

Reinforcing the division of South America are the Gran Chaco, a semi-arid, sparsely populated lowland region roughly at the center of the continent; the wetlands of the Pantanal; and the Atacama Desert. They are as difficult to traverse as they are inhospitable to human settlement.

South America’s largest and most important cities are therefore found primarily on the coasts. Their situation is particularly pronounced on the Pacific Coast, where there is little room between the ocean and the Andes. Cities along the Atlantic Coast have a little more breathing room – people were able to settle in the Rio de la Plata Basin, which boasts fertile soil, useful river systems and hospitable climate and terrain – but they are nonetheless densest near the ocean.
 
 
Complexions Change
 
The inability to project power over the entire region has plagued South American empires and countries throughout history. Before Europe colonized the region, the Incan Empire was the predominant power in the Pacific region. At its height, it comprised Peru, Ecuador, large parts of Bolivia and Chile and smaller sections of Argentina and Colombia. The Incas were resourceful and formidable, but they could never really expand past the Andes. There was no single pre-colonial empire in the Atlantic region. Broadly speaking, the Tupi dominated Brazil, the Guarani controlled Paraguay and parts of the Plata Basin that extended into southern Brazil, and groups related to the Mapuche inhabited much of the southernmost portion of the continent.

European colonization, especially Spanish and Portuguese colonization, changed the complexion of South American power but could not escape its geographic constraints. Spain, for example, could govern the Viceroyalty of Peru easily enough but found it more difficult to govern the territory as a single unit as it added territory to the east. So it divided the area into three viceroyalties – Peru, New Granada and Rio de la Plata – that correspond with the continent’s natural geographic barriers.

The emergence of capitanias – autonomous territories controlled by high-ranking generals but still technically under the viceroyalty banner – likewise illustrate the limits of power projection. Chile had been lumped into the Peru Viceroyalty because it was on the same side of the Andes Mountains. But distance and desert obviated the need for a middle man in Lima, so Chile instead interacted directly with the Crown.
 
 
In the Atlantic region, geography pitted Spain and Portugal against each other. Portugal arrived in 1500 and began to colonize Brazil, focusing largely on coastal areas with good ports. It could not expand west because of the Amazon, Chaco and Pantanal, so it went south, to the Rio de la Plata Basin, a desirable tract of real estate in central South America east of the Andes. It is large, hospitable and arable, with natural irrigation systems. Spain, meanwhile, had arrived in southern South America and, having taken control of territory west and just east of the Andes, likewise turned its attention to the Rio de la Plata Basin.

Spanish and Portuguese interests thus collided in central South America. As it happens, the basin in which they fought was flat, unobstructed terrain, ideally suited for combat. Years after they fought there, subsequent wars waged in the same vicinity would eventually produce the modern states of Bolivia, Paraguay and Uruguay, which served as buffer states between Argentina and Brazil.

A final example of obstacles to power projection comes from the Spanish colonies’ wars for independence in the early 19th century. Simon Bolivar led an independence movement in the north that included Venezuela, Colombia, Ecuador and eventually Peru, while Jose de San Martin led the independence movements in the south that included Argentina, Chile and initially Peru. Bolivar ambitiously tried to create a united Pan-American entity from the wars of independence but, when faced with the difficulty of unity in South American terrain, ceased to do so. Instead he ruled Venezuela, Colombia and Peru as separate entities, giving each of these countries the individual identities that exist today.
 
Contemporary Candidates
Modern South America is thus shaped not by what leaders of the past could do but by what they could not do. The geography is just as divisive today as it has ever been. Currently, neither the Pacific nor Atlantic region has a natural leader – but not for a lack of candidates.
 
The Atlantic Coast
 

In the Atlantic region, Brazil could be such a leader. It borders all South American countries, save Chile and Ecuador. It is the fifth-largest and fifth-most populous country in the world. It boasts the ninth-largest gross domestic product in the world at $1.8 trillion, according to the World Bank. With its low population density and ample mineral, hydrocarbon and agricultural resources, it has all the makings of an even stronger economy.

But Brazil faces two initial obstacles to realizing its potential. First, the government has yet to consolidate the country. The country’s core consists of the triangle formed by Rio de Janeiro, Sao Paulo and Belo Horizonte. The remaining periphery can be divided into three regions – the South, Center-West and North-North East. To build national strength, Brazil’s core must have strong social, economic and infrastructural ties to these three regions. Presently, the South, which sits largely on uncomplicated, flat terrain, is the only one of the three firmly connected to the core. Inadequate infrastructure and economic development between the Center-West and North-North East and the core fuel economic and social disparities, making it all the more difficult to bring them into the fold.
 
 
Argentina is nearly as potent as Brazil but would struggle to subordinate its neighbor to the north. Though it is South America’s second-largest economy, it is just a third the size of Brazil’s (21st globally). It has the size and resources to help keep Brazil in check but not enough to overpower it.
The remaining Atlantic region nations are even less equipped to challenge Brazil. Paraguay and Uruguay are buffer states, fated to play their larger neighbors off one another as the situation warrants. Paraguay is particularly resigned since it is a landlocked nation wholly dependent on others for maritime trade. Venezuela’s position on the southern rim of the Caribbean means that the United States will make sure Caracas is never powerful enough to challenge U.S. influence in the region, in turn limiting its influence in South America. (Venezuela admittedly isn’t doing itself any favors right now.)
 
The Pacific Coast
 
In the Pacific region, Peru is best positioned to assume a leadership role. Peru was the seat of power in the pre-Columbian era. It still boasts mineral, metallurgical, hydrocarbon and agricultural resources that allow it to support a large portion of its domestic needs. It also has a burgeoning manufacturing sector. Eight of its 10 largest cities are along the coast, which facilitates trade and communication.

On the surface, Colombia appears to also be a potential candidate for Pacific power. The country’s economy is on the rise (it was especially so before oil prices dropped), and now that the country’s longest insurgency has come to an end, security has improved. But what helped shelter the insurgents for so long is precisely what hinders the construction of a viable regional power: mountains and jungles. Even before it was colonized, Colombia never had a great empire based there like Inca in Peru. This is because the terrain lends itself to poorly connected and uncoordinated population centers. And, like Venezuela, Colombia borders the Caribbean Sea, and though it is a strong U.S. ally, Washington would never allow it to challenge its power.

Other countries don’t qualify. Chile is one of the most developed countries in South America, but it is so narrow, so dependent on energy imports and so far removed from the rest of the continent that it could never overtake it neighbors. Bolivia, another landlocked nation, is at the mercy of others for trade. Ecuador is even smaller in area than Bolivia, and only slightly less alienated.
 
 
The countries of South America have been too preoccupied with their own issues for the past half century to worry about projecting power abroad. In that time they have experienced dictatorships, rebuilt their governments after toppling the dictatorships, clashed with domestic militant groups and suffered economic crises. Competing for regional power or expansion was secondary to survival. But even if they dedicated themselves to regional hegemony, and even if they de facto led their respective region, they could never subsume the other.
 
Circumstance
As important to South America is its location. The continent sits in the Southern and Western hemispheres between two oceans, making it remote from major trade routes and seats of power. In short, it is a peripheral region and, as such, was a latecomer to the global economy. Consequently, economic development has come slow to South America, and its domestic issues are magnified.

Geographic barriers, an abundance of natural resources and a legacy of colonialism created an economic dependency on raw materials. From the European perspective, the purpose of the colonies was to provide wealth for the monarchies and ready-made markets for the consumption of manufactured goods. To this day, the production and export of commodities links South American countries to the rest of the world. They all but define trade ties to virtually every region, most notably China, India and other Asian nations. Growing demand for their resources only aggravates the problem.

In some areas of production – sugar cane, soy, corn, copper, iron ore – South American production can drastically affect commodity prices and supply. With other commodities – wheat, coal, beef, oil – these countries significantly factor into global supply but do not single-handedly affect the global market. In these cases, the commodities have a much larger importance and impact on the individual economies than on the global supply or price.

Production and control of these commodities has been a major source of social conflict in South America as government desires for economic performance ran counter to some local demands. In the area of agriculture, the government must balance the domestic consumption with the desire for export revenue – something that pits producers against government regulators, as is sometimes the case in Argentina. In mineral extraction, the profits of mining companies come into conflict with the health and livelihoods of underpaid workers and regional governments. It is little wonder, then, that Chile and Colombia, two major mineral-producing countries, have seen major mining protests throughout the years. Extractive industries and supporting infrastructure projects, moreover, create environmental concerns among indigenous communities and activists, as can be observed in Peru, Bolivia and Brazil.

Other sources of friction are inevitable so long as South American countries adopt economic policies meant to reduce their vulnerability to commodity prices, develop domestic industry and shift away from an emphasis on raw materials. So far, they have experimented with various schemes of import substitution (a policy that replaces foreign imports with domestic production, which is often costlier), industrial subsidies, import tariffs and general protectionist measures. But most have not worked. Brazil and Argentina are now moving ahead with economic reforms while Ecuador and Venezuela still cling to failing policies. Peru, Colombia and Chile are trying to compensate by turning to free trade and finding areas of competitive advantage.

South America shows that while the laws of geopolitics may be immutable, the way nations obey them are circumstantial. The things that divide the region are the same things that have prevented the kind of conflict that exists in other places – it’s hard for groups to clash if they are not forced to confront one another. But South America has a role to play on the global stage, even if it’s only recently trying to figure out how to play it.


Dueling Hotheads

The War of Words that Could Go Nuclear

By Veit Medick, Juliane von Mittelstaedt, Christoph Scheuermann, Wieland Wagner and Bernhard Zand

 A North Korean intercontinental ballistic missile                        A North Korean intercontinental ballistic missile

 

President Trump's "fire and fury" tirade against the regime of Kim Jong Un has escalated tensions with North Korea. A military conflict with the country would have catastrophic results. Is there still a diplomatic way out of this mess?

It's always the same ritual in August in South Korea. Not far from the shared border on the 38th parallel, artillery fires at targets supposed to represent North Korean tanks. Helicopters fly at low altitudes, fighter jets thunder through the air and tanks roll across beaches as around 80,000 South Korean soldiers and American troops conduct joint exercises simulating a defense against an attack from the north. The maneuver has already triggered serious crises in the past.

But this year, the nervousness peaked two weeks before the maneuvers. No tanks or troop deployments were required, all it took was these words: "North Korea best not make any more threats to the United States. They will be met with fire and fury like the world has never seen."

Donald Trump fired off these words on Tuesday night, slightly hunched forward, with his arms crossed and chandeliers and golfing plaques in the background, terrifying the rest of the world.

It was the sharpest warning yet to the regime in Pyongyang, bordering a declaration of war. By doing so, Trump ignored the unwritten doctrine that a U.S. president doesn't boast of his nuclear arsenal like a teenager. He doesn't seem to care that the weapons are intended as a deterrent and that they do not exist to be used. Had he gone one step further, by threatening to lay Pyongyang to waste, it would have been difficult to distinguish him from Dictator Kim Jong Un.

Even the North Koreans, who do not shy away from making their own abrasive threats, criticized his "nuclear war hysteria" and described the statement as "extremely reckless."

A Verbal Tweet

The statement appears to have been triggered by an article published a shortly before in The Washington Post. It stated that North Korea had produced a miniaturized warhead that could fit inside long-range missiles theoretically capable of reaching the United States. The story was based on an analysis from the Defense Intelligence Agency that the president had presumably been aware of it.

Despite that fact, it appears that the president felt he needed to comment on the newspaper report.

The New York Times reported that Trump had neither planned his choice of words in advance nor discussed them with his advisers -- despite the possibility that it could lead to an explosive conflict. The words slipped off the president's tongue at his New Jersey golf club like a verbal tweet, only more dangerous. It was as if he wanted to prove that, even during his vacation, he had the last say in the crisis. He had self-confidently tweeted in January: "North Korea just stated that it is in the final stages of developing a nuclear weapon capable of reaching parts of the U.S. It won't happen!"

Still, the fact that Trump improvised his statements doesn't make them any less dangerous. To the contrary. Trump is actually adding fuel to the fire and, as such, is increasing the risk of a military conflict with North Korea. It's ironic that a country with a tiny economy and a gross domestic product equivalent to only about half the amount Americans spend on their pets is capable of developing nuclear bomb-equipped long-range missiles.

German Foreign Minister Sigmar Gabriel criticized the "aggressive language," saying it evoked Kim Jong Un. "There is no military solution to this conflict," Gabriel told DER SPIEGEL. "The risks are so massive, for all parties, especially in Korea of course, but also for the region and the whole world."

Grave Consequences

A war would likely mean the deaths of hundreds of thousands, the destruction of the South Korean capital city of Seoul, possible attacks on U.S. military bases in East Asia and maybe even on American cities. North Korea would be laid to ruins and it would create a shock to the entire global economy.

Given its grave potential consequences, nobody is interested in this war, not even Donald Trump -- at least that's the hope. If things go well, then it may just be a trial of strength between Trump and Kim that ultimately results in negotiations. But the concern is that it could be followed by a series of new and uncontrollable threats and counterthreats that escalate the situation. At some point, one side could see itself forced to attack in order to pre-empt a first strike by the other side.

Seldom has that threat been as great as it is right now, given that nuclear warheads now exist on both sides of the Pacific, representing an existential threat to each end. On the one side, you have in Trump an unrestrained and unfocused Twitter tycoon who has achieved very little during his first 200 days in office. On the other side, you have North Korea's dictator, a man for whom shill war cries are merely a staged show of power.

At the end of July, the North Koreans released a floridly martial warning that they would "pre-emptively annihilate" any country that threatened the regime's "supreme dignity" by "mobilizing all kinds of strike means, including nuclear ones." Following Trump's "fire and fury" tirade, North Korea responded by saying that, if necessary, it might launch four intermediate-range missiles that would land in the sea around Guam, a U.S. Pacific territory that is home to an air base. A sixth nuclear test is also likely soon.

In the past, most U.S. presidents have put up with this kind of saber rattling. But not Trump, who responds to just about every threat with a counterthreat. On Wednesday, he just kept going, tweeting: "My first order as President" was to renovate and modernize America's nuclear arsenal. "It is now far stronger and more powerful than ever before," he wrote, despite this being untrue. He then tweeted: "Hopefully we will never have to use this power," adding, "But there will never be a time that we are not the most powerful nation in the world!"

Trump: 'Wasn't Tough Enough'

When asked by journalists on Thursday if he had gone too far with his statement, Trump countered, "maybe that statement wasn't tough enough."

When asked what could be tougher than "fire and fury," he responded: "Well you'll see. You'll see."

Trump was then asked if he was considering a preemptive strike, to which he replied, "We don't talk about that."

But he followed that by saying, "North Korea better get their act together or they are going to be in trouble like few nations have ever been in trouble."

Many had hoped that the recent appointment of John Kelly as the new chief of staff might help bring a little bit of calm and order to the White House, but this week's comments show that the president cannot be reined in. Together with National Security Adviser H.R. McMaster and Defense Secretary James Mattis, former general Kelly is considered to be one of the few levelheaded members of Trump's close team. Mattis and Kelly already agreed months ago that one of them would always be in the United States in order to monitor the president's orders and decisions.

Otherwise, there are few people capable of influencing Trump's North Korea policies. Many positions remain vacant at the State Department and there is a lack of experts who could develop a strategy for North Korea. These days, Secretary of State Rex Tillerson is essentially a battery-powered robot vacuum cleaner who tidies things up without making much noise. It was Tillerson himself who very suddenly announced in March that, "The policy of strategic patience has ended." But he was more conciliatory a few days ago, saying that Washington does not seek regime change in North Korea.
 
After Trump's fire and fury tirade, he seemed incapable of coming up with something better than saying there was no reason to worry about the president's statement and that the "American people should sleep well at night."

Fuel on the Fire

It is a sign of the chaos in Washington that the defense secretary, of all people, escalated the situation on Wednesday by warning North Korea it must "cease any consideration of actions that would lead to the end of its regime and destruction of its people."

But how great is the threat posed by North Korea?

The U.S. estimates that Kim now has up to 60 nuclear weapons, and he is intervening personally to ensure his military technology specialists are working fast. "He appears to be using a carrot and stick approach," says Lee Ho Ryung of the Korea Institute for Defense Analyses in Seoul. In 2016, the dictator had himself photographed in front of a miniaturized warhead for the first time. At the time, many experts wondered if the silver ball might be a fake, but few still doubt its authenticity today.

The miniaturized warheads mark a breakthrough for the country -- one that military experts had initially thought was only possible in two years' time. It remains unclear whether North Korea has the capabilities or the precision necessary to strike targets in the U.S.

Analysis of July's intercontinental-ballistic-missile test suggested that the missile had burned up as it fell through the Earth's atmosphere. For that reason, Robert Litwak of the Woodrow Wilson Center in Washington believes Kim's missile tests create a "new urgency" in the debate over the nuclear program, which he describes as Kim's "Manhattan Project," but that it will still take another year of two until Pyongyang will have nuclear-tipped missiles capable of striking targets thousands of kilometers away. Still, experts have often gotten things wrong in the past and Pyongyang appears to be making rapid progress.

A 'Political' Weapon

North Korea's state propaganda machine has already hailed the young leader as a military commander who has won numerous battles. He can already boast that he has fulfilled the legacy of his grandfather Kim Il Sung and his father Kim Jong Il, that he has protected the Stalinist dynasty from intervention by a major power thanks to the possession of nuclear weapons. Natural disasters, famines and ever-stronger sanctions did nothing to dissuade the Kims from achieving their goal. Kim Jong Un's most important strategic goal now may be recognition as a nuclear power -- possibly through the kind of compromise the U.S. reached with India.

"(North Korea) is developing its nuclear weapon for a political reason," concurs Ra Jong Yil, who is also the former deputy director of the South Korean intelligence service. He doesn't believe that Kim would actually use his arsenal. In the longer term, he argues, his goal is for the U.S. to withdraw its military from South Korea, an assessment shared in Japan. Sources in Japan's General Army Staff do not believe Kim to be suicidal enough to risk his power through a retaliatory strike against the United States.
The China Question

Kim has also been successful economically. He is transforming Pyongyang into one big propaganda backdrop with modern high-rises and amusement parks. Once empty streets are now experiencing traffic jams and many subjects who had previously been completely cut off in the hermetically sealed country can now be seen making calls and surfing the net on their smartphones. The boom has been financed through the export of raw materials and foodstuffs as well as through a large number of trading companies operating out of China. In addition, the intelligence services in Seoul estimate that North Korea also has stationed around 7,000 computer experts, spies and hackers abroad. A single hacking attack last year on Bangladesh's central bank supposedly yielded a booty of $81 million.

That's why it seems unlikely the most recent, and thus far strongest, United Nations-imposed sanctions can stop Kim. Resolution 2371, which was also backed by China, is aimed at curbing North Korea's exports by $1 billion -- about one-third of its overall exports. It also bans countries from allowing in workers from North Korea and from entering into joint ventures with North Korea. To secure China's vote for the sanctions, however, the U.S. reportedly made concessions. For example, Beijing is still allowed to continue its oil deliveries to North Korea.

It's also the reason Mark Fitzpatrick of Washington's International Institute for Strategic Studies is skeptical about the effects of sanctions. "The sanctions will undoubtedly not be fully implemented," he says. "North Korea will find other avenues of income." He suggests increasing the pressure through a naval blockade.

China's Role

For now, though, the situation largely hinges on China. Trump has been trying for some time now to apply pressure on Beijing, but those efforts have been unsuccessful so far. He once again warned China on Thursday that it must do more, claiming that the U.S. loses "hundreds of billions of dollars" a year in its trade with China and that this would not continue. That is unless, Trump argued, China helps him with North Korea. But this isn't the first time he's made threats like these, and it's hard to imagine Beijing still taking this U.S. president seriously anyway.

"It's good that China went along with this most recent, significant tightening of the sanctions and that it now also wants to implement them in a resolute way," says German Foreign Minister Gabriel.

Pyongyang, he says, must understand that it has no more partners in its "aggressive path of provocation." But is that really what China wants?

According to Chinese Foreign Minister Wang Yi, the UN resolution will help the leadership in Pyongyang make the "correct and prudent decisions." The truth, though, is that Beijing doesn't believe that sanctions will work.

"Decades ago, China was facing similar pressure from the outside," says Jin Qiangyi, the head of the Center for Inter-Korean Studies at Yanbian University. "At the time, China didn't give up either. Beijing thus knows from its own experience that the effect of sanctions is very limited."

It believes the opposite to be true: The experience with famine in the 1990s, he argues, showed that sanctions lead to suffering among North Korea's population and only encourage the regime to harden its position. Beijing approved the sanctions to counter the accusation that China only sides with Kim -- and also because a growing number of Chinese people are now critical of China's loyalty to the dictator in Pyongyang.

Beijing's Interests

Beijing's recipe for resolving the conflict is primarily to pass the buck to the U.S. and its allies and to call on them to negotiate directly with North Korea. Officials in Beijing have preached that it will only be possible to convince North Korea to freeze its missile and nuclear program if Washington, Seoul and Tokyo stop conducting joint military maneuvers in the Western Pacific.

China's suggestion can't be dismissed out of hand. Bringing the two rivals to the negotiating table would at the very least prevent a further escalation. But so far, Beijing hasn't shown any sign it would itself like to take on greater responsibility.

This fuels the suspicion that Beijing is less interested in finding a solution than it is in safeguarding its own interest -- namely that of breaking the United States' hegemony in the Pacific and rising to become the region's leading power.

Of course, Beijing would also prefer it if Kim were to freeze his missile and nuclear program and stop provoking others. But what frightens Beijing more than North Korea's atomic weapons is the idea that the regime in Pyongyang might one day collapse, precipitating reunification under the leadership of Washington and Seoul -- a development that could result in the stationing of American soldiers along China's own frontier.

In order to assuage such fears, it has been reported, Henry Kissinger, the old master of diplomacy with China, recently advised Secretary of State Tillerson to provide some guarantees to Beijing, including a large-scale withdrawal of American troops from the south in the event of reunification.

This, he is said to have argued, was the only way for America to eliminate Beijing's reservations about the idea that North Korea might no longer exist one day as a buffer state.

For now, Beijing considers the outbreak of a new Korean War to be unlikely. But the closer North Korea gets to its goal of building an intercontinental ballistic missile armed with a nuclear warhead, the greater that risk grows. And what would Beijing gain from being the leading power in a region if it descended into chaos?

Few Chances for a Diplomatic Solution

In Tokyo and Seoul, meanwhile, people are almost as worried about the U.S. and China reaching an agreement without them as they are about military escalation. Both countries want to continue amassing their own arms. Japan's defense minister now argues his country has to have the capability of carrying out pre-emptive strikes. Even South Korea's new president is striking a more aggressive tone. Moon Jae In took office with the goal of furthering reconciliation with the North, but now he is calling for a comprehensive overhaul of South Korean defenses.

As catastrophic as a war would be, there are few chances of a diplomatic solution, and that is the major dilemma in this conflict.

In 1994, the Clinton administration signed an agreement with Kim Jong Il, who promised to stop reprocessing fuel rods in exchange for oil delivery. But the North Korean leader, who is the father of Kim Jong Un, secretly continued it. A further attempt in 2005 also failed. As long as the people in power in Pyongyang believe they need nuclear weapons to secure their power, it seems, they will not be prepared to give them up.

Trump, it turns out, only has bad options at his disposal. Even the powerful U.S. military lacks the capability to hit all the North's military installations simultaneously and prevent Kim from launching a retaliatory strike. Most experts are certain that the only thing that can keep Kim in check is a mixture of sanctions, cyber-warfare and isolation -- and that the world will ultimately have to come to terms with North Korea as a nuclear power.

This wouldn't be a new thing. When Josef Stalin and Mao Zedong built their first atomic bombs, pre-emptive strikes were also discussed. Fortunately, Trump's predecessors acted level-headedly, and the Soviet Union and China ultimately became nuclear powers. Since then, the fragile logic of mutual deterrence has prevailed.

Trump is now 71 years old. He grew up in the most peaceful period that his country has ever experienced. Hopefully he hasn't forgotten that.