Issue 2018: Market Structure

Doug Nolan
 
 
Financial conditions are much too loose. They remain too loose at home; they remain too loose abroad.

January 3 – ETF.com (Heather Bell): “…ETF flows really blew away previous records. Flows into exchange-traded funds were going full blast throughout the year and finished on a particularly strong note. A whopping $51 billion in new money came into U.S.-listed ETFs during December, pushing inflows for the year to $476.1 billion. Total assets now top $3.4 trillion. The data, which comes from FactSet, includes flows for every trading day of 2017. The $476.1 billion figure was far and away a record for annual inflows, blowing past the previous all-time high from last year of $287.5 billion.”

Think of this: 2017 ETF flows surpassed the previous year’s record flows by 66%. And while U.S. equities attracted the strongest flows at $180 billion, international equities were not far behind at $162 billion. There’s never been anything comparable to this Market Structure.

The Nasdaq100 jumped 4.0% in 2018’s initial four sessions. The Nasdaq Computer Index surged 4.2%. The Semiconductors jumped 5.8%. The Nasdaq Industrials gained 3.1%, the NYSE Healthcare Index 3.2%, the Philadelphia Stock Exchange Oil Services Sector Index 5.1% and the S&P500 Index 2.6%. The mania is global. Germany’s DAX jumped 3.1% in four sessions, France’s CAC 40 3.0%, Spain’s IBEX 3.7%, and Italy’s MIB 4.2%. Japan’s Nikkei jumped 4.2%, Hong Kong’s Hang Seng 3.0%, and the Shanghai Composite 2.6%. Notable EM gainers included Brazil (3.5%), Russia (4.6%), Argentina (7.1%), Poland (2.5%), Czech Republic (2.5%), Romania (3.0%), Philippines (2.5%) and Pakistan (5.1%). Portending a wild year in the currencies, a number of EM currencies went nuts this week.

Bubbles are self-reinforcing but inevitably unsustainable inflations. Asset Bubbles are fueled by some underlying source of unsound monetary inflation. Major speculative Bubbles and manias are always propelled by key misperceptions and resulting monetary disorder. Bubble flows intensified in 2017, as misperceptions became only more deeply embedded in the Structure of Securities Market Pricing. Loose finance is ensured indefinitely.

The U.S. (Bubble) economy is energized. Strong earnings will be further inflated by lower corporate tax rates. Meanwhile, there’s a stimulus-fueled synchronized global economic boom. European growth is the strongest in years. China has set another 6.5% GDP growth target. Throughout Asia and with scores of other EM economies, things are booming. Whether on a U.S. or global basis, there is a broad consensus view that “fundamentals” are exceptionally constructive. Lost in all the euphoria is the critical issue of finance: global finance is alarmingly unsound.

The 10-year anniversary of the 2008 crisis arrives this year. Amazingly, a decade has passed yet global central banks continue with quantitative easing and ultra-low rates. At the onset, central bankers believed they could employ QE to goose inflation and risk-taking. Then, with inflation dynamics having regained normal traction, central banks would simply wind down “money printing” operations. Everything would settle nicely back to normal.

But it was all flawed. Inflationist doctrine failed. And as archaic as it sounds, the world is today trapped in the Scourge of Unsound “Money.” Central banks inflated a global securities market Bubble and have been incapable of extricating themselves from market domination. Each year sees the Bubble inflate to only more precarious extremes.

2018 will likely see (in the neighborhood of) an additional $1.0 Trillion of QE. This amount, however, will be down significantly from 2017. The ECB slashes its monthly purchases in half starting this month (to about $36bn). The Fed has plans to reduce balance sheet holdings, while the BOJ has of late scaled back purchases. Markets have been conditioned to believe QE reduction doesn’t matter. This complacency will be tested in 2018. Last year’s concern for waning central bank liquidity operations has been supplanted by this year’s heady confidence that it’s not an issue.

From my analytical perspective, the global market boom has been financed by two extraordinary (interrelated) sources. First, Trillions of QE have directly financed inflated and over-liquefied global markets. Second, I believe leveraged speculation has played a major role in exacerbating liquidity excess. Importantly, QE-related liquidity coupled with the perception that open-ended QE is available to backstop markets has fostered an environment conducive to speculative leveraging. In short, the leveraging of central bank balance sheets has incentivized the aggressive expansion of speculative securities and derivatives leverage globally. And the bigger the Bubble inflates the less willing central banks will be to tighten financial conditions. This only further incentivizes risk-taking and leveraging throughout global markets that have over years become progressively too comfortable pushing the risk envelope.

Central bankers confront a historic dilemma. They perpetuated a prolonged major Bubble inflation. Despite a strengthening global economy and conspicuously speculative markets, central banks in 2017 failed to move forward with “normalization.” Financial conditions further loosened when they needed to have tightened. At this point, when it comes to monetary tightening central bankers lack credibility. The view that central bankers will avoid any actual tightening of financial conditions has become deeply embedded in a extremely distorted marketplace.

At this phase in the cycle, markets would typically fret central banks “falling behind the curve.” These days, however, markets see zero possibility that the Fed (or any central bank) would resort to “slamming on the brakes.” At this point, it would appear only a significant change in the inflation backdrop would have the markets fretting the prospect of a true tightening cycle.

The general backdrop is increasingly supportive of U.S. headline CPI moving above the 2% threshold in 2018. Labor markets are tight, and the growth in manufacturing employment has attained decent momentum. With an increasing number of sectors overheated, companies will be forced to pay up for talent. And with sales strong and inventories slim, expect further acceleration in housing prices and construction. Crude prices have surpassed $61, with the weaker dollar stoking commodities prices generally.

It’s no coincidence that securities markets have succumbed to speculative Bubble Dynamics in the face of economic, financial, social, political and geopolitical unrest. For several decades now, unstable finance has fostered serial boom and bust dynamics. Central bank intervention has only increased the scope of Bubbles, their duration and the severity of consequences. Wealth inequality, disillusionment and anxiety reached a crisis stage. In the face of upheaval, decisions have been made to let the “money” flow.

Speculative markets welcome fragile underpinnings, confident that central banks will continue to goose the markets. Markets relished the Trump administration’s chaotic first year. The more unnerving the Washington backdrop the more likely it became that the President and the Republicans would throw all their energy into must-have tax legislation. One and done?

With all the tax reform hype and market euphoria, it’s easy to disregard longer-term ramifications for about the most partisan tax legislation imaginable. The powerless big “blue” states have taken one on the chin. And when all is said and done, I doubt Republicans will win the PR battle on this one. Taxes will be going up for many; an election promise broken to many. This will be seen as yet another gift to the wealthy and corporate America. Come November, the Republicans hope to receive credit for a booming economy. Expect Democrats to be the more energized party.

Exuberant markets are numb to political dysfunction. And with stock prices setting daily records, there’s no difficulty dismissing the Washington Spectacle. Tax legislation was likely an aberration. Republicans were desperate for a win, so they came together and passed legislation. 
 
The pendulum will now swing back. The dismal fiscal backdrop will have the so-called “deficit hawks” spooked. Attention will turn to reelection. Fixated on Tuesday, November 6th, Democrats have no incentive to play ball. Trump’s 2018 agenda could be DOA.

Pundits will trumpet earnings, earnings and more earnings. After receiving the gift of big corporate tax cuts to end 2017, talk will shift to “politics don’t matter.” Politics could matter greatly in 2018. There’s the ongoing Mueller investigation. An investigative shift to past financial issues (and potential money laundering) could spark to a constitutional crisis. Many are raising questions as to the President’s mental fitness for the highest office. Some Democrats will look for an opportunity to move on impeachment proceedings. In summary, this is one big, ugly unfolding mess that doesn’t matter – until it does.

There are extraordinary political uncertainties, including the mid-terms. The Republicans could very well lose the power to push through legislation. And while bullish equities strategists extrapolate lower taxes and higher earnings years into the future, there’s a scenario where the repeal of Republican tax (among other) legislation commences in about three years.

Geopolitical risks are even more unnerving. Perhaps North Korea backs down. Trump and the U.S. military may not, arguing this problem has been left to fester to the point that action must be taken. On multiple fronts, relations with China have been cooling. The President has said, “I want tariffs. Bring me some tariffs!” It’s worth noting the U.S. November trade deficit surpassed $50 billion for the first time since March 2012. Especially if other agenda items face resistance, the President may lean more aggressively on administration trade policy. A tougher stance toward China will see little pushback – except from Beijing.

The prevailing view has inflation dead and buried. The backdrop is ripe for an upside surprise. If focus turns to boom-time labor tightness, a manufacturing renaissance, and a fledgling housing construction boom and attendant bottlenecks - prospects for rising import costs could be enough to arouse a secular shift in inflation psychology.

2018 is set up for a Historic Year. Global Bubble markets are dominated by the dangerous misperception that central bankers have it all under control. I believe the extraordinary liquidity backdrop is acutely vulnerable to an unanticipated bout of de-risking/de-leveraging dynamics. The expectation is that 2018 will be a stable continuation of 2017: financial conditions will remain loose – or, why not, even looser. But unless global central bankers are completely reckless, there will be heightened pressure in 2018 to commence “normalization.” The Powell Fed will have its hands full.

Why do Bubbles burst? At some point, Bubble Finance turns unmanageable. On the upside, Bubbles create their own self-reinforcing liquidity and momentum. Things turn crazy near the end. It’s just so easy to make money. Everyone should be wealthy, and nothing causes as much angst as to watch your neighbor get rich (thank you C.P. Kindleberger).

It’s the parabolic speculative blow-off that seals a Bubble’s fate. A “melt-up” in prices is sustained by only progressively larger speculative flows. The higher prices inflate the greater the amount of finance required sustain the Bubble. In the heart of the mania, these flows are sustained by extreme speculative leveraging. Finance becomes deranged. Such a Market Structure creates latent fragilities – manic speculative leveraging and the rapidly elevating risk of a bout of destabilizing “Risk Off.”

I see overwhelming support for my view that we are witnessing history’s greatest financial Bubble. Things turned crazy in 2017 and, if the first four sessions of 2018 are any indication, markets are taking “crazy” up a notch.

Can bond markets avoid trouble for yet another year – without facing the comeuppance one would expect after years of loose finance? With fiscal deficits and inflation likely on the rise, when will bond holders finally demand a semblance of reasonable risk premiums? When will bond holders focus on long-term risk-adjusted real returns rather than short-term funding costs and rate differentials? Global bond markets are in the greatest Bubble in history, yet worry of Market Structure is nonexistent.

The ETF industry recently surpassed $3.4 Trillion. Do 2018 flows again surpass the previous year’s? Here again, Market Structure is a serious issue. “Money” has flooded into “the market” through perceived safe and liquid ETF instruments. A surprising bout of “Risk Off” would test market liquidity and perceptions.

Central bank liquidity; faith in central banker monetary management; seemingly unshakable global bond markets; and the bubbling ETF complex have been integral to the global collapse in market volatility/risk perceptions (i.e. VIX). Shorting “volatility” has for years now been a huge money-maker. Amazingly, selling market risk “insurance” during a central-banker ensured drought has become one massive Crowded Trade on a global scale. This is a huge accident in the making, and this Epic Structural Market Flaw could easily become a major Issue in 2018.

Forecasting a catalyst for a bursting Bubble is risky business. There are any number of potential accidents in this now tightly integrated global economy and financial Bubble. China’s Bubble is a historic accident in the making. Like global central bankers, Beijing appears for now to have everything under control. They also have no experience with the downside of an unparalleled Credit Cycle.

Massive 2017 financial flows gave EM Bubbles a further lease on life. The weak dollar in 2017 helped devalue their still mounting dollar-denominated debt problem. A global “Risk Off” would see an abrupt reversal in their liquidity position. One of these days – perhaps even in 2018 – there might be some worry about Chinese and EM financial institutions. It’s been such a long cycle. How much bigger did the fraud issue inflate during 2017’s Credit bonanza?

I expect the cryptocurrency Bubble to burst in 2018. Seems like we’re set up for major cyber security issues. Will there be even more damaging weather disasters?

There will be numerous surprises and unexpected developments. I just wish I could share in all the optimism. But Bubbles are just so destructive. Markets continue to grossly misprice risk. Resources – real and financial – are being poorly allocated. Too many uneconomic enterprises are lavishing in boom-time finance. Real economic wealth is being redistributed and destroyed, while asset price Bubbles ensure wealth illusion and a perilous lack of discipline. Speculation doesn’t matter; deficits don’t matter; excess doesn’t matter; and debt doesn’t matter. Market Structure doesn’t matter.

Because of the unprecedented globalization of Bubble Dynamics during this protracted cycle, I have special concern for geopolitical risks. Pondering what might unfold this year leaves me uncomfortable.


The new world disorder and the fracturing of the west

The geopolitical situation remains tense, although the world economy is improving

Martin Wolf


© FT montage/Getty



We have reached the end of an economic period, that of western-led globalisation, and a geopolitical one — the post-cold war “unipolar moment”. This is what I argued almost exactly a year ago. The question was whether the world would experience an unravelling of the US-created, post-second world war liberal order into deglobalisation and conflict, or a resurgence of co-operation. A year into the presidency of Donald Trump, we should return to this point. In brief, unravelling is even more likely.

Experience has underlined the special character of Mr Trump’s presidency. On a daily basis, he violates the behaviour and attitudes the world expects of a US president. But the exploitation of office for personal gain, indifference to truth and assault on institutions of a law-governed republic are all as one should have expected. A liberal democracy only survives if the participants recognise the legitimacy of other participants. A leader who calls upon his officials to prosecute erstwhile opponents is a would-be dictator, not a democrat.

Character is one thing; actions quite another. So far, Mr Trump has governed mainly as a traditional Republican “pluto-populist”, delivering policies to the plutocracy and rhetoric to his angered base. Yet his characteristics are still to be seen, in his consistently mercenary attitude to US alliances and narrowly mercantilist views of trade.

The Trump presidency has weakened the cause of liberal democracy (democracy that rests on a neutral rule of law). In former communist countries of eastern Europe, the style of plebiscitary dictatorship (euphemistically called “illiberal democracy”) characteristic of Vladimir Putin’s Russia seduces admirers and encourages imitators. Tayyip Recep Erdogan’s narrow victory in the referendum on presidential power moved Turkey further in this direction.




Yet the UK’s 2016 Brexit referendum has not, so far, attracted imitators inside the EU. In France, Emmanuel Macron stemmed the populist and xenophobic tide. But the German elections have weakened the country’s ability to respond to Mr Macron, while the forthcoming Italian elections might prove disruptive not just for Italy, but for the whole of the eurozone.

Arguably, the most important of all the political developments of 2017 was in China. Here Xi Jinping has apparently established supremacy over the Communist party and reinforced the supremacy of party over state, and state over the Chinese people. Of the world’s strongmen, he has emerged the strongest — the leader of a rising superpower.

In 2017, then, autocracy was on the rise. The “democratic recession” continues.

What, meanwhile, has happened to global co-operation? Here, too, we saw significant developments. One was the decision of Mr Trump to pull out of the Trans-Pacific Partnership, in which US allies, notably Japan, had invested so much, and to renegotiate the North American Free Trade Agreement. Another was the administration’s decision to pull out of the Paris climate agreement.

In the opposite direction was the rhetorical attempt of Mr Xi to pick up the mantle of globalisation. On balance, the forces against co-operation made progress last year, as did those against democracy. That is not surprising when the world’s leading country has a president who sees conflict as the norm.

These developments have to be set against longer-term trends. Most important, the position of today’s high-income countries, though still enormously powerful, is in relative decline. China’s military spending is rising sharply, relative to that of the US, even though it remains at just 2 per cent of gross domestic product. The share of high-income countries in world output has fallen by about 20 percentage points since the beginning of the century, at market prices, and their share in world merchandise trade has fallen by 17 percentage points (see charts).




Here are a few implications.

First, these political developments have fractured the west as an ideologically coherent entity. Close co-operation among the high-income countries was largely a creation of US will and power. The centre of that power currently repudiates the values and perception of interests that underpinned this idea. That changes just about everything.

Second, modern western ideals of democracy and liberal global markets have lost prestige and appeal, not just in emerging and developing countries, but in the high-income nations themselves. While no alternative economic system has yet won the day, the appeal of xenophobic populists and authoritarians (often the same) has risen.

Third, managing the world economy, the global commons (notably climate) and security issues, demands co-operation between high-income and emerging countries, above all China. The old days of domination by the leading high-income countries are over. Securing co-operation among such diverse countries is extremely hard.





Finally, there is a real risk of conflict between the US and China, as Harvard’s Graham Allison argues in his book, Destined for War. Optimists will argue (rightly) that economic interdependence and nuclear weapons make war insane. Pessimists will respond that humanity has a huge capacity for blundering into disaster. Maybe the generals who surround Mr Trump will fail to keep him under control. Maybe they will even promote a ruinous war over North Korea.

If 2017 underlined the geopolitical stresses, it also saw a healthy global economic upswing. How do these things relate? That will be my topic next week.


Bitcoin and cash cast a shadow over banks

No one fully understands the rising challenge to the regulated payment system

John Gapper



It does not feel coincidental that the bitcoin frenzy lifted the cryptocurrency to new highs this week as HSBC escaped the threat of criminal prosecution for having allegedly laundered at least $880m for Mexican drug barons. The fiercer the regulatory squeeze on banks, the greater the demand for other means of storing and moving money.

Cryptocurrencies traded peer to peer rather than being settled through banks have so many uses that it is impossible to know how much demand is driven by criminality. One thing is clear: banks face growing rivalry from a shadow payment system that ranges from cryptocurrencies to electronic platforms including Alipay and mobile wallets such as M-Pesa in Kenya.

The old way to transfer money without having to go through a bank is cash, which is obstinately persistent. Despite the expansion of credit, debit and contactless cards, nearly everyone uses cash regularly. The drug smuggler who launders money across borders in high-value banknotes is an outlier; most cash loyalists find comfort in its familiarity and reliability.

While cash transactions used to be the mainstay of banks’ services to individuals and small businesses, this is fading as they concentrate on electronic payments, encouraged by regulators. A dispute has broken out between UK banks and independent operators of free cash machines, who complain that card issuers will create “ATM deserts” by paying them less per withdrawal.

The difficulty of drawing cash directly from banks does not stop people from wanting to use it. As Victoria Cleland, chief cashier of the Bank of England, admitted in a recent speech, cash is “a puzzle”. The value of notes in circulation rose by 10 per cent last year, the fastest rate in a decade: the more that banks bear down on a messy payment method, the more some resist.

This is reminiscent of the rise of the shadow banking system in the early 2000s as lightly regulated credit vehicles sprung up alongside traditional bank lending. This time it involves what Dan Awrey and Kristin van Zwieten of Oxford university call the shadow payment system: electronic payments settled by banks are expanding and so are the alternatives.

Non-cash transactions such as debit and credit card payments are growing by 11 per cent a year, squeezing out cheques. The spread of cards and contactless payments is making it easier to pay for even small items electronically. That suits banks, which run transaction platforms and supervisors that want to curb money laundering.

But cash is especially valued by people who either do not have much money, or have plenty. The former comprise lower-income families who find it easier to budget with a tangible form of money. One US Federal Reserve study found the highest allegiance to cash among 18-to-24 year olds and households earning less than $25,000 annually.

Cash is also private. In some economies, people use cash because they do not trust governments or the rule of law: 41 per cent of Romanians use cash to pay their rent or mortgage, according to an ING study. Even in Germany, only 28 per cent of people believe card and bank payments are highly private.

Some of the wealthiest use cash for this reason, amassing €500 and SFr1,000 notes, which can be stashed in Swiss bank vaults when interest rates are low. High value banknotes are also used by criminals for laundering, as the US Drug Enforcement Administration says, “drug trafficking is a very cash-intensive exercise”.

This binary pattern of use by the lower income and the rich applies to shadow electronic payments. M-Pesa developed in Kenya as a means of storing value on mobile phones rather than in banks. Grab, the Singapore-based ride-hailing company, takes payments for rides on GrabPay, its mobile wallet, and makes loans to drivers based on patterns of GrabPay income.

Meanwhile, cryptocurrencies were partly created as a challenge to fiat money issued by banks and central banks, and the bitcoin pioneers included criminals using trading platforms such as Silk Road. Bulk cash seizures by US law enforcement have fallen from $800m in 2010 to less than $400m last year, partly because it has become easier to launder cash electronically.

There are legitimate roles for cryptocurrencies — even speculation in bitcoin futures on exchanges. But the fact they are settled through a blockchain ledger, the underlying technology, rather than by banks under the direct oversight of regulators, is part of their appeal. Just as Germans want privacy by using cash, bitcoin holders seek out the shadows.

This leaves a core deposit and payment system, which is tightly regulated and moving to cashless methods, alongside a growing periphery. Cash and cash-like platforms, some tied to banks and others operating at the technology frontier, form a poorly understood and regulated alternative.

Judging by their liking for cash, cryptocurrencies and mobile wallets, many people appreciate having a shadow system. Whether they know how it works, and the risks they are taking, is another question. From past experience of financial crises, it is likely that no one really does.


Innovation

Tapping AI: The Future of Customer Experience at Verizon Fios

Verizon


Justin Reilly, head of customer experience innovation for Verizon Fios, is projecting that 80% of value creation in artificial intelligence (AI) will be in business-to-business [B2B] applications, and the rest in consumer services. In an interview with Knowledge@Wharton during the Mack Institute for Innovation Management’s fall conference on Emerging Innovation Leadership Challenges for Global Firms, he also noted that Generation Z is increasingly becoming protective of personal data and may start withholding it from companies unless offered compensation, while millennials will continue to favor companies that make positive social contributions. Reilly, who was a conference speaker, also suggested that in a world of vast automation via AI, companies that learn how to preserve a human touch should have a competitive advantage.

An edited transcript of the conversation appears below.



Knowledge@Wharton: Could give us a synopsis of your conference talk?

Justin Reilly: I spent a lot of time talking about how we think about innovating inside of a big company. I’ve been an entrepreneur my entire life, so this is the first time I’ve worked inside of a large company. I chose a Fortune 14, I guess, to be my first time.

We talked a lot about Generation Z trends, about how we think about becoming a product company, how we shift organizational structures, what it takes in our opinion to keep up with emerging tech, and then how we’re solving some really key problems in our business as we face the reality of being disrupted from a lot of different angles.

Think about the genesis of Verizon, the phone company that is now playing in everything from fiber to media to artificial intelligence. Those things are happening at scale all over the world. So it’s an exciting place to be — there’s a lot of change.

I have responsibility for our core innovation products, for everything that touches the customer outside of our core TV and fiber products.

Knowledge@Wharton: What are some of the most innovative things in that category?

Reilly: I have an entire group focused on artificial intelligence and machine learning. Mostly that manifests itself in a conversational UI [user interface] experience, affectionately known as a chat bot. So probably the most consumer facing thing that is in production that customers are playing with right now is a chat bot experience that we have in Facebook Messenger … and it solves every problem from answering the question of what’s on tonight, getting TV recommendations, to being able to reset your router, to know where your tech is, to pay your bills, etc.

Knowledge@Wharton: Tell us more about AI and machine learning. There’s also a lot of hype around it. It’s like trying to separate fact from hopes and dreams, and a lot of those hopes and dreams will become reality one day. But let’s say for the next two years, which things will actually happen?

Reilly: There are a couple of problems with what is going on with AI right now. People are referring to things that aren’t core machine learning neural networks — what would be referred to affectionately as AI — as [if they were] artificial intelligence: basic linear decision trees, basic data analytics. Certainly [these are] building blocks towards artificial intelligence, but when folks flood the market with “we are an AI company,” or “we are doing AI,” it becomes really hard to differentiate between those things.

Knowledge@Wharton: A simple calculator, in a way, has artificial intelligence.

Reilly: That’s right. Especially if it remembers something you did. The most interesting trends in AI are going to be in supervised learning, which is a little bit further along, and much further along than unsupervised learning. [It provides] the ability for you to make a couple of interactions with a piece of technology … [and] for that machine to learn what you are doing. But then, it is taught [new skills] by an employee, a product manager or a machine learning engineer on the other side.

For example, we had a chat bot interaction during the Floyd Mayweather, Jr.-Conor McGregor [boxing] fight. Over time, when people were coming into the chat bot to purchase the fight, they would use words that were MMA [mixed martial arts] slang, for lack of a better term. And because we had natural language processing, understanding and generation interaction as well as a neural network behind the bot, with a little bit of supervision from a machine learning engineer, it learned those terms quicker. So when the next person came in they knew that this type of language meant this: Show this result, give this experience.

That, I think, is going to be the most interesting set of interactions for any brand going forward. But it’s fundamental to giving someone an experience where they can give you that type of data. And then the second thing is whether you have the right data, that it’s organized in the right way, and then you can build learning algorithms based off of it.

Most of the benefit in AI probably is going to be in large-scale trucking and warehousing and infrastructure — anomaly detection. Because all of those things don’t necessarily rely on a human interaction, so you don’t have to spend a lot of time thinking about how the things interact, you can focus just on the data set, the learning, the feedback loop. So I would say if you were to try to pie-chart the world — probably 80% of the value creation in AI is going to be in B2B or large scale infrastructure, and about 20% in customer value creation.

In my opinion, the 20% is going to happen in places like customer service where there’s a lot of costs for the business so they’re very incentivized to make the experience better. Customers don’t like, for example, sitting on the phone with someone for two hours. So there’s a lot of a kind of symbiotic relationship between brand investment and customer needs that will allow for an investment strategy. Everywhere from inside of brands to venture capital, if you look at a lot of where the AI money is going from a VC perspective it’s either in large infrastructure or core customer-focused needs like customer-service interactions.

Knowledge@Wharton: You have projects for this year, next year, three years down the road. What about a little bit beyond that?

Reilly: For us, because of our interaction with the home, we’re going with fiber right into your home, we have a tremendous amount of intelligence of what happens on the network … to provide a better experience, to provide more utility.

What I think is going to be key for Verizon, specifically Fios, in the future is how that intelligence gets better as homes become smarter, and how that will improve your utility over time. It’s very easy to see a future where everything in your home is connected, they all speak to each other, they’re running on a fiber network so it’s very clear, secure and fast. And you constantly are leaning into that experience — being better.

There is a lot of thought, though, that you’re just going to have a world of a bunch of personal assistants. I actually think that the personal assistant space is going to be crowded in the next three to five years, and if you imagine the kind of app atrophy, or app kind of clutter that we’ve experienced on smartphones, you’re going to see that same thing with personal assistants, whether it’s Alexa or Siri or 40 other things that you will have to evoke with a wake word to make that thing happen.

And then … about five years out, it will converge back to a couple of key players and we’ll get it right.

Knowledge@Wharton: What about security?

Reilly: When I got to Verizon about two years ago I noticed that we had a long way to go on pure digital product innovation — having our digital experiences feel like Google, Facebook, Amazon. But one thing that we do right is the network.

We’ve been a phone company … we’ve been a network company, for a long time. And we constantly get the network right. If you were to look at where our investment is, we’re spending billions of dollars to make sure that in smart cities, smart homes, we have not only just the network infrastructure to make those things fast and work well for you, but to make sure that they are secure over time.

It’s one of the benefits of fiber — the feedback loop of all of the things going on in your home when you connect to Wi-Fi through fiber. It’s tremendous. We’re constantly looking at the next generation of routers that have deeper security, IoT [internet of things], MQTT [or machines-to-machine IoT connectivity] protocols — all of these things that drive session management and overall semantic security inside of your home, that sequence the sessions, provide cryptography, that provide anomaly detection … so that you can trust us with your data. That is the forefront of everything that we’re doing from an engineering perspective.

The problem with the smart home market right now — and if you look at the trajectory, it’s been relatively flat for the last five to eight years — is that when someone buys their first smart home device, if they don’t get immediate utility out of it they never buy another one. Once they buy three to five, they’re more likely to buy 10, and roughly they’re on a path to buying 20.

Knowledge@Wharton: So what are these 20 things?

Reilly: Most of them are light bulbs, thermostats, security cameras, things that make a single room more useful. So what you see is better adoption if I make a room smart first versus making different parts of my house smart, because the total utility of you as a human in that space gets better. That is the key focus. What is holding up the smart home market is the standard for management across all of these different hardwares. Everyone is trying to figure out what that means.

Knowledge@Wharton: So it’s the old VHS/Beta issue?

Reilly: Right. And you can’t manage them all from one place. There are a bunch of hubs that people were trying to play in. I think our opportunity as we ship more and more smart home intelligent internet hub experiences is to drive light management of all of those things so that you have all of your things in one place. And if you need to go deeper with the usability, you can pop out the Nest app, or Canary’s app and have a deeper experience.

Knowledge@Wharton: What will be those things that will excite customers?

Reilly: If you spend a lot of time with customers in their home, the things that we do every day are the things that take a lot of time, right? Taking the laundry out of the washer and putting it in the dryer, pushing the toaster down, running the dishwasher. I fundamentally believe that as those appliances become more intelligent, a lot of the human utility will come from more intelligent dumb devices that we currently have in our house.

[However,] I’ll give you an example … [of] the problem with a lot of what is being built today. There was a refrigerator that was out about a year ago that would tell you if you were out of milk. So you could ask, well do we need that? And what I would say is, I don’t think we need that.

A refrigerator came out about six months ago that doesn’t do that, but when you tap the door it makes the door translucent. You can see through it and see all of the things in there. That’s a light incremental innovation that is really great. We’ve been thinking a lot about this, and I fundamentally believe that if you make something that is “dumb,” for lack of a better term right now, more intelligent, you have to keep the core of what that thing is.

What do people use refrigerators for today? They leave notes for the family, they hang things that are important, right? They tell stories on their refrigerator. When you spend time at people’s homes, that’s what most families use refrigerators for. So why are we trying to build features that don’t do at least that thing better than it does today?

Maybe the translucent thing is actually the more useful thing. Maybe it’s an amazing, rich storytelling hub for your home that allows you to leave notes for your loved ones, that allows you to interact with other parts of your house. If you take that approach to every single thing in your life, every one of these smart things, it starts to inform how you actually drive value.

Knowledge@Wharton: What else is it that is important to know about where this AI world is going?

Reilly: That’s a large question. I think large brands playing in artificial intelligence have a fundamental responsibility to humans to get this thing right.

What I mean by that is we’ve all gone from talking to each other as humans to looking at our phones as we walk down the street. We’ve all had these things change the way we interact with humanity. The next wave of contextual, personalized, artificial and highly intelligent cognitive experiences have the potential to push us into a world that has much more disassociation with reality, with people, etc.

Knowledge@Wharton: One observation about Facebook has been it considers itself at times to be just a platform.

Reilly: I fundamentally disagree with that if large percentages of the world interact with you as a brand, and get large sets of information [from you] — for example, 61% of Americans get their news from Facebook and they trust the things that their friends post. For large sets of consumers on our network who are doing a lot of things, we have a responsibility as a brand to build great things for them that drive value in their lives. But also, we have a responsibility to make sure that we are doing what is right for the future of how our children interact with technology.

Knowledge@Wharton: What does doing it right look like?

Reilly: There are a lot of things that brands could do that would drive a lot of cost out of the business, drive a lot of revenue into the business, based on personal information, that would drive sets of behaviors from customers, that maybe aren’t the right thing to do.

Given the technology today, and the pathway that we’re on, we could probably fully automate our entire business. There are a lot of brands that will do that…. In the next three to five years, some of this basic AI automation will just be a free, open source tool that you can use.

Just like Squarespace has done with building websites — 15 years ago building a website cost $100,000 — it was a huge thing. Now you can go to Squarespace and get a free one. AI is going to be no different. But I think we have a responsibility to keep the human touch in a lot of these experiences for the better good of both the experience and humanity.

You could also argue a different angle, which is it’s actually a competitive advantage to have the human touch in a world of full automation. So if you imagine where we’re all walking around not actually talking to each other, and interacting with all of the brands and content and music, and all of these things that we like, but [doing it] completely through whatever device. Maybe it’s just everywhere. Maybe you can just walk up to everything, and they know it’s you.

Then maybe human touch is the differentiator in that world. And maybe it’s also contributing to a containment of disassociation with the world. A lot of futurists talk about this moment in time that could possibly happen where large groups of people unplug. They pull themselves away from the matrix, for lack of a better term. I don’t know if that thing will happen at scale as much as people want it to, but I do think if brands get this thing wrong it definitely will happen.

So how do you do that world? Something just perfectly simple I have done has changed the way I interact with technology. I don’t have any notifications on my phone anymore. I’ve turned all notifications off, because I travel all of the time, and there are thousands of emails. This thing was driving my life. And as I have turned notifications off, I’ve reclaimed my time. I’m the person in tech thinking about this, and I’ve said I’m not going to have these notifications. I have one or two things with emergencies, with family members, etc., that come to my home screen, but everything else I decide [whether it has] to go in.

Knowledge@Wharton: Do you think that companies will compete on this idea?

Reilly: I do. Think Toms Shoes. There was a big period of time when there was a delineation between for-profit companies and not-for-profit companies. And then Tom Shoes came in and said, “Hey, we’re a hybrid. If you buy a shoe from us we’ll [also] give it to [the disadvantaged].” Millennials love that, because there’s a sense of social good in the millennial generation.

If you look at what Generation Z expects from brands, they expect utility in return. Not just a better experience, but utility in return for what they view as currency which is their data. So if you are not very clear on what the utility is that you are driving from them, you’re not even going to get a shot at my data.

There are a whole host of startups thinking about, what does it mean to de-enroll your data from entire brands? What does it mean to say, “Hey Google, you no longer have — or hey Verizon, you no longer have — the rights to my data because you’ve done something that I don’t stand by. And so now I’m going to pull my identity away from your platform.”

There’s nothing to suggest that that won’t become a thing that empowers individual humans. So then in that world, what is your differentiation? … What makes you a better company — and it doesn’t have to be social good. It should be, but it just has to be how you approach the world, and then how your users feel about that.

I’m not sure the next generation is as concerned with privacy as privacy proper as we think about it. Millennials certainly, and every generation before that. I think Generation Z just says, my mobile telephone number, my address, my email address, these things are currency. So if you think you just get the right to those things — I’m already paying you real currency, right? So why do you get this right to this thing? And the experience economy, the social media revolution has kind of resorted us to this idea that if the thing is free, then we pay with our attention. But we haven’t had that conversation around the data component and what that means.

I think this next generation of consumers is going to blow a lot of these things up just in fundamentally how they think about the world. They’re just more advanced, more thoughtful. They’ve never grown up in a time without technology.

I’ve been in co-creations where a seven year old has said, “Hey, why did you put the hamburger menu on the right side? Your shelf nav should do this thing.” And you’re thinking, how do you know these words? You’re not even a trained user experience expert. But this is how they interact with technology, and their knowledge is just far and away superior….

Knowledge@Wharton: You’re talking about a digital consumer boycott that could go viral, right?

Reilly: And maybe it’s table stakes. Maybe it’s a feature that you can just opt into. And you can say it’s a boycott, or you can say at some point it becomes business as usual to how you interact, or how you connect into the world. Your plug in moment is now informed. There are a lot of things like this where people are dabbling, ad blockers, all of these things, but imagine if you actually had control over your identity….

Knowledge@Wharton: It’s so interesting because everything for years has seemed to go the other way. Service provider are just collecting data and we have no control and all of that. But now you’re saying people may wake up and say — or at least the Generation Z may — that this is kind of like my medical records, this is my private stuff. And you don’t get it without me having trust in you, or me liking the use that you’re putting it to.

Reilly: And to that point, if you look at something like blockchain: If I no longer need you — said bank — for you and I in this moment to exchange funds, I don’t need a third party to validate that — because our crypto handshake is good enough for you and me. Then where is the data transfer? You and I don’t need to transfer data, so what happens in that moment?

To your point about electronic medical records, there’s a lot of really interesting work done in this space, because if you look at infectious disease or oncology, one of the biggest problems in care is not being able to take the most perfect information of your visits across different providers. And so if you had identity management that also encompassed everything in your life, you could show up with your full medical history in your identity management software, for lack of a better term … and say, “Hey mister provider, I just pushed this thing to you and now you have perfect information.” I don’t have to wait for the fact that, yes, five years of my medical history is in an EMR, but the other 15 are in stacks of paper all around, and we’ve got to scan it in and fax the document to you, something I know you’re not going to read. So there’s a lot of upside in this idea across industries.


The Dangerous Delusion of Price Stability

William White

Bank of England

BASEL – The major central banks’ vigilant pursuit of positive but low inflation has become a dangerous delusion. It is dangerous because the policies needed to achieve the objective could have unwanted side effects; and it is a delusion because there is currently no good reason to be pursuing the objective in the first place.

In the 1970s, when inflation in the advanced economies rose sharply, central banks rightly resisted it. The lesson central bankers took from that battle was that low inflation is a necessary condition for sustained growth. But, subtly and over time, this lesson has morphed into a belief that low inflation is also a sufficient condition for sustained growth.

That change may have been due to the benign economic conditions that accompanied the period of disinflation from the late 1980s to 2007, commonly referred to as the “Great Moderation.” For central bankers, it was comforting to believe that they had reduced inflation by controlling demand, and that their policies had many beneficial side effects for the economy. After all, this was the demand-oriented narrative they had used to justify tight money to begin with.

But then the world changed. From the late 1980s onward, low inflation was largely due to positive supply-side shocks – such as the Baby Boomer-fueled expansion of the labor force and the integration of many emerging countries into the global trading system. These forces boosted growth while lowering inflation. And monetary policy, far from restricting demand, was generally focused on preventing below-target inflation.

As we now know, that led to a period of easy monetary conditions, which, together with financial deregulation and technological developments, sowed the seeds of the 2007 financial crisis and the ensuing recession. The fundamental analytical error then – as it still is today – was a failure to distinguish between alternative sources of disinflation.

The end of the Great Moderation should have disabused policymakers of their belief that low inflation guarantees future economic stability. If anything, the opposite has been true. Having doubled down on their inflation targets, central banks have had to rely on an unprecedented array of untested policy instruments to achieve their goals.

For example, many central bankers are now recommending the use of “macroprudential” instruments to manage systemic risks in the economy – which, in turn, will allow them to keep interest rates “lower for longer.” The problem with this approach is that there is little, if any, empirical evidence to suggest that such policies will work as intended.

Central bankers sometimes rationalize their current policies not by extolling the benefits of low inflation, but by underscoring the heavy costs of even mild deflation. Yet while there is ample evidence showing that high inflation is more costly than low inflation, it is hard to find similar evidence that mild deflation is all that costly.

In fact, the widely held assumption that consumers and corporate investors will extrapolate from past price declines and hold off on making purchases as a result of deflation has essentially no empirical support behind it. Recent consumer responses to sectoral price declines in various countries, not least Japan, all suggest the very opposite.

True, as a matter of arithmetic, deflation increases the real (inflation-adjusted) burden of debt service. But if debt levels are at onerous heights as a result of easy-money monetary policies, it is not obvious that the solution to the problem is still more easy money.

Central banks’ fixation on positive but low inflation under today’s prevailing economic conditions is also increasingly dangerous. Global debt ratios have risen sharply since the financial crisis began, while traditional lenders’ margins have been squeezed, raising questions about their overall health. And as lending has continued to migrate further into the “shadows,” price discovery in financial markets has become severely compromised, to the point that many assets now seem to be overvalued.

These developments constitute a threat not just to financial stability, but also to the workings of the real economy. Moreover, one could argue that easy money itself has contributed to the unexpectedly strong disinflationary forces seen in recent years. Owing to easy financing and regulatory forbearance, aggregate supply has risen as “zombie” companies have proliferated. Meanwhile, aggregate demand has been restrained by the debt headwinds – yet another result of easy monetary conditions.

In view of these conditions, continuing to insist on monetary easing seems particularly ill advised. With so many potential dangers on the horizon, central bankers should at least consider rethinking the fundamental assumptions underlying their policies.

So, what should policymakers do? In the immediate future, governments must stop relying so much on central bank policies to restore sustainable growth. Rather than obsesses over inflation targets, policymakers should (belatedly) start asking themselves what practical measures they can take to prevent another crisis from erupting. Equally important, they need to ensure that they have done everything they can to prepare for such a scenario, in case their preventive measures prove inadequate.

Looking even further into the future, when some semblance of “normality” has been restored, central banks should focus less on hitting near-term inflation targets, and more on avoiding “boom-bust” credit cycles. Unlike slight deviations from inflation targets, or even slight deflation, the latter actually are costly.


William White, a former deputy governor of the Bank of Canada, and a former head of the Monetary and Economic Department of the Bank for International Settlements, is Chairman of the Economic and Development Review Committee at the OECD.


Switzerland’s Central Bank Made $55 Billion Last Year—More Than Apple

SNB expects record profit on higher global equity and bond prices and a weaker Swiss franc

By Brian Blackstone

The SNB accumulated its huge reserves after years of foreign-exchange interventions, particularly during Europe’s debt crisis, when it created francs and used them to purchase foreign assets in a bid to weaken the currency. Photo: ruben sprich/Reuters 
 

ZURICH—Switzerland got a lot wealthier in 2017, thanks to its central bank’s emergence as a major money manager with a nearly $800 billion portfolio of foreign stocks and bonds.

The Swiss National Bank said Tuesday it expects to report a record annual profit of 54 billion Swiss francs ($55 billion) for last year—a staggering sum equal to 8% of the country’s gross domestic product. By comparison, if the Federal Reserve were to run a profit of similar scale relative to the U.S. economy, it would be about $1.5 trillion. The Federal Reserve has earned an annual profit of around $100 billion in recent years.

The profit is more than Apple Inc. earns in a year, and more than JPMorgan Chase & Co. and Berkshire Hathaway Inc. combined. Those are all giant, world-spanning corporations, while the SNB employs about 800 people. Its chairman—among the best-paid central bankers—earns about $1 million a year.

The SNB is one of the few central banks with listed shares. Its share price more than doubled last year, and was up 3.4% Tuesday.


MAKING BANK
The Swiss central bank´s profits soared last year,
as a weaker swiss franc raisedf the value of its massive
portfolio of foreign stocks and bonds.

Profit, latest fiscal year



FOREIGN CURRENCY INVESTMENTS




But the Swiss National Bank can’t lock in its paper profit by selling chunks of its assets, for fear of lifting the franc’s value and hurting exports while weakening consumer prices. That likely will keep its balance sheet at the mercy of financial markets this year.

The SNB’s profit was lifted by a trio of positive forces: low bond yields preserved the value of its foreign bonds that account for 80% of its foreign reserves, higher stock prices raised the value of its equity holdings, and the weaker Swiss currency made those foreign assets worth more in franc terms.

The euro strengthened nearly 10% against the franc last year. Euro-denominated assets are the largest currency holding of the SNB, followed by the dollar.

Here’s how the SNB profits from buoyant asset markets and a weaker franc. At the end of September, regulatory filings showed it owned more than 19 million shares of Apple, its largest U.S. stockholding. Apple’s shares rose nearly 10% in the fourth quarter, which would have added almost $300 million to the SNB’s profit, assuming it didn’t buy or sell shares. The dollar strengthened 0.7% against the franc during that time, too, which would have added another several million francs when the value of that investment was translated into the Swiss currency.

Switzerland’s central bank has accumulated about 760 billion francs in foreign bonds and stocks through years of foreign-exchange interventions, particularly during Europe’s debt crisis, in which it created francs and used them to purchase foreign assets in a bid to weaken the currency.

Other central banks like the Federal Reserve, European Central Bank and Bank of Japan also have amassed large portfolios consisting primarily of bonds. But those assets are denominated in their own currencies. What sets the SNB apart is that its balance sheet is comprised almost entirely of foreign assets, exposing it to huge foreign-exchange risk.

Things haven’t always gone the SNB’s way. In 2015, the central bank’s decision to abandon a ceiling on the franc’s value caused the franc to soar in value, leading to a 23 billion-franc loss that year.

The Swiss can’t spend this latest windfall. Booking its profit would require the SNB to sell some of its foreign bonds and stocks that included nearly $3 billion in Apple stock and $1.5 billion in Facebook Inc. at the end of the third quarter. The SNB’s equity investments—which comprise 20% of its foreign assets—replicate broad indexes.

And while central banks like the Federal Reserve transfer most of their profits to their governments, the SNB is in the early stages of a five-year profit-sharing arrangement whereby the maximum amount it can transfer to the Swiss federal and regional governments is just two billion francs a year.

That agreement runs until 2020. It also pays a small amount—1.5 million francs annually—to its private shareholders. Private shareholders have little or no say over who manages the bank or how it is run. The SNB is mostly owned by Swiss states, known as cantons, and cantonal banks.

The SNB said it would allocate about five billion francs to its provisions that guard against future fluctuations in exchange rates. The rest of its paper profit will go to a distribution reserve to ensure that the SNB can still make future payouts even in the event of a loss.


Europe’s Era of Harmony Is Over

By George Friedman

 

The European Union is engaged in a two-front fight for its own survival. On the western side, the United Kingdom has voted to leave the EU, and Brussels and London are struggling to find a mutually beneficial basis for the future. To the east, the bloc has admonished the government of Poland, an EU member, for actions it deemed undemocratic. It is threatening to bar Poland from the EU decision-making process and to cut off funds that it gives Poland under its own formula.
Once the Brexit vote was cast, confrontation was inevitable. But facing off with Poland, the largest country in Eastern Europe, at the same time as the Brexit negotiations was a choice – and on its face, a strange one. This oddity is compounded by the fact that Poland is not alone in facing Brussels’ ire. The charges made against Poland are similar to those made against Hungary, and there are similar rumblings in Brussels about the Czech Republic, although it has not matured into a full confrontation except over immigration. Put another way, a major western power is pulling away from the EU at the same time that the EU appears to be pushing away a substantial part of its membership in the east.
Idiosyncrasies of Democracy
On an abstract level, it would seem that the periphery of the European Union is pulling away from the center. And the center has quietly debated whether that’s a good thing. There has been some talk in the central region of either creating a separate union consisting of Germany, France, Belgium and the Netherlands, or creating a bloc within the existing bloc. The point would be for these countries to stop being responsible for countries not ready to operate at the center’s level of performance. It would mean that southern Europe, with its economic problems, and Eastern Europe, with its distinctly different political culture, could go their own way.
It would seem that this is what the EU is doing now, though if so, it is happening unconsciously. The European Union is not a nation-state; it operates by process. It struggles with flexibility, even when, as in the case of the Brexit talks, both parties need a deal. Similarly, participation in the bloc comes with conditions that limit what countries can do internally, and even if it is locked in painfully difficult negotiations with the U.K., the EU is prepared to challenge the eastern bloc, almost as though it were on autopilot. The EU has many problems, but perhaps the most interesting is this: It wants to be a unified entity, but the rules that create its process keep it from acting with geopolitical rationality.
Brussels’ criticism of Poland is that it is behaving undemocratically. Last year, the government took steps to gain more control over television and radio outlets, and now it is discussing legislation that would place restrictions on foreign media. The epicenter of the storm, however, is Poland’s plans for judiciary reform that would give the government more control over supreme court judges and the courts in general. The counterargument from Poland is that its government was democratically elected. It did not hide its right-wing proclivities from the voters, but on the contrary, emphasized them. Everything it does now, it does with a democratic mandate. The same can be said of Hungary and the Czech Republic. So how can these countries be undemocratic?
Incoming Polish Prime Minister Mateusz Morawiecki gives a speech to present his program to lawmakers on Dec. 12, 2017, at the parliament in Warsaw. JANEK SKARZYNSKI/AFP/Getty Images

The countries that founded the European Union had very different institutional structures. The United Kingdom had no supreme court until 2009, and it still lacks a written constitution. For a good part of the 20th century, it had only government-funded and government-run radio and television and barred other entrants to the market, though it had a vibrant and large publishing industry. France had a law making it illegal to insult the president. Germany barred any political movement that was deemed Nazi. These are not bad laws in the least. They were variations not on democracy – which all three countries were – but on liberalism. Each built a liberal democracy based on its history, and it was understood that there can be variations on the theme of democracy. The one thing that could not vary is the right to national self-determination through free elections.
When the EU was created, it was caught between two imperatives. One was to retain the right to national self-determination. The other was to harmonize the various members. Most of the harmonization that was accomplished was economic in nature, but the EU also pushed for political harmony. In practice, this meant limiting national self-determination to fit the standards of what was acceptable to the major members (with British oddities accepted but not recommended – Brussels expected written constitutions).
But then the EU admitted members whose histories differed from their own. This was particularly the case with Poland and other Eastern European countries. Poland, for example, was the first country that Nazi Germany invaded, and it experienced horrors that few other European countries have. After German occupation came Soviet occupation. The countries of Eastern Europe lived through a long, dark night. East Germany did as well, and the politics of that region bear the scars.
Acts of Disharmony
When the Eastern Europeans finally broke free of the Soviet Union, they dreamed of becoming European, which in their minds meant joining the EU and NATO. They created governments that emulated the Western European governments. It was a period in which these countries searched for redemption, and they believed redemption meant putting their past behind them. They bought into the idea of the European as a species of human, rather than simply a member of one of several nations that had signed the same treaty. The Europeans wanted them to harmonize, and they badly wanted to harmonize.
It has been almost 30 years since the Cold War ended. The generation that came to power in Eastern Europe and led their countries into the EU is mostly gone. The new generation in charge longs for the past. It is not always a pretty past, but then neither is Germany’s or any other European country’s. But it is their past, and the era of obsessive harmonizing with Europe is over.
What is clear about Poland, Hungary and the Czech Republic is that their publics chose not to harmonize with Europe, in the same way and for the same reasons that the United Kingdom chose not to remain in the EU. The process of harmonization is based on a homogenized sense of what it is to be European.

Applied rigorously – on matters from nomenclature of cheeses, to how courts ought to be organized, to how many immigrants should be admitted – harmonization undermines national self-determination and national identity.

Given the variations that are normal among democracies, Eastern Europe would assert its own right to idiosyncrasy; no one should be surprised when Hungarians elect a government that could not be elected in Luxembourg, because Luxembourg’s history is not the same as Hungary’s. But in the land of harmony, an act of disharmony is a threat to the system.
The European Union is following its process, but it is also trying to hold together something that is coming apart. It has tried to align national self-determination with harmonization, and it no longer works. It can’t let go of harmonization or all that would be left is a free trade zone, and Europe would go back to being a continent and not a proto-state. As the situation becomes more threatening, the threats become shriller, but the threats are simply reflexive attempts to keep the periphery from flying off in all directions and taking the center with it.
The periphery is coming apart. Whether those countries leave the EU, are pushed out or stay is of little consequence. The common experience of Eastern Europeans makes them unique. The experience of southern Europeans in the past 10 years makes them unique. Britain has never been anything but unique. And Germany is by far the most unique, the most unlike any other nation in Europe. What the EU doesn’t want to face is that Europe is a continent of many unique nations and nothing more.
The U.K. leaving and Poland being pushed out is not a strange geopolitical maneuver. It is simply part of an idea that could never have worked, and is not working.