Depending on the Undependable

By John Mauldin

The welfare of a nation can scarcely be inferred from a measure of [GDP].”

—Simon Kuznets (who developed GDP), 1934

At the risk of restating the obvious, production should result in a product the producer can recognize. That’s the case even for intangible products. Artists know their songs even if hearing a pirate copy.

This also applies to a country’s aggregate production, i.e., Gross Domestic Product. Of course, we can’t expect the government to count every single widget we make. Nor should we want them to; the collection process would be pretty intrusive. But they should be able to make a reasonably close estimate.

Yet we have no such estimate. As I explained last week, we use GDP because we have nothing better, but it misses a lot. Business, government, and especially Federal Reserve policymakers look at GDP when they make important decisions. Is it any wonder that flawed data leads to flawed policies?

Today we’ll extend the GDP discussion, looking at where these numbers originate, what they miss, and what the Fed in particular does with them. As you’ll see, we need better data… but it’s not at all clear Fed officials would use such data correctly, even if they had it.
GDP Genesis

GDP comes from the Commerce Department’s Bureau of Economic Analysis. Compiling it is a giant, difficult, never-ending task, one the BEA staff takes seriously. From time to time, we hear stories about political interference, but I think that unlikely. Too many people are involved to keep any such efforts secret.

The BEA has a handy, colorful, two-page sheet on its website that explains today’s GDP in big letters. Here is how they define it.

Source: BEA

As they explain it, GDP is the total market value of the goods and services produced within the US each year. Seem simple?
It’s not. Those seemingly simple terms hide enormous complexity.

Several centuries ago there was a big debate about what “production” meant. The classical economists had little concept of manufacturing. To them, it was all about land, and mainly agriculture. This “physiocrat” philosophy originated in France, assuming wealth derived solely from land and agriculture.

The physiocrats thought merchants and manufacturers simply shuffled the fruits of agriculture and contributed little to the overall economy. The First Industrial Revolution pretty much put that theory to rest.

That worked fine for a few centuries until we started producing ephemeral yet valuable things like social networks, for which consumers paid with their attention instead of their money. Unsurprisingly, with the advent of the information and digital society, there is yet another debate on what is the measure of true value and wealth. More on that later.

BEA wrestles with thousands of such questions. Some are harder to quantify than others. The answers go into the master formula, C+I+G+NX = GDP.
Or, as BEA explains it…

Source: BEA

That first category, PCE, is both a component of GDP and the Fed’s preferred inflation measure. They have been trying (and failing) to get its annual change up to 2%.

Business investment has also been lagging, in part because PCE growth has not been enough to require new production capacity.

Government spending has done the opposite of lag, instead growing at a rapid and accelerating pace. And as I noted last week, there was considerable debate about whether including government spending was simply double counting, as at one time back in the dark ages government spending correlated directly with taxation. Some argue, not unreasonably, that government spending is actually a drag on total GDP when properly measured.

Net exports is another way of looking at the “trade deficit.” Our imported goods subtract from GDP but, if they cost less than domestic alternatives, can give consumers and businesses more money to spend, which boosts GDP. So exports help but imports don’t necessarily hurt.

This formula made at least some sense when they began using it in the 1940s. Now, less so. But if you are a Federal Reserve governor, charged with generating economic growth, those are the knobs you can turn. Ditto if you are a president or member of Congress. Most everything they all do, from tax and trade policy to interest rates to “stimulus” spending, aims to change one or more of these GDP inputs.

As BEA’s graphic shows, GDP is the market value of the goods and services we produce. That’s fine, as far as it goes. Usually it suffices, but it presumes a) markets exist and b) they can identify a fair and accurate value. That is increasingly not so.

For instance, what is the market value of Google maps, Facebook, or Wikipedia? All are free to consumers. They have no market value, yet they’re clearly valuable.

This is a big problem for GDP. Here are MIT economists Erik Brynjolfsson and Avinash Collis, writing in Harvard Business Review last year.

GDP is often used as a proxy for how the economy is doing. To look at it, you would think it is a relatively precise number that signals every quarter whether the economy is growing or shrinking. If it goes out to two decimal points, how can it not be precise? (Note sarcasm.) However, GDP captures only the monetary value of all final goods produced in the economy. Because it measures only how much we pay for things, not how much we benefit, consumer’s economic well-being may not be correlated with GDP. In fact, it sometimes falls when GDP goes up, and vice versa. And that is especially true for the individual, as we will see.

The good news is that economics does provide a way, at least in theory, to measure consumer well-being. That measure is called consumer surplus, which is the difference between the maximum a consumer would be willing to pay for a good or service and its price. If you would have spent as much as $100 for a shirt but paid only $40, then you have a $60 consumer surplus.

To understand why GDP can be a misleading proxy for economic well-being, consider Encyclopedia Britannica and Wikipedia. Britannica used to cost several thousand dollars, meaning its customers considered it to be worth at least that amount. Wikipedia, a free service supported by donations (which I encourage), has far more articles, at comparable quality, than Britannica ever did. Measured by consumer spending, the industry is shrinking (the print encyclopedia went out of business in 2012 as consumers abandoned it). But measured by benefits, consumers have never been better off.

That all makes sense, but what can we do about it? Brynjolfsson et al. did a series of experiments in which they asked people how much money they would want in order to give up Facebook, or Wikipedia, or other hard-to-measure “free” services. The answers varied but they were able to calculate averages, which were surprisingly high. US consumers would want about $500 annually to give up Facebook—quite a bit more than Facebook generates in ad revenue.

That means Facebook, alone, would have added 0.11 percentage points per year to US GDP from 2004 through 2017. Add the consumer surplus for other free services and we could be undercounting growth by a full percentage point annually.

That doesn’t mean Facebook or Google are our economic saviors. The point is that our prime economic growth measure, GDP, is missing an enormous amount of “value” simply because it doesn’t fit the formula. This has consequences.

Central bankers, in the US and elsewhere, are not oblivious to these measurement problems. They know their data is flawed, even as they call their policies “data dependent.”

Jerome Powell discussed these same issues in a speech last October 7 called Data-Dependent Monetary Policy in an Evolving Economy. (That was the same speech, you may recall, in which he casually mentioned the Fed would begin injecting new reserves to deal with the then-unfolding repo crisis. I said at the time it didn’t inspire confidence, and indeed they are still pumping now, months later.)

Powell argued the Fed can do its job even with imperfect data. He described some of the challenges I did above, even giving Brynjolfsson a couple of footnotes.

The advance of technology has long presented measurement challenges. In 1987, Nobel Prize-winning economist Robert Solow quipped that "you can see the computer age everywhere but in the productivity statistics." In the second half of the 1990s, this measurement puzzle was at the heart of monetary policymaking.

Chairman Alan Greenspan famously argued that the United States was experiencing the dawn of a new economy, and that potential and actual output were likely understated in official statistics. Where others saw capacity constraints and incipient inflation, Greenspan saw a productivity boom that would leave room for very low unemployment without inflation pressures.

In light of the uncertainty it faced, the Federal Open Market Committee (FOMC) judged that the appropriate risk‑management approach called for refraining from interest rate increases unless and until there were clearer signs of rising inflation. Under this policy, unemployment fell near record lows without rising inflation, and later revisions to GDP measurement showed appreciably faster productivity growth.

This episode illustrates a key challenge to making data-dependent policy in real time: Good decisions require good data, but the data in hand are seldom as good as we would like. Sound decision making therefore requires the application of good judgment and a healthy dose of risk management.

Fair enough. To paraphrase Donald Rumsfeld, you go to the FOMC with the data you have, not the data you want. But Powell doesn’t seem to get this idea of “market pricing” when the market is interest rates.
He said this:

The Federal Reserve sets two overnight interest rates: the interest rate paid on banks' reserve balances and the rate on our reverse repurchase agreements. We use these two administered rates to keep a market-determined rate, the federal funds rate, within a target range set by the FOMC.

Think about his last sentence. Federal funds is a “market-determined” rate that must stay in the range the FOMC decrees. That is nonsense. If fed funds has to stay within a range Powell’s committee sets, it isn’t market-determined.

It is FOMC-determined with a little bit of wiggle room, the amount of which is also FOMC-determined. And the FOMC determines it using data Powell himself says is “seldom as good as we would like.”

See the problem?

Here’s the real question. If they did have good data, would Powell and other central bankers use it? Count me dubious. They like their flexibility too much. They proclaim themselves data-dependent, then use the data’s flaws to justify doing whatever they really want.

And that data has an agenda. As an example, it looks like Judy Shelton is running into trouble getting confirmed for the Fed. Mainstream economists don’t like her, perhaps because she says things like this (from Friday’s WSJ):

The increasing financialization of gross domestic product is unhealthy because the growing size and profitability of the finance sector comes at the expense of the rest of the economy and increases income inequality… The kind of economic growth that increases living standards across all income levels occurs under conditions of monetary and financial stability.

Yet another way that the Fed “looking at the data” distorts the economy and GDP. Because the data they look at is helping Wall Street, not those who are struggling day to day. Here’s Annie Lowrey writing in The Atlantic.  

Viewing the economy through a cost-of-living paradigm helps explain why roughly two in five American adults would struggle to come up with $400 in an emergency so many years after the Great Recession ended. It helps explain why one in five adults is unable to pay the current month’s bills in full. It demonstrates why a surprise furnace-repair bill, parking ticket, court fee, or medical expense remains ruinous for so many American families, despite all the wealth this country has generated. Fully one in three households is classified as “financially fragile.”

Yet the Fed thinks we need more inflation.

My 2020 Forecast and the Coronavirus

The Federal Reserve makes national monetary policy. Just as national average inflation probably doesn’t reflect your personal situation, the nation’s average GDP doesn’t reflect individual situations. I have written about this in the past, especially in my exchanges with Ray Dalio.

Viewed through income and affordability lenses, there are multiple Americas with different needs. Different companies and regions would probably prefer a tad bit more nuance in interest rate policy.

GDP, or any other national average, simply can’t capture all the variation in a country as large as the US. That greatly reduces its analytical value.

Here’s Guggenheim CIO Scott Minerd on the problem of measuring economic growth.

From 1961 through 1966, average annual US Gross Domestic Product (GDP) grew about 5 percent, while the unemployment rate averaged 4.8 percent, and inflation was under 2 percent. Knowing just these data points, you would never get a sense of the economic and social inequities that led to 1967’s Long Hot Summer of race riots.

In 2006 and 2007 most investors and policymakers missed the signs that the engine of economic growth associated with rapid house price appreciation would prove to be the source of global financial disaster.

Economic historians will recognize 1966 as the beginning of a 16-year secular bear market. Stock benchmarks didn’t recover until 1982 and on an inflation-adjusted basis not until 1992. Note that in the chart below from my friends at Real Investment Advice there were four recessions during that period.

Now we have just gone through the first decade in US history without a recession. They also note the New York Fed recession probability is getting uncomfortably high.

Source: Real Investment Advice

I have said repeatedly for the last three or four years that I don’t expect recession within 12 months (you can’t really see much further than that in the data) barring some “exogenous shock” from outside the US. I usually cite Europe and China as the main possibilities.

My 2020 forecast was for slower growth but no recession.

But now we may be getting that exogenous shock via China’s coronavirus.

Good friend and fishing buddy David Kotok of Cumberland Advisors has long been a keen epidemic watcher. It’s kind of his personal thing. He was all over SARS, Ebola, Zika and others. Now he says what we all know: China is lying about the data.

China cannot be trusted on any statistic. We have suspected that for years, with plenty of evidence. Now we have absolute proof.

It is literally impossible for epidemiologists, even without government pressure, to accurately know the number of deaths caused by the virus until after the fact. They can make guesses, but they do it without good data. In this case, it seems they were making politically pressured lowball guesses and now are trying to catch up.

The best bet is to ignore the statistics and watch what the Chinese government does. From private sources, I have read quite chilling accounts of wartime-like policies—absolute lockdowns. My friend Dr. Mike Roizen says that’s the right thing to do. This virus is not SARS. It is transmittable well before you have symptoms, and there is now very credible evidence the virus can survive up to 12 days outside the body—say on a hospital table or in an apartment building.

The expectations that factories will reopen soon may not be met. And while the deaths are truly tragic, the coronavirus is clearly going to have an economic impact, too.

My favorite China bull now believes it probable China GDP will drop significantly this quarter. Note, 15% of US foreign trade is with China. Europe and others are also being impacted, which will affect our exports to them.

Please understand, I am not calling for a recession at this time. But the potential for an exogenous shock is higher now than at any time in the last 10 years. Hopefully, modern medicine will come up with a vaccine quickly. There is reason to be hopeful on that front—possible vaccines are already in animal trials in both the US and China. But the economic impact won’t wait.

We should also understand something else about the recovery. It’s tough to administer stimulus policies to areas that are in military lockdown. But the moment this virus is under control, China will likely go into the greatest stimulus campaign of the century. I know that’s saying a lot. It will impact global markets. It won’t surprise me to see the Fed proactively cut rates and for the ECB and other central banks to inject even more liquidity. As they say, stay tuned…

SIC Registration Is Open

We’ve just seen how complex the concept of GDP is. And it’s not the only one: Nearly everything in the realm of economics and finance is complex (and often complicated, which is not the same thing). That’s why I read so much—understanding how all the threads of the tapestry fit together is not an easy task.

Thankfully, I have friends and colleagues to help me and my readers out. And one of the greatest concentrations of knowledge in our business is at our annual Strategic Investment Conference, May 11–14. I’ve never seen anyone attend who wasn’t impressed with the valuable information handed out by the bucketful.

If you’ve never attended an SIC, you simply have to. It’s an experience like no other. If you have attended before, you’ll be pleasantly surprised—because this year, at the request of our “SIC regulars,” we limited attendance to only 450 people. That gives you more one-on-one time with the Mauldin Economics team and the faculty. It also let us pick a smaller, more high-end venue for our event: the gorgeous Phoenician resort in Scottsdale, AZ.

Speaking of the faculty, we have secured two famous billionaires for our blue-ribbon lineup. The first is keynote speaker Sam Zell, chairman of Equity Group Investments and five other NYSE-listed companies. He founded and chaired the largest office REIT, which was sold for $39 billion in 2007. He also introduced the first Brazilian and Mexican real estate companies to the NYSE. He is listed on Forbes’ “100 Greatest Living Business Minds” together with names like Warren Buffett, Bill Gates, Mark Zuckerberg, and Jeff Bezos.

The other headliner is Leon Cooperman, a man with more business awards than grains of sand on our Puerto Rican beaches. In 1991, Leon retired as chairman and CEO of Goldman Sachs Asset Management to launch Omega Advisors, which he ran for 27 years before turning it into a family office.

That’s just a small glimpse of what you can expect at this year’s SIC, and I can’t wait to greet you there in person. You can see the rest of the lineup for what is going to be the best SIC ever at the website. But hurry—more than half of the 450 available seats are already gone. Get all the details and register here.

And with that I will hit the send button. I’m not going to New York, electing to stay home and write.

Your watching for exogenous shocks analyst,

John Mauldin
Co-Founder, Mauldin Economics

Britain after Brexit will not be alone, but it will be lonelier

The UK is entering a new world, going its own way while superpowers dominate

Martin Wolf

Brexit Road Drill
© James Ferguson

“At last we are alone.” My father told me he heard these words from an elderly gentleman sitting beside him on the London Underground in June 1940, just after the fall of France. The same insularity animates Brexit. It was an illusion then — it was not the UK alone, but an alliance with greater powers that won the second world war. It is an illusion now. The UK will not be alone, but it will be lonelier.

We cannot know what would have happened if the 2016 referendum had the opposite outcome.

That is the road not taken. But we know some results and may at least guess at others.

Brexit is a decision to separate the UK from the institutions governing the continent of which it is necessarily a part. One result is certain: British people will lose the right to move and work across the EU, as will citizens of EU members to live and work in the UK. That is a reduction in freedom. It is the result of insisting that one should not have both a British and a European political identity. This is a victory of narrowness.

The direct influence of British political choices on those of the neighbours will also vanish. British politicians will press their noses against the EU windows as decisions that affect them are made. Those decisions will determine the evolution of the single market and EU trade and climate policies.

Without the UK, the EU will still have 450m people and produce 18 per cent of world output. It will also remain the UK’s most important trading partner. The UK’s self-exclusion will matter.

A graphic with no description

Moreover, never in my lifetime has a British government been so determined to inflict economic damage on its own people. The government’s own analysis, published in November 2018, concluded that, under a bare-bones free trade arrangement of the type the government seeks, UK gross domestic product per head is likely to be about 5 per cent smaller than it would otherwise be, over the long term.

Elimination of net immigration from the European Economic Area would increase the loss by 0.5 percentage points. It is possible that the UK will lose close to half of its potential increase in GDP per head over the next decade, with grim implications for government revenue and spending.

This ignores the short-term costs. Sajid Javid, chancellor of the exchequer, has told business to abandon calls for regulatory alignment with the EU, stating that they have had three years to prepare. That is nonsense. Nobody has known (or even now knows) what agreement, if any, will be reached. The combination of uncertainty about the outcome with minimal time for adjustment is grotesquely irresponsible.

Brexiters will claim that, freed of the “dead hand” of EU regulation, the UK will thrive. This is likely to prove a fantasy. One reason is that the UK already has a highly deregulated economy, notably in the labour market. Is the UK going to abandon current regulations over the environment, product standards, financial soundness and so forth? That is very unlikely.

Moreover, the big failings of the UK — its ultra-low investment rate, weak productivity growth, poor infrastructure, high regional inequality, and long educational tail — have nothing to do with EU membership. Brexit may eliminate many excuses. It will not solve any of these problems.

A graphic with no description

That is far from all. If there is no trade agreement with the EU, or one that proves disruptive, a blame game is sure to ensue. Within the UK, Remainers will blame Leavers and vice versa.

More important, the government might blame the EU for an unhappy outcome, and vice versa.

Such discord could well take on a life of its own, driving Britain and the EU further apart. It is even possible to imagine an angry and destructive UK seeking to co-ordinate with Donald Trump’s US against the EU. The consequences would be devastating.

The UK’s departure, let alone the nightmare of prolonged hostility, is also likely to shape the future EU. Britain played a central role in promoting the single market and a liberal EU trade policy. Its departure is likely to weaken the influence of more economically liberal northern countries against the others.

The EU is then likely to be more inward-looking than it would otherwise have been. Yet it is also likely that Brexit will reinforce the solidarity of a more beleaguered EU. Either outcome will much affect the UK.

The UK is also likely to find it hard to exercise much independent influence upon a world entering an era of great power rivalry. Next to the US, China or the future EU, it is an economic minnow, albeit a large one. In such a world, reliance on multilateral institutions is likely to prove futile.

Again and again, Britain will face choices over which side to choose in struggles, perhaps over technology or standards, that are occurring far over its head. All this will be very uncomfortable. Not least, the UK will frequently find itself a supplicant in relations with powers greater than itself. It will have to be nimble and humble. That may work. But the control it is allegedly taking will be illusory.

A graphic with no description

The UK is entering a new world. It is forcing its people to abandon their rights in Europe. It is standing aside from the European project of structured and peaceful co-operation. It is choosing to be an independent island next door to what seems likely to remain an integrated European giant.

It is deciding to go its own way in a world dominated by rivalrous superpowers. It is doing so on the promise of greater control over its own destiny. It is, not least, acting against the wishes of the majority of its own young people.

Will this separation endure? Nobody can know. But it is quite likely to last a long time. In my own view, it is a huge blunder. But the moment is now upon us. We must live with its consequences.

A Global Economy Without a Cushion

From 1990 to 2008, annual growth in world trade was fully 82% faster than world GDP growth. Now, however, reflecting the unusually sharp post-crisis slowdown in global trade growth, this cushion has shrunk dramatically, to just 13% over the 2010-19 period, leaving the world economy more vulnerable to all-too-frequent shocks.

Stephen S. Roach

roach111_westend61_getty images_shipping trade

NEW HAVEN – With the benefit of full-year data, only now are we becoming aware of the danger the global economy narrowly avoided in 2019. According to the International Monetary Fund’s latest estimates, world GDP grew by just 2.9% last year – the weakest performance since the outright contraction in the depths of the global financial crisis in 2009 and far short of the 3.8% pace of post-crisis recovery over the 2010-18 period.

On the surface, 2.9% global growth doesn’t appear too shabby. But 40 years of perspective says otherwise. Since 1980, trend world GDP growth has averaged 3.5%. For any economy, including the world as a whole, the key to assessing growth implications can be found in deviations from the trend – a proxy for the so-called output gap. Last year’s shortfall from trend (0.6 percentage points) brought growth uncomfortably close to the widely accepted global recession threshold of approximately 2.5%.

Unlike individual economies, which normally contract in an outright recession, that is rarely the case for the world as a whole. We know from the IMF’s extensive coverage of the world economy, which consists of a broad cross-section of some 194 countries, that in a global recession about half of the world’s economies are typically contracting, while the other half are still expanding – albeit at a subdued pace.

The global recession of a decade ago was a notable exception: by early 2009, fully three-quarters of the world’s economies were actually shrinking. That tipped the scales to a rare outright contraction in world GDP, the first such downturn in the overall global economy since the 1930s.

For global business-cycle analysts, the 2.5-3.5% growth band is considered the danger zone. When world output growth slips to the lower half of that range – as it did in 2019 – the risks of global recession need to be taken seriously. As is typically the case for official, or institutional, forecasts, the IMF is projecting a modest acceleration of annual world GDP growth in 2020 and 2021, to 3.3% and 3.4%, respectively.

But as the physicist Niels Bohr once said, “Prediction is very difficult, especially if it is about the future.” Just ask the IMF, which has revised down six consecutive iterations of its global forecast. Obviously, there is no guarantee that its latest optimistic projection will be realized.

Downside risks are especially worrisome, because a 2.9% growth outcome for the world economy underscores the lack of a comfortable cushion in the event of a shock. As I noted recently, predicting shocks is a fool’s game.

Yet the draconian measures that China is now taking to contain the lethal Wuhan coronavirus only serve to remind us that shocks are far more frequent than we care to think. A few weeks ago, it was the possibility of a hot war between the United States and Iran. And before that, there was the increasingly contentious US-China trade war.

The point is that below-trend global growth, especially when it moves into the lower half of the 2.5-3.5% range, is nearing its stall speed. That leaves the world much more susceptible to recession than it would otherwise be in a more vigorous environment of above-trend global growth.

The same message comes through loud and clear in gauging the risks to the global trade cycle – long the major engine of global growth in an increasingly integrated, supply-chain-linked world economy. The IMF’s latest assessment put global trade growth at just 1% in 2019 – its seventh consecutive downward revision. Indeed, last year was the weakest trade performance since the historic 10.4% plunge in 2009, which was the worst contraction since the early 1930s.

Compared to the 5% average over the 2010-18 period, the slowdown of world trade growth to just 1% in 2019 is all the more alarming. In fact, it was the fourth-weakest year since 1980, and the three worse years – 1982, 2001, and 2009 – were all associated with global recessions.

Global trade growth has never recovered to its pre-crisis pace, a shortfall that has been the subject of intense debate in recent years. Initially thought to be a consequence of unusual weakness in business capital spending, there can be no ignoring the impact of protectionism following the start of the US-China trade conflict.

Now that the two sides have agreed to a truce in the form of a “phase one” trade deal, there is hope that the trade prognosis will improve. Reflecting that hope, the IMF’s January update calls for a modest rebound to 3.3% average growth in world trade over the 2020-21 period.

But with the average US tariff rate on Chinese imports likely to remain at about 19% after the accord is signed – more than six times the pre-trade-war rate of 3% – and with worrisome signs of escalating US-Europe trade tensions, this forecast, like those of the past several years, may turn out be wishful thinking.

All this bears critically on the precarious state of the global business cycle. Historically, the rapid expansion of cross-border trade has been an important part of the global growth cushion that shields the world economy from all-too-frequent shocks. From 1990 to 2008, annual growth in world trade was fully 82% faster than world GDP growth.

Now, however, reflecting the unusually sharp post-crisis slowdown in global trade growth, this cushion has shrunk dramatically, to just 13% over the 2010-19 period. With the world economy operating dangerously close to stall speed, the confluence of ever-present shocks and a sharply diminished trade cushion raises serious questions about financial markets’ increasingly optimistic view of global economic prospects.

Stephen S. Roach, a faculty member at Yale University and former Chairman of Morgan Stanley Asia, is the author of Unbalanced: The Codependency of America and China.

Argentina’s creditors fear the worst after IMF talks begin

Promise of ‘deep debt restructuring’ sent price of bonds lower last week

Benedict Mander in Buenos Aires and Colby Smith in New York

Concerns among investors were heightened after the new leftist president Alberto Fernández appeared to endorse anti-IMF comments by his vice-president

As Argentina attempts to win the IMF’s support for a $100bn debt restructuring, the sabre-rattling of the leftist government is stoking fears among creditors of a messy default.

Formal talks between the fund and Buenos Aires began last week and have already provided clues on how tough the process might be for bondholders. The price of Argentina’s government bonds sank after the 37-year-old economy minister Martín Guzmán told legislators on Wednesday that a “deep debt restructuring” would be required, and that the government would not try to balance its budget until 2023 at the earliest.

The country’s century bond — seen as a landmark in its economic recovery when it was issued three years ago — dropped almost 3 per cent the next trading day to 43 cents on the dollar, having started the year at more than 50 cents. The price of another government bond maturing in 2028 slipped to less than 45 cents. On Monday they remained close to these levels, which indicate a high probability of default.

Not everyone was convinced by Mr Guzmán’s tough rhetoric. “The youngster is living in Peronist La-La land,” said Walter Stoeppelwerth, chief investment officer at Portfolio Personal Inversiones, an investment bank. In Mr Stoeppelwerth’s view, neither the IMF nor the country’s creditors would accept a deal based on the government’s stated position.

However, concerns among investors were heightened after the new leftist president Alberto Fernández appeared on Thursday to endorse anti-IMF comments by his vice-president, Cristina Fernández de Kirchner. Ms Fernández de Kirchner, the combative former president from 2007-15, had remarked that the fund also needed to accept a “substantial” haircut, or loss, after lending Argentina $44bn since a 2018 currency crisis. The IMF’s managing director Kristalina Georgieva told Bloomberg on Sunday that a haircut would not be possible.

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Last week, too, Argentina unilaterally postponed interest payments on a local currency-denominated sovereign bond, after it failed to convince enough investors to accept a loss on the face value of their debts.

Patrick Esteruelas, head of research at Emso Asset Management, said the tough stance from the government — which insisted that it refused to be “held hostage” by foreign holders of the bond — was an attempt to clean up a “mess” created by a recent stand-off between the Province of Buenos Aires (PBA) and its creditors.

The local government had tried to postpone a $250m January payment until May, but failed to convince its largest debtholder, Fidelity, which owns about a quarter of the province’s 2021 bonds. In the end, the province agreed to pay the money owed and pledged to restructure its remaining stock of foreign debt.

Marcos Buscaglia, a founding partner of Alberdi Partners, an economic consultancy in Buenos Aires, said the PBA episode showed Argentine policymakers were “afraid of a default”, which could trigger a renewed run on the peso and push inflation — which exceeded 50 per cent in 2019 — even higher. Argentina’s economy is in its third consecutive year of recession.

But according to Mr Esteruelas, the government’s decision to play hardball with holders of the local sovereign bond shows that it “internalised some of the lessons” drawn from the PBA affair. “This resets the stage,” he said.

Investors now insist that the government must present an economic plan that would explain convincingly how it plans to repay creditors, if it wants a swift and amicable resolution to the stand-off. So far, it has refused to do so.

“When there is so much uncertainty on the delivery [of certain economic targets], if you go to investors with haircuts . . . it is hard for them to be receptive,” said Polina Kurdyavko, head of emerging markets at BlueBay Asset Management.

Few investors are likely to accept a haircut of as much as 40-50 per cent, as implied by Mr Guzmán’s spending plans. That could make it tricky for the government to resolve the debt crisis by its self-imposed deadline of March 31.

“It is going to be a tough sell because time is on the bondholders’ side,” said Gustavo Medeiros, deputy head of research at Ashmore Group, another bond investor. “If they come and say a 50 per cent haircut and no coupon payment [for a few years], forget about it. There is no deal.”

Despite clear tensions between the government and private creditors, the role of the IMF is more ambiguous. Buenos Aires has had stormy relations with the fund in the past, but its endorsement of the government’s financial programme would help to seal a deal with creditors.

Analysts suggest that the IMF may favour a bigger haircut on Argentina’s debt to ensure that its own loans can also be repaid. “Paradoxically, the IMF will be the government’s best ally in the negotiations with bondholders,” said Mr Buscaglia.

But that could change. If the government does not meet its March deadline for an agreement with its debtholders, the fiscal conditions put on the government by the fund “may grow”, said Eduardo Levy Yeyati, an economist in Buenos Aires.

How Dangerous Is the Wuhan Coronavirus?

By: Ryan Bridges

The political and economic effects of the new coronavirus – both in China and across the globe – hinge overwhelmingly on just how successful efforts to stop its spread are likely to be.

Forecasting these, therefore, requires us to take a closer look at the mechanics of both contagion and containment.

When determining how dangerous an infectious disease can be, microbiologists and epidemiologists need to know two numbers: R0 (called R-naught) and the case-fatality rate (which is actually a ratio, not a rate).

The former estimates how infectious the disease is, while the latter provides an insight on its virulence.

R0 is an attempt to calculate how many people will catch a disease from an infected person. An R0 of 2, for instance, means that an infected person will spread the disease to two other people. But this is not an easy number to calculate. A paper published in the scientific journal PLOS One describes two methods for finding R0.

One involves hunting down every contact of several infected people to determine how many get sick and averaging the results; the second involves calculating an estimate by plugging cumulative data into equations that serve as infectious disease models.

But, as an article in The Atlantic explains, R0 is even trickier than that. It can change depending on external circumstances. A public health campaign or an effective quarantine could lower R0, while the virus’ spreading to a region with poor health care could increase R0. Perhaps the most salient point is that an R0 greater than 1 suggests that the infection will spread, while an R0 less than 1 suggests it will fizzle out.

As its name implies, the case-fatality rate estimates the percentage of deaths that occur among infected people. The Wuhan coronavirus has an estimated case-fatality rate of about 2 percent, meaning that there are two fatalities for every 100 cases of the disease. Science News reports that “the [World Health Organization] says less than 2 percent of patients who have fallen ill with 2019-nCoV have died, most often from multi-organ failure in older people and those with underlying health conditions.”

But just like R0, this number can be tricky to calculate and interpret. First, the true number of cases is hard to know for sure, since people who contract a mild version of the disease don’t go to the hospital, don’t get tested, and don’t become tallied in the official statistics. Second, the case-fatality rate will vary inversely with the quality of a health care system. Wuhan was so overwhelmed by the coronavirus that hospitals were turning away patients.

It is quite likely that some people who died could have been saved had they received treatment. Combined, these facts would suggest that the case-fatality rate for the Wuhan coronavirus is lower than 2 percent, especially if an infected person is treated in an advanced nation with a good health care system. Indeed, an article in Reuters concluded that infections have been underreported. As of publication, data from Johns Hopkins show that of the more than 1,000 deaths, only two have occurred outside mainland China (in the Philippines and Hong Kong).

Despite the difficulty in calculating R0 and the case-fatality rate, these numbers are worth estimating because they help place a new disease in the context of what is known about other diseases. The R0 of measles could be as high as 18, while the case-fatality rate of seasonal influenza is approximately 0.1 percent.

Thus, preliminary numbers suggest the Wuhan coronavirus is less infectious than measles but deadlier than seasonal flu. But, because of the sheer number of cases of seasonal flu (which number in the millions), the global death toll from influenza is far greater, estimated to be approximately 300,000 to 500,000 deaths annually.

Containing the Coronavirus

The global economy surely will take a substantial hit from the coronavirus. This will be the result of China’s massive, citywide quarantines, a decrease in industrial output, and travel restrictions and supply chain disruptions. Many such efforts to contain the coronavirus are disproportionate to the threat.

China’s massive quarantines will probably work to an extent – after all, preventing people from traveling within and between cities will help curb transmission of the virus – but this measure cannot be implemented in free societies. In non-authoritarian countries, only individuals can be quarantined, and this has been adequate to prevent the spread of disease. (When Ebola came to the United States, it didn’t spread far thanks to effective treatment and isolation procedures.)

Citywide quarantines also aren’t necessary because the best way for uninfected people to remain that way is to wash their hands frequently and to avoid touching their face while in public. It’s difficult to say whether wearing a mask accomplishes anything. On the one hand, masks catch respiratory droplets, which is why sick people and those with whom they are in close contact absolutely should wear them.

On the other hand, viruses are so tiny, they can pass right through masks. To the extent that a mask prevents a person from touching his or her face, then a mask may provide some protection. However, the Centers for Disease Control and Prevention does not recommend that healthy people wear a mask in public.

While coronaviruses can spread via frequently touched fomites (objects, such as doorknobs, that can transmit an infection indirectly to another person), it is not known how long they can survive outside the body on surfaces.

While some scientists believe that coronaviruses can last only a few hours, a newly published literature review in the Journal of Hospital Infection concludes that they “can persist on inanimate surfaces like metal, glass or plastic for up to 9 days, but can be efficiently inactivated by surface disinfection procedures… within 1 minute.”

Because exports from China take 30 to 40 days to arrive in the United States (if shipped via ocean freight), there is virtually no chance that exported products could infect Americans – unless the export is an infected human, animal or animal product.

When Overreactions Are Rational

The most serious threat to the global economy is not from the virus itself but from overreaction. Chinese manufacturing plants sit idle due to sick or quarantined workers. Travel into and out of China has been reduced. These overreactions are understandable, however, because scientists and public health officials have expressed a lot of uncertainty about the virus.

When faced with uncertainty – particularly when that uncertainty potentially involves death – people (especially politicians) behave cautiously. (From the American perspective, restricting travel to China has the side benefit of squeezing that nation’s economy even further.)

The general public hates uncertainty. But scientists live in a world of probability and are very comfortable dealing with uncertainty. This is also why scientists rarely use words like "never" and "always." (We know better from experience.

At one time, we thought all swans were white, until we went to Australia and found black swans.) This difference between the public and scientific community on the relationship to risk creates a communication gap that further feeds the uncertainty.

Ultimately, the future of the Wuhan coronavirus is not knowable.

Like the other major coronavirus epidemics that preceded it, the Wuhan virus is thought to have jumped from animals to humans. SARS terrified the world, but then quickly vanished. MERS, on the other hand, is now endemic, meaning there are a few cases that occur all the time. The Wuhan virus could follow either path or some other path entirely.

Just like an economic recession, an infectious disease outbreak provokes strong psychological responses.

Life will return to normal when enough people believe that it’s okay to return to normal.

Is Berkshire Hathaway Antifragile?

by: Chris Wallendal CFA
- Berkshire Hathaway has amassed a record cash horde of over $128B, or greater than 23% of the company's current equity market capitalization.

- Berkshire Hathaway's large cash position should be viewed as a potential war-chest, not as a drag on the company.

- As explained by Nassim Nicholas Taleb, cash reserves are antifragile, whereas debt creates fragility.

- I conclude that the record cash pile lessens Berkshire's fragility, but there are still too many risks to label the company antifragile as a whole.

- Still, I believe that there is a better than not chance that the market will present Buffett an attractive investment opportunity in the not far future, and so I own BRK.B.
Berkshire's Cash Balance
Berkshire Hathaway (BRK.A) (BRK.B) has more than doubled its cash and short term investments over the past four years as its portfolio and subsidiaries continue to generate significant cash flows for the holding company. This is likely to have further swollen from the $128B reported in 3Q2019 as the company has not made any recent "elephant size" acquisitions. "Elephant size" may soon need to be upgraded to "whale size" if much of this cash is to be put to work in a single transaction, while the likelihood of Buffett suddenly finding multiple targets at attractive prices seems remote with equity prices near record levels.
This has led to calls for Berkshire to use it or lose it via dividends and/or large share repurchases. The current low returns on cash and equivalents adds to this sentiment. Others suggest that the company may simply be patiently waiting for more opportunistic prices, perhaps envisioning a grander repeat of the Goldman Sachs (GS) preferred stock and warrants deal from 2008.
I agree with the latter and want to expand further on how this is consistent with Warren Buffett's "Owner's Manual" for Berkshire shareholders and on how this relates to some of the insights of Nassim Nicholas Taleb, author of the Incerto Series (Skin In the Game, Antifragile, The Black Swan, Fooled by Randomness, and The Bed of Procrustes).
An Owner's Manual
Warren Buffett wrote "An Owner's Manual" in 1996 (with periodic updates) as a way to inform shareholders of how he and Charlie Munger would approach managing the holding company of Berkshire Hathaway. In Buffett's usual colloquial fashion, he describes the company's sparing use of debt as follows:
The financial calculus that Charlie and I employ would never permit our trading a good night’s sleep for a shot at a few extra percentage points of return. I’ve never believed in risking what my family and friends have and need in order to pursue what they don’t have and don’t need.
He goes on to describe how the "float" from the insurance subsidiaries and deferred taxes are two large sources of low-cost funding which, while creating liabilities, come without the drawbacks of debt. The majority of the operating subsidiary debt is matched to long term assets in the railroad and utilities businesses and is non-recourse to the holding company.
Regarding the stock market, Buffett describes his aim to collect assets at attractive prices over the long term as being aided, not hurt by, falling prices:
Overall, Berkshire and its long-term shareholders benefit from a sinking stock market much as a regular purchaser of food benefits from declining food prices. So when the market plummets – as it will from time to time – neither panic nor mourn. It’s good news for Berkshire.
This applies to purchasing entire companies or marketable securities, as well as the ability for the portfolio companies to buy back their own shares at depressed prices.
This implies that Buffett is willing to retain earnings and wait for market opportunities. He does, however, have a mechanism to check that he is creating value:
The five-year test should be: (1) during the period did our book-value gain exceed the performance of the S&P; and (2) did our stock consistently sell at a premium to book, meaning that every $1 of retained earnings was always worth more than $1? If these tests are met, retaining earnings has made sense.
So far, Berkshire Hathaway has met that test, so presumably we shouldn't be holding our breath for a dividend or large share repurchase.
The Opposite of Fragile
Please Mishandle Antifragile PackageSource: Antifragile: Things That Gain From Disorder
In Antifragile: Things That Gain From Disorder, Taleb explains that the opposite of fragile is not strong, robust, or unbreakable as most people seem to think. Rather, the exact reverse of fragile is that which benefits, i.e., is strengthened by stressors and shocks. This is such a foreign concept that Taleb needed to coin a new word for it - "antifragile".
However, he also gives many examples of how all living things and surviving systems must have some measure of antifragility in order to survive in an unpredictably changing environment. The stress of exercise makes us stronger, not just in our muscles, but also by increasing our bone density and causing a cascade of beneficial health effects which we cannot fully understand given the complexity of our biology. Another example can be found in psychology - while post-traumatic stress syndrome is well-known (fragile), much less discussed is post-traumatic growth, individuals who are psychologically stronger as a result of surviving a trauma (antifragile). Tom Brokaw used "The Greatest Generation" to describe those who grew up during the Great Depression and World War II. Taleb even points out how committing a crime can destroy a fragile professional, say a money manager, or enhance an antifragile actress by getting her more publicity.
This concept can also be applied to debt, which creates fragility. Sure, if all goes according to plan and the individual or company repays their debts, they will have benefited from the loan in terms of spending or investing power. However, they risk losing most or even all of their net worth if the unforeseen and unfortunate befalls them.
Cash savings are the exact opposite of debt. As such, it doesn't just create financial robustness, but can also be viewed as creating antifragile optionality for the saver. Taleb likens it to redundancy in a system. Just like having spare parts (two kidneys, or extra inventories of a commodity, for example), having extra spare cash can be highly beneficial when an unforeseen opportunity arises.
Is Berkshire Hathaway Antifragile?
From the above, it is obvious that having an enormous cash stockpile well in excess of its debt and operating/reserve requirements reduces fragility for the company.
In addition, the insurance and reinsurance businesses are also, if well-managed, capable of being antifragile. Why? Taleb points out that if they suffer losses (the stressor) which do not take them under, then they can often use the disaster which caused the loses as an excuse to raise premiums. However, the insurance underwriting business only accounts for 2.7% of Berkshire's total net earnings.
Taleb also points out that sheer size can create fragility, as in too big to fail interconnected banks. However, in Berkshire's case, this is mitigated by the largely decentralized and hands-off style of management at the holding company, allowing even the wholly-owned operating companies great freedom to run themselves.
Although utilities may hold up relatively well in an economic downturn, the company's railroads, energy, consumer products, building products, jet sharing, etc. would all take a hit along with the vast investment portfolio, which includes large investments in the very fragile banking sector. So taken as a whole, Berkshire Hathaway is not antifragile in the short run in the event of a shock or recession, but may prove less fragile than the market as a whole due to the cash pile. This could lead to antifragility in the longer term if the cash is well-invested at depressed prices before a market recovery. However, such "contingent antifragility" does not make sense as it requires future events which are impossible to accurately forecast.
Despite the fact that Mr. Buffett has lived for nearly nine decades and may live quite a bit longer, I do not believe him to be immortal. All individuals are fragile. So even though he has carefully thought about and planned for his succession, it is likely that his eventual removal will change investor sentiment towards the stock, at least among those who believe that his investment track record is the reason to own the stock. Taleb has much to say on the subject of past returns as well, especially in Fooled By Randomness, but for the purposes of this article, I'll limit my comments to just that thought. To repeat: if some owners of Berkshire Hathaway stock are there because they believe that Buffett's future returns will drive out-performance, then it seems to follow that his loss would change their sentiment in a negative way.
So although the company's growing stash of cash and Warren Buffet may both still be around for a future market crash, there is no way to forecast if and when he will make a whale of an investment or what the result will be over time. However, I am willing to bet a modest portion of my portfolio on the possibility that this will happen and I thus do own the stock.
Note that an investor can also replicate this less fragile composition of Berkshire to say, the S&P 500, by simply owning a smaller amount of stock and a large cash position in their own portfolios.

Brexit Is Finally Here. Now What?

By: Cole Altom

This week, the United Kingdom departs the European Union. For nearly three years the world has watched London exhaust itself over the political deadlock, delayed departure timelines, referendum propositions, and changes of political leadership. The world is well aware of what Brexit could mean for the U.K. and international markets, yet less has been said about what it will mean for the geopolitics of Europe.

The U.K., the EU’s second-largest economy, will withdraw from the region’s largest economic and political institution. Moments like these in history are bound to carry heavy, lasting geopolitical consequences with them, and this is especially the case in a post-Brexit Europe.

As the Union Jack is lowered from flagpoles outside EU buildings this Friday, cracks in the EU’s institutional unity will be exposed, further throwing off the political balance between various regional blocs over matters like the eurozone, migration and regulatory policies, and reactivating the fault lines of one of Europe’s most historical competitions between Germany and France.

Economic Impact and the Regional Divide

When it comes to financial growing pains post-Brexit, the EU won't go unscathed. While the political distraction of Brexit will fade, the EU will be forced to replace the U.K.’s contributions to its budget and navigate deeper, looming financial questions.

Divergences will deepen between net contributors (mostly northern European states) and net recipients (southern and newer EU members to the east) over budget size, regional spending, integration, and of course, the eurozone. Brexit’s greatest economic impact will be on the EU’s inner workings, in the absence of one of the union’s largest budgetary contributors.

One of the largest sources of European tension will feature the EU budget, 11.26 percent of whose contributions in 2018 came from the U.K., the third-largest net contributor after France and Germany. Brexit is a large budgetary loss for the EU, an institution that has struggled with increasing financial contributions among newer, eastern European members.

To make up for it, the EU has promised to reduce regional spending with the European Regional Development Fund (ERDF) and European Social Fund (ESF), and has pressured its wealthier, northern members to bump up budget contributions each year. (Germany will fill most of the gap, providing the largest share of upward of 33 billion euros by 2027.)
EU Budget Contributions by Member State, 2018

And these financial adjustments will not come without political tension. Brussels’ call to increase net budget contributions from wealthier northern states and keep the budget close to 1 percent of gross national income has indicated the growing influence of Germany, the Netherlands, Denmark, Austria and Sweden, the so-called “frugal five,” to maintain a more conservative budget that restricts regional spending.

Most southern and eastern members are more dependent on the union’s regional spending and have begun to protest further cuts. This divergence over spending will inevitably spill over into the EU’s fundamental debate over prized farm subsidies, rebates and how to narrow the growing gap between net recipients and net contributors.

Northern, southern and eastern states also diverge on post-Brexit economic priorities — lingering differences that could aggravate European political disunity. While the EU’s northern members seek to co-opt the UK’s financial industry and preserve free trade, Brussels faces conflicting interests among its southern and eastern members that seek out agreements that can improve their own domestic financial situations, particularly the protection of agricultural cultivation and fisheries.

EU members also disagree over the scope of the union.

Brexit will intensify the ongoing debate between EU members that wish to expand the EU with more accessions, and members that seek to conserve the size of the union and deepen integration among existing members, placing a greater emphasis on institutional reform. This divergence is the crux of the EU’s disunity, an imbalance that will become more volatile once the UK withdraws.

Politics, Defense and Foreign Policy

Before Brexit, the EU was already divided. There have been many concerns that Brexit will populist, eurosceptic movements that could further jeopardize the EU’s political and economic unity. France’s far-right leader, Marine Le Pen, said after the 2016 Brexit referendum that “The UK has begun a movement that will not be stopped.”

However, these fears are exaggerated. Brexit has actually rallied pro-EU sentiment across the continent, with 61 percent of respondents in member states (excluding the U.K.) saying their country’s membership in the union was a good thing, according to a European Commission survey this year, up 8 percent from results shortly after the Brexit vote in 2016. The same survey reported that trust in the EU has increased in all member states, reaching its highest level since 2014.

The institution is as popular as it was after the 1992 Maastricht Treaty, making any campaign for Swexit, Italexit, Nexit — really, any movement ending in “exit” — a risky venture. Britain’s costly Brexit saga has caused anti-EU parties in Italy, France, Germany, Austria and the Netherlands to dial back calls to depart the EU, refashioning their campaigns to focus on “reform” and “institutional change.”

The loss of the U.K. will send shockwaves through the bloc over foreign affairs and security. Brexit is a key influencer in the EU’s increasing experimentation with regional defense frameworks. Already, we have begun to see EU lawmakers attempt to recalibrate Europe’s defense structure, with calls to bolster its Common Security and Defense Policy and create a European Defense Fund.

The loss of the U.K. is a loss of the EU’s largest defense budget contributor and second-largest armed force (right behind France), as well as the potential to weaken relations with the U.S. The U.K. contributed approximately 328 million euros to the CSDP in 2018, although it contributed modestly to EU CSDP missions and operations.

And the U.K. also lent greater weight to the EU’s foreign policy. The loss of the U.K., with its array of full-spectrum defense capabilities and its status as a permanent member of the United Nations Security Council (that wielded veto power on decisions involving sanctions, multilateral intervention, and security crises), is a blow to the EU’s foreign policy agenda.

Then there is issue of how the U.K. bridged transatlantic policies. The U.K.’s historical “special relationship” with the U.S. brought more clout to the EU, giving Brussels assurance that Washington was (somewhat) on the same page regarding defense, foreign policy and free trade.

With the U.K. departing and a more hostile U.S. changing its relationship with the EU (threatening tariffs, troop withdrawal from Germany), Europe has been forced to seek new defensive alternatives. Certainly, the North Atlantic Treaty Organization is alive and well, but if the tensions over the 70th anniversary NATO summit tell us anything, it is that many EU members remain nervous about a lack of European military independence.

EU members have begun to mold Europe as an autonomous actor in security and defense. The EU has begun to establish defense initiatives that run parallel to and compliment the NATO framework, endorsing measures that increase intra-EU defense cooperation such as the European Defense Fund, the Permanent Structured Cooperation, and the Coordinated Annual Review on Defense.

While Europe has been strategizing for a more autonomous defense structure before the Brexit referendum took place, the U.K.’s withdrawal plays European anxieties over its lack of regional defense capabilities and will accelerate the EU’s efforts to increase cooperation.

An Age-Old Rivalry

Perhaps the greatest geopolitical consequence of Brexit is the reactivation of German-French power competition for EU leadership. The absence of the U.K. will allow Germany and France to rise to the occasion as mediating powers and policy leaders in the EU. However, this does not come without tension.

Germany and France have historically been competitors in Europe, and as the German economy began to slow down and France sought a greater role in the EU, competition intensified. Ironically, the U.K. felt shut out of a French-German “romance” that dominated EU decision-making on certain issues, despite the U.K. not being a eurozone member (many Brexiteers cited this exclusivity as a reason to withdraw).

Yet, the U.K.’s departure demonstrates how a perceived bilateral relationship was truly trilateral before Brexit — the U.K. held considerable weight in balancing out French-German tensions.

France is in a slightly more advantageous position than Germany post-Brexit. Germany, already on the precipice of a recession, faces a series of financial constraints, as it is expected to step up its financial contributions to replace the U.K. And because of these financial constraints, Germany must lead the charge in shrinking regional spending and slowing integration to where the budget does not exceed 1 percent of GNI.

Germany sees this measure as a necessary policy, a way to smooth over wrinkles in the EU’s institutional framework before deepening integration, a policy that Berlin sees as a risk for further fragmentation. The U.K. was Germany’s ally in reigning in budgetary expansion and helped create a united front against the EU’s southern bloc.

However, now Germany remains the sole enforcer, earning the reputation of “bad cop” among newer, eastern EU members that rely on these funds. France has already begun to seize on this opportunity and carve out a new leadership role, establishing itself as the "anti-expansionist, pro-integrationist" alternative to Germany.

European Parliament Seats Before and After Brexit
(click to enlarge)

It has harnessed southern and eastern members’ frustration with a hesitant, introspective Germany and has branded itself as Europe’s “change-maker” through a series of ambitious, expansionary policy proposals that Paris likens to an EU “renaissance.” France has led the call for quick-paced integration, deepening the relations among existing states as a way to combat disunity.

France has also advocated a larger budget as an economic and social model for Europe, remedying southern members’ systemic financial issues and combating rising populism that could undermine the EU. And despite Germany’s calls to quicken accession, France has publicly opposed accession talks with Albania and Northern Macedonia, to Berlin’s chagrin.

This inevitable tug-of-war between Paris and Berlin has already begun to play out, with France contradicting German intentions by calling for military self-reliance, undercutting Germany’s bid for support of the Nord Stream II pipeline, flirting with the prospect of improving relations with Russia, and attempting to undermine Germany’s negotiating status at the Berlin Conference on Libya — just to name a few. However, we should not expect any resurrection of the Maginot Line anytime soon.

In the face of nationalist movements and disunity in Europe, France and Germany understand that they have to show a united front. While both powers will take advantage of this new power vacuum left by Brexit, their EU leadership statuses demand limited cooperation. It is not a happy marriage, but divorce is not in the cards.

As the U.K. enters its transition period with the EU, the distraction that Brexit once occupied in Europe will begin to slowly subside, giving way to the structural issues that weighed down EU unity long before Brexit.

In Brexit’s wake are a series of geopolitical shifts leading to the rebalancing of Europe.

Lingering debates over the eurozone, the budget and spending, and expansion and integration will spark a crisis over securing European legitimacy and unity.

And taking center stage in this crisis will be the German-French balance of power, experimenting with strengthened leadership roles to mold a new EU agenda and a remodeled Europe. While this Friday will mark a new chapter for the U.K. as a nation, it will mark a new era for continental Europe.