Let the Facts Speak: Q4 2020 Z.1

Doug Nolan


I received a friendly email a few weeks back from a reader inquiring whether my analysis is Fact or opinion. 

Well, it’s my opinion that the world is in the “Terminal Phase” of history’s greatest Credit Bubble. 

It is opinion that U.S. and global equities markets are historic speculative Bubbles, fueled by runaway Monetary Inflation and Acute Monetary Disorder. 

It’s my opinion that markets in U.S. stocks, cryptocurrencies, corporate Credit and derivatives have evolved into full-fledged manias. 

It’s certainly my opinion that this all ends very badly.

But this week’s CBB is about Facts rather than opinion. 

History informs us that money and Credit are critically important – ignore their disorder at your own peril (policymakers at all our peril). 

That’s a Fact. 

The Fed’s Z.1 “flow of funds” report is our quarterly glimpse at Credit and financial developments – where "the rubber meets the road". 

As far as I’m concerned, the Facts Speak for themselves. 

It was another quarter that corroborates Bubble Analysis. 

Facts provide the foundation for my analysis and opinions, and Z.1 data reflect monetary inflation spiraling out of control.

Total Non-Financial Debt (NFD) ended 2020 at $61.167 TN, or a record 292% of GDP, having increased $27.8 TN, or 83%, since the end of 2007. 

NFD ended 2019 at 254% of GDP, up from 230% to end 2007; 189% to end the nineties; 186% at the end of the eighties; and 140% to conclude the seventies.

NFD inflated an unprecedented $6.778 TN, or 12.5%, during 2020. 

For perspective, NFD expanded on average $1.831 TN annually over the previous decade. 

NFD grew $2.452 TN during 2019, somewhat below the all-time record $2.899 TN recorded during the mortgage finance Bubble year 2004. 

NFD expanded $941 billion during Q4, more than double Q4 2019’s $458 billion, and up from Q3’s $808 billion. 

NFD surged $9.230 TN, or 17.8%, over two years.

The Credit Bubble continues to be fueled by a mind-boggling expansion of government debt. 

Outstanding Treasury Securities jumped $700 billion during the Q4. 

For the year, Treasuries surged an unprecedented $4.582 TN, or 24%, to a record $23.601 TN. 

Treasuries rose $5.759 TN, or 32.3%, over two years. 

Since the end of 2007, Treasuries have ballooned $17.550 TN, or 290%. 

Treasuries ended 2020 at a record 113% of GDP, up from 42% to end 2007.

Agency (GSE debt and MBS) Securities gained another $248 billion during Q4 to surpass $10 TN ($10.114 TN) for the first time. 

This boosted 2020 growth to $685 billion (7.3%), the largest expansion since 2008. 

For perspective, Agency Securities on average increased $133 billion annually during the previous decade. 

Agency Securities expanded $1.002 TN over the past two years.

Combined (“Washington Finance”) Agency and Treasury Securities expanded $5.267 TN, or 18.5%, during 2020 to a record $33.715 TN (2-yr growth of $6.761 TN).

Treasury and Agency Securities increased to a record 157% of GDP, up from 92% to end 2007. 

It’s worth noting Agency and Treasury Securities comprised 73% of total NFD growth over the past two years (6.761/9.230)

Led by unmatched Treasury and Agency issuance, Total Debt Securities rose $1.212 TN, or 9.2% annualized, during Q4 to a record $53.920 TN. 

Total Securities surged $6.499 TN during 2020, ending the year at a record 248% of GDP (up from 204% to end ’07).

Total Equities surged $8.092 TN during Q4 to a record $64.503 TN, with a stunning nine-month gain of $21.474 TN. 

Gaining $9.878 TN for the year, Total Equities ended 2020 at a record 308% of GDP. 

This compares to previous cycle peaks 187% at Q3 2007 and 210% during Q1 2000. 

It’s worth adding that Equities-to-GDP reached a high of 71% in September 1987, fell to a post-crash low of 54%, and did not surpass the ’87 peak until Q4 1991 (77%).

Total (Debt & Equities) Securities surged $9.303 TN during Q4 to a record $118.422 TN. 

Total Securities gained $16.378 TN, or 16.0%, during 2020, surpassing 2019’s record $13.191 TN increase. 

Total Securities ended 2020 at a record 566% of GDP. 

This was up greatly from previous cycle peaks 387% during Q3 2007 and 368% back in Q1 2000. 

For additional perspective, Total Securities-to-GDP ended the eighties at 194% and the seventies at 148%.

Inflating securities values continue to inflate Household Net Worth. 

And while headlines and articles refer to “household wealth,” it’s important to distinguish between real economic wealth and perceived wealth generated from massive monetary inflation and market Bubbles.

Household Assets surged $7.223 TN during Q4 to a record $147.211 TN. 

And with Liabilities increasing “only” $297 billion (to a record $17.057 TN), Household Net Worth surged $6.925 TN to a record $130.155 TN. 

For the year, Household Assets inflated $12.587 TN and Liabilities rose $652 billion, with Net Worth surging $11.935 TN. 

This annual gain was second only to 2019’s record $12.702 TN surge (that crushed 2013’s previous high $8.712 TN). 

Household Net Worth inflated an unparalleled $24.637 TN, or 23%, over two years, ending 2020 at a record 622% of GDP. 

This was up from 485% to end 2007; 448% at the end of 1999; and 378% to conclude the eighties.

Household holdings of Financial Assets surged $6.185 TN, or 25% annualized, during Q4 to a record $104.570 TN (2020 gain $9.867 TN). 

Financial Assets-to-GDP ended the year at 499%, up from 2007’s 374%; 1999’s 357%; and 267% to end the eighties. 

Total Equities (Corp Equities and Mutual Funds) jumped $4.165 TN during Q4 to a record $34.994 TN, with a one-year gain of $5.084 TN, or 16.4%. 

Total Equities surged $9.364 TN, or 35.2%, over the past three years. 

For comparison, Total Equities inflated $5.037 TN during the three-year Bubble period 1997 to 1999. 

Household Total Equities holdings ended 2020 at a record 172% of GDP. 

This compares to previous cycle peaks 104% during Q2 2007 and 115% for Q1 2000. 

Total Equities-to-GDP ended the eighties at 47%.

Reminiscent of the mortgage finance Bubble period, Household Real Estate holdings gained $915 billion during Q4, surpassing the previous record $852 billion increase back in Q3 2005. 

For 2020, Real Estate inflated $2.267 TN (strongest annual gain since 2005’s $3.122 TN) to a record $35.789 TN. 

Real Estate as a percentage of GDP jumped to 171%, up from trough 2011’s 129% to the highest reading since 2007’s 178%.

The Federal Reserve’s Balance Sheet (Assets) jumped $197 billion during Q4 to a record $7.600 TN. 

For the year, Fed Assets inflated an unprecedented $3.220 TN, easily surpassing the previous record $1.319 TN gain from the 2008 crisis response. 

The Fed’s Balance Sheet has now inflated $6.648 TN, or 700%, since the end of 2007, rising from 7% of GDP to 36%. 

During 2020, the Fed purchased $2.677 TN of Treasuries, more than doubling its holdings to $5.218 TN. 

The Fed bought no Agency securities until 2008, and after last year’s $677 addition it held $2.148 TN at the end of the year.

The inflating Federal Reserve Balance Sheet continues to fuel a corresponding inflation within the banking system. 

Bank (Private Depository Institutions) Assets jumped $554 billion, or 9.7% annualized, during Q4 to a record $23.454 TN. 

Assets surged $3.402 TN, or 17%, during 2020, dwarfing 2008’s previous record $1.249 TN increase. 

The Asset “Reserves at the Fed” rose $252 billion during Q4 to a record $2.995 TN, with a one-year gain of $1.446 TN.

Banking system Debt Securities holdings rose $274 billion to a record $5.790 TN, with Agency/MBS Securities surging an unprecedented $279 billion, or 36% annualized. 

Agency/MBS holdings jumped $740 billion during the year, or 28%, to $3.375 TN. 

This was more than three-times 2019’s record $189 billion increase. 

Annual purchases had averaged $104 billion over the previous decade. 

Treasury holdings increased only $17 billion during Q4 to a record $1.204 TN, though holdings expanded a record $325 billion, or 37%, for the year (up 63% in two years).

As new QE-generated Federal Reserve “IOUs” (“reserves”) are funneled to the banking system in exchange for deposits, the upshot has been an unprecedented expansion in Bank Deposit Liabilities. 

Total (Checking and Time & Savings) Deposits jumped $651 billion during Q4 to $18.866 TN. 

For 2020, Total Deposits surged an unprecedented $3.344 TN, or 21.5% (vs. 2020’s $3.220 TN gain in Fed Assets). 

The previous record annual gain in Bank Deposit growth was 2019’s $855 billion. 

Deposit growth had averaged $597 billion annually over the previous decade (Total Deposits up 122% since 2007). 

Total Bank Deposits as a percentage of GDP jumped from 72% in one year to a record 90%. 

Bank Deposits-to-GDP ended 2007 at 59% and the nineties at 48%.

Lending was traditionally integral to the business of banking. 

Loans declined $68 billion during the quarter to $12.092 TN. 

For 2020, Loans expanded $365 billion, or 3.1%. 

Loans ended the seventies at 73% of Bank Assets. 

This ratio then dropped to 68% by the end of the eighties, 65% to end the nineties and 58% by 2010. 

Loans-to-Bank Assets fell to 52% to end 2020.

And while bank lending in the real economy may be rather stagnant, the same cannot be said for Broker/Dealer lending into the securities markets. 

Broker/Dealer Loans expanded a record $100 billion, or 84% annualized, during Q4 to a record $574 billion. 

For 2020, Broker/Dealer Loans surged a record $164 billion, or 40%. 

This compares to previous cycle peak growth of $79 billion in 2006 and $75 billion in Bubble year 1999.

Total Broker/Dealer Assets jumped $168 billion, or 19% annualized, during Q4 to a record $3.676 TN. 

Assets increased $207 billion, or 6.0%, for the year. 

Repo Assets gained $43 billion during the quarter to $1.322 TN.

And while on the subject of booming asset-based lending businesses, it’s worth noting total system Mortgage lending posted its strongest growth since the mortgage finance Bubble period. 

Total Mortgages increased $738 billion, or 4.6%, in 2020 to a record $16.783 TN. 

This was the largest rise since 2007’s $1.084 TN. 

Home Mortgages gained $477 billion to a record $11.666 TN, the largest increase since ‘07’s $722 billion.

The Rest of World (ROW) category remains an intriguing facet of Bubble Analysis. 

ROW holdings of U.S. Financial Assets surged a record $3.317 TN, or 36% annualized, during Q4 to a record $40.352 TN. 

For all 2020, ROW holdings rose $5.584 TN, or 16.1%, surpassing 2019’s record $4.800 TN increase. 

Over two years, ROW holdings were up $11.169 TN, or 37%. 

After ending 2007 at $15.842 TN, ROW holdings have surged 192%. 

ROW holdings ended 2020 at 193% of GDP. 

This compares to 109% to end 2007; 76% at the end of the nineties; and 30% to wrap up the eighties.

The Q4 gain was led by a $1.612 TN increase in Total Equities holdings to a record $11.618 TN, with a one-year gain of $2.523 TN, or 28%. 

Debt Securities increased $186 billion during the quarter to a record $12.955 TN, led by a $171 billion increase in Corporate Bonds. 

For 2020, Debt Securities surged $884 billion, with Corporate Bonds gaining $501 billion.

It was a manic week for U.S. equities. 

The small cap Russell 2000’s 7.3% surge increased y-t-d gains to 19.1%. 

The Banks (KWB) jumped 4.3%, boosting 2021 gains to 26%. 

The Broker/Dealers surged 5.8%, the Midcaps 5.3% and even the Utilities jumped 4.5%. 

The Goldman Sachs Most Short Index surged 10.6%, increasing y-t-d gains to 40.4%.

Meanwhile, Treasury yields jumped to new one-year highs. 

Ten-year Treasury yields rose six bps to 1.63%. 

The five-year Treasury inflation “breakeven rate” surged another 10 bps to 2.58%, the high since July 2008. 

Examining Z.1 data, it’s surprising consumer price pressures have remained somewhat contained to this point (although significant Credit growth is being directed to the asset markets). 

But inflationary pressures are now mounting rapidly and Trillions more Credit – including unrelenting fiscal and monetary stimulus – are in the offing.

The Facts support the view that a major bear market is unfolding in long-term Treasuries and fixed income securities.

Welfare in the 21st century

How to make a social safety net for the post-covid world

Governments must remake the social contract for the 21st century


After the Depression and the second world war, voters and governments in rich countries recast the relationship between the state and its citizens. 

Now the pandemic has seen the old rules on social spending ripped up. 

More than three-quarters of Americans support President Joe Biden’s $1.9trn stimulus bill, which is due in the Senate and includes $1,400 cheques for most adults. 

And in the budget on March 3rd Britain extended a scheme to pay the wages of furloughed workers until September, even as public debt hit its highest level since 1945. 

Such boldness brings dangers: governments could stretch the public finances to breaking-point, distort incentives and create sclerotic societies. 

But they also have a chance to create new social-welfare policies that are affordable and which help workers thrive in an economy facing technological disruption. 

They must seize it.

The past year has seen a wild experiment in social spending. The world launched at least 1,600 new social-protection programmes in 2020. 

Rich countries have provided 5.8% of gdp on average to help record numbers of workers. 

Government debts are piling up, but so far low interest rates mean that they are cheap to service. 

The public’s mood had already been shifting. Britons used to grumble that layabouts sponged off the welfare state; now they are more likely to say help is too stingy. 

Last year over two-thirds of Europeans said they supported a universal basic income (ubi), an unconditional recurring payment to all adults. 

Affluent professionals have had their gaze drawn to the working conditions of those who deliver food and look after the sick. 

The struggles of women who have dropped out of the workforce to care for children and the elderly have become impossible to ignore.

The social safety net in many rich countries was creaking before covid-19 struck. 

Modelled on the ideas of Otto von Bismarck and William Beveridge, it had often failed to cushion workers from globalisation and technological and social change. 

In 1999-2019 the number of Americans aged 25-54 outside the labour force grew by 25%, or 4.7m, over six times more than the number who received help from the main assistance programme for displaced workers. 

As health-care and pension costs soared in recent years, governments cut back support for working-age people. 

Between 2014 and 2018 Britain’s state-pension bill grew in real terms by £4bn ($5.8bn), even as the rest of its welfare budget shrank by £16.5bn. 

A dwindling share of middle-income jobs and the growth of the gig economy fuelled fears that labour markets were changing faster than flat-footed governments could.

With the public and some economists cheering on, it is tempting for politicians to stoke the economy with more ad hoc spending, or put in place vast schemes such as ubi. 

Instead they need to take a measured, long-term view. 

The safety net must be affordable. Tight budgets, not milk and honey, will define the 2020s. 

The annual deficit of big advanced economies was 4% of their combined gdp even before the pandemic—and much ageing is still to come. 

Already bond yields are rising again. 

Social spending must flow quickly and automatically to those who need it—not, as in America, only during crises when a panicked government passes emergency legislation. 

And governments need to find mechanisms that cushion people more effectively against income shocks and joblessness without discouraging work or crushing economic dynamism.

The first step towards satisfying these goals is to use technology to make ancient bureaucracies more efficient. 

Postal cheques, 1980s mainframe computers and shoddy data need to be relegated to the past. 

In the pandemic many governments temporarily short-circuited their existing systems because they were too slow. 

In Estonia and Singapore digital-identification systems and a disdain for form-filling became an asset in the crisis. 

More countries need to copy them and also to ensure universal access to the internet and bank accounts. 

The call for efficient administration may sound like tinkering but one in five poor Americans eligible for wage top-ups fails to claim them. 

Nimbler digital-payment systems will reduce the need for costly universalism as a fail-safe, and allow better targeting and quicker response times. 

Digital systems also permit the emergency option of making temporary cash payments to all households.

That is the easy part. 

Balancing generosity and dynamism is harder. 

Part of the solution is to top up the wages of low-paid workers. Anglo-Saxon countries have done this well since reforms in the 1990s and 2000s. 

But wage top-ups are of little use to the jobless and are often scant compensation for people who lose good jobs to forces beyond their control. 

Paltry support for the unemployed in Britain and America preserves incentives to work but at high human cost. 

The sparsity of social insurance has undermined political support for creative destruction, the catalyst for rising living standards. 

Continental Europe tends to underwrite traditional workers’ incomes more generously. 

But the distortion of incentives leads to higher unemployment and divisions between coddled insiders and a precariat. 

Both sides of the Atlantic lack a permanent safety net that insures gig workers and the self-employed.

There is one country that combines labour-market flexibility with generosity: Denmark, which spends large sums—1.9% of gdp in 2018—on retraining and on advising the jobless. 

These interventions stop the unemployed from falling into dependency. 

The inadequacies of policies elsewhere are often glaring. 

Britain’s efforts have flopped. 

America’s comparable spending is less than a 20th as large as Denmark’s, even though the few lucky beneficiaries of its “trade-adjustment assistance” earn $50,000 more in wages, on average, over a decade.

Bungee economics

For years social spending has favoured the elderly and an outdated safety net. 

It should be rebuilt around active labour-market policies that use technology to help everyone from shopworkers who are victims of disruption to mothers whose skills have atrophied and those whose jobs are replaced by machines. 

Governments cannot eliminate risk, but they can help ensure that if calamity strikes, people bounce back. 

Will ‘copycat economics’ in emerging markets have to end?

Some countries will find it difficult to match the fiscal expansion and central bank support in developed economies

David Lubin

Brazil has a particularly high public debt burden, with Citi estimating it comes to almost 95 per cent of GDP © Reuters


How do policymakers in emerging economies decide how to run their countries? The answer has a lot to do with how policymakers in advanced economies do things.

There is a copycat tendency or, put more politely, a “demonstration effect”: the policy choices of governments in developed countries create a menu of options from which governments in emerging economies make choices.

That fact makes for an uncomfortable prognosis these days. Developed countries are loosening policy to an extent that, if echoed by emerging economies, could end badly for some.

For most of the past few decades, the tendency among EM policymakers to take ideas from advanced economies has been remarkably helpful. One example of this is the history of trade liberalisation. In the 1960s and 1970s, the US and western European countries were busy cutting tariffs and reducing non-tariff barriers to trade. Seeing the fruits of this, developing countries followed suit in the 1980s and 1990s to boost growth rates. Another example is inflation targeting, which has now been adopted by a succession of emerging economies.

International economic integration and declining inflation have been generally good news for emerging economies. But it’s not so obvious emerging economies can follow all the latest fashions with equal success.

What characterises policymaking in advanced economies these days is, on the one hand, a bias towards apparently unrestrained fiscal expansion; and, on the other, central banks that are cooperatively keeping the cost of that debt down through bond purchases.

This subordination of the central bank to the finance ministry has a name: “fiscal dominance”. It was a common enough feature of policymaking in the decades after the second world war, but gradually lost its appeal when inflation started to make itself visible in the 1970s, which led to an era of “monetary dominance” as central banks were handed more and more authority to control inflation.

Now we’re back in a low-inflation world, fiscal policy has the upper hand and central banks are accommodative. This arrangement seems to work fine in rich countries, where investors are still happy to hold government debt even though there’s so much more of it yielding diminishing returns.

The reason these countries can get away with this is they have something that emerging economies generally lack, namely monetary credibility. And that’s painful for countries such as Brazil and South Africa.

These two have exceptionally high public debt burdens: Citi estimates Brazil’s is nearly 95 per cent of gross domestic product, and South Africa’s is 75 per cent. Debt burdens this big are particularly worrying because in each of these countries the long-term inflation-adjusted interest rate is considerably higher than the rate at which these economies are likely to grow in the foreseeable future. That gap between the real interest rate and the real growth rate will cause problems over time.

So why can’t Brazil or South Africa just implement copycat economics and get their central banks to buy bonds, reduce the long-term interest rate to tolerable levels, and keep on spending?

The reason is that, because these countries’ lack of growth potential inhibits the credibility of their money, investors want compensation for the risk of owning Brazilian or South African debt. If yields get pushed down too low through intervention by central banks, investors will begin to feel unrewarded, and the result will be capital outflows and endlessly weakening currencies. In the end, the only response to this might have to be stopping money leaving the country by imposing capital controls.

There’s no easy way around this: copycat economics seems to have found its limit. Or has it?

Last month India’s government, already sitting on a debt stock worth some 90 per cent of GDP, announced its intention to run large budget deficits for years, while the Reserve Bank of India has launched a bond-buying effort designed to put a ceiling on Indian bond yields at 6 per cent in nominal terms.

So far the market’s reaction has been forgiving. India’s monetary credibility is intact, for now, largely thanks to the market’s confidence that the country can grow fast in the future.

Good luck to India, and to Brazil and South Africa should they follow. For investors looking at EMs, finding places where copycat economics still works may become a valuable skill.


The writer is head of emerging markets economics at Citi 

No Peace for the Middle East

The Arab-Israeli normalization deals are unlikely to bring stability to the fractured region.

By: Hilal Khashan


The Middle East’s location has long made it an arena for great power competition. 

Over the past few centuries, the region has seen conflict between the Ottoman and Iranian empires, and Russian and Western meddling in its affairs. 

The Anglo-French establishment of the Middle East state system in the 20th century failed to bring stability. 

Iran and Turkey went on to build the foundations of a modern state on their own, and the newly rising Arab states, divided as they are, have not managed to come to terms with the creation of a Jewish state in Palestine. 

The Egyptian and Jordanian peace treaties with Israel also failed to spread peace and stability throughout the region.

Today, the recent normalization deals between Israel and the United Arab Emirates, Bahrain, Sudan and Morocco once again promise to open a new chapter in Middle East relations. 

But its complex problems and diverse political landscape mean peace is still out of reach for this fractious region.

Relying on the West

When former U.S. President Donald Trump visited Saudi Arabia in May 2017 to attend the Riyadh summit, he announced the formation of the Middle East Strategic Alliance, a kind of security partnership that would help fill the power vacuum in the region. 

He wanted to create a unified defense mechanism and common economic and energy platform that would prevent China and Russia from filling the void. 

Both Turkey and Iran boycotted the summit, believing that it was part of an effort to undermine their influence. 

Either way, the MESA never materialized because Egypt, Jordan and Qatar did not see Iran as a security threat, and Kuwait and Oman preferred to mostly stay out of the region’s explosive conflicts.

In fact, most Arab countries, with the exception of Saudi Arabia, did not take the MESA seriously, believing it would turn them into pawns rather than allies. 

The project was never likely to stem the region’s chronic instability as it ignored the local issues – state repression and regime intolerance of peaceful opposition – that so often cause it.

But the U.S.-brokered plan was emblematic of a larger problem: Arab countries have been largely unable to cooperate with each other and often prefer to rely on a Western mediator. 

The Arab League’s 1950 Joint Defense and Economic Cooperation Treaty collapsed because Egypt and Saudi Arabia feared domination by Iraq’s Hashemites. 

The Joint Arab Command, established in 1964 as a platform from which to confront Israel, quickly became defunct, making Israel’s stunning victory in the 1967 Six-Day War even easier.

When Egypt made peace with Israel in 1978, the Arabs held a summit in Baghdad and decided to establish the Eastern Front between Syria and Iraq to make up for the loss of Egypt. 

But the project failed because of the personal rivalry between Hafez Assad and Saddam Hussein. In 1991, right after the end of Operation Desert Storm, the Gulf Cooperation Council states signed the Damascus Declaration with Syria and Egypt, both of which agreed to provide troops to help support Arab security, but the agreement was later scrapped because the Saudis preferred to rely on Washington’s support instead.

For many in the Middle East, the ideal scenario would be for Saudi Arabia to establish an alliance with Israel and Turkey as a countervailing force against Iranian regional ambitions. 

This makes sense: Israel is eager to partner with the larger Gulf countries such as Saudi Arabia and the UAE, and Turkey has of late tried to befriend Arab countries. But such an alliance is still beyond reach. 

Ankara has had little success in wooing Arab states, with the exception of Qatar and Libya’s beleaguered Government of National Accord. 

And the Saudis are paranoid about trusting their fellow Arabs, believing they're only interested in Saudi money and in subverting Riyadh's rule. 

But with the Biden administration scaling back ties with Saudi Arabia, Riyadh will need to rethink its hesitancy.

Emerging Israel-UAE Alliance

For the UAE, its rapprochement with Israel is about more than just normalizing relations. It believes their relationship can evolve into an economic and military alliance. 

Abu Dhabi has strategic needs that it believes Israel can help meet in areas such as agricultural technology, food self-sufficiency, cybersecurity, tourism, high-tech and commerce. 

It sees itself and Israel as having modern economies and efficient armed forces that can change the shape of the region. 

Abu Dhabi Crown Prince Mohammed bin Zayed Al Nahyan wants to transform the UAE into an economic empire safeguarded by a strong military and a network of relations with strategic partners, chief among them the U.S. and Israel. (Notably, China had a mixed response to the Israeli-UAE peace accord. It issued a vague but measured response that warned against ignoring the Palestinian question and further radicalizing the region.)
 



Israel and the UAE have different expectations of the normalization deal. 

Abu Dhabi’s crown prince has delusions of grandeur and thinks Israel needs him to legitimize its existence. 

As a hub for air transport, education, culture and media, the UAE believes it can link Israel to the region and thus to the rest of the world. Israel, on the other hand, wants to build an alliance against Iran. 

It’s unlikely that the UAE would go along with such a project, especially since the Biden administration is pursuing a diplomatic path to solving the Iran nuclear issue, and the UAE would not join an alliance that brings with it the risk of war without U.S. backing.

Their prospects for economic cooperation are also limited. 

The UAE’s economic development hinges on its ability to maintain domestic stability, which goes hand in hand with Sheikh Mohammed’s policy of fostering good relations with military dictators such as Egypt’s Abdel-Fattah el-Sissi, Libya’s Khalifa Haftar and Sudan’s Abdel-Fattah Burhan, and ambitious leaders like Saudi Arabia’s Mohammad bin Salman. 

A potential armed conflict with Iran is therefore out of the question.

Indeed, in many ways, their economic interests don’t align. 

Israel plans to link its Haifa Port to the Maritime Silk Road component of Beijing’s Belt and Road Initiative. 

The project bypasses the Persian Gulf, to avoid the volatile Strait of Hormuz, and will effectively reduce the significance of the UAE’s Jebel Ali Port, currently the largest in the Middle East.
 


It’s therefore unlikely that the UAE-Israeli entente will go beyond security cooperation, which was already in the works between Israel and several Arab states for years, including with Jordan since 1948, Egypt since the Camp David agreement, and the Gulf countries since the 2002 Arab Peace Initiative. 

In the Middle East, alliances with Israel are difficult to build because Israel inevitably emerges as the leading force and its Arab allies the junior partners. 

The balance of power tilts decisively in Israel’s favor.

Russo-Turkish-Iranian Triangle

The two major Middle East players left out of the emerging Arab-Israeli alliance are, of course, Turkey and Iran – both of which have complicated relationships with an external power that often looms over many regional conflicts, Russia. 

To some extent, Russia, Turkey and Iran seem to have more bringing them together than pulling them apart. 

Russia and Turkey’s total trade rose from $4.5 billion in 2000 to $25.7 billion in 2018. 

The balance of trade favors Russia because of Turkey’s import of Russian oil and gas. 

Turkey also has a negative trade balance with Iran because of its imports of Iranian energy. 

U.S. sanctions on Iran, however, have hurt trade between the two countries – which shrank from $25.7 billion in 2013 to $3.4 billion in 2020. 

Turkey hopes to increase trade with Russia to $100 billion and with Iran to $30 billion.

However, the ideological and historical differences among the three countries, as well as their rivalry as regional powers, rule out any chance of them becoming close allies. 

Russia and Turkey have different agendas in Syria, and Ankara’s intrusion into the South Caucasus, especially in support of Azerbaijan in the Nagorno-Karabakh conflict, irritates Moscow.

Turkey’s relationship with Iran is also complex. 

The two countries need each other economically and are keen on keeping channels of communication open despite their sharp political divisions. 

In the absence of a unified Arab world, competition between Turkey and Iran is likely to eventually escalate as they seek to dislodge each other in their near abroad, especially in Syria and Iraq.

Syria gives Iran access to the Mediterranean, Hezbollah in Lebanon and the Israeli border. 

For Turkey, Syria provides land access to Lebanon, Jordan and the Arabian Peninsula. 

As for Iraq, it was for centuries a battleground between the Ottoman Empire and Persia. 

Saddam Hussein’s ouster in 2003 made Iran the dominant force in Iraq, but Turkey is also trying to establish a foothold there – which could revive their historical rivalry in the country. 

With proven oil reserves totaling 115 billion barrels, which could rise to 215 billion once the rest of the country is explored, Iraq will be a major focus for Turkey in the future.

For now, however, Turkey’s reliance on Iran (and Russia) for oil and gas is the main factor preventing tensions from escalating. 

But Ankara is also seeking alternative sources. 

It already has a stake in the Caspian Sea’s oil reserves through the Baku-Tbilisi-Ceyhan Pipeline, the Trans Adriatic Pipeline, the Trans Anatolian Pipeline and the land-based component of China’s BRI. 

It’s also drilling for gas in the Eastern Mediterranean, though many countries have expressed concern about its operations there.

Real peace in the Middle East remains elusive. Trump’s MESA project did not take off, and the Israel-UAE alliance is unlikely to lead to any concrete changes. 

Turkey and Iran may find it challenging to get over their past disagreements and concentrate on potential economic cooperation.

The one remaining factor is China. 

It has succeeded in establishing economic ties with U.S. allies in the region, especially Israel, Saudi Arabia and the UAE, without compromising its business links to Iran and Turkey. 

But its investments will not bring prosperity to the Middle East. 

The Chinese project requires regional stability and willingness to cooperate, both of which are woefully absent in the Middle East. 

What’s more, China has become increasingly authoritarian. 

Its Social Credit System is an attempt to control all aspects of people’s lives in China and could be spread to other parts of the world as part of the BRI. 

In a region that remains gripped by violence and factiousness, China’s rise will not bode well.

What Could Cause a US-China War?

Thucydides attributed the war that ripped apart the ancient Greek world to two causes: the rise of Athenian power, and the fear that this created in the established power, Sparta. To prevent a new cold or hot war, the US and China must avoid exaggerated fears and misperceptions about changing power relations.

Joseph S. Nye, Jr.



CAMBRIDGE – When China’s foreign minister, Wang Yi, recently called for a reset of bilateral relations with the United States, a White House spokesperson replied that the US saw the relationship as one of strong competition that required a position of strength. 

It is clear that President Joe Biden’s administration is not simply reversing Trump’s policies.

Some analysts, citing Thucydides’ attribution of the Peloponnesian War to Sparta’s fear of a rising Athens, believe the US-China relationship is entering a period of conflict pitting an established hegemon against an increasingly powerful challenger.

I am not that pessimistic. In my view, economic and ecological interdependence reduces the probability of a real cold war, much less a hot one, because both countries have an incentive to cooperate in a number of areas. 

At the same time, miscalculation is always possible, and some see the danger of “sleepwalking” into catastrophe, as happened with World War I.

History is replete with cases of misperception about changing power balances. For example, when President Richard Nixon visited China in 1972, he wanted to balance what he saw as a growing Soviet threat to a declining America. 

But what Nixon interpreted as decline was really the return to normal of America’s artificially high share of global output after World War II.

Nixon proclaimed multipolarity, but what followed was the end of the Soviet Union and America’s unipolar moment two decades later. 

Today, some Chinese analysts underestimate America’s resilience and predict Chinese dominance, but this, too, could turn out to be a dangerous miscalculation.

It is equally dangerous for Americans to over- or underestimate Chinese power, and the US contains groups with economic and political incentives to do both. 

Measured in dollars, China’s economy is about two-thirds the size of the US economy, but many economists expect China to surpass the US sometime in the 2030s, depending on what one assumes about Chinese and American growth rates.

Will American leaders acknowledge this change in a way that permits a constructive relationship, or will they succumb to fear? 

Will Chinese leaders take more risks, or will Chinese and Americans learn to cooperate in producing global public goods under a changing distribution of power?

Recall that Thucydides attributed the war that ripped apart the ancient Greek world to two causes: the rise of a new power, and the fear that this created in the established power. 

The second cause is as important as the first. The US and China must avoid exaggerated fears that could create a new cold or hot war.

Even if China surpasses the US to become the world’s largest economy, national income is not the only measure of geopolitical power. China ranks well behind the US in soft power, and US military expenditure is nearly four times that of China. 

While Chinese military capabilities have been increasing in recent years, analysts who look carefully at the military balance conclude that China will not, say, be able to exclude the US from the Western Pacific.

On the other hand, the US was once the world’s largest trading economy and its largest bilateral lender. 

Today, nearly 100 countries count China as their largest trading partner, compared to 57 for the US. 

China plans to lend more than $1 trillion for infrastructure projects with its Belt and Road Initiative over the next decade, while the US has cut back aid. China will gain economic power from the sheer size of its market as well as its overseas investments and development assistance. 

China’s overall power relative to the US is likely to increase.

Nonetheless, balances of power are hard to judge. The US will retain some long-term power advantages that contrast with areas of Chinese vulnerability.

One is geography. The US is surrounded by oceans and neighbors that are likely to remain friendly. China has borders with 14 countries, and territorial disputes with India, Japan, and Vietnam set limits on its hard and soft power.

Energy is another area where America has an advantage. A decade ago, the US was dependent on imported energy, but the shale revolution transformed North America from an energy importer to exporter. 

At the same time, China became more dependent on energy imports from the Middle East, which it must transport along sea routes that highlight its problematic relations with India.

The US also has demographic advantages. It is the only major developed country that is projected to hold its global ranking (third) in terms of population. 

While the rate of US population growth has slowed in recent years, it will not turn negative, as in Russia, Europe, and Japan. 

China, meanwhile, rightly fears “growing old before it grows rich.” India will soon overtake it as the most populous country, and its labor force peaked in 2015.

America also remains at the forefront in key technologies (bio, nano, information) that are central to twenty-first-century economic growth. 

China is investing heavily in research and development, and competes well in some fields. But 15 of the world’s top 20 research universities are in the US; none is in China.

Those who proclaim Pax Sinica and American decline fail to take account of the full range of power resources. American hubris is always a danger, but so is exaggerated fear, which can lead to overreaction. 

Equally dangerous is rising Chinese nationalism, which, combined with a belief in American decline, leads China to take greater risks. 

Both sides must beware miscalculation. 

After all, more often than not, the greatest risk we face is our own capacity for error.


Joseph S. Nye, Jr. is a professor at Harvard University and author of Do Morals Matter? Presidents and Foreign Policy from FDR to Trump.