Zoltan Pozsar Saves The Western World

Those calling for a quick return to 2% inflation in advanced economies are “naively optimistic.”

That was one, among many, messages from the incomparable Zoltan Pozsar, whose latest missive was another case study in ambitious holism, misplaced or not.

Pax Americana was the great enabler of globalization, and globalization the great enabler of lowflation, Pozsar said, reiterating the increasingly consensus view that central banks were given far too much credit for decades of subdued price growth across the developed world.

Even Fed officials have acknowledged as much in 2022, from Jerome Powell’s uncomfortable quip (in Sintra) that policymakers “now understand better how little we understand about inflation,” to Tom Barkin’s express concerns that the Fed’s “success in managing inflation over the last twenty years was partially enabled” by structural, disinflationary tailwinds.

Pozsar contends that the so-called TRICKs (Turkey, Russia, Iran, China and North Korea) are “trying to poke holes in the Pax,” and that those efforts mean inflation will remain “a big risk.” The “distrust” inherent in the fracturing of two key marriages (“Chimerica” and “Eurussia”) is set to perpetuate a deglobalization push that was already well underway prior to the pandemic.

What started with populism and protectionism gained fresh momentum as the virus exposed the perils of just-in-time, while the war laid bare the existential risk, for Europe, of outsourcing energy security and, for Russia, of entrusting a country’s sovereign wealth to a system of inside money beyond the sovereign’s control. In Pozsar’s telling, one consequence of deglobalization will be a shift from “The Great Moderation” to “The Great Reflation.”

Last month, Pozsar argued that the US needs an “L”-shaped recession — a straight line drop in demand. Jerome Powell, he contended, would risk a US depression (with a “d”) to slay inflation. In his latest, Pozsar asked what could provide the “/.” Eventually, we’ll need to get from “L” to “L/” — from the straight-line drop and flatline to a reacceleration. Pozsar’s answer: Government-led investment. More poignantly: A massive, multi-trillion dollar industrial policy aimed at re-arming “to defend the world order,” re-shoring “to get around blockades,” re-stocking and investing in commodities and re-wiring the grid for the energy transition.

On the way to that conclusion, Pozsar drew several parallels to the financial system. It’s hard to say whether these analogies — a fixture of his work — are the result of someone unable to extricate himself from the frames of reference he knows best, or an effort to leverage knowledge accumulated in his area of expertise to solve problems in other fields. I suppose it doesn’t much matter. Credit where it’s due (and regular readers know I harbor mixed feelings about Pozsar), his exposition was remarkable.

“Global supply chains, whether they produce military or civilian goods, are facing a Minsky Moment – a Real Minsky Moment,” he wrote, adding that (abridged),

Paul McCulley’s term referred to the implosion of the long-intermediation chains of the shadow banking system that marked the onset of the Great Financial Crisis. Today, we are witnessing the implosion of the long-intermediation chains of the globalized world order: Masks, baby formula, chips, missiles and artillery shells, for now. The triggers aren’t a lack of liquidity and capital in the banking and shadow banking systems, but a lack of inventory and protection in the globalized production system, in which we design at home and manage from home, but source, produce and ship everything from abroad, where commodities, factories, and fleets of ships are dominated by states — Russia and China — that are in conflict with the West. Inventory for supply chains is what liquidity is for banks. In 2007-08, big banks ran on ‘just-in-time’ liquidity: The dominant form of liquidity was market liquidity, for which you could always sell assets into a deep market without moving prices, so you did not have to have liquidity reserves at the central bank. Similarly, big corporations today run ‘just-in-time’ supply chains for which they assume that they can always source what they need without moving the price.

He described Germany’s energy predicament in Lehman terms. Do note: Economy Minister Robert Habeck did the same in June. “Minsky moments are triggered by excessive financial leverage, and in the context of supply chains, leverage means excessive operating leverage,” Pozsar wrote, noting that in Germany, “$2 trillion of value added depends on $20 billion of gas from Russia,” which equates to 100x leverage, “more than Lehman’s.”

Zoltan went further. “If Taiwan makes the chips for the missiles the US sends it for self-defense but has to wait for missiles because they are needed in Ukraine instead or it can’t ship them to the US owing to a sea and air blockade imposed by China, the US is operationally ill-equipped to support a two-front war,” which, in effect, means Pax Americana, globalization and lowflation are running on “infinite leverage.”

He likened the insurance provided by Pax Americana for global supply chains to capital for banks. Banks were short on capital in 2008, but fortunately for them, they were deemed too big to fail. Globalization is likewise viewed as too big to fail, which means it needs a bailout or, as Pozsar put it, “a hegemon to maintain order.” Russia and China, he wrote, are akin to shorts betting against the solvency of the US banking system. That bet, Zoltan suggested, can’t be countenanced and must be “squashed quickly and decisively.”

Currently, the US is attempting to buy time — think of efforts to slow China’s technological development. Time, Zoltan conceded, is necessary “to build the fabs needed to regain ‘semiconductor sovereignty,'” or, more to the point, “to make chips at home for the missiles that defend the US-led world order.” But that’s not enough. The US “can’t win by slowing progress.” Hence the need for industrial policy.

The West, Pozsar said, must “pour trillions” into the “to-do” list mentioned above — the re-arming, re-shoring, re-stocking and re-wiring. That’s what’s needed to “ensure that the West wins the economic war [and] overcome[s] the risks posed by ‘our commodities, your problem,’ ‘chips from our backyard, your problem’ and ‘our straits, your problem.'” (Those are allusions to the approach adopted by Russia and China towards the West in 2022, and represent a stark departure from the Western-centric, ‘our currency, your problem’ system.)

Executing on the to-do list will be “commodity intensive” and “capital intensive,” and it will be “interest rate insensitive” and “uninvestable for the East.” The commodity-intensive nature of the push will be inflationary for obvious reasons. It’s a demand shock in a supply-constrained environment set against a backdrop of underinvestment in commodities. Worse, lots of commodities are in the hands of an antagonist.

The implication is that if the West does implement a version of Pozsar’s four-point plan, it could “easily drive another commodity supercycle,” he said. But this supercycle would unfold in a warring, multipolar world, where the only thing more scarce than commodities will be the cooperation, trust and trade necessary to obtain them.

As for capital intensity, governments and the private sector will have to borrow. The cost of that borrowing can’t be a factor, Zoltan suggested. “The to-do list will have to be executed regardless of whether the Fed hikes rates to 3.5% or 7%,” he wrote. “Hell or high water, executing is imperative — industrial sovereignty depends on it.” Private equity will eventually be crowded out given interest rate sensitivity and considering that “industrial policy done right, with overwhelming force” will eventually leave no room.

Finally, the East will have no incentive to invest in these efforts and every incentive not to. “It makes absolutely and categorically no logical sense to roll their investments in G7 debt claims, not just because of what happened to Russia’s FX reserves, but also because rolling a $1 trillion portfolio of US Treasury securities means that you will fund the West’s effort to re-arm, re-shore, re-stock and re-wire against the East,” Pozsar said.

As for when all of this spending and investment by the West to save itself from oblivion and restore the world order should begin, Zoltan offered a simple timeline: “Yesterday.”

Read more: Zoltan Pozsar Bears Witness