Category Archive: Interviews

1. Rules of Restraint

   November 18, 2023 11:49 am Comments Off on Rules of Restraint

   The majority of countries in the world have some sort of fiscal rule: an institutional constraint on fiscal policies to discourage government overspending and reduce political influence on state expenditure. But these rules have their own politics. As Clara Zanon Brenck and Pedro Romero Marques write in their recent Phenomenal World essay:

   Fiscal policy can help resume economic activity and maintain social stability—a precondition and ultimate policy aim of a social democratic pact. But when rigid and ostensibly apolitical fiscal rules moralize the public spending debate in favor of sound finance, responding to changing economic conditions with blunt compliance mechanisms, such a path cannot be pursued.

   In October, Zanon Brenck and Romero Marques were joined by Max Krahé for a Phenomenal World panel on the politics of fiscal rules in Brazil, Germany, and the European Union. Romero Marques is the research coordinator at MADE, the research center on macroeconomics of inequalities at the University of Sao Paolo. He has a PhD in Economics from the University of Sao Paulo, and his research focuses on the distributive aspects of contemporary Brazilian financialization, as well as the international monetary system. Zanon Brenck is an associate at MADE and holds a PhD in Economics from the New School. Her work focuses on inequality, debt dynamics, and taxation. Krahé is the Research Director of the Dezernat Zukunft, which he co-founded in 2018, and received his PhD in political economy from Yale University.

   The conversation, moderated by Alexandros Kentikelenis, analyzes the evolution of fiscal management over the past two decades, in the aftermath of the Eurozone debt crisis and the resurgence of the Workers’ Party ( the Partido dos Trabalhadores, or PT) in Brazil. The panelists discuss the increasingly legal nature of fiscal rules, their relationship to party politics, and prospects for reform, demonstrating how technical debates hold major consequences for the working classes. A recording of the event can be viewed here. This transcript has been edited for length and clarity.

   A discussion on fiscal rules

   Alexandros Kentikelenis: The fiscal rule is a long-lasting constraint on fiscal policies through limits on budgetary aggregates, like limits to the fiscal deficit. The IMF, the world’s guardian of fiscal orthodoxy, says that “fiscal rules typically aim to correct government incentives to overspend and to ensure fiscal responsibility and debt sustainability.” We can recall limits of 60 percent debt-to-GDP ratio or 3 percent deficit limits that many countries did not comply with in the EU. Fiscal rules are prevalent across the world.

   Fiscal rules are intended to provide incentives for governments not to overspend—especially during good times—but they also have key drawbacks. Strict fiscal rules may reduce the scope of governments to adjust policy in response to unexpected shocks like economic crises. Equally importantly, they may limit available spending necessary for making economies more resilient, not least, to the risks posed by climate change. In Latin America, evidence shows that public investment is the category of spending that is most adversely affected by fiscal rules. For these reasons, understanding the political economy of fiscal rules is more important than ever. Fiscal rules form part of the infrastructure of contemporary capitalism, both in the global North and in the global South. 

   Max, can you speak to the role of fiscal rules in Germany?

   Max Krahé: The history of Germany’s fiscal rules begins with debate in the late 1980s and early 1990s. Germany used to have a golden fiscal rule that said the state had to balance the budget. However, the state was allowed to enter into a deficit through the volume of investment spending. The Constitutional Court was frustrated with this, because nobody could delineate what precisely was an investment and what wasn’t. In 1989, the court ruled that the state had to provide a more precise definition. While this led to some reforms, there were no significant changes. The Maastricht Treaty process occurred in parallel to this domestic German contestation, linking notions of German reunification and European Monetary integration. The Maastricht process introduced quantitative fiscal rules—the famous 3 percent extent limit on annual deficit and the 60 percent on debt-to-GDP-ratio. As history moved forward, and frustration with the German fiscal rules bubbled up again, another ruling by the German Constitutional Court later expressed the court’s displeasure with government policy. In the early 2000s, both Germany and France broke the 3 percent limit or deficit. In response, European fiscal rules were reformed to allow a temporary breach of the 3 percent rule, quantified as a 0.5 percent limit on your structural deficit. 

   In 2006-2007, a commission was instituted to examine German federalism, in particular, how the fiscal relationship works within the federation. The European reform of 2005 had introduced the possibility of a structural deficit limit. In 2008, the Schuldenbremse (“debt brake”) federal constitutional reforms—instituted ahead of the 2009 elections—marked a decisive moment for Germany’s debt/deficit protocols. During the financial crisis of 2008, the conservatives agreed to a fiscal stimulus on the condition that the state harmonized them with the quantitatively precise European rules, as opposed to the loose golden rule of the Constitutional Court. 

   This moment resulted in the shortened versions of the debt brake, which are still in place in the Constitution, making them incredibly difficult to repeal. In Germany, you need a two-thirds majority, requiring the conservatives, namely the CDU and CSU. The German debt brake is a limit on the deficit that completely ignores debt levels. It has no interest in the debt stock, only in the annual deficit, and it limits the annual deficit to a structural deficit of 0.35 percent of GDP. There’s also a cyclical component: if you’re in a recession, you can spend a little bit more, and if the economy’s doing well, you have to tighten your ship a little bit. 

   The operationalization of that is a complicated story. Today, European rules have a preventive arm, to prevent countries from getting into trouble in the first place. The centerpiece of that is the so-called medium-term objective. This tells the state to run their fiscal policy so that they have a 0.5 percent of GDP structural deficit. If you’re kind of getting out of hand, this kicks in. This means you have to have a deficit of plain deficits, not cyclically adjusted, that is less than 3 percent, and your debt-to-GDP ratio should be lower than 60 percent. If you violate those rules, an excessive deficit procedure (EDF) will be initiated. Unlike the European rules, the German rules are immediately binding—the German government can immediately be brought in front of the Constitutional Court for breaking the rules. It’s a hard quantitative limit with a legally-binding nature. Breaking the European rules initiates a long and complicated procedure, which involves the political voting of states. 

   AK: Are reforms necessary? If so, what are their prospects? 

   MK: In the 2000s and 2010s, the Eurozone suffered from slack, high unemployment, very low interest rates, and very low inflation. All the macroeconomic indicators indicated that there was plenty of spare capacity that was not being used. Monetary policy was at the zero lower bounds, or the effective lower bound. Even quantitative easing couldn’t push the economy to full employment, and instead have side effects on asset prices such as housing. There was a clear case for more fiscal stimulus, but it kept running into the fiscal rules. 

   While the high-level structure of Germany’s fiscal rules is written in the Constitution, the cyclical component is government by decree—it’s easier to change than the Constitution. We at Dezernat Zukunft looked to see if there’s space for improvement. The way that it currently works is that you have a projection of potential output, and you have a projection of what you expect actual GDP to be. If your projected, actual GDP is significantly below your projected potential output, you have a so-called output gap—that generates additional spending space. Potential output, however, is unobservable, and the calculations involve a high degree of discretion. Depending on the macroeconomic situation, reform ideas can yield significant additional spending space. We’re currently in conversation with the government which has decided to look into research, and we’re also engaged in bureaucratic trench warfare with the relevant civil servants and the relevant ministries that do these calculations. We’re trying to convince them that there’s a better way of doing this.

   The European level also has a reform effort around the fiscal rules. The European Commission has tabled a proposal, which would put a new tool in the fiscal rules toolbox. This new tool, the debt sustainability analysis (DSA), originally came from the IMF. It’s worth highlighting the extended timeframe of the reform effort. DSAs are meant to work with spending plans ranging from four to seven years, put forward by member states. The DSA begins at the end of those spending plans. At the end of the timeframe, your debt-to-GDP ratios—projected from fourteen to seventeen years—must be lower. Those projections are going to be extremely assumption-driven. 

   How do we fix these reforms? The current rules are very strict, but killing this reform effort means that when they come back next year it might be so politically untenable, that this could be a reset button and space could be created for a better version of the reform. If that’s not possible, then at least prevent the worst—Germany’s currently pushing for quantitative benchmark, meaning if you’re not meeting the targets then automatic tightening takes place

   We also look at the interest rate assumptions inside the DSA given the long time horizon. Market-based interest rate assumptions bring a risk of doom loops. Let’s say Italy’s expected interest rates look bad, and there’s a DSA. The DSA based on bad interest rates gives even worse results, and the markets look at those results, and drive up spreads even more. To prevent this kind of doom loop, you should not use market interest rates in your assumptions for the DSA. 

   The framework for DSAs needs to evolve. The current European rules are determined by a so-called output gap working group, staffed by civil servants from various national ministries. Extremely important discussions happen there—they are very technical, but highly politically consequential. It is important to replace that body with something more political and more transparent. These discussions need to take place out in the open, not in the shadows. They must be held publicly and own up to their politics.

   AK: Pedro and Clara, can you speak about the debate around Brazil’s fiscal rules?

   pedro romero marques: Since 2016, Brazil’s fiscal rule prohibited the government’s spending to increase in real terms for twenty years, effectively freezing state spending. Of course, some economists and specialists argued that the state’s finances would not be able to keep up with the state activity with this rule, but the consensus around the difficulty regarding the spending cap only came in 2020 during the pandemic, when it was clear that the spending cap wouldn’t be able to accomodate emergency expenditures. It was already expected that the winner of the 2022 election would propose an alternative—now that responsibility is with Lula’s Workers’ Party.

   

   How did Brazil adopt this strict rule? The origins of the spending cap are around 2013–2014 when fiscal surpluses became fiscal deficits in Brazil. The fiscal responsibility law of 2000—not a constitutional rule—was established to complement the inflation-targeting regime in Brazil. It required the government to define fiscal results targets each year, leading to some predictability in fiscal policy. The PT came to power in 2003. It’s important to note that the fiscal responsibility rule was enforced during the whole period of PT rule, with no difficulty in complying until 2013. There were fiscal surpluses, and the debt-to-GDP ratio had fallen. But in 2013, fiscal deficits led to a sharp increase in the debt-to-GDP ratio in Brazil. This mobilized an austerity discourse, motivated by right-wing opposition and traditional media that accused the PT government of being irresponsible and fiscally negligent, despite the trajectory of the debt-GDP-ratio in the decade prior. This discourse was powerful in Brazil; it was a key factor in the changes to Brazil’s political system. It was also responsible for the spending cap approval.

   Brazil’s debt-to-GDP ratio and Federal Govt borrowing requirement (Dec 2001 to June 2023)

   

   The economic dynamics that caused this pro-austerity surge are very interesting. Looking at the literature, we can see that distributive questions related to the PT’s growth model were important. In the 2000s, Brazil was part of the “Pink Tide” in Latin America, in which left-wing governments profited from international and domestic favorable conditions to increase government expansion in social policy to reduce poverty and inequality levels. During this period, it was common that social spending, both in real terms and share of GDP, increased. The problem began when the economy started to decelerate around 2011. Consequently, the falling revenues and the increasing trajectory of social spending compromised the Fiscal Responsibility Law around 2014–2015.

   

   The trajectory of social spending in Brazil is resilient. This is related to several redistributive mechanisms placed in the Brazilian constitution that allow government spending to increase with policies like the increase of the minimum wage value. The PT’s redistributive model was structurally placed in practice, making it difficult to stop only through politics or policy action. 

   The actions taken to remove the fiscal structure of the Workers’ Party came in two ways. First, the reaction came politically and President Dilma Rousseff, Lula’s successor, was removed from power in 2016, due to charges of committing fiscal crimes. Secondly, the spending cap ultimately stopped the process of increasing social spending. From 2016 to 2022, a constitutional rule of the spending cap was the fiscal rule in Brazil. In 2022, Lula was reelected over Bolsonaro with a very small margin. He won with a large coalition, but also with a Congress not politically aligned. Under these conditions, Lula is preparing the new fiscal rule. 

   CLARA ZANON BRENCk: Now, the PT needs to meet certain conditions in order to gain trust from their coalition that they won’t “break the country” again. This discourse around the PT almost “breaking the country” is why we have debt caps in the first place, and the new PT government is tasked with proposing an alternative.

   The PT’s new proposed rule is very restrictive. It’s very dependent on tax revenues and contradicts Lula’s promises for greater social spending. The need for social spending and investment will not fit into the new rule. The new rule makes the government dependent on the private sector to foster growth for greater revenues, which will then allow for social spending. 

   The proposed rule allows real growth that establishes a minimum of real primary expenditures growth of 0.6 percent. It connects the real growth of expenditures to the real growth of revenues, allowing expenditures to grow 70 percent of the growth rate of revenues of the previous year, if the government meets the target. Just like the fiscal responsibility law, the government needs to establish a target for the primary result. However, this target is a bit more flexible, because it has a range that can be + or – 0.25 percent. It’s already a surplus rule because you’re limiting 70 percent of expenditure, but there’s a counter-cyclical mechanism that requires the 70 percent to be within a range of 0.6 percent and 2.5 percent. So if the economy is growing too much, and if your revenues grew 5 percent in the previous year, 70 percent of that would be 3.5 percent, but then you have a cap of 2.5 percent. If the economy is growing rapidly, you cannot increase your expenditures rapidly. 

   During a crisis, in which revenues decrease, there’s a limit of 0.6 percent. You don’t need to cut expenditures, you can grow 0.6 percent in real terms. Consequently, it guarantees a minimum but it also has a limit that makes this counter-cyclical movement. If you don’t meet the primary target and you’re less than -0.5 percent of your target, then some things must change. Wages of public servants cannot increase. If the primary targets are not met, you also have to grow 50 percent of the revenue growth while also staying between 0.6 percent and 2.5 percent. This is a complicated rule, but it allows real growth, it has a counter-cyclical movement, and more importantly, it establishes a minimum for investment. In Latin America, investment is the first to be cut when we cut expenditures. 

   The expenditures of this rule are much lower than the expenditures of the previous PT governments. The government has much less space, and the rule reduces the size of the state related to GDP over time, because it restricts expenditure growth to 70 percent of revenue growth. Even in the more optimistic case of GDP growth, the government is shrinking. The counter-cyclical rule limits the growth of the state. 

   The size of the State under the Sustainable Fiscal Regime

   

   

   This is a complicated situation—we will not be able to sustain this rule in the long term, and if we do, we will have to change public spending. The rule needs to change to give a minimum for spending for health and education, or it will force us to cut government benefits such as Bolsa Familia. The minimum wage is linked to government expenditures, because many benefits are tied to the minimum wage. If you increase the minimum wage, public expenditures also increase. If you increase revenues, you also have a rule that connects health and education to those revenues. However, the cap doesn’t allow the overall spending to increase. In the end, investments will be left out, despite the budgetary minimum. You can cut investment if revenues are less than expected. 

   This new rule is still a very strong austerity rule, but the debate around it was limited. The functioning of the rule was barely discussed, because the consensus was that we needed a rule that restricts government spending in some way. The PT, a government that increases spending and thinks about the importance of government spending in the economy, is actually the one proposing this rule. This shows you the strength of the pro-austerity discourse. 

   Growth is left to the market, because public spending will not be enough for investment beyond social spending. To finish with a quote from our Phenomenal World essay, “The fiscal rules claimed to insulate fiscal policy from political influence, but this is its own form of politics. So it constrains and reduces the space for the working class whenever in power to influence fiscal policy and pursue distribution redistribution.” 

   AK: What is so concerning is how fiscal rules exit the state’s fiscal architecture and enter its legal architecture by being constitutionalized. They fundamentally transform the political economy and the ways in which different politicians as well as civil society can engage with these rules. As Max described, the part of the Schuldenbremse that relates to the structural deficit cannot be touched. We can only play with how we understand the cyclical component. The constitutional dynamic yields a set of pressures and politics of its own. 

   In principle, I agree with Max’s recommendations on transparency and high-level politics, but doesn’t transparency also yield unwanted politics? Of course, we remember the discourse around the lazy Southern Europeans and the hard-working Germans and Dutch people subsidizing them. If we have this high-level political approach, won’t this invite that sort of politics, on which political parties build their entire raison d’etre? 

   MK: The politics of discussing fiscal roles within Europe has been ugly in the past. Things got very, very ugly in the 2000s, and over the 2010s they improved a bit. It took a lot of time, longer than in the Anglosphere. But eventually, the European discussion has accepted that this form of austerity is destructive. By 2019, we had reached a place where the old fiscal rules were viewed quite skeptically, even in countries like Germany and the Netherlands. During Covid-19, both German rules and European rules were suspended very quickly. Moreover, significant stimulus packages, which, as in the US, led to a far faster exit macroeconomically from the crisis. Politics, especially in the early 2010s, were really ugly, but discussing them made it better over time. 

   The politics of not discussing the fiscal rules are arguably worse, especially since the rules as they are currently being proposed will not succeed, especially if they’re too tight. There are two outcomes. The first is a terrible rule that would wreck Southern European economies that attempt to stick to them, and in turn create huge resentment in the South. The second option is that these countries fail to abide by these rules, out of realism. In the German and Dutch political sphere, people will say that “no one is sticking to the rules,” this will cause political troubles in the North. 

   Going forward, I do think that the 2020s look much better for fiscal rules in Europe than the 2010s. I attribute this largely to a pivot in the French position. In terms of public debate, the French have been in favor of more reasonable fiscal rules. However, when push came to shove in the 2010s, they didn’t stick up for this position, because they didn’t really need it and it would have been politically costly. I think in the 2020s, the French are very keen on fundamentally refurbishing the nuclear fleet. That’s precisely the kind of thing that’s very effective, safe, and able to be quickly financed through debt. These are extremely long-lived assets that allow for higher leverage. If the French really pushed for allowing higher leverage, they should have that financial conversation publicly and build trust. Hopefully, we will get better fiscal rules through this process. 

   AK: Pedro and Clara, you ended by arguing that fiscal politics limit the ability of governments to spend on the working class, ultimately preventing them from living up to the fiscal promises they make during their electoral campaigns. If cuts need to happen, could they be made to disproportionately affect those with higher incomes, who are able to purchase health services or educational services on private markets, thus protecting those of lower socioeconomic status? If the pie of social spending has to remain the same in real terms, is there distributional space? 

   PRM: You make an interesting point on the changing nature from the economic to the legal character of fiscal rules. I want to make two observations. In Brazil, this legal side was diminishing. Dilma’s government was punished with regards to its budget management, and then the constitutional law in the spending cap that halted our capacity to conduct public policy.

   The new fiscal rule is not constitutional, and its punishment is not legal but economic. Both fiscal rules and social expenditure interact with the constitution and are at stake. This new rule is a policy option by the government to endorse social assistance programs, such as the Bolsa Familia, while entering a trade-off, which means that they will probably have to reduce provisions related to public health and education, as well as pensions and social security. This is related to the Brazilian state’s new form of social policy— opting for social assistance and income transfer policy, rather than public health and education in a way that would remind us of the welfare state. This would punish the poorest classes—social assistance can take people out of extreme poverty, they can remain poor. Importantly, Brazil needs free, universal, and well-funded public health and education. To me and Clara, adapting the size of social spending in the new rule will lead to a significant reduction in these provisions.

   AK: There’s an assumption around some degree of coordination between fiscal policy, administered by ministries of finance, and monetary policy, dictated independently by central banks. Can fiscal rules work in tandem with monetary orthodoxy, and if so, to what extent? Can we reform fiscal rules without reforming the central bank? 

   Also, why is Brazil so worried about deficit and debt? Brazilian debt is mostly denominated in Reals, and its domestic debt. Is the concern pure ideology or does it make economic sense? Is the government just terrified of having to go back to the IMF? 

   CZB: The answers are related. The origin of the fiscal rules in Brazil is the inflation-targeting regime. We had a period with very high inflation rates in the 1990s, and to control that, we had a change in our currency and system that ended with what we call the macroeconomic tripod. This is the inflation-targeting regime on the monetary side, and the fiscal responsibility law on the fiscal side. There’s the idea that you must control government spending to control inflation. 

   At the beginning of this year, we had nominal interest rates at 13.75 percent, in real terms around 8 percent. The central bank maintained that rate as they waited for the fiscal rule. We have a difficult situation where the inflation-targeting regime holds monetary dominance over the fiscal policy.

   If you reduce interest rates to control debt, you change the whole macroeconomic tripod. This would move the exchange rate and affect inflation—our biggest fear in Brazil given our past experiences. Consequently, all the discourse revolves around controlling inflation. The fear of growing debt was employed during Dilma’s presidency for her impeachment. As an ideological discourse, there was no actual evidence our debt was exploding and that we were going to careen off into high inflation. The Brazilian state is quite well positioned economically regarding rampant high inflation, but inflation is used ideologically. 

   AK: Max, I also wonder if you can speak to the coordination between monetary and fiscal policy. Given the current policy priorities around the green transition, what are the immediate next steps for strengthening the EU’s fiscal capacity? One option, of course, is reforming the fiscal rules. Another option could be to establish a permanent fiscal capacity through some kind of permanent investment fund that may be modeled after the Recovery and Resilience Fund (RRF). 

   MK: In a well-functioning macroeconomic regime, you would absolutely coordinate fiscal and monetary policies to achieve desired macroeconomic outcomes. In the European context, the European Central Bank (ECB) has actually been a fairly cooperative player. They’ve put in place the “transmission protection instrument”—a protective umbrella for states like Italy, whose interest rates might increase through spreads over Germany—which I’d argue is a key component for improving the European macrofinancial architecture. The ECB has said that as long as you meet certain criteria, including abiding by the fiscal rule, they will buy your bonds. The weight is then on sticking to the rules, which can put states in a difficult position—either you chop your leg off in order to abide by the rules and get the ECB protection, or be at the mercy of the bond markets without ECB protection. The operative issue that’s preventing reasonable cooperation between monetary and fiscal in Europe right now is the fiscal rules. It’s not the obstructive or excessive conservatism on the ground. 

   I don’t see the potential for a permanent RRF in Germany—both the conservatives and one of the three coalition parties aren’t willing to touch it before 2027. In Italy, a major beneficiary of the RRF, the spending is not fast enough—a result of lack of administrative capacity, which itself owes to a state of near-permanent austerity. I wouldn’t put too much weight on the RRF or RRF replacement. Fiscal rules reform is a much more promising space due to the highly technical nature of its structure. If you get the right players to support Green New Deal financing, you can make projections linked to Green New Deal spending, and so on. I am much more observant of the fiscal rules space. 

2. Swap Structure

   November 8, 2023 7:07 am Comments Off on Swap Structure

   Have interest rate swaps (IRS) become the modern repurchase agreements (repos)? In the latest essay in the ongoing series on Market Microstructures, I argue that shifts in the liquidity market have fundamentally altered the function of IRS in the global financial system. Today, IRS are used to fill funding gaps and compensate for failures in the repo market. 

   The following interview with Ralph Axel, an interest rate strategist at Bank of America (BofA), builds on this analysis, providing insights into the fixed-income market. Extensive experience in sales and trading desks has given Axel a thorough understanding of market structures, models, and risks. Below, we delve into the market structure of interest swaps, its connection with the wholesale money market, and regulator responses. 

   An interview with Ralph Axel

   ELHAM Saeidinezhad: Bank of America, which is a big player in the fixed-income market, is known for being one of the largest dealers in IRS—financial contracts in which parties exchange fixed interest payments with floating ones based on a notional amount. They create markets in IRS and sell them to participants such as asset managers and primary dealers, and they also make markets in fixed-income futures, and Treasury securities.

   Let’s examine the market structure for IRS. What is the dominant force that is fundamentally altering the market structure?

   Ralph axel:  In recent years, the Commodities Futures Trading Commission (CFTC) has discussed introducing new regulatory rules. These are aimed at examining the creation of new products for trading and defining capital requirements for swap dealers and major swap participants. The discussions are ongoing, with the CFTC working to ensure that new products benefit the market, while also considering the capital requirements of those involved in transactions. The CFTC aims to promote efficient markets while strengthening participant’s balance sheets.

   ES: These rules are separate from those introduced after the 2007-08 Great Financial Crisis (GFC), which were focused on increasing transparency in the market in the aftermath of GFC. Regulators have now shifted their attention.

   RA: Since the financial crisis of 2008, increasing transparency has been a crucial goal. In order to achieve this, regulators have implemented margin rules for high-quality collateral and clearing rules to push trades towards central counterparties (CCPs). These measures help create visibility, which was sorely lacking in 2008. It took a lot of work to know where IRS were located, who was facing whom, and what collateral types were used. Clearing and margin requirements have been at the forefront of regulators’ efforts to improve risk reporting, measurement, and tracking.

   Recently, regulatory focus has shifted towards strengthening swap participants’ balance sheets through higher capital requirements and closer examination of new products that may be considered swaps.

   ES: As someone who follows the markets closely, do you think these regulations are necessary?

   RA: These additional swap regulations aim to address issues in the repo market, albeit indirectly. I will later explain how the IRS and repo markets are connected. Going back to your question on regulation, in the repo market, current regulatory proposals that aim to push for repo clearing seem unnecessary.  In the swap market, the existing mandates introduced in Dodd-Frank and Basel III have already led to a smooth transition into swap clearing. Clearing swaps involves directly or indirectly submitting the swaps transactions to a Derivatives Clearing Organization (“DCO”) registered with the CFTC. In the government fixed-income market, for instance, the Government Securities Clearing Corporation (GSCC) has played a key role in this, handling government securities swaps with ease. In general, this process has been successful and has led to the development of relatively robust swap markets.

   ES: What is driving regulators to impose more restrictions on the IRS market? I am specifically thinking about capital requirements and new product rules that the industry has criticized.

   RA: The new regulatory interventions, although happening in the swap market, are not intended so much to fix the IRS structure but to stabilize the repo market. The repo market is a crucial wholesale funding market that helps to move cash around the financial system. The swap market plays a major role in enabling the flow of funds through the repo market. Therefore, regulators pay close attention to the happenings in this market.

   In the repo market, regulators, particularly the US Securities and Exchange Commission (SEC), advocate for the central clearing of the repo and US Treasuries to promote transparency. Similarly, the CFTC also pushes for increased swap clearing to enhance transparency in the IRS market. In addition to these mandates, the CFTC has implemented new capital requirements to improve the risk management and risk-absorbing capacity of the swap dealers and major swap participants. These regulatory developments positively impact both the repo and IRS markets.

   ES: You mentioned that swaps are crucial infrastructures supporting the repo market. The relationship between wholesale funding and swap markets is fundamental to the functioning of the financial system. Strangely, this connection is often disregarded in academic discussions. How do swaps make it easier to facilitate wholesale funding?

   RA: It is possible to observe a connection between the IRS market and the repo market by examining the business model of major swap participants. These entities, including asset managers and primary dealers, frequently use repos to raise funds and manage liquidity. In fact, asset managers constitute almost a quarter of the participating firms in the repo market, while primary dealers account for nearly 50 percent of the participation. These entities use interest rate-sensitive fixed-income securities, such as US Treasuries, as high-quality collateral to obtain cash in the repo market.

   Asset managers need to access funding through fixed-income securities. However, their funding depends on these securities’ price, which exposes them to price risks. To mitigate this risk, IRS can be used as a hedging solution. In the meantime, the repo market determines the funding costs for these firms, which are represented by the interest rates. At times, the repo market may offer unattractive or high rates, which interest rate swaps can mitigate. This process, known as interest rate management, enables asset managers to exchange these rates for more desirable and attractive rates. It is important to note that the conditions of the IRS market can impact the functioning of the repo market.

   But again, from an operational standpoint, it is striking how well the wholesale funding functions when you look at repo markets. 

   ES: The repo market is currently functioning well. However, as you previously mentioned, asset managers could use swaps to manage their funding costs if the repo market were to offer unattractive rates. This is a crucial function of swaps in the funding market.

   RA: An IRS is a financial instrument that helps entities manage their interest payments, including those related to activities in the repo market. Additionally, swaps help asset managers manage cash flow. For instance, asset managers can use IRS if they need to adjust their portfolio’s duration. Duration refers to the average time it takes to receive all of a bond’s cash flows, weighted by the present value of each cash flow. It is the payment-weighted point in time at which an investor can expect to regain their original investment. Liquid swap markets partially exist because swaps provide these essential funding-centric services.

   ES: Interestingly, IRS are often overlooked as a funding strategy. 

   RA: Yes, non-practitioners sometimes do not recognize the IRS market’s full potential. Typically, swaps are used either to hedge or speculate, which are their more classic functions. Hedging is an important because it can be used by both financial and non-financial corporate entities. For instance, if IBM plans to issue a bond within the next year and wants to avoid a situation where interest rates rise by 100 basis points, it can hedge today using the swaps market. This enables companies to plan more precisely for the future, leading to a smoother business cycle, even outside financial markets.

   ES: Should we expect spillover effects between the repo/US Treasuries and swaps markets due to regulatory developments such as clearing mandates?

   RA:  It is important to note that anything that limits the accessibility of high-quality collateral, including US Treasuries, for entities such as asset managers will increase the cost of repo funding. This increase in cost will also have implications in the IRS market. This is because the cost of managing the interest rate risks associated with these fundings will also increase. Similarly, any factor that increases the hedging costs will also cause an increase in the funding costs. Therefore, it is crucial to be meticulous when creating clearing/regulatory rules that affect the expenses of derivatives and repos. The functioning of the swaps and repo market are closely related.

   ES: The costs from the swap market, where interest rate management takes place, spill over to the repo market, where access to funding is provided, and vice versa. Regarding the new regulations on clearing mandates, are practitioners concerned about the costs that the restrictions may bring?

   RA: A more important question that needs to be addressed—who bears the costs? Specifically, when it comes to clearing, regulators must clarify who is responsible for bearing the costs. Are clearing house owners or capital owners on the hook? Additionally, how is the cost distributed among the participants? These are important questions.

   ES: Our focus has been on asset managers, but the Silicon Valley Bank (SVB) failure shows that banks also extensively use IRS. Can you explain banks’ applications for swaps?

   RA: The banking system holds approximately 17 trillion in deposits and frequently adjusts its fixed and floating rate exposures on both the asset and liability sides. Banks may opt for a fixed-to-floating rate swap through the IRS market to match their overall balance sheet interest rate exposure more effectively. The system is functioning well as these entities can trade swaps in a relatively liquid manner without encountering significant difficulties in determining market pricing, executing trades, determining trade size, and exiting positions without disrupting the markets.

   During the pandemic in 2020, swaps functioned properly while the cash market (i.e., the US Treasury market) needed the intervention of the Fed. Because people could not exit the market smoothly and functionally, the Fed had to buy many Treasuries. The current swap market is not in an emergency that requires fixing. However, it should be improved, simplified, and made fairer over time.

   ES: During the pandemic, you mentioned that investors faced difficulty in selling US Treasury holdings while they more smoothly unwound their swap positions. Although financial theories offer various ways for investors to exit swap contracts, what are the most commonly used methods in practice?

   RA: If a client has a swaps position initiated a few months or years ago, they usually approach a “swap dealer.” Like the BofA trading desk, these dealers could be large or smaller swaps dealers. These dealers have standardized pricing methods, crucial for clearing and enabling clients to exit their positions. The client would provide their swap’s payment schedule and maturity date, and the dealers would make a market in the swap. The client could enter or exit the swap, just like trading any other financial asset.

   ES: Earlier, you mentioned that the swap market was resilient during the pandemic because participants could smoothly enter or exit swap positions. Liquidity is a service offered by swap dealers such as BofA, vital in making the market for interest rate swaps. Can you tell us more about their business model and whether there will be any significant changes to their transactions or model due to regulatory changes in the near future?

   RA: We have trading desks for various financial instruments like IRS, repos, treasury securities, mortgages, corporate investments, high yield, commodities, and currencies. Each desk has a different business model. Generally, businesses require a certain amount of capital to operate, which can generate a certain return, making it attractive or unattractive. Sometimes, a business may not have a high return on equity, but it’s still important to keep it running as it provides a vital side service to other attractive businesses. Decision are made not only based on a business’s its return on equity but also on how it fits into the overall capital market operations. Swaps and cleared products are crucial to meet the demands of our client base. Interest rate risk and sensitivity are inherent in the fixed-income market, which makes swap dealers a fundamental part of the financial market infrastructure.

   ES: Standardization is a significant side effect of clearing mandates. Does standardization make the market-making more accessible, attractive, or challenging?

   RA: Standardization is very important. The value of any market lies in how usefully it facilitates trade. You can trade less standardized assets. But as you move away from the standardized products, the markets become less deep. And the pricing becomes more volatile, and liquidity deteriorates. We see that in many markets—Treasuries, mortgages, etc.—that started standardization before the swaps market. That is why important markets, such as mortgage-backed securities (MBS) and Treasury markets, are highly standardized.

   As you move away from standardized products, markets become less deep, and your pricing and liquidity are lower. This is why the IRS market is also growing highly standardized. We only have a financial system because the market can fulfill a need. We have a swaps market because so many entities have financial risk and the need to manage interest rates. They need to exchange fixed payments for floating payments. Everyone benefits if you have a IRS market that exchanges fixed for floating rate payments. But as it becomes more specialized, the number of people open to using the market declines—it becomes less valuable.

   ES: I want us to focus on the hedging momentarily. Some practitioners differentiate between hedging and risk management. In academic and policy discussions, they are often used interchangeably. Are there any differences between these two terms?

    RA: Risk management is a broader concept than hedging. Usually, when hedging, there are very specific instruments whose risk profile is changed. Let’s say a bank has a mortgage-backed security sensitive to interest rates. That’s a specific interest rate exposure, so they might trade a swap specifically geared towards reducing the interest rate exposure on that mortgage-backed security. Risk management more broadly incorporates more generic ideas. 

   Borrowing costs are a function of the overall interest rate level and its specific credit profile. As a corporation borrowing money in capital markets doesn’t know precisely what its borrowing costs will be next year, it can’t perfectly hedge. Likewise, as its credit profile can change in a year, it can’t really hedge—it can only hedge the approximate overall level of interest rates. Risk management tends to be performed by corporations that wants to manage overall exposure to borrowing costs by locking in their costs through a fixed tenure swap. That’s different from hedging the interest rate risk on a specific security.

   ES: I am also curious about the role of CPPs in all of this, including hedging. A CCP becomes a counterparty to trades with clients that are different market participants. Recent reports from the CFTC display concern for the behavioral diversity among CCP clients—hedge funds, asset managers, insurance companies, pension funds, and so on. Should we be concerned about this?

    RA: I think the more, the merrier. If you only had banks in the swap market, they would likely all go the same way—if they are generally making thirty-year fixed-rate loans, they all have similar risk exposure. They will all want to go in the same direction in the swap market to offset it. That would create a lopsided demand; you wouldn’t have many players or entities wanting to take the other side of that trade. When banks, hedge funds, insurance companies, asset managers, and corporations take different risks in different directions, the chances of a balanced market is much greater. Diverse entities spread risks, which is extremely important.

   ES: We started our conversation by discussing regulations and collateral (margin) rules. I want us to go return to that point. One of the things that the CFTC is trying to understand is whether there is a causal relationship between margin requirements and the liquidity of the IRS market—whether margin requirements create funding issues in the market. What do you think about this relationship between margin requirement and liquidity?

    RA: We have seen some problems with margin requirements. In the UK, pension funds struggled to meet margin requirements because the market had huge moves. The prices of assets declined significantly, and they were asked to put more margin in to protect against default. Suddenly, these funds were not able to make their margins. It’s thus important to have somewhat predictable margin requirements. If volatility picks up suddenly, you have margin requirements that were not projected or planned. That can be disruptive; if you can’t meet your margin requirements, you must unwind your position in the clearing house.

   That forced liquidation, sometimes called fire sales, is a risk. You can have caused liquidation problems for other reasons, like suddenly needing to meet liabilities. We want to minimize fire sales because they significantly impact the prices and liquidated assets and carry chain effects. We must figure out ways to reduce the risk of fire sales and forced liquidation by making margining more transparent and predictable. It’s very tough to do that because margin requirements move with volatility, but it is important to make margining less disruptive.

   ES: Finally, I want to discuss the hierarchy of financial instruments, where cash is at the top. CFTC reports mention that market practitioners prefer to hold cash as collateral and seem pretty puzzled about it. Is this the case, and if so, why?

    RA: Cash doesn’t have price risk, and everything else does. If you post treasuries and their price decreases, you might need to post more. That’s the main problem with non-cash—it has this exposure that can make it less valuable. The problem is that to get cash, you often have to borrow it; entities rarely have lots of cash sitting around because it’s an expensive thing to do. So, practitioners face a tough choice on the right collateral to use.

   Treasury bills have minimal price risk, while thirty-year bonds have a lot of price risk. Then you might have other types of securities, like government bonds issued by Germany or Canada, and so on. These might have the same property of moneyness as T bills or cash. It is undoubtedly essential to have some flexibility in the collateral types used. 

   One of the great things about insurance companies in the United States is that they naturally hold a lot of corporate bonds of various types. It’s beneficial that many insurance companies have collateral arrangements that allow them to post those corporate bonds. If something happens with a margin call for an insurance company, they typically will be able to adjust the margin to, let’s say, an increased margin requirement because they’ll post more of the assets that they already own, they don’t have to go out and find these assets to post.

3. Oil and Politics in the Mid-Transition

   October 26, 2023 1:51 pm Comments Off on Oil and Politics in the Mid-Transition

   A world with terminally declining oil demand has never been experienced before, but the growth era for fossil fuels is ending, as many producers, investors and forecasters are acknowledging. This does not put climate goals in close reach, as CO2 flows need to fall far more dramatically to reduce the stock that is already too high. But pathways to both energy independence and strategic export industries no longer have to involve fossil fuels. Instead, they center on new manufacturing capabilities and technologies, mineral resources, and increasingly delicate trade relationships and security alliances.

   Countries highly dependent on fossil fuel exports are seeking to diversify. Among the wealthiest countries in this category, Norway has been doing this most decisively via its sovereign wealth fund. Meanwhile, Gulf Coordination Council countries are deploying footloose petrodollars via private acquisitions targeting new industries and an increasing focus on development finance, especially vast forest carbon offset deals. Several low-income countries with fossil resources are hoping to develop them in time to exploit a declining market; while others such as Colombia and Ecuador are exploring ways to transition to new industries before the price decline.

   Today fossil fuel markets still involve great power plays between producers and consumers. Russia’s invasion of Ukraine was funded and buoyed by its export earnings and its apparently captive market for gas; the response by western countries also sought to weaponize fossil fuel markets through price caps and prohibitions on shipping insurance. Fossil fuel demand can change much more quickly than production, which—for oil in particular—expands slowly and capital intensively, and retrenches painfully for both sovereign and commercial producers especially those that rely upon higher prices. This lends itself to lumpy, chaotic pricing shifts, captured by the phrase “the mid-transition” developed by Emily Grubert and Sara Hastings-Simon. A recent IMF working paper, co-authored by one of our panelists, William Oman, applies this concept to cross-border relations to produce a framework that suggests both winners (China, India, Japan) and losers (Saudi Arabia, the US, Russia).

   Every country, whether a net supplier or importer of energy and transition minerals, is grappling with the new world.

   To discuss these issues, we convened a panel with Amy Myers Jaffe, Morgan Bazilian, William Oman,¹ Alex Turnbull, and Adam Tooze. You can watch the full discussion here. The following transcript was edited for clarity.

   A discussion on the geopolitics of a transitioning global energy system

   ADAM TOOZE: The theme of the panel could hardly be more topical. We are facing something completely new, a world which is now embarking on an energy transition in various messy, incomplete, but nevertheless highly dynamic ways. Our task for today is to begin digging into the geopolitical questions that arise from this.  

   Some of the questions that immediately arise: How do we think about who the winners and the losers are going to be? What are the prospects for various types of mineral-exporting countries? How does a world with terminally declining oil demand look? Getting into the weeds, we have to speak of an electric vehicle (EV) shock. This is happening as fast as anyone anticipated it could possibly happen, and in very dramatic ways—driven, of course, by China. How do we imagine a new generation of EV-centered subsidies playing out? What does the future of a more distributed energy system look like—one which doesn’t rely on the hunter gatherer model of discovering fossil fuel reserves, but instead is centered on farming wind and solar power?

   

   AMY JAFFE: I’m a big fan of Emily Grubert’s concept that we’re starting to build out the new energy system, but we haven’t integrated it or figured out how to get it to work well with the old energy system. I would say that oil demand itself is not going to fall evenly—there’s still a lot of places where oil demand is rising. The bottom line is, as we move forward, oil has become less inelastic. In the past oil served certain functions—especially in vehicles, but also in certain petrochemical sectors and other sectors—for which there was no substitute. Therefore prices could go way up and stay there until somebody drilled for more oil. But today with the digital world, I am able to own an EV. And even if I don’t own an EV, there is a strong possibility that I know someone who can give me a ride with an EV or that I can access a ride-sharing service with an EV. Individuals and communities can now actually move away from oil. 

   But we have a problem, which has arisen from the invasion of Ukraine. We’re now at the fiftieth anniversary of the OAPEC oil embargo, but we’re still not out of the woods: if OPEC+ pick a price that’s too high and we fail to damp down the inflationary pressures, high interest rates are going to crash the housing market in different locations. We could see a return of a pretty dire picture if we don’t get this right.

   I want to make one more point as we’re going to delve into metals. When you put a metal in my vehicle or in my virtual power plant setup, I’ve got to have it there probably for a decade. And then—because we’re talking ten years from now—I’m going to be able to recycle it. The US Inflation Reduction Act (IRA) is giving out billions of dollars for recycling of metals, and Vitol and some of the other big commodity traders are investing in recycling of metals as well. People want to argue that Chinese government controls these metal assets for processing, or that there’s a lot of these metal resources in this country or that country, but it’s not the same as oil and gas because you don’t burn it in one minute and then it’s gone forever.

   We need to move away from that storyline—which I do believe is a very oil industry-oriented storyline—that somehow these metals are just as bad. I’m not saying metals don’t have environmental impacts that need serious consideration, but it’s really a very different kind of thing. People said we’re going to run out of lithium—now there’s been a world historic find of lithium in India, so much that they’re not going to need to import lithium from anyplace else. Like oil, I think metals will suddenly appear in ways we didn’t imagine they would. It’s a commodities market, and commodities have a way of showing up when somebody needs them.

   TOOZE: Thank you so much for taking us into metals, oil, and finance all in one fell swoop. Morgan, which bit of this subject do you want to pick up for us?

   MORGAN BAZILIAN: I’ll say five things. The first is that, in 2008, I co-wrote one of the only textbooks that’s been written on energy security. It has the catchy title of The Analytical Methods for Energy, Diversity, and Security. In the second paragraph of the introduction, we warned about the dependence of Europe on Russian natural gas. It was obvious then. There were meetings of ministers happening all over 2008 to 2009 about transit through Ukraine. 

   The second is, I co-authored wrote a paper that was published in Nature, resulting from a scenario exercise we did for the German government—not the German Department of Energy or Economics, but the Ministry of Security, similar to the US State Department. In the paper, we came up with four different scenarios, wildly different outcomes, of things like oil versus renewable energy; we also included other fossil fuels and different kinds of energy. The most important outcome was that there would be—will be—winners and losers. It’s very easy to make goals. We see that all the time. Many of the world’s powers—maybe most—now have net-zero climate goals. In fact, Russia brought their net-zero goal to the climate talks six weeks before the invasion of Ukraine. And so one can be rather cynical about the value of making high-level political statements. The planning is extraordinarily difficult—not just politics, but engagement with communities and funding. 

   The third is, I co-authored a piece that tried to look at security in a different way. I believe we coined the term “actorless threat,” which was a way to look at how you move, at least in the US, from a military Carter Doctrine perspective on security toward a situation where there’s no place to put military force, per se—there’s nowhere to target a missile. The examples we gave were the COVID pandemic and climate change. 

   The fourth has to do with critical minerals. The straw man argument that we have to make an analogy between oil security and mineral criticality is long debunked. But a few things in the critical mineral space are important to keep in mind. One, it is true that China dominates, and the US is not going to catch up in the very short term—not just because China has planned for this over the last three decades, but also because they’re not waiting for us. They’re presently making enormous investments in those sectors. Two is that you have to think across supply chains and critical minerals. No one needs the raw minerals themselves; the value for the economy goes up as you move along the value chain to advanced manufacturing. The markets for these different things are minute, in most cases. They have very poor price signals, and they’re not liquid. Those are significant threats. There’s plenty of the stuff in and on the Earth, but there are challenges to using it. 

   The final thing I’ll say is that, at the Payne Institute, through satellite data, we see light and we impute heat. In other words, we calculate heat through basic equations of physics, and through that we have really a very different way to look at how energy security, national security, and human security are being reshaped. That has long been the purview of the intelligence community and the military; now those functions are, as an example, at a public university in Colorado.

   TOOZE: Thank you so much Morgan. That was fascinating. So, William, I’ll call on you, then Alex, and we’ll start going back and forth.

   WILLIAM OMAN: There’s been a lot of focus on the ways in which geoeconomic fragmentation and geopolitical rivalry matter for the prospects of global decarbonization; however, as my coauthors and I argued in our “Mid-Transition” paper, that there’s been much less focus on the potential impact of global decarbonization on geoeconomic fragmentation and geopolitical rivalry—the other way around. We build on the concept developed by Grubert and Hastings-Simon of the mid-transition, which we interpret as a volatile, unstable, and potentially chaotic period where we have the fossil-based energy system persists even as low-carbon technologies rise. We have some modeling results that show very large changes in energy exports, trade balances, and GDP among G20 countries at the 2030, 2040, and 2050 horizons. 

   A main conclusions of our paper is qualitative: the world economy may be entering this mid-transition, unstable phase. This is happening even as climate impacts and other impacts of the polycrisis worsen. In this context, there’s a real risk of the world economy being increasingly exposed to cross-border risks of an economic and financial nature, which would deepen fragmentation. This could ultimately disrupt national economies, global trade, and potentially even the international monetary and financial system. That would, in turn, interfere with countries’ ability to decarbonize. 

   In my view, the focus on winners and losers is missing a very big blind spot, which is that we’re facing a huge collective action trap related to political economy. Neither the middle classes in high-income economies nor the majority of developing economies have the means in the current international institutional configuration to achieve the transition. We are seeing the simultaneous occurrence of significant costs related to climate policies and rules of the game that prevent many countries from achieving a rapid transition. The risk is that this could give rise to a significant political backlash, with the rise of populist and extremist parties. We’ve already seen this recently in Germany, where regional elections over the summer were won by AfD, the far-right party; also the U-turn of Rishi Sunak.

   

   TOOZE: Thank you. This whole mid-transition issue is one that we’ve got to come back to. Alex, can I ask you to wrap up this first round of comments?

   ALEX TURNBULL: With the Australian National University (ANU), I’ve been modeling the details of these mid-transition dynamics, particularly with respect to China. China is in some respects far more advanced in activities like stockpiling, though they are loath to disclose these things, which leads to some interesting forensic econometric work. We have been modeling how China has been reconfiguring its internal logistics to essentially exit coal markets, and how their changes in grid investments could immensely accelerate the process. We are also trying to pick apart what exactly China does with its strategic petroleum reserve. China has really deep capacity, though its disclosure is not excellent, which makes it very hard for other countries to coordinate their behavior in response or anticipation.

   There’s also the issue with China—much like a lot of other countries and particularly the US—where it is a large domestic producer of a lot of fossil commodities, but also newer energy products. The issue is that you can have this very turbulent dynamic where a country can previously be a large importer of things and then make a very rapid phase shift to self-sufficiency, both policy-led and in response to changes in demand dynamics. This, of course, has very big macro implications for anyone who trades with China in commodities. 

   This mid-transition is almost, in physics terms, a phase shift. Unpredictable and nonlinear, it leads to very peculiar dynamics, where Europe can be absolutely hurting for gas one year and then swimming in it the next. It’s a volatile period.

   In the stockpiling work, I’ve taken a cue from China’s State Reserve Board behaviors, which offers a model for how other countries can achieve a smoother supply growth of these critical transition minerals. Having worked on, I think, seven lithium bankruptcies over the past twelve to fifteen years, it seems quite clear to me that the way we are not managing this challenge optimally this in the West.

   TOOZE: Thank you so much, Alex, for that perspective from the market. Sitting here with my historian’s hat on, I’m tempted to paraphrase Keynes. In the long run, are we always going to be in the mid-transition? I can understand why we need transition thinking; what I’m really puzzled by is the idea of the “mid.” That seems like a teleological construction that implies that we know that we get there, but you all are saying that the transition we’re embarking on is turbulent and there are many obvious points of resistance.

   JAFFE: I love how you framed it because I think you’ve really clarified down to the nub. I wanted to throw out an example from the state of California, which I think is further along in the so-called mid-transition than many other locations—even more than China. Because even though, as Morgan correctly points out, China has been plotting this line for themselves for decades, they are still highly dependent on coal—are in fact one of the world’s largest importers of oil. They’re buying LNG from the US as well. Despite our complicated relationship, they have ponied up even more for the new LNG terminals than the Europeans. 

   California seems to me a microcosm of what can go right and what can go wrong. One of the things that comes about in the mid-transition is that companies take different strategies—they have to decide what to do, and that’s influenced by what they’re forced to do by policy. California has this policy, which seems to be quite effective in terms of implementation—the low-carbon fuel standard, as per which fuel providers have to show increasing decarbonization or purchase carbon credits, which will get more expensive over time. 

   California is a weird gasoline market. Theoretically, you could ship in gasoline from Singapore or some other location, but there’s a limited number of ways you can bring it in by pipeline, which is the way most fuel moves around. They’re a little bit of an island nation in the sense that if a refinery breaks or something goes wrong, it has an instant price impact. 

   In California, a few of the refinery players have realized that as people move away from oil, a race emerges between those left with market power and governmental efforts to get people into electric cars and other kinds of transport solutions. The whole thing has blown up into a political scandal about this premium for gasoline prices in California, which is not really a direct result of carbon pricing or anything like that but more a symptom of the mid-transition. Because you have had refinery closures, there is market power. 

   A question arises: Are we going to say that the refineries are utilities now, keeping them open until there’s enough people to move? As Morgan also correctly points out, there’s also a justice issue. Are we going to accept a situation where people who are wealthy and have EVs or other means of transportation do fine, but those with an old vehicle that needs gasoline get socked with very high gasoline prices? Even though they’re further ahead on electric car deployment, boast a higher percentage of renewable energy, and are doing really well with batteries, a mismatch may still be brewing—a power struggle between the state government and refining industry over the path forward.

   TOOZE: William, when you talk about your mid-transition trap, how deep is that trap? The mid-transition concept has this incredibly strong teleological implication that we can define the middle. To me, it’s a little bit like the interregnum idea which floats around critical political economy that we’re between hegemonic structures. I’m always tempted to ask, what convinces you that there’s another one coming? In your modeling, how destabilizing is it to the overall narrative of transition?

   OMAN: We argue the transition is actually more of a transitory phase—not in the traditional sense of decarbonization policy discussions, where its basically presented as a controlled trajectory on a certain timeline with a certain shape of the curve. We interpret it in a slightly different way, as this volatile, unstable, and potentially even chaotic phase characterized by the persistence of fossil-based energy systems and the rise of certain low-carbon technologies. 

   We see the risk of a trap because of numerous cross-border feedback loops. To give you one example, the materialization of physical climate risks hit hydropower in Latin America, directly leading to a buildup of fossil infrastructure to offset that. Multiple countries face sovereign debt crises arising from different sources, which have led to an inflow of foreign direct investment into extractive sectors to address these countries’ foreign currency needs. There are also huge gas projects in Argentina. The climate crisis will continue to be fueled by all this.

   We also have in the background these biophysical dynamics going on that are, in principle, irreversible—contrary to the crises that we’re all used to thinking about such as the Great Depression, which can ultimately be reversed. That’s why I think there’s a blind spot on this discussion about winners and losers—because we will all be losers, in an absolute sense, if the current configuration persists. That is because we are likely to see these very significant binding constraints materialize both on resources and supply chains. 

   Regarding the policy implications, I want to speak about international coordination and cooperation, which has become a bit of a cliche. Regarding critical minerals, do we need an international agency? The International Energy Agency (IEA), World Bank, and International Renewable Energy Agency (IRENA) are all jockeying for leadership on supply and prices; however, I see this goal as a very concrete policy agenda for international cooperation. In the context of geopolitical rivalry, China and the US in particular make cooperation extremely difficult, but I think this has to be a kind of working hypothesis for a policy agenda. Because at the moment, I don’t see this being at the center of policy discussions.

   TOOZE: Alex, in the markets do you see solid conviction around the 2050, 2060, 2070 horizon for decarbonization? Or do you see the markets pricing for some sort of mixed and very unstable environment?

   TURNBULL: No-one cares about 2050, not really even in bond markets.

   JAFFE: Well, I think the question is: Are people today making capital investments with their eye out in a distance or only on the next couple of years?

   TURNBULL: I’ll give you an example. It is very hard to fund pumped hydro assets right now because they are five- to seven-year capital works projects, which are predicated upon diurnal price cycling spreads. The good news is that batteries have gotten a lot cheaper, and there’s a number of other, more modular long-term energy storage options. In Australia, we’re seeing this mid-transition get to a good place. During the Ukraine shock, electricity prices moved in sympathy with fuel costs, namely coal and gas. But now enough people have installed solar—utility but primarily residential—and the battery supply is large enough that gas burns on the Australian grid are probably going to drop by 50 to 60 percent. 

   From an industrial organization point of view, Australia is a little bit like Canada. Not as big and competitive a country as the US, it’s a little bit clubby. People tend to extract rents and engage in portfolio bidding. That’s going to completely break down because you suddenly have more players with peaking capacity, and that’s probably going to destroy pricing power on the market. Prices are going to be essentially pinned by a marginal cost of solar, plus or minus whatever spread a battery needs to make on a diurnal basis. 

   In oil and energy markets, the media coverage sometimes makes me want to scream. The reason is, it’s very hard to observe China’s petroleum stocks because they don’t like to report them. You can get it from satellite services for the above-ground stuff, and then for the below-ground there is the strategic petroleum reserve. The first rule about the strategic petroleum reserve in China is you don’t talk about strategic petroleum reserve—a lot of consultants who used to provide that data have been harassed and left China. But you can back it out by looking at stock flows.

   The funny thing is everyone talks about oil and ventures being super low right now globally; however, if you zoom out of the accounting anomaly in China, we’re probably at record stocks. China has been building up its petroleum reserves like crazy during COVID. As soon as they stopped, the market kind of fell out of bed. In a weird way, China’s been acting like a covert central bank of oil, a fact which is not very well appreciated.

   JAFFE: Are they trying to help the Russians? I mean, they’re taking oil from the Russians.

   TURNBULL: They have a really interesting problem. They had structurally declining diesel demand because they moved a lot of coal transport from trucks to rail. As a result, diesel cost per kilometer went down about 75 percent. Consequently, diesel demand fell, but it’s gone to the moon more recently because they’ve been buying all this heavier Russian crude and running it. Their real estate sector is so sick, though, they’re not able to use it. 

   My estimate is they’re sitting on about 200 million barrels of diesel stocks right now, which is quite a lot. But then just a couple of weeks ago, they decided not to bump their quota for exports. They’re either planning to blockade someone in the not too distant future, or this is just really incoherent policy.

   JAFFE: A lot of people say that they need diesel for reasons other than their economy.

   TURNBULL: Yes, and one thing I’ve been mulling over as we model things like coal and the grid build-out is, when you have a lot of pumped hydro and a lot of distributed solar, you don’t need as much gas for peaking, so maybe their LNG demand falls quite sharply. It hard to draw conclusions about Chinese governmental policy, as the data is not easily available. It is occasionally profitable, but not exactly easy work.

   JAFFE: One of their motivations for going green, quite honestly, was that the US now has its own oil. The US had this big boom with shale, and still has a thriving refining industry. The strategy of China going green was to be much more self-sufficient. That’s part of why it’s hard for them to commit to closing coal. And then the question is, if I’m building up all this oil, and the US has its own oil, why did I feel I needed all that oil?

   TURNBULL: They stockpile everything, and they are honestly great traders—maybe not as good as Glencore, but close.

   JAFFE: They’re stockpiling oil at a high price, no? They think it’s going higher?

   TURNBULL: They built most of their SPR over 2020 when transport demand imploded. More recently, over the pas three, four weeks, they have completely stopped importing. It’s like the Bank of Singapore managing a trade-weighted band for their currency—China’s effectively got a band for oil that they are quietly enforcing, which I think is kind of a good thing from an inflation stability point of view.

   

   TOOZE: Standing back from this, are we basically saying that the importing side drives this industry over the medium- to long run? In these transition stories, it’s the demand side that’s really king, right? It’s all very well to have your own oil, but in a sense it could just be a kind of a giant pile of stranded assets, especially if they’re expensive.

   TURNBULL: It’s good to have stocks so you can manage price volatility. China has been significantly growing its oil production and gas production in the last couple of years. Both are good things to have in order to manage price. A lot of transition assets are quite long-dated investments; wind and solar are about twenty-five years of cashflows. So if you can manage the cost of capital, that’s desirable for allowing the transition to occur. It’s an interesting tension, though—if China’s trying to enforce a price band of $70 to $90 per barrel, and Saudi Arabia requires, to break even fiscally, $85 to $90 to $95. It is also a question of, if you are an oil exporter, how do you fund your transition to the next thing? Whatever Saudi Arabia may want to export in fifteen years, it will be affected by buyers managing reserves in a different way. There’s lots of funny national interactions that are occurring, which are perhaps not as well publicized as they should be.

   TOOZE: I want to spin around and ask about copper. In the news coverage of minerals and metals, lithium is the heartbreaker—everyone expects it to make money, and then you go bankrupt because somebody discovered another lithium thing. If you look at the world through the lens of the Financial Times or The Wall Street Journal, however, the vision you get is a looming issue in copper because the expansion of capacity has not been there. Existing mines in Latin America are unpromising for political reasons, and the investment lags on these things are gigantic. If there’s one thing we feel reasonably confident about, it’s that we’re going to need a lot of copper, only a part of which can be acquired through recycling. Allowing for the fact that, in general, we buy the market dynamics in innovation and recycling and everything else, is copper the exception to that story? Or is that another kind of fallacy of commodity journalism? 

   BAZILIAN: I think about all these discussions in terms of priorities. There’s almost no country in the world where climate change is an actual political and social priority. And if you don’t have something prioritized then you’re not going to get very much done about it. 

   From both a public policy perspective and an investment perspective, we can do the right thing for the wrong reasons. When we think about critical minerals, the only reason that they are being talked about it—at least in the US, and to a large degree in other OECD countries—is because of the angst with China. It’s not because of some mid-transitions struggle or climate change imperative. In the US, of course, that means it’s one of the only things that’s remotely bipartisan. You could see that in the Congress if it were actually functioning. 

   Down to copper: Copper is very important for energy transitions; it’s very important for electrification, especially. It also happens to be incredibly important for munitions. Is there some sort of dearth in copper? No, there’s no dearth of resources of copper. But there are issues in countries that have copper—including political conflict the Democratic Republic of the Congo (DRC). Everyone talks about the DRC in the context of cobalt. But cobalt is a secondary mineral—you mine for copper, not cobalt. There are political challenges in Peru, Chile, the US, and on and on. 

   Interestingly, copper is not on the US Geological Survey critical minerals list. It is on the newer list that came out of the Department of Energy. That doesn’t mean it’s more or less critical. Of course it’s critical, and you’ve had some famous energy people like Dan Yergin write reports with S&P about it recently. Will it halt the energy transition? No, it will not. But people need to keep in mind that some people are more concerned about using copper for munitions than they are for transmission lines. I come back to my point about priorities—if you don’t understand where the priorities are, then you’re very unlikely to come to a reasonable answer or solution.

   TOOZE: I take that point. It is sobering to scan the world’s governments and ask who, in fact, is taking this seriously. Is there an energy expansion happening? Or is it the same old process, with new and added sources being thrown into the mix, pell mell? William, you had something you wanted to add?

   OMAN: I wanted to pick up on what you just said about energy symbiosis, the additive dynamics between energies and energy sources—which, I think, is another big blind spot in discussions. Independent of any trade and geopolitical tensions between the US and China, Europe faces a really steep challenge in terms of acquiring critical mineral. Europe’s supply of critical minerals contains only 3 percent local production; the target is to get to 10 percent by 2030, and to 40 percent of refining of metals by 2030. This is a huge challenge. There is also the fact that the EU taxonomy for sustainable activities does not include mining activities, and the related Sustainable Finance Disclosure Regulation requires that investors explain how their investments take sustainability into account, with the implication being that investment is not being steered toward the decarbonization-relevant mining sector. This is despite the fact that technical experts cited aluminum, copper, nickel, cobalt, lithium, lead, zinc, and precious metals as being essential for the transition. There’s a real contradiction there, with pretty big ramifications. 

   It’s important to realize that copper is not just important for the energy transition, it’s part of the vitamins of the economy. If we continue on the current trajectory of expanding consumption at the global level and gradually increasing income levels, this implies massive needs for copper for reasons independent of the energy transition. And speaking of EVs, there’s some big challenges that are being sidelined in discussions. The CEO of Stellantis recently said that if EVs are not affordable, you can’t leave a big chunk of the US middle class without freedom to move around. There are rumors that European Commissioner Thierry Breton reassured the auto industry in Europe that they would be able to export internal combustion engine vehicles to developing economies. The pushback on EVs comes from those saying the grid may not be stable enough in many developing countries, putting aside the question of affordability. 

   One last point on energy symbiosis. Vaclav Smil pointed out in Energy and Civilization: A History (2017) that a fundamental fact of energetics is that every transition has to be powered by the intensive deployment of existing energies and prime movers. It’s important not to underestimate the extent to which coal is needed to produce steel, which is currently needed to produce EVs, and so on. We may be able to decarbonize steel at some point, but we are not there yet.

   JAFFE: Morgan raises an important point: What is your priority for different materials? And how might that manifest itself in a war situation, as opposed to during peacetime?

   Part of the storyline of the Industrial Revolution, then followed by the World Wars, was that there were a large number of electric cars in the US in the 1910s. There was a lot of metal that was needed for munitions, as was mentioned above about copper. The US president deployed Ford Motor Company and other organizations to provide gasoline trucks and chassis and change their assembly line from electric to fuel-based vehicles to facilitate sending those vehicles to help Europe in the war. A war could actually be a definitive feature in shuffling away from a technology if it requires taking up materials.

   TOOZE: I’m trying to pull together the strands of this fascinating exchange. We started out with a kind of script, which was energy transition—we are mid-transition in regards to falling oil demand. And what I’m hearing is something different and more complicated. 

   Picking up Morgan’s point, maybe the energy transition is really no one’s priority. The real priority is great power competition logic, which energy technologies may play into. There’s every reason to think the Chinese government would, from their position in the world, have a substantial interest in diversifying their energy sources and stockpiling oil and minimizing their dependence on seaborne routes. But the way Alex described it, it’s not really a one-way street. It’s not an unwinding. It’s actually a kind of strategic play between the Saudi and Chinese governments. 

   And then we have a kind of general skepticism about California, a warning about the fragility of Europe, and Morgan’s point about how, really, when the chips were down, everyone clustered around fossil again. And then from William, a series of questions about the fragile states in-between. Because as complicated as the status quo is, the world that comes next for many of them looks even more complicated. 

   TURNBULL: You’re the historian, but I’m not sure state behavior and priorities really change much, ever. When you throw a new technology in the mix, whether that’s nuclear weapons or cheap renewables and storage, all that changes is the lay of the land in terms of priorities and edges countries can get. 

   Given the current trade contention over EVs—if EVS exist at a reasonable price point and people are willing to purchase them—companies, particularly like Geely, really cannot compete with the Volkswagens. So they just said, alright, if we’re going to be relevant, we have to go all in EVs. There was definitely a good amount of state support, but there was also a calculus that we’re not going to have an export sector in this space otherwise. And of course, they’ve succeeded wildly there. 

   I’m not sure priorities really changed that much; I think Morgan’s absolutely correct on that. But once these technologies get to certain price points and availability, people have to deal with them. They have to integrate them into their calculus one way or the other.

   TOOZE: How bad does the climate crisis have to get before it has impact on these systems? William reminded us that we’re all losers unless something acts. Implicitly, what we’re saying is that, for all relevant purposes, over the next ten to fifteen years, the climate crisis is actually bracketed for the big actors in the system.

   TURNBULL: I would say that the bad thing about the climate crisis is that hydrological cycle intensification tends to destroy infrastructure. The good thing about renewable technologies is that they tend to be sort of anti-infrastructure. 

   The Panama Canal water levels are quite low right now. Shipping is starting to be constrained, and most global shipping is just moving around joules. That means we’re getting to a point where there’s a real confluence between bookish security people and people that care about climate.

   JAFFE: Europe installed a giant amount of renewable energy. They put in solar, and Germany added batteries. They made announcements that they’re going to triple their targets for renewable. So I think the war actually hastened the transition, not the other way around. It just set back last year’s emissions for some temporary fixes.

   TOOZE: Morgan’s hypothesis becomes more relevant when you ask the question: Can the most progressive government in Europe get serious about heat pumps? In fact, that is very difficult. But Morgan, you wanted to come in?

   BAZILIAN: I liked what Alex said about this convergence of interests. That’s why you see the military in the US talking about climate and security. And what Amy said—of course, it’s exactly right that you asked, what will it take to take climate seriously? War is one thing. But to go back to my point, we can use things people really care about—like security, like air and water pollution, and like economic development—as prime motivators that will help the climate as well. You can get some of these happy coalitions. But if you insist on transacting everything through a climate lens, it is, in my view, not the most powerful nor the most effective way to make those transitions.

   TOOZE: There are some constituencies where you may be able to sell climate head on, but in the vast majority of places, it’s got to be in combination with, exactly as you put it, either pollution, or cheap energy, or development, or national security. It’s got to be coupled.

4. Marketing War

   September 30, 2023 5:00 am Comments Off on Marketing War

   Sudan’s ongoing war between the Sudanese Armed Forces and the Rapid Support Forces has killed thousands and displaced millions. The current crisis follows years of political upheaval across the country. In late 2018 and 2019, mass protests calling for democratic rule led to the collapse of the President al-Bashir’s thirty-year regime. By the summer of 2019, different factions of a military-civilian interim government had agreed to embark on a transition to democracy, but in October 2021, the commander of the Sudanese Armed Forces—with the aid of the Rapid Support Forces—took control of the nation in a military coup. Since April, a conflict between the two generals and former allies has descended into what many observers have called a civil war.

   Magdi el Gizouli is a scholar of the Sudan whose main interests involve political economy and intellectual history. He writes for the Rift Valley Institute and his blog Still Sudan. In the following interview, Magdi el Gizouli discusses the ongoing war and the long history of “accumulation by militia” in Sudan. Looking back at the country’s role in the war in Yemen and the policies of the transitional government, he links Sudan’s militarization to its place on the periphery of the global economy.

   An interview with Magdi el Gizouli

   Adam Benjamin: What are the origins of your scholarship on Sudan?

   Magdi El gizouli: Intellectually, I belong to the tradition of the Sudanese communist movement. Most of what the Communist Party produced in the 1960s and ‘70s was about ways of explaining Sudan’s political evolution. There were many politically minded pamphlets and books, with a predominance of historical narration, things that sound very biographical, autobiographical, and heavily contested.

   There’s a large body of work on political economy that came from a sort of academic left in Sudan in the 1970s and ‘80s, though some of these authors were not necessarily aligned with the Communist Party. That sequence of work stopped somewhere in the late ‘80s. Since then, there has been very little investigation, for instance, of the emergence of oil in Sudan, the types of insurgencies that evolved in the last twenty or twenty-five years. The whole Marxist approach to the world became a sort of memory in Sudan’s intellectual history. My own interests come from trying to understand how the current situation came about, including the predicament of people like myself who are spread around the world, in cycles of migration and expatriate labor. I also sought to understand the longevity of President al-Bashir, who ruled from 1989 to 2019. I’m still baffled by how he was one of the longest rulers in Sudan since the exit of the Turkish Ottomans. Now, I’m interested in the aftermath we’re living through.

   AB: Can you describe the context of the most recent and ongoing iteration of the conflict?

   Meg: The current war is described in some influential circles, especially in the media, as a war between two generals leading two military formations. The first is the Sudanese Armed Forces (SAF), the state army that goes back 100 years, when the British established a standing army in Sudan. The second is the Rapid Support Forces (RSF) which emerged from an insurgency and counterinsurgency campaign against the Khartoum government, which was, as many authors have noted, counterinsurgency on the cheap. The RSF initially recruited fighters from the pastoral belts in North Darfur and set them against Darfurian insurgents and their communities but has since developed into the war machine it is today with battle experience in Sudan, Yemen, the Central African Republic, Libya and Chad. Today, it has the contours of a civil war. People of many social backgrounds are being mobilized, willingly or unwillingly drawn into it. There are not many choices left when a war plays out in a capital city. In any case, describing it as a war between two generals might not give a true sense of its depth and spread. 

   The proximate reasons for the war, however, do lie in the barracks, in a dispute over command and control. Two leaders—the RSF’s Mohamed Hamdan Dagalo (General Hemditi) and the SAF’s Abdel Fattah al-Burhan—were capable of working together, including in the coup of October 25, 2021. They sidelined politicians who had taken over the reins in the transitional government following the collapse of President al-Bashir’s regime in 2019.

   But al-Burhan and Hemditi’s ability to work together was undermined by the fact that they were resourced by two competing networks, each tied up to a different regional power bloc. The conflict seemed for many observers, including myself, almost inevitable. The first rumblings of this war go back to the formalization of the RSF as a separate fighting force independent of the SAF chain of command in 2013. These rumblings became considerably louder with the ouster of President al-Bashir when the RSF leader was officiated as the effective deputy head of state. He probably soon recognized that the offices of the Republican Palace on the bank of the Nile could easily become luxury observer balconies, and that the arteries of power flow out of the SAF headquarters. 

   AB: What do you mean by competing networks?

   MEG: Talking about regions invites a racialized logic which simplifies but does not clarify. It is true that recruitment to the RSF ranks is predominantly from Darfur and Kordofan, and senior officer ranks are populated by people from riverine Sudan. The two fighting forces share in the common resource of the pool of young people who have lost out in the rural economy, a surplus workforce. How do two brothers end up fighting in two different camps? This occurs not for ideological reasons, but because of the contingencies of a militarized job market and regional networks of power, commodities, and weapons. 

   There is an old trading network in north and central Sudan, making up Sudan’s bourgeois. Through trade, they have relationships of accumulation with the external world that rely on systems of rural extraction around agricultural commodities within Sudan. These center around forest commodities like gum arabic, agricultural products like sesame, grain from the plains of Central Sudan, and livestock. These systems of trade and extraction from the rural countryside have a long history. The establishment in Sudan grew out of the world of itinerant traders from the riverine heartland known as the jellaba who feature strongly in this history as major protagonists. 

   AB: You describe the system in your article “Creatures of the Deposed” as a sort of accumulation via rural militia. What is the rural militia’s relevance to the situation?

   MEG: The rural militia has many iterations, including the slave army that Zubayr Pasha recruited in the 1870s to topple the Darfur Sultanate. The British also recruited militias in the Nuba Mountains and relied on them to get ahead of militant resistance. In a way even the Sudanese army, initially the Sudanese battalions in the Egyptian army, began as a sort of militia. Regimentation was no easy task and hasn’t yet succeeded. The history of the Sudanese army is in many ways the history of rebellions against its authority from within its ranks and from without. There were militias raised in the 1980s, after the big famine of the Sahel, as part of the war against the SPLA in southern Sudan, which became a ravaging force in border zones between northern and southern Sudan.  

   The most successful version of the rural militia is the RSF, because the interests of that particular militia coincided with regional interests that didn’t exist in the 1980s or even before. Besides fighting an internal war in the desert zones and clay plains of Darfur, this particularly successful militia had the opportunity to fight a petrodollar funded war in Yemen. Some elements of that happened in the Libyan-Chadian war in 1980, but not with that scale, level of armament, or experience in fighting. The RSF had been fighting in Yemen for a few years before the al-Bashir government was toppled. This created an opportunity where there were independent relations between the RSF leadership and their employers in the United Arab Emirates (UAE) and Saudi Arabia, independent of the formal channels of the Sudanese Armed Forces. It became a sort of expatriate private security firm that young people looked to as a way of improving their livelihoods. 

   The war in Yemen was a doorway to these aspirations. Sudan had suffered the big post oil slump after the secession of South Sudan. There was a big deficit in the balance of payments and foreign exchange. There was a massive inflationary wave, and people needed to supplant their wages. One way of supplanting the wage of soldiers was to give them the opportunity to fight an external war, with foreign patrons.

   In that vein, UAE-based companies were recruiting fighters in Khartoum through employment agencies. People thought they were being recruited to work in supermarkets in the UAE, and they ended up in training camps in Libya. This caused a public outrage—a democratic outrage. People marched in the capital and attacked the UAE. This was the democratic blossoming of the 2018-19 revolution which ultimately facilitated the end of the al-Bashir regime. 

   In one way, the crisis of the RSF began when the war in Yemen cooled down. Thousands of fighters came back to Sudan from Yemen, and they needed income, employment, and some level of insurance. These were all young people who still had years of fighting careers ahead of them. The RSF had to manage its cash economy in terms of its investments, and it needed to find a purpose for these fighters. Any other corporation would start shedding off workers, but it’s very hard to shed off soldiers. There were two ways ahead for the RSF. Either it would dismantle itself in some way, which wouldn’t align with the interests of its leader Mohamed Hamdan or his Gulf patrons, or it would expand. But there was nowhere to expand except by capturing the state. The RSF commanded a significant portion of Sudan’s newfound gold, a new commodity that the old trading system was not capable of absorbing because it was geographically spread in a way that taxing it property and managing its labor force and its export routes or smuggling routes would require a widely spread mobile armed force with a stake in the commodity. The RSF was that armed force. 

   AB: So the relationship with commodities is malicious? 

   MEG: Yes, absolutely. These gold mines were spread all across the country, and since as early as 2016, the RSF served as a privatized army to provide security along transit routes, to transport equipment, and to smuggle gold out of the country. It was involved in running a parallel export system of gold to its benefactors in the United Arab Emirates. The UAE is effectively the sole recipient of Sudanese gold abroad—it has an almost complete monopoly over its gold exports. At the time, Sudan was under sanctions. After Khartoum’s readiness to sign the Abraham Accords with Israel in 2020, the United States started lifting the sanctions. But the UAE’s monopoly and facilitation of gold exports from Sudan precedes the signing. 

   The RSF discovered other networks as well: if you have a well-functioning smuggling network around gold, the same network could function for other items, including narcotics. In a sense, the RSF was functioning like a big mafia. This explains its penetration into urban neighborhoods, because many people became tied up in the RSF system through the narcotics market. The RSF could still funnel narcotics—just as it did with gold—through Port Sudan or the Khartoum airport, because in a way, it was part of the state. 

   The RSF works in the countryside through its investment in debts—a market in debts, people-selling by index. The RSF was heavily involved in those sorts of Ponzi schemes, in places like Nyala, al-Fasher and later on in Khartoum. The collapse of oil and the devaluation of the Sudanese currency by the interim government led to a big inflation wave after 2019, facilitating this market of debts for a vast tract of impoverished people. The RSF was a lending agency that could trap people into debts, even lending people to serve traders’ prison sentences, and that’s how it managed to enter rural trading networks beyond northern Darfur. 

   The commodities that allowed the RSF to penetrate into the urban and rural worlds were gold, debts, narcotics, arms, and contraband cars. Cars helped attract capital from outside Sudan to tie up with the RSF system. There was a massive influx of contraband cars coming in from Libya, these were mainly stolen or hijacked in the Sahel zone. You could buy such a car at a discount price in Khartoum with the blood of the previous owner on the headrest of the seat. In the Khartoum network, they were turned into reusable capital. There was a lot of organized looting, lending, drug selling, and an illicit trade of arms. This provided a lot of people with a source of income. The RSF is a big employer. You could find a job with RSF as a soldier, but also in many other functions. This was an alternative network of opportunities away from the state system—with its degrees and paperwork—and away from the crushingly exploitative agricultural labor system. 

   AB: You describe a status quo with the RSF, the militia form, and these networks of merchant capital emanating from Khartoum and the Nile Valley. In other places, you’ve also written that the Sudanese revolution of 2018-19 represented a rupture with the status quo of sequential military dictators, forged out of an alliance of informal workers and radical students. In this most recent iteration of the conflict, what is the position of the Sudanese revolution, its democratic ambitions, and the neighborhood councils that it formed? 

   MEG: What is unfolding is, in a way, the counter-revolution. The first element was the military crushing of the sit-in in Khartoum in June 2019, which involved the RSF. Now, it’s not just one part of the city but the entire city that is being crushed. Militarized systems don’t tolerate the democratic impulse that comes from revolutionary movements. 

   The revolution isn’t just these few events, the revolution is that impulse. I don’t think that impulse has died. In my opinion, even the war is in part a response to the problems raised by this democratic impulse which found its expression in 2018. But the urban world that sustained that revolutionary impulse is being destroyed by war. While many observers might mock the urban revolutionaries as dreamers, they did express an emancipatory trend in society. This democratic trend came from the contradictory world of the Khartoum milieu, now turned into rubble. 

   I think it would be too hasty to make definitive statements on Sudan’s revolutionary movement. It’s a devastating war—the scale, scope, and depth are yet to be fully understood. But history is cunning. The challenge is how to align the urban crisis and the rural crisis in one synthetic moment. There is the fascist answer of the RSF, and then the democratic answer offered by those trying to sustain life. The RSF promises redistribution based on plundering private property; it relies on a princely figure, racist rhetoric, and a praetorian fighting force.  

   The left, or whatever is left of the left, has not come up with a coordinated answer. It has the practice, the experience, and the resistance committees, but it doesn’t have the machinery. Still, you can see the flourishing of regional towns as a response to the war in Khartoum, as if the capital is being exported to places like Kassala, Gedaref, and Shendy. These were small, sleepy towns for the past forty years, and now they’re becoming lively, bubbly places, of course, under extraordinary conditions and immense pressure. Still, it’s as if a new urbanity is being rediscovered outside the limitations of the capital. 

   AB: In another article, you point to neoliberal trade policies and austerity measures as key hindrances to the revolution and the demand for democratization. What role has neoliberalism played in the longer history of the deterioration of both the Sudanese revolution and the situation between the RSF and the Sudanese Armed Forces?

   MEG: Neoliberalism does not just have a role, it is the logic central to this entire argument. The RSF itself is a neoliberal army. It is the privatized version of an army in the third world, in a rural periphery. If Margaret Thatcher were to create an army in rural Sudan, it would be the RSF. It functions as a corporate structure; it is led by a single family and is not answerable to anybody. There is no way of controlling or challenging the demands or decisions of the RSF leader. Here, the market system creates new commodities and sells them, even when no market previously existed. The narcotics the RSF sells, crystal meth for example, are a completely novel commodity in the Sudanese market. The need for narcotics is a creation of the market system. 

   In that article, I was hinting at Sudan’s severe inflationary crisis. The inflationary tensions needed to be eased in order to make the revolution pay out to the people. The dividends of the revolution would serve to relax the market pressures on Sudan’s citizens through policies like free health care and free education. These objectives of the revolution were never achieved because the movement involved two major elements: laboring people from the informal sector aligned with a radical sector of students, and a leadership comprising Sudan’s expatriate classes, well-paid professionals often working abroad. The former were the foot soldiers of the revolution, but the leadership had largely neoliberal inclinations. 

   Taking cues from the UN and the IMF, their model was based on the premise that if you enact a free market system, austerity measures, and liberal market reforms, a flourishing entrepreneur-friendly environment—possibly with a nascent democratic state—might arise. This was the Western formula for democracy, and it would work if you applied it hard enough. One application of that was to push through austerity measures and currency devaluation measures, which have a history in Sudan going back to the 1970s. These measures amplified the rural-urban crisis in ways unseen before. The only remedy of the transitional government was the so-called Family Support Program, which was supposed to be a cash transfer program supported by the World Bank. It didn’t work organizationally or financially. 

   The first finance minister in the interim government, Ibrahim al-Badawi, said it very clearly—Sudan would need to shed its debts—or around USD70 billion—and it needed another $10 billion to get going somewhere. That was the depth of its crisis. Of course, nobody in the international community, no democracy-loving statesmen would put anything close to that on the table. Austerity prevented the funding of the democratic transition in Sudan. Once the size of the bill became clear and even before the coup d’etat of 2021, most of those who promised to support pulled back their wallets and left Sudan to its crisis.

   The transitional government had two contradictory objectives: austerity and democracy. But austerity could only be enforced through military means. If you want a democracy that imposes austerity, you need to have a certain level of ideological dexterity and capability, as well as the mediation of parties like the Social Democrats and Christian Democrats. Sudan is very far from that. The interim government did not have the kind of ideological control required to enforce austerity via democratic means. In Sudan, the system could not withstand the pressures and demands. Eventually, it made everybody poor, and so everybody looked for a weapon as a way of making money in a poor environment.

   AB: You’ve outlined the neoliberal dimension that influenced the application of this democratic impulse. What are the roles of other organizations in this process that might be operating contrary to this neoliberalism—such as communists, Islamist parties, or Sufi brotherhoods?

   MEG: The postcolonial political order in Sudan has lost the ability to reproduce itself. You can see that in the deterioration of the Communist Party, but also in the deterioration of the Islamic movement. Many of the movement’s leaders are semi-functional, incapacitated by their own financial interests and private lives. You can find senior Islamist figures in the RSF today. There is no longer a coherent Islamic movement, and their splinters have little to do with Islamist ideology. You see the same problem in the communist movement. Some of the RSF’s top propagandists had a history in the communist movement and its satellite organizations. 

   One of the slogans of 2018-19 was that the army belongs in the barracks, and the RSF should be dissolved. As you probably know, all fantasies have a tendency to become nightmares. Now one might argue that the RSF is being dissolved by firepower, and the whole country has become a barracks. The military is everywhere. In fact, the revolutionary movement correctly named the problem of militarization. It’s playing out as a war. 

   It’s difficult to speculate about revolutionary events of this scale. But what I can see is that Sudan’s democratic culture is threatened by the destruction of urban life, especially in Khartoum. The city’s cultural achievements, intellectual achievements, its heritage, and its symbols are being destroyed. The city’s legacy goes back to the first demonstrations of informal laborers in the 1920s and the 1923-24 White Flag League. The city will probably reinvent itself, but in forms that I’m not sure I can predict at the moment.

   AB: The situation in Sudan is not entirely unique. What does accumulation via rural militia and the status quo mean on a world scale? And what does this tell us about peripheral capitalism more broadly?

   MEG: There are some scholars who focus on the question of Sudan’s mercantilism, characterizing the economy as a kind of truncated capitalism or an inefficient capitalism. 

   But Sudan does not have a truncated form of capitalism; instead, I’d argue that this is how it works in the periphery. When there is a dominant center that decides a country’s currency standards, determines its labor policies, and holds a monopoly on its only export, the country will remain truncated. Only war can deepen that capitalism, because the economy must perform more functions of primitive accumulation, the type of functions that come out of militarizing security incidents or turning security into a private enterprise. 

   One function of the RSF has been transforming the security of trade routes, agriculture, and the harvest season into marketable commodities. If you want to secure your harvest, you need to pay off the RSF to make sure that you’re protected. This is how the trade and the market system work in countries like Sudan. Safety, and even the moral economy of mutual aid, must become marketable. I think this tells you something about what happens when there’s nothing left to sell except bare labor, which, in today’s circumstances, is the militarized labor of a sixteen-year old who has to fight in Yemen to keep the family alive. This is the exploitation of labor in its militarized form. You’re turning from a productive economy that works around consumable products into a destructive economy that works around narcotics, contraband cars, and humans—soldiers for killing bodies in somebody else’s wars. 

   This phenomenon isn’t confined to the RSF. Maybe Sudan is something of a pioneer, but you can see similar occurrences in places like Yemen, Syria, Iraq, and Afghanistan. This is a belt of countries in which integration into the mainstream is failing, so the militia form is becoming the most efficient way to keep societies functioning in a market system. These countries are blocked from integration by walls of trade, but also by seas of corpses like the Mediterranean. To my eyes, this is the world that is emerging. 

5. Defining Bidenomics

   September 2, 2023 8:00 am Comments Off on Defining Bidenomics

   A new American industrial policy—“Bidenomics”—has arrived, consisting of the Inflation Reduction Act (IRA), the Infrastructure, Investment and Jobs Act, and the CHIPS and Science Act. The proclaimed goals of Bidenomics are to propel a green energy transition to confront climate change, revive American manufacturing and union density, and check China’s economic and military power. President Biden recently described this economic agenda as a “fundamental break from the economic theory that has failed America’s middle class for decades now, trickle down economics.” National Security Adviser Jake Sullivan criticized “a set of ideas that championed tax cutting and deregulation, privatization over public action, and trade liberalization as an end in itself,” synthesized in the belief  “that markets always allocate capital productively and efficiently.” The Biden administration, in other words, has been forthrightly repudiating neoliberalism, at least on the level of rhetoric. 

   A new landscape for political and economic struggle is emerging, but many questions remain. Will Bidenomics actually help achieve the critical goals of reviving working class power and confronting climate change? To what degree does this new political economic paradigm signal a sharp break from neoliberalism? How closely is Bidenomics linked to US policy concerns around Chinese dominance and the threat of a “New Cold War”? Finally, where do these policies leave the global South? 

   In the following conversation, Daniel Denvir interviews Daniela Gabor, Ted Fertik, and Tim Sahay. Daniela Gabor is professor of economics at University of the West of England (Bristol). She studies development and debt with a critical macrofinance lens and researches the capitalist derisking state. Ted Fertik is a historian and strategist at the Working Families Party. Tim Sahay is the co-editor of The Polycrisis, focusing on the domestic and international political economy of climate. Listen to the discussion on The Dig here. The transcript has been edited for length and clarity, and is co-published with Jacobin Magazine.

   A conversation with Ted Fertik, Daniela Gabor, and Tim Sahay

   Daniel denvir: First coined by outside observers, “Bidenomics” is a term now embraced by the Biden administration. What is Bidenomics, and what does it have to do with industrial policy?

   Ted fertik: From the perspective of the administration, Bidenomics has three key aspects. First, there’s a distributional aspect, about building the economy “from the bottom up and the middle out,” which is an explicit rejection of trickle-down economics. Second, there’s a sectoral industrial policy aspect. Third, there’s an emphasis on place-based policy—both in a global and a domestic sense, with a lot of concern for communities that have borne the brunt of deindustrialization.

   TIM SAHAY: Bidenomics is a new legislative and macroeconomic policy mix, developed by Democratic Party elites to contain the threat of Trumpism. It’s their answer to the question social democrats are asking the world over: Why can’t the center hold? Their diagnosis is that economic and political polarization was created by the winner-takes-all, low investment, low growth, neoliberal policy regime. The gap between those with and without college degrees widened (that’s the class component) along with the gap between “Super Zips” and suburban and rural areas (that’s the place element), which created political instability. 

   They want to reverse these trends by pursuing a legislative investment agenda to restore broad-based growth. On retaking Congress, they pursued a “big fiscal” program—to put money into people’s pockets as well as increase the overall sum of public and private investment. Bidenomics also has a macroeconomic component of running a hot labor market with the Fed targeting full employment and risking inflation going above the 2% target. Together these created a high pressure economy that creates upward mobility for people at the back of the labor queue. The gaps between black-white unemployment rates and wage growth for those with and without college degrees has narrowed dramatically.

   How do you design spending packages with those class, place, race inequality-reversal goals? These policy provisions include “buy American” and “make in America” requirements, subsidies for manufacturers, federal loan guarantees for green projects, place-based incentives, and public R&D to boost future growth. They include plugging the terribly patchy welfare system through earned income tax credits, unemployment insurance, and SNAP expansion. These have been paired with pro-labor provisions that seek to increase union density and create jobs for those without college education. 

   How do you pay for it? Do you tax or do you borrow? Here their choice was to make bills “paid for” by progressive taxes on the rich and closing tax loopholes of Fortune 500 companies. This component of Bidenomics should not be forgotten. The different factions of the Democratic party—Wall Street and Silicon Valley friendly centrists and progressives—had a slugfest in Congress over taxes. That reduced the size of the spending packages, leaving behind whole swathes of Democratic caucus priorities—childcare, pre-K, schools, public housing, public transit. One must remember that Bidenomics has been hugely contested and shaped by the thin Congressional majorities that it is trying to fix.

   DD: There are three key legislative aspects to Bidenomics: the 2021 Infrastructure Act, and the 2022 CHIPS and Science Act, and Inflation Reduction Act (IRA). What does this bundle of legislation set out to do? How does it seek to expand productive capacity in particular sectors to drive the green energy transition? And how do the three pieces of legislation fit together? Can it be said, as Lachlan Carey and Jun Ukita Shepard do, that CHIPS is the brain, Infrastructure the backbone, and IRA the engine? Is it really that coherent? 

   TS: That is a good metaphor. While I don’t think that the Biden White House and Senator Schumer and Speaker Pelosi made an active decision to split up the bills—that was forced on them in negotiations with moderates—there is a coherence. CHIPS and Science Act is the “brains,” because it is aimed at improving research and development, and pours money into the entire alphabet soup of American science: technology, medicine, biotech, and all of R&D agencies. Furthemore, those agencies have their own research institutes—such as the National Institutes of Health—which are spread across the country, not just located in the high tech clusters around Cambridge, Massachusetts or Silicon Valley. Therefore they would help reverse polarization by bringing innovation and productivity to other clusters across the country. 

   As for infrastructure, the Investment and Jobs Act is the “backbone” in the sense that it’s meant to create the grid and rural broadband. For example, $60 or $70 billion have been funneled into modernizing the grid, which is presently unable to take on the huge amount of renewable energy that needs to be installed. The IRA is an “engine” in that it comprises an enormous artillery of public finance for loans, grants, and tax credits that build out this renewable energy system while driving manufacturing growth. But legislatively they have different logics. CHIPS and IIJA are bipartisan with 14 Republican senator votes, while IRA is Democrats-only. The bills were split up against the desire of progressives in Congress who lost leverage in that compromise.

   TF: Though it has perhaps been less emphasized in recent debates, the Biden spokespeople would claim that the American Rescue Plan (ARPA), which was passed on a pure party line vote in March 2021, serves as the fourth Bidenomics bill. It is based on the idea of running the economy hot, using raw fiscal power to juice aggregate demand. It also included programs like the expanded Child Tax Credit, which points towards the aspiration of Bidenomics to make structural changes to the US welfare state, even though these were ultimately shorn from what became the IRA. 

   The coherence of these bills can be found in understanding the set of problems that they’re meant to address. In an earlier talk that Tim and I gave, we laid it out as a triangle: what China’s rise means for the US economy and its “global leadership,” the question of the US political system and the sort of intertwined questions of inequality and populism, and lastly, climate. All of these three terms interact in important ways.

   DD: Daniela, you’ve argued that these measures are fundamentally flawed as they prioritize a narrow form of government intervention, namely, the derisking of private investment. What is “derisking”? And why does it fail to get us to where we need to be in terms of reaching zero emissions and other related goals like increasing union density and raising worker wages?

   Daniela Gabor: Let me take a step back from derisking and spell out how I think about Bidenomics as somebody outside of the US domestic politics process. First, what does it displace? It displaces a lack of political willingness to engage with questions relating to the climate, employment, and workers rights. Second, what does it offer as a replacement? Some form of increased state intervention in these issues. 

   As it “brings the state back,” what kind of state-capital relationship does Bidenomics put in place? I describe this relationship as “derisking,” though it’s not a term that I came up with but rather one that has been used, particularly by private finance, to conceptualize the role of the state in mobilizing private capital for the energy transition in the global South: changing risk-return profiles to make investments more attractive for private finance.

   To put it in the words of the Biden administration, it’s about “crowding in” private investment. The basic logic of the approach is to bribe private capital into fulfilling the certain policy priorities that are considered otherwise unachievable. It is constrained by the fact that we still live under an architecture of macroeconomic policymaking that puts independent central banks at the helm and subordinates fiscal policy to the priority of inflation-targeting. 

   In my view derisking is a conceptual lens to think about the relationship between state and private capital that is created through the return of the state in climate politics. This derisking approach is an inadequate script for the climate transition, and it will not achieve the structural transformation needed for alignment with the Paris targets.

   Carrots and sticks

   DD: Instead of bribing capital, you argue instead for the formation of a “big green state.” What is that? And what tools would a big green state wield to discipline capital?

   DG: Bribing is at the core of derisking in the sense that the state absorbs some risks from private investments in order to make certain public policy priorities investable—by improving the price signal or risk-return profile of those priority projects through fiscal, monetary, or regulatory measures.

   With derisking, because the logic is of partnerships for investability, the state cannot discipline private capital into strategic priorities when market conditions change or when profitability conditions change—which is precisely what a big green state can do. It can move away from the logic of the market signal by enforcing closer controls on the pace and nature of private investment or just through public ownership. Another thing the big green state can do is change the relationship between the institutions of macroeconomic policymaking, ushering closer coordination between, for example, the central bank and finance ministry to support a more disciplined approach to industrial policy.

   DD: Ted and Tim, are some of what Daniela characterizes as carrots actually sticks?

   TF: There are a few angles from which we can approach this subject. One is to ask what progressive aims were encoded in the IRA and might not in fact follow the derisking logic that Daniela articulates. Another angle is to consider things that are getting done through regulation, or that could get done through regulation, but lie outside this particular piece of legislation. Still another angle is to consider parts of the agenda that did encode a disciplining logic but did not make it into the final legislation: for example, the clean energy payments program, which essentially mandated the full decarbonization of the power sector in the United States, and which didn’t pass.

   dd: Because of the balance of political forces.

   TF: Yes. We could also consider if and how this derisking logic might be defensible from a progressive point of view. For instance, there is a real theory which posited that you could get much more fiscal bang for your buck through the use of the tax code that enabled a much greater amount of climate spending than what the Congressional Budget Office would normally allow. These uncapped tax credits are what Tim has called “bottomless mimosas.” But ultimately, we should discuss if these moves affect the balance of political forces, which is at the most basic level why we get the reality we get. 

   There’s obviously an immense amount of truth to what Daniela is saying. The core idea behind the legislation is to redirect—whether through pushing or coaxing the flow of private investment towards socially or politically useful purposes. People are very explicit that they ultimately expect the amount of private investment to be much bigger than public investment. I don’t think the situation is as extreme as some of what you see in discussions about how to get green investment flowing to the global South, where the ratios (“billions to trillions”) are astronomical. But the underlying logic is the same.

   TS: As regards the balance of political forces, let’s recall that the Bidenomics legislative package had to make its way through Congress, where it was hemmed in by three major forces. One was the deficit hawks: those who don’t want spending to be greater than revenue, and want every dollar of spending to be backed by a dollar raised through politically costly taxation. This group includes figures like Treasury Secretary Janet Yellen, speaker Nancy Pelosi, and Biden himself.

   The second was China hawks in Congress and the administration, who took the baton from the Trump administration and drove a very aggressive agenda focused on China containment. They insisted on onshoring chips and solar panel manufacturing, remaining careful about critical minerals, and increasing the Pentagon’s budget to mount a two-front war against Russia and China. 

   The third group are fossil capitalists, or fossil hawks, whose influence has grown tremendously in the last ten or fifteen years. Under Obama, Congress strongly supported the shale boom in the Appalachian and the Permian Basin with subsidies and approvals of pipelines and terminals. By 2015, the United States had become the world’s largest oil and gas producer. By 2021–2022 when these bills were being negotiated, these fossil hawks in Congress demanded an increase in drilling and no sticks on fossil capital.

   Dg: The US CHIPS Act draws on previous models of successful industrial policy, particularly in East Asia. Specifically, it mandates comparative state institutions whose purpose is to monitor and discipline capital to fulfill strategic priorities. Why was it possible for the US to build such comparative institutions into the US CHIPS Act but not in the IRA? Is it because the power of fossil capital operates differently in these different spaces? CHIPS maybe doesn’t have the same kind of political concern for fossil capital that the US IRA has.

   Dd: And also perhaps the positive motivation of geo-economic and geopolitical conflict with China —which, depressingly, seems to be the sort of motivation that can overcome almost any obstacle in American politics?

   Tf: An interesting dynamic is that CHIPS activated anxieties about corporate concentration on the left in a much more intense way than the IRA did. While the IRA offered opportunities for profit making over a ten or twenty year horizon, CHIPS promised to funnel billions of dollars directly to four or five companies that already had a massive market share within their respective sectors. The Progressive Caucus in the Congress was public about their concern. For example, the ban on stock buybacks in CHIPS—which is not actually in the legislation itself, but rather in a subsequent rulemaking that the Commerce Department undertook—was something the Progressive Caucus explicitly fought for. While we were all absolutely in favor of investments in science and technology, and understood the need for resiliency and supply chains, we did not want this to amount to a massive exercise in corporate welfare. 

   TS: Are these subsidies corporate welfare? I’m not persuaded by the binary between CHIPS and the IRA. To begin with, what do we mean by sticks?

   Certainly the IRA doesn’t have very many actual penalties, but there are two important ones. Firstly, it’s a tax bill, because the deficit hawks insisted that it be made into a tax bill that pays for itself. How is IRA spending to be calculated? Well, the Congressional Budget Office is going to score the bill, determining how much spending has occurred via tax credits, and demanding they be matched by “revenue raisers,” i.e taxes.

   The Biden administration, right from the get go in March of 2021, when the American Jobs Plan and the American Family Plan were released, also introduced an entire slew of measures that were intended to raise $4.5 trillion through taxes. That basically entailed reversing the Trump era tax cuts on Fortune 500 companies and installing a new tax on those earning more than $400,000—recall Biden promised not to raise taxes on anyone making less than that amount. But during negotiations, corporate forces essentially said, “Screw you, you aren’t going to tax us,” and so $4.5 trillion fell to $2.5 trillion, finally down to $1.75 trillion in the House bill. The final bill is still a tax bill, but it’s much smaller. It puts a 15 percent corporate alternative minimum, which will generate $200 billion of taxes. That’s a penalty on tax-avoiding corporations, and it gives the IRS more money to go after tax-evaders. And there’s a 1 percent tax on stock buybacks included in IRA.

   Dg: But this is not a penalty. It’s not a stick that ensures the companies who receive subsidies are pursuing the industrial policy objectives of the government. If anything, it’s the opposite. 

   Ts: Yes, it’s a general tax on capital and not a specific penalty on firms that obtain subsidies. My point is that the IRS—which is under threat, but partially reconstructed under the Biden administration—is the agency through which much of US industrial strategy is being channeled. The Treasury, which is interpreting Congress and writing rules, needs to hire enough staff to monitor these uncapped tax credits and prevent those bottomless mimosas from turning into champagne for the rich or into carbon sludge. Without strong enforcement, greenwashing firms could show up at the Treasury door with greenwashed projects—which then would turn the IRA programs into a form of corporate welfare.

   DG: I worry when progressives are told to celebrate a situation in which the distributional outcome favors capital. The idea that your tax officers are going to be in charge of green industrial policy is wishful thinking. Let’s not confuse that state of affairs for successful green industrial policy—let alone progressive distributional outcomes.

   I don’t know when an IRS tax officer is going to say to Ford or to Tesla “your electric vehicles are getting larger and larger and are using more and more resources.” What we need instead are regulations for smaller electric cars and legislation to support electric public transport. We have to be critical and careful as we leave behind the status quo that was against any kind of progressive climate politics, and move into a “bottomless mimosas” approach, which even some unions in the US are questioning as not so much in favor of either creating skilled jobs. There are grounds for skepticism. 

   Labor

   dd: It seems like a basic point of debate here isn’t so much whether this new industrial policy is beset by the contradictions of neoliberal capitalism, which everyone accepts, but rather whether it is pointing us in any sort of promisingly new direction. 

   tf: IRA does discipline fossil capitalism in that it includes a fee on methane that was viciously fought by the fossil fuel industry. If progressives could not get outright sticks, then we pushed for carrots to encourage good behavior and this is why much of the labor movement was genuinely enthusiastic about the IRA. Consider the basic clean energy tax credit, which is going to incentivize wind, solar, geothermal, and so on. While the baseline credit you get for installing such generation facilities is 6 percent, that goes up to 30 percent if you pay prevailing wage for construction, which is a 24 percent differential. This does not guarantee union organization—not by any stretch—but it very significantly levels the playing field between nonunion and union labor. 

   There are many provisions that encourage private investors to meet certain priorities. There’s an energy communities provision that gives an additional bonus tax credit for locating generation in certain places that were heavily dependent on the fossil economy or that suffered from impacts of extraction. There’s a 20 percent bump to encourage investments in low-income communities.

   Another provision called direct pay, which progressives rightly count as a big win, means that public and nonprofit entities can for the first time receive tax credits as a direct cash payment, even though they have no tax liability. As a result, municipal governments, for example, can get in on the clean energy game in a way that they were structurally excluded from before, which creates the opportunity for public ownership. 

   DD: This was crucial to the feasibility of New York’s recently passed Build Public Renewables Act.

   tf: Absolutely. It helped move the dug in opposition of the New York Power Authority and the New York State Governor towards a basic openness because, thanks to direct pay, they could tap into a massive amount of direct federal funding to build renewables themselves. 

   There were some major progressive goals that were brought into the initial debates about how to structure industrial policy for the auto industry. A publicly owned competitor to private car companies was obviously never on the table, but everybody agreed that a key component of decarbonizing the economy was decarbonizing autos and finding the highest road pathway forward. 

   Initially the bill encoded a union bump on the EV tax credit: $4,000 on top of the $7500 general EV credit if it was made in a union facility. This was meant to be an explicit bonus to the unionized auto sector in the northern Midwest. And a disadvantage to the nonunion foreign and US automakers that mostly produce in Right to Work states in the South. The union bump was viciously opposed by the EU, as well as Canada and Mexico. And it was opposed by Joe Manchin, who anticipated foreign nonunion EV production coming to West Virginia. It was slashed.

   What emerged finally from that fight were some progressive elements from Manchin: an income cap that prevents rich households making over $300,000 from getting the EV tax credit, and $4000 used car incentive. 

   But there were significant shortcomings that people in the administration didn’t like, and that the auto unions like UAW have been rightly upset about. The structures in the clean energy tax credit don’t exist in the manufacturing tax credits—there’s little in the law on the manufacturing tax credits or in Department of Energy loans to automakers that encourages prevailing wage or any labor standards. 

   DD: It is a split-screen situation with labor and the IRA/IIJA because on the one hand, you have this recent huge win by the steel workers at Blue Bird electric bus factory in Georgia, which unionized thanks to the EPA’s rule for their clean school bus program—which states that recipients of funds must agree to union neutrality and bars the use of federal funds for anti union activity—something that the steel workers used to their advantage, and won a very notable victory in the South.

   On the other hand, the UAW just released statement from the new militant leadership of their union, attacking this DOE plan to lend $9 billion to Ford to build three battery plants with no labor strings attached. It’s part of this more general concern from the UAW that the move to EVs will accelerate, rather than reverse the decline of union density in auto manufacturing. 

   What sort of terrain has Bidenomics created for labor?

   DG: A 24 percent tax credit is a lot more than 6 percent, and so Ted’s case sounds persuasive. One of the difficulties with the Biden administration is that it is like an onion with an outside layer of progressive politics but with a hard inner core of pro-capital distributional politics. 

   I want to see the data as to the extent to which the announced IRA private investments are really using the 24 percent tax credit. Is the only possible way to achieve better working conditions to bribe private capital? I have some doubts about that. 

   But I also know being in Europe, that our trade unions were looking enviously at the Biden administration process of working with unions saying “in Europe, nobody involves us to the same extent.” 

   On the one hand, you can look at the glass half full and say, “this is the best that we could do.” But if you look at the glass half empty, in the end, this process leaves the extent to which labor rules will be adopted at the discretion of private capital. The big green state could say to a company: “you must have this level of wages, if you don’t want to come under very strict provisions for decarbonization.”

   DD: I would add to that that whether the glass is half full or half empty probably depends on what corner of the labor movement you’re looking at that glass from. The building trades have done well, while from the manufacturing side, whereas UAW has a lot less leverage provided by the IRA to unionize manufacturing workers once the facilities are built. 

   TF: I think the question about the terrain of labor struggle post Bidenomics legislative package is an interesting one. You have had episodes about the Protecting the Right to Organize (PRO act) which would have substantially increased penalties on employers and made illegal anti-union practices. But we couldn’t win it. The votes were not there to force it through in reconciliation, despite 90 percent of the Democratic caucus supporting it. 

   The IRA does absolutely encode protectionism in the form of critical minerals provisions for batteries and final assembly requirements. This creates a really significant incentive to locate production of all aspects of the auto supply chain in the US or in North America. These elements have been the source of immense controversy between the US and its trading partners. So to the extent that you have trapped private capital in the US you could say that will help union density in the auto sector by reducing the threat of offshoring, which has hung over so much of auto unionism for the past fifty years. Not just offshoring abroad, but also the even more important movement of production from union to nonunion states. 

   On the other hand, the absence of the big green state type provisions that Daniela was talking about means that so far this investment is happening in right-to-work states. Georgia has probably been the most sophisticated and aggressive in its policy of attracting those investments with subsidies, a classic Southern economic development strategy. These states are the most militantly anti-union and will fight any beachheads of UAW or other industrial unions with every tool at their disposal. 

   Still, it’s hard for me to see how labor is in a worse position within the auto sector post-IRA than it was before. I completely understand Shawn Fain criticizing the Biden administration for a $9 billion loan to Ford that has very few strings attached and withholding endorsement. That’s probably just the way that these fights are gonna play out. The UAW has to figure out a strategy for getting in there and organizing those workers and they’ll find, I think, so long as you have the Biden administration, there’s a supportive National Labor Relations Board that’s willing to really go after companies for unfair labor practices. 

   TS: The Biden administration says it will use grantmaking discretion to encourage higher labor standards. But they are not trying very hard. As Lee Harris at the American Prospect has reported, jobs in the solar industry are currently pretty crap jobs. Workers are hired mostly through temporary staffing contractors—insecurity, harassment, and abuse are rampant. Another example is TSMC, one of the big beneficiaries of CHIPS act $52 billion, which refused to sign a project labor agreement with local unions, and employed mostly nonunion labor. Can the Department of Commerce really play hardball when the US needs TSMC more than TSMC needs the US?

   DG: That anti-labor stance of the derisking state is not a specific US dimension. European private capital has fought very hard at home as well to make sure that it minimizes any progressive disposition of any of the return of the state in industrial policy or climate policy. 

   I think there is a geopolitical angle to discuss here, about why Europeans activated all their misgivings when the US started doing large-scale derisking of the climate transition, but not when China did it. China has done this for much longer. And in many ways Europeans were much more relaxed about creating markets for Chinese solar manufacturing, than they have been about creating markets for US solar or car manufacturing. It has to do with geopolitical tensions within the US-EU alliance. 

   Politics

   DD: I think that all this really gets us to the real theory of politics behind the IRA and Bidenomics more generally. Bidenomics recognizes historically that the New Deal order created a material basis for a mass political constituency for New Deal coalition politics, namely through unionization and labor winning this historically high share of the national income. It recognizes that neoliberalism—which the Biden administration refers to pretty consistently in with the phrase “trickle-down economics”—was geographically uneven, created an extremely unequal distribution of income, and that this created the material basis for reactionary populism.

   Are the investments of Bidenomics creating a new material basis for liberal democratic politics?

   DG: From the discussion that we’ve had so far my takeaway is that, like neoliberalism, Bidenomics presents workers with the same choice: either you’re excluded or exploited. So it doesn’t seem to me that it really kind of amplifies or creates a terrain for some really radical reorganization. 

   As a European who lives in the UK and who was born in another country where the state played a much more important role in the public provision of public goods it’s hard for me to imagine, as a US worker, how much of a change I will see in my daily life from Bidenomics. The concern is we get worse jobs and a lot of the fiscal resources go into profit for private capital, and we get the same financialization of public goods that we’ve had so far. So what is it that we’re really getting? I’m not claiming to have an answer, but I don’t think the answer is “everything will be better.”

   TS: The Bidenomics idea was not only to increase union density through a legislative push, but also to structurally improve the bargaining conditions for labor by running a full employment macroeconomic policy. Biden, in a budget speech in 2021 said “instead of workers competing with each other for jobs that are scarce, we want employers to compete with each other to attract workers with higher wages.” It is a conscious push to increase employment and reduce the reserve army of labor. 

   Full employment policy was complemented fiscally by the American Rescue Plan’s generous unemployment insurance of $400 per unemployed worker per week, which allowed people to leave crappy jobs and move to higher productivity and better jobs. So structurally labor is in a much better bargaining position with some of the lowest rates of unemployment in fifty years. 

   TF: There’s a couple of distinct theories of politics that you hear articulated and I’m not sure which one the Biden people subscribe to. One theory is the “deliverism” theory of Democratic Party majorities: you deliver investments, you deliver jobs, people credit you with improvements in their lives, and they vote for you. Another theory is the political opposite of that, which is about “locking in” the policy, but not necessarily focusing on the electoral outcomes. That theory says that whether or not Republican voters continue to vote for Republicans, the flow of benefits and investments into those districts will make it awkward for Republican officials to try and eliminate the policy. This is why Biden-adjacent people celebrate the large investments in red districts which they have no hope of flipping.

   Then there is a broader theory here that goes to Daniela’s core point about derisking, which is that the left always thought that locking in climate policy would require the building up of a green capital sector, which would be able to exercise political power, at least partially, to offset the power of fossil capital within the US political economy. This will require beneficiaries of climate policy to exist—as it does for, e.g. defense policy—in every congressional district in the country.

   DD: I’m skeptical that a new material basis for a new Democratic majority will be built through investment. Consider the New Deal, where objective economic growth or rising wages didn’t build that coalition, but rather unions—intermediary organizations that help people make collective political sense of the economic situation. 

   DG: I am further skeptical of the theory that you can build up green capital, particularly in Republican states, to create political lock-in. The experience of Spain in the 2000s derisking solar industries with feed-in tariffs provides evidence against that argument. The carrots for private investment were so attractive that Spain found itself with a disorderly expansion of green solar capital. When the political cycle turned, and macrofinancial conditions turned, a new government stopped those carrots, which led to a severe crash. And the experience we have had in Europe of using these kinds of derisking approaches to building private solar capital is that it can very quickly run into fiscal constraints.

   Fossil capital

   DD: We keep touching on fossil capital, and the rollout of green energy, which is only half the energy transition, we must also just stop burning fossil fuels as soon as possible. But the Biden administration including through the IRA has, in many cases ramped up fossil fuel production. What are the Bidenomics tools, if any, for ending fossil fuel production?

   DG: In Europe from around 2017, the strategy was to explicitly combine carrots for sustainable activities with penalties on fossil capital, particularly through the European Central Bank and the Bank of England. The approach acknowledged that we cannot wait for this logic of derisking that simply waits for market processes to drive fossil fuels out. This was rather revolutionary for central banks that usually don’t want to intervene or don’t want to be seen as intervening in the allocation of capital. 

   Central banks designed “sustainable taxonomy” frameworks, to penalize dirty capital. And the European Central Bank said that climate is within our mandate of price stability, because the climate crisis can have financial stability aspects, and also because the financial sector can amplify the climate crisis by lending to fossil fuels. The logic of the approach was that if a financial entity has fossil fuel bonds in their portfolio, the central bank will penalize the holding of these bonds, driving up the price of their credit, thus eliminating subsidies to carbon capital. 

   DD: How did Bidenomics disrupt that trend in European policy making?

   DG: The carrots of Bidenomics gave more momentum to the lobbyists opposing the penalty based on regulation in Europe, because every company that was being penalized said they would move to the US! It became much more difficult politically to stay on course with Europe’s much stronger decarbonization framework that penalizes private capital. 

   TS: Fossil fuels continue to receive the lion’s share of government subsidies. Fossil fuels are extremely expensive for not just the planet but for governments to maintain, fiscally speaking. European governments did a massive amount of deficit spending after the Ukraine war began, to put money into company’s pockets and into people’s pockets to defray their energy bills. Researchers have estimated more than 800 billion euros of subsidies were given to fossil capital in just one calendar year since the Ukraine war! Compare that 800 billion euro figure with the congressional green spending from the IRA, that amounts to, according to the CBO, about $40 billion a year. 

   DD: Melanie Brusseler writes: “private asset ownership and market coordination cannot perform the synchronized dance of investment and divestment, nor bear the cost of maintaining excess capacity… a boom in private renewable projects will not on its own orchestrate a planned build out.” Why is public ownership important for achieving decarbonization? 

   TF: The part of the IRA that can contribute to public ownership are the direct pay provisions that we spoke about earlier, which many local and state officials around the country are taking advantage of. That’s one of the exciting post-IRA terrains of struggle—to build those institutions and that capacity to increase the role of public ownership.

   But that alone is not going to move us fast enough. There are the Paris goals, and there’s the reality of the acceleration of the climate crisis. Without a public balance sheet playing a bigger and more aggressive role, we are not going to tackle things like the flood exposure of so many communities, and what that does to insurance markets, and what that does to home prices—much less than we are able to gradually decommission fossil infrastructure that we have in this country and around the world.

   Without more assertive public ownership and a big green state with sticks, there is a real fear that the public just ends up absorbing the costs of the climate crisis as companies go bankrupt, as homeowners lose their shirts, and the public sector just picks up the mess in the worst kind of derisking way: the socialization of all the losses. We have to find ways to bring in the public sector more proactively, in a manner that costs less and is more equitable, and less reactive. 

   DG: A recent Common Wealth report makes a persuasive case even for fiscal hawks that public ownership, particularly of the energy sector, is cheaper than derisking private renewables. 

   There is also the long-term, orderly decarbonization case, not just for public ownership, but for a wholesale change in the current macrofinancial regime. I don’t think public ownership is enough, though it’s necessary. We also need a change in the way that we think about the state’s balance sheet in the climate crisis. At the moment we have a disorderly expansion in both green and fossil capital. We have to remind ourselves that we need to shrink certain sectors. The state will by necessity have to have a much larger balance sheet that it has at the moment. And for that, it will need a central bank that works with a very different logic of coordination with the state to support a big green state. 

   What we don’t have enough of is building institutional capacity of the state to discipline private capital into climate strategies. In my paper that informs my arguments about Bidenomics, I write about the use of monetary derisking by central banks to intervene in government bond markets, which at the moment basically preserves their stability for private finance.

   New Cold War

   DD: Let’s talk in some detail about China and what many are calling a “new Cold War.” Bidenenomics seeks to deny certain advanced semiconductor technology to China, to exclude Chinese source components and critical minerals from supply chains, and more generally, to check China’s economic development and military power. Jake Sullivan, in a much noted “new Washington Consensus” speech described this new approach as a departure from optimistic assumptions of a rules-based global order. 

   But the real US problem with China is not illiberalism—Saudi Arabia and Israel don’t bother the US. When did it become such a bipartisan norm to perceive China’s rise as an almost existential threat to the US? And lastly, what sort of state is China? Is it a derisking state, a big green state, or something else entirely?

   Tf: The first thing to note is that there is a very significant element of self-critique among the US policy making elite when it comes to how they talk about China. There was an optimism, a popular theory of “convergence,” around China’s integration into the global economic order, especially upon its entrance into the WTO in 2001. That theory said that as China liberalized economically, its political system would also liberalize. (Jake Werner and Toby Chow, for example, argue that this was actually happening for a period of time in the 2000s and early 2010s.) 

   China became much more geopolitically and militarily assertive in the wake of the 2008 crisis. While the US was rather hobbled by the collapse of the housing market, China pulled off a world-historic stimulus program and mass-building program. The investment of the Chinese state basically floated the entire world economy for about a decade. Some people see this as the moment when Xi Jinping consolidated power within the Chinese political system and began to author a much more statist economic policy, with documented cases of economic coercion. There’s a perception across the US political elite by 2018 that China had changed—they flipped positions, from seeing China as a benign partner to an active threat.  

   The self-critique then runs on two levels. Firstly on the economic level, one cannot overstate the significance that the China shock literature has had on policymakers; they cite David Autor’s articles by name, which is otherwise unheard of. Of particular impact has been the work of economists who documented how the economic opening to China, starting in 2001, led to the decimation of American manufacturing. In a paper published after the 2016 election, they showed that counties and metropolitan statistical areas that had seen the heaviest import penetration from China were those that flipped towards the Republicans. Opening up to China seemed to have had more significant domestic economic consequences than anybody had anticipated in the 90s and early 2000s. 

   Second, on a climate level, by 2021, US policymakers had woken up to the realization that China was absolutely dominant in key green manufacturing sectors, where previously it was believed that China mainly focused on “ low end assembly stuff,” while all the cutting edge, high value added stuff was still located in the global North. But suddenly, they had to admit that China controls 90 percent of the market for solar panels, controls critical minerals, dominates the battery supply chain, and so forth. As it became clear that an energy transition was necessary—that, one way or another, there is going to be a massive replacement of machines across the globe—policymakers came to fear that China was going to dominate those industries, which they would prefer to be located within the US, and producing for the domestic markets, but also competing with China in what they anticipate to be the booming export markets of the future. 

   Lastly, there are genuine conflicts of interest between the US and China when you look at Taiwan, and the broader East Asia security questions and military alliances. 

   DG: Europe faced the same concern for longer. In the 2000s, solar industries in Germany and Spain were affected quite significantly by the Chinese state’s ability to scale up manufacturing of clean tech. The response used to be, “It doesn’t matter, because we want the market to work.” There was a powerful ideological commitment to globalization. If you look at recent attempts to emulate Bidenomics, there has been a shift. There’s an understanding that markets used to work well, but massive Chinese industrial policy has distorted market signals in clean tech. They now are looking to do the distortions themselves. 

   For the moment, I think there is a combination of the big green state and derisking in China. The Chinese state and the internal market allows for scaling up, and one can do many things that are not possible in smaller countries. It’s important to remember that this isn’t just a story of states, but also of financial globalization. There are lots of European companies in China, it does not simply erupt on the international scene to threaten US hegemony in isolation. Significant profits were to be made by locating in China for a long time—European and US corporations defended that arrangement, which they cannot do now for political reasons. 

   DD: What should we make of the role played by this New Cold War in motivating US green industrial policy? What does this new industrial policy represent, given the serious threat of escalation? What might a stable geo-economic and geopolitical settlement with China look like?

   TF: It is disquieting, and it should trouble us very deeply. There is a tendency among some progressive forces to want to see this geopolitical aspect as ancillary to industrial policy, but I’m not sure that’s true precisely because the shift in the US policy elite’s attitudes towards China is one of the preconditions for everything that we’ve seen. We must stay focused on these dynamics, on how industrial policy tools might get deployed to ratchet up geopolitical and military tensions. We should oppose escalatory moves, forcefully and forthrightly. And I do think it is important to oppose the semiconductor export bans, which are not an indispensable part of the overall package, and which none of the forces that came together to pass the legislation signed off on necessarily. There is less attention to these dynamics than there were, for example, to the question of how US global power manifested itself in the 2000s. 

   In my view, we need to start talking intentionally about “order building”: the institutions of international relations, security, and cooperation, especially around development and finance. This includes the idea that one can’t imagine a global political or economic order or a security order without a significant role for China. Coexistence must be the name of the game. We have to work to develop these institutional frameworks on the baseline conviction that war would be an absolute apocalyptic endpoint, that we have to do everything in our human power to avoid.

   Ts: The US policy-making elite’s theory of how to contain China is based on two premises. The first is that technology is driving China’s economic growth, and the second is that China doesn’t know how to make innovative new technology—they can only copy, acquire, or steal. Following from these premises, the containment of China is taking the form of preventing access to high-end technology. This is what Jake Sullivan means when he talks about “building high walls around a narrow yard” of AI, biotech, green tech, and so on.

   I’m not so sure that new technology is the engine behind Chinese economic growth. Chinese growth has been powered by domestic investment largely in the technologies of the second industrial revolution, together with a gigantic real estate boom, and a logistics boom that created a vast internal market. 

   As for innovation, the Chinese state has been investing heavily in R&D for at least ten to fifteen years now—tens of thousands of Chinese engineers and scientists and doctors have trained at the MITs and Stanfords of the world. They are as close to the technological frontier in many sectors, if not further ahead, than the US. Therefore, even if one believes that it is necessary to contain China, it’s unclear to me that technological decoupling can succeed on its own terms. Obviously, there is a massive risk of backlash too: it could drive away American allies, slow down innovation, slow down climate investments, increase the prices of goods, and lead to domestic inflation.

   dg: I also want to consider the possibility that China is a kind of a strawman, or a useful Trojan Horse that provides a way out of this crisis of capital accumulation. To put it another way, the Chinese threat—which is real in that it challenges US hegemony—offers a political narrative that allows for the reimagination of the role of the state, which can now become engaged in climate politics. Even in countries like the US, you can build an infrastructure or an architecture of derisking which, as it becomes bigger and bigger, can create profit and opportunities for private capital. You need a straw man, an adversary for these political forces to come together. But our planet doesn’t care about the China-US conflict. 

   dD: The climate crisis is global in scope. Do the IRA and Bidenomics point toward any sort of more internationalist approach to fighting climate change? 

   ts: The IRA doesn’t have any explicit provisions for countries in the developing world. There’s no transfer of American taxpayer dollars or cheap money. Rather, the Biden administration argues that anything the US does to accelerate production of green goods will lead to a drop in prices, allowing for cheaper exports to developing countries. That theory then requires a policy agenda of IP-free green technology transfer to developing countries that the administration is currently not pursuing.  

   The broader issue is that developing countries have a much narrower fiscal space, and much smaller tax bases from which to give out tax subsidies. Their fiscal space is very constrained by dollar debt crises, and structurally higher interest rates. For a successful global energy transition, the IMF and the World Bank would have to be reformed to make the cost of financing cheaper and not police their debt-to-GDP ratio. But that’s not been the Biden administration’s international agenda.

   DD: If the global South is not provided with an economically viable path to do green development, why would they stop burning coal?

   Dg: The progressive rhetoric of the Biden administration is at its thinnest when it comes to the “New Washington Consensus” for countries in the global South—behind which the Wall Street Consensus is very much hardwired. The derisking development paradigm recommends that global South countries need to blend a little public money with a lot of private finance to kick-start investment in the energy transition and public goods. A great irony that I see is that the US is protesting the fact that countries consume cheap, renewable tech from China—but then it turns around and says, ah, the global South should be happy the US IRA is going to reduce the cost of cleantech imports.

   The Biden administration is not supporting a mandatory involvement of private creditors in debt-ridden countries in the global South, or pushing for more grants or more concessional finance to go into public goods, or supporting technology transfers, the last of which China is doing. For example, a Ugandan state-owned company is producing electric buses for public transport with Chinese technology—this is what technology transfer looks like in a revamped, post-neoliberal framework. Such an arrangement does not exist in Bidenomics. Instead, the US and Europe are singing from the same hymnsheet—you want green industrial policy, do it through derisking—which then puts pressure on global South countries to hand more and more of the fiscal and regulatory reins to private capital to, say, make green hydrogen competitive.

   Tf: To the extent that things can change, it seems to me likely that they will be driven by geopolitical developments, much more than any enlightenment on the part of the US government or financial apparatus. Some negotiated packages, as in the case of Indonesia, have involved aspects of technology transfer, but it’s coerced. The US is making concessions because they are seeking the alignment of strategically positioned states. We’re likely to see more of these geopolitical gradients on deals relating to international development and finance, with states leveraging their relative positions. The double-edged sword is that this is feeding into dangerous escalatory dynamics. 

6. Fragile Democracies

   July 29, 2023 3:30 am Comments Off on Fragile Democracies

   Pranab Bardhan is Professor Emeritus of Economics at University of California, Berkeley. Among the foremost global scholars of development, distribution, and trade, his twelve books and more than one hundred fifty journal articles cross disciplinary boundaries in an effort to critically grapple with the conditions needed for a more equitable society. In Land, Labor, and Rural Poverty, he considers the relationship between land tenure, agricultural employment, and rural poverty. The groundbreaking Political Economy of Development in India integrated Marxian class analysis with a rational-choice methodology and a Weberian institutional lens to reflect on the structural impediments that have slowed India’s industrial growth. His new book, A World of Insecurity, re-examines the conditions underlying democratic disenchantment. 

   In what follows, King’s College Lecturer in Comparative Political Economy Poornima Paidipaty interviews Bardhan on the rise of the global right, the nuances of decentralization, and the role of the state in pursuing paths forward.

   An interview with Pranab Bardhan

   POORNIMA PAIDIPATY: A World of Insecurity (Havard, 2022) covers a wide range of topics, from current economic inequality to the rise of populism and the importance of renewing institutions of social democracy across the globe. Maybe you can start by telling us about the inspiration behind the book—as a writer, what motivated you to piece all of this material together?

   Pranab bardhan: As a political economist, I’ve noticed that politics in many countries I’m interested in, both rich and poor, has been moving rightward (the major exception being in Latin America, but even there, leftwing victories have been fragile). I was interested in understanding this global shift. Everyone talks about the rich countries—Trump, Johnson, LePen, Meloni, the Sweden Democrats, among many others. Developing countries get less attention. In my study, I look at three developing countries: India, Turkey, and Brazil. 

   Existing work on the rise of the right revolves around the question of inequality—even in countries where it’s not rising, it is already very high. But again, much of this work is focused on Western Europe and the US, and I was interested in broadening this scope. Despite having worked quite a lot on inequality as an economist, I had a sense that this was not the full story. In particular, I felt that it doesn’t answer an essential question: Why are working people rallying under the banner of multi-millionaires? This is particularly confounding given that these billionaires, once they come to power, almost inevitably reduce taxes on the rich and weaken restrictions on the financial and corporate sector. 

   Another motivation for writing the book is that existing discussions tend to exclude any reflection on the Chinese model as an alternative. I discuss the advantages of the Chinese model of economic development, but also emphasize that many of the ugly features of Chinese development are the result of the underlying authoritarianism. After a lengthy discussion of these benefits and downsides, I suggest that authoritarianism is neither necessary nor sufficient for promoting the beneficial aspects of Chinese policy making and governance. 

   Finally, I took the book as an opportunity to reflect on what comes next—what do we do about this global trend? I devote the second half of the book to this question, trying to conceptualize what I call the rejuvenation of social democracy. How do we cultivate new thinking about social democratic transformations?

   Pp: In the last decade, many scholars have highlighted the impact of rising economic inequality on political polarization and social stratification. One of the things that distinguishes your book is the distinction you draw between inequality and insecurity. Can you talk about the importance of those terms?

   Pb: I argue for a shift in emphasis from inequality to insecurity. I question the explanatory value of inequality on the basis that on the whole, workers are far more concerned with their living standards relative to others in their community than they are with the top one percent. They don’t know or care about the lifestyle of the global elite. However, workers are acutely aware of the sources of insecurity in their life. Among these, economic insecurity is obvious: job loss, rising cost of living, and so on. This is especially true in rich countries, since China’s entry into the WTO in 2001.

   But in the book, I also discuss other sources of insecurity. One of these I call cultural insecurity. Culture is an ambiguous term, but this sort of insecurity takes specific forms—in rich countries, it often manifests as fears over immigration. In my view, the economic side of these fears are not really what is at play, especially since immigration has been repeatedly proven to bring net economic benefits. The fears are I think primarily about threats to a perceived “traditional” form of life. The role of perception is important here; firstly, because second and third generation immigrants tend to assimilate into local traditions, and secondly, because surveys have found that people tend to grossly overestimate numbers. They have an exaggerated perception of insecurity.

   Developing countries tend to attract far less immigration, and as a result, the cultural issue often takes a different form—religious majoritarianism or ethnic nationalism. This is the case in both Turkey and India, as well as in Poland and Hungary. These movements are tied together by what I refer to as “manufactured victimhood”: when the majority population somehow has a contrived fear of victimization by a minority. This is often the result of historical resentment. For example, in India there is a resentment among Hindus that Muslims ruled six hundred years ago. During the Bosnian War of the 1990s, I remember seeing a cartoon in which a Bosnian Serb and a Bosnian Muslim were stabbing each other, with one saying, “This is for 1432” and the other saying “this is for 1521.” This stoking of historical memory is something right wing demagogues are very good at. 

   Pp: I share your skepticism regarding the explanatory power of rising inequality, in terms of explaining the global shift towards rightwing populism. On the face of it, much of this rightwing support is not coming from those people hardest hit by unequal economic distribution. For instance, Modi supporters in India often come from groups that have seen quite a few economic benefits in recent years and whose prospects have not shrunk in absolute terms. Many of them are part of the rising lower middle classes.

   The fact that insecurity is a question of perception is also a great point. But just as there isn’t a direct correspondence between economic deprivation and support for rightwing populism, the people who feel insecure over rising numbers of migrants, for instance, are often located in areas with fewer immigrants (relative to large metropolitan areas). What is the relationship between this perception of insecurity and our changing global political economy?

   Pb: There is as you say a huge difference in the support base for these parties between rich economies and poorer ones. In the US and Western Europe, the right is popular among older, rural, less educated voters. By contrast, much of Modi’s support comes from aspiring urban youth. Major metropolitan areas like New Delhi, Mumbai, and Bangalore voted for Modi—this is a sharp contrast to cities like New York, Los Angeles, and Chicago. These rising groups are mobilized by resentment for what they perceive to be a Western liberal elite. 

   Pp: Can you talk us through some of the emerging alternatives to liberal capitalism?

   Pb: I think one of the tensions that we see emerging very clearly now is that between the local and the and the federal or international. Political mobilization around this issue doesn’t fall neatly onto our inherited political axes—the notion of community is often leveraged by the left, but equally one of Brexit’s key slogans as “back to the community,” i.e. back to the local community and away from Europe. 

   There is a lot to be said for communitarian ideas, given that big bureaucracies often trample upon local initiatives and local ingenuity. Much of my work has been focused on structuring decentralization in India—I’ve written theoretical papers and also collected data on village surveys carried out especially in West Bengal. But having grown up in India, I’ve seen how oppressive local communities can be. We should not have an idealized notion of how a small village operates with respect to caste, gender, and so on. 

   This debate dates back decades; it was one of the key differences between Mahatma Gandhi and one of the founders of the Indian constitution, B. R. Ambedkar. Gandhi mobilized around the notion of the village republic, while Ambedkar described the Indian village as “a sink of localism, a den of ignorance, narrow-mindedness, and communalism” during the constitutional debates of 1948. We are all familiar with the issues that arise from insiders seizing local political space—zoning restrictions, professional licensing, school financing, and so on. Decentralization thus has the capacity to worsen and entrench local inequalities.

   Government intervention can help catalyze changes of oppressive practices within communities. It can also help smooth out intra-community inequalities—in earlier research, I’ve examined how land distribution impacts political cooperation. Small communities are at a disadvantage in dealing with natural disasters, market mishaps, infrastructure investments, and the like. But there are also things local governments do very well; I try to find the balance between the two in my chapter on communities. 

   Pp: This ties back to your argument about state capacity. There is an emerging dialogue in India regarding the importance of federalist structures, with some scholars and activists arguing for more decentralization of power. This strand of thinking argues that Modi and the BJP (through their brand of populism) are not turning away from India’s foundations; instead they are building upon the historical institutions of a Nehruvian state, which used centralized power in order to expand state capacity. The solution to rightwing populism, according to this view, is more decentralization and less power in the hands of the central government. This conversation is gaining ground in light of southern states’ rejection of the BJP in recent elections. In the US, it’s exactly the reverse: the federal government is seen as a protector of civil liberties while states are seen as sites for the erosion of those liberties. 

   Pb: In the book, I argue that one advantage of the Chinese model is its unique blend of political centralization combined with economic and administrative decentralization. India exemplifies just the opposite: a decentralized political system with strong regional power groupings, combined with economic centralization whereby regions depend on finance from the government. As I mentioned earlier, this discussion dates back to the writing of the Indian constitution. At the time, Ambedkar advocated for more central power in order to combat the oppression of lower castes, like his Mahar community, a Dalit group in Maharashtra. That’s why he advocated a partial centralization. Nehru was also concerned with keeping the country together in the aftermath of Partition. As a result of these two elements, I think they gave the central government an unfair amount of power. 

   Few governments can do what the federal government has done in India—if we think, for example, of Nehru’s handling of the communist control of Kerala in 1959. As per the advice of Indira Gandhi, who was president of the Congress Party at the time, Nehru imposed President’s Rule in Kerala, whereby the central government dismissed the elected state government. That’s an example of a central government openly violating the wishes of an electorate. This has been repeated in several states over the decades.

   This happened in an even more extreme form recently, with the state of Jammu and Kashmir. Without consulting the population, the state was broken into three centrally administered territories. Can you imagine if the federal government in the US broke up California? It’s inconceivable. American federalism gives more power to local states. In the 1940s, when they considered what form an independent India should take, one idea put forward was that of a Confederation. This was proposed in order to stop Partition, but the notion was eventually dropped. 

   In China, provincial and sub-provincial governments have a lot more power. This also means that they have a far better system for managing infrastructure financing and construction at the local level. Urban infrastructure is governed by companies organized by the city government. Out of the total government expenditure for the whole country, the amount that is spent at the sub provincial level, not even at the state provincial level, is more than half of the total government expenditure. In India it is about three percent.

   Indian municipal governments lack taxation power and are therefore financially strapped. Much of social expenditure takes place at the level of states, but money is controlled by the central government. I refer to this as India’s vertical fiscal imbalance, and I think the weak performance of local bodies in India in the delivery of services and facilities is in part tied to it. By contrast, Chinese local governments are active in business development and not just in service delivery. 

   Pp: Let’s turn to some of the solutions that the book puts forward. Your recommitment to social democracy seems to resist widespread proclamations about the failure of democratic institutions. What exactly do you have in mind?

   Pb: My main focus is on universal basic income (UBI) and job creation. For developing countries with fairly weak social safety nets, UBI can be very effective–particularly in mitigating gender disparities. In countries like India, the overwhelming majority of women are not earning any income, despite performing back-breaking domestic work. But roughly 80 percent of Indians have a bank account today. A government transfer would hugely empower women who currently depend on their partners for survival. UBI becomes very appealing from the starting point of insecurity: offering an exit option for those who have been forced into work like manual scavenging for centuries due to their caste. Minimizing sources of insecurity is, I think, a more powerful justification than that of anti-poverty—it avoids the discussion of substituting income transfers for other social safety programs which may in fact be more effective at reducing poverty levels. 

   I also suggest that UBI can be effective at strengthening labor movements by unifying the interests of informal and formal, unionized and nonunionized, service and manufacturing workers. In India as in many developing countries, we see a small island of unionized workers surrounded by a vast ocean of informal workers. That small group gets access to benefits like pensions which the others do not have. Policies like UBI, which benefit both formal and informal workers, help bridge this gulf, softening labor market divisions. 

   I also stress the importance of wage subsidies for the employment of young people, who are largely unemployed or underemployed in much of the developing world. And I reiterate the power of job creation via the green energy transition, as well as the importance of giving labor a voice in corporate governance. 

   Pp: Maybe we can end by considering a few questions which are related to the issues you take on but are outside the direct scope of your book. You mention Branko Milanović’s book, Capitalism Alone (2019), which argues that whatever criticisms we may have of capitalism, it has been responsible for transformative economic mobility over the past two centuries. 

   That defense of capitalism presents crucial questions regarding sustainability: both ecological sustainability and distributional sustainability. For example, Milanović focuses on the period since the 1970s, when low inflation enabled large scale, debt-financed consumption, and subsequently a manufacturing boom, which raised commodity prices in places like Sub-Saharan Africa. This is more equitable than what we had before, but is it sustainable? 

   Pb: The challenge, I think, is to harness technological innovation towards social ends. We ought to make sure that the advances we make prioritize the interests of workers and give them a voice in decision-making. Democratizing the decision making structures in large corporations can allow us to determine the rate and pattern of innovations more collectively. We also need to democratize our politics—the largest democracies in the world (India and the US) both have elections funded by private donors. Under the anonymous electoral bond system, businessmen and companies are able to secure party favors. If we’re going to reform our politics in the interest of the public, we ought to look at the sort of public funding models used by Belgium, Spain, Germany, Sweden, and Canada.

7. Working Capital

   July 22, 2023 7:00 am Comments Off on Working Capital

   The Federal Reserve has provided payment and settlement services for more than a century. But FedNow, the instant payments service rolled out in late June 2023, is the first new Fed payments rail in fifty years. Though payment and settlement are crucial pillars of economic transations and global money flows, disinterest persists regarding these financial pipelines.

   Tim van Bijsterveldt is Executive Director-Liquidity & Account Solution Specialist at JPMorgan Chase & Co. Based in Singapore, he helps corporates free up cash and improve their cost base. In this interview, van Bijsterveldt and Elham Saeidinezhad discuss the structure of the wholesale payment system and the role of corporate treasurers in navigating and transforming it. Read Saeidinezhad’s overview on risk management and the payments system here.

   An interview with Tim van Bijsterveldt

   ELHAM SAEIDINEZHAD: Would you please walk us through what you do daily at JPMorgan Chase—who are your clients, what are their problems, and how do you help them resolve them?

   TIM VAN BIJSTERVELDT: Broadly, I’ve got two types of clients: traditional corporates and digital businesses. They’re interested in balancing short-term and long-term investments while ensuring payment obligations are met. For a corporate treasurer, aligning investment timelines with the corporate debt maturity profiles is a classic payment consideration.

   However, risk management has been added to payment-related concerns in recent years. Before, treasurers were concerned with moving money around. Today, they’re tasked with ensuring that the money is in the right currency and amount, exactly when they need it. It is worth emphasizing that the recent supply chain disruptions have added to the need for risk management. Traditionally, companies did cash forecasting on a forty-five-day or thirteen-week period. After the disruptions resulting from COVID, including the Suez Canal blockage, they’ve begun to ask whether it’s possible to bring forecasts down to one to three days. Corporate treasurers have started to look not just at risks but also at risk management strategies, such as mitigation and automation.

   This has happened across traditional corporate and digital economy clients, despite the different stakes in the supply chain issues. Digital supply chains don’t always contain goods; some may sell licenses, meaning their client will never own that product.

   On the other hand, manufacturers purchase from independent factories and sell their products to their customers. In doing so, they legally swap ownership from one party to another. As a result, traditional manufacturers generally are better positioned to forecast demand for their commodities, such as automobiles, agricultural products, etc.

   ES: A firm’s business model, traditional versus digital, shapes its sales and hence, its liquidity management strategies. There needs to be more understanding, in academia as well as policy circles, of the different techniques that corporate treasurers use to manage liquidity. A fragment of monetary theory, called Money View, pioneered by Perry Mehrling, which studies liquidity management in broader macroeconomic conditions, thinks of corporate treasurers’ function as primarily balancing between elasticity and discipline—the flexibility to meet daily payments without holding too many liquid assets. That is in the spirit of what Hyman Minsky called “the survival constraint.” What do you make of that?

   TvB: This understanding of corporate treasurers’ payment solutions, meeting daily survival constraints, is useful but somewhat incomplete. Treasurers operate with three buckets of cash. The first serves operational needs—what we need to get through the day. Based on what happened yesterday, we account for any big anticipated payments or cash influxes. If I’m short on money but know I have a cash inflow coming in later, I will likely delay my payment run rather than borrowing externally. The less external borrowing, the better. This is meeting survival constraints.

   However, corporate treasurers have other types of cash management concerns. Their solutions to these concerns might have broader implications for the modern ecosystem. The second bucket of cash is precautionary—what we keep under the mattress in case the business, or the market, suddenly falls short of liquidity. Notably, precautionary cash management is beyond deciding whether the company is liquid enough to meet today’s cash flows. Indeed, corporate treasurers regularly change payment solutions to manage precautionary cash, even when they have enough short-term liquidity. This sort of pocket cash is placed somewhere accessible, a bank account or money market fund, which we can redeem early. The corporate treasurer’s job is regularly changing how much money to hold in such funds and accounts.

   Finally, we have the reserve cash, which is invested for long-term acquisition or long-term debt payment. These might be placed in structured deposits like the FX market. In this case, the corporate treasurer might be certain that the firm can meet its daily survival constraint in the domestic currency. The firm might also have enough liquid assets in money market funds and similar institutions. Still, it is the job of corporate treasurers to manage long-term payments, for instance, the ones denominated in foreign currency, by undertaking long-term investment strategies that include structured products.

   It is important to note that risk management solutions are embedded in the second and third types of cash management strategies. In the second type, the corporate treasurer wants to safeguard the payments against funding shocks in the financial market or disruption in the supply chains. In the third type, most treasurers explicitly try to protect their firms’ cross-border payments against fluctuations in the foreign exchange market.

   ES: As you described, risk management is embedded in modern payment solutions. Traditional risk managers are usually among the corporates’ most innovative groups, whenever market conditions change. Given that corporate treasurers, traditionally tasked with managing payments, are also doing risk management, how might their approach to their job change?

   TvB: One clear example is the  change in the interest rate trajectory. Many treasurers kept their money in bank accounts, when the interest rates were near zero. It was cheaper to borrow externally than spend your own money. Since interest rates have increased, we see them using their money more. This is a change in liquidity management, induced by interest rates.

   Regarding market events, we see much more placed in the precautionary bucket and far less in the reserve bucket. Translating this into the risk management perspective means that corporate treasurers are mostly concerned about supply chain and funding market disruptions, due to the change in the interest rate environment, rather than fluctuations in the foreign exchange market. Even reserve cash companies are increasingly looking for products they can redeem early if needed.

   ES: Is there a  way to tackle such problems?

   TvB:  At the core of this problem is that many treasurers do not have a complete view of their money across entities and the world. They have different banking relationships; they have no choice in some markets. For example, you often cannot decide where people will pay in Korea. Instead, the payee tells you which bank they will pay into. And not all of these local banks are connected to global payment networks like SWIFT. For example SWIFT messages do not carry Chinese characters—that means you have a lot of banks in China that are not connected. One e-commerce company that I work with in Asia, because of what they do, they will always need local banking partners. They’ve enabled everyone they can on SWIFT, but it only gives them 60 percent visibility.

   Most of the time, we start asking how we can increase visibility and then shift to thinking about increasing control—often through cash consolidation. The level of control you have as a treasurer depends on your banking partner, but it also depends on your internal organization. Suppose you’re a company that has grown through acquisition. In that case, the financial controller of the acquired company might continue to hold onto the money, particularly if they have been doing well. In many emerging markets, we also have family-owned companies where relatives do not always want to share ownership of liquidity. In that case, you need to consider family issues—you may not have access to a company’s liquid assets.  Locations where you operate also determine whether you can mobilize cash effectively between companies, often supported by intercompany loans.

   We often look at cash on the balance sheet to assess liquidity. We look at the level of short-term debt versus long-term debt, the weighted average cost of capital. How costly is it for them to attract capital if they need it? That gives us a sense of how creditworthy the company is but also the value-add of cash consolidation. We then look at where they operate: whether in markets with fungible currencies like the US, Europe, Singapore, Australia, Hong Kong, etc.; in semi-restricted markets like Thailand, Indonesia, Chile, or some countries in the Middle East, where it’s fairly easy to move foreign currency in and out but not the local currency; or in highly restricted markets like Argentina, India, Vietnam and quite a few in Sub-Saharan Africa, where it can be challenging to get money out.

   ES: So capital control measures in different jurisdictions affect payments and firms’ ability to manage their cash. We don’t normally recognize the impact of capital controls on payments in international finance literature. Can you elaborate?

   TvB: Capital controls affect firms’ payment solutions and ability to mobilize cash. Sophisticated treasury organizations are moving towards what we call an “in-house” bank. Using the company’s resources for financing, an in-house bank consolidates treasury functions—such as funding, FX, and cash management—into one central entity, rather than having each subsidiary work through a different local bank. It allows corporates to observe banking, currency risk, and payments centrally, with little restrictions for fungible currencies.

    A firm operating in semi-restricted markets can consolidate intercompany loans through strategies such as in-house banking. Such concentration means most loans are denominated in US dollars rather than the local currency. Nonetheless, this challenges local branches of such firms because they suddenly face new US dollar exposures. This is why even when companies decide to take money out of a semi-restricted country, it is recommended to prioritize risk management strategies such as natural hedging—ensuring that the payments and collections offset each other and only taking out excess structural expenses.

   We observe a shift towards commercial arrangements between different companies rather than intercompany loans. In this case, for example, a local firm becomes the service provider to the in-house bank or central entity. In the process, this payment strategy changes the business model for the parent company. Before, the firm would deal with its clients in different countries through local entities. But now, a company in an open economy would invoice clients directly while another local company in a closed economy would provide the service to the other company’s client. For example, as a chair producer, I may not want to deliver chairs from Singapore (an open economy) to Thailand (a closed economy). Instead, I would pay a local Thai company to make and deliver the chairs the person bought. I have funded the Thai entity for its operations through commercial arrangements.

   This arrangement, called “cost-plus-funding,” doesn’t fall under inter-company loan regulations. It is a commercial flow, as if I bought something from the company. Because it’s a commercial flow, there are no capital controls.

   ES: You mentioned the benefit of a natural hedge—ensuring that the inflow and outflow match. How often do companies use this strategy to hedge against risks such as foreign exchange?

   TvB: Primarily, companies try to operate in a single currency. For example, oil and gas companies mostly care about the US dollar. They are more likely to accept the risk of a fluctuation in the value of the local currency to the dollar and hold 80-90 percent of their balance sheets in dollars. The risk is preferable to the cost of actively managing the funds in other currencies that may apply to their downstream businesses.

   However, matching the currency denomination of the cash inflows and outflows is sometimes possible and preferred for other industries, where local entities often have payment obligations and collections in the same currency. In such instances, a company should only consider structural excess to be made available to the in-house bank to avoid unnecessary conversions.

   ES: New trends like the growing global commodities market segmentation seem to make natural hedges more difficult. Indeed, the Russia-Ukraine war gave rise to severe dislocations in many commodity markets.

   TvB: Such sudden fragmentation of physical markets have potential payment repercussions and important implications for the ability of corporate treasurers to use natural hedges. This is an important consideration for the payment, and I am still waiting to see it being discussed extensively.

   ES: Now, I want to connect the hedging with the currency hierarchy. The idea is that not all currencies are created equally in global trade. Reserve currencies, such as the US dollar, are at the higher layer of the hierarchy and are the most stable, while the rest are at the lower layer. Let us, for the moment, accept such a characterization. From a corporate treasurer’s perspective, can we argue that the higher up the ladder of currencies your interests are, the less likely you are to hedge?

   TvB: It’s more about proportion than hierarchy. For example, if I’m between 70 to 90 percent dependent on a single currency, I might not want to invest time in managing the risk. On the other hand, if I have large commercial flows denominated in different currencies or operations, I want to manage this risk more actively.

   Every time firms do a Forex transaction, they might be subject to value dating. In Forex trading, the value date is a future delivery date on which counterparties to a transaction agree to settle their respective obligations by making payments. For example, converting USD to Thai Baht takes two days, simply because of the time zone difference. The converting company loses two days’ worth of money in the process. In addition, the prices can fluctuate. FX swaps help the corporate treasurers fix the rates in advance.

   So to have same-day access to Thai Baht, a company needs to open an account in Thailand. And a natural hedge helps reduce the number of time FX transaction is required. We help companies develop strategies to access foreign currencies straightaway. One is sweeping: the automated transfer of funds between two accounts. The other is notional pooling, where I can have one account in deficit if another account is in surplus. So if I have a negative Singaporean dollar but a positive US dollar, my access to Singaporean dollars is not seen as borrowing. Companies can take out a basket of fungible currencies, and as long as the overall remains positive, they can draw down against it at preferential rates. This solution also removes the risk of settlement or payment disruption because automated payments will continue to go through as long as they have sufficient money in any currency.

   ES: Let’s shift to looking at the payments system more broadly. In a loose characterization, the first step is when the payment happens, and that’s the job of treasurers. In the second stage, the clearing, the exchange of payer-payee information occurs. And in the last phase, the final settlement happens between banks. We’ve been discussing the first stage and how JP Morgan helps treasurers navigate their complex options. But once these decisions are made, the clearing and final settlement should also happen. Can you talk more about the relationship between these three stages?

   TvB: The funding of the payment obligations is indeed the responsibility of treasurers. There are different payment methods for payment initiation or collection. One is wires, either domestic or cross-border, which is often used for high-value and urgent transctions. Another is real-time payments such as FedNow but there are transactional limits on these that are often not high enough for companies to pay their invoices. Alternatively, they may use ACH for less urgent, bulk payments or leverage direct debits to collect funds.

   Each of these has a different mechanism for clearing with central banks but each also have a different processing time and risk profile. The Fed wire doesn’t require too much explanation. Cross-border wires have changed a lot in recent years. It used to take up to a week from the US, but now technologies are available that effectively wire within two minutes, using blockchain. ACH often can cancel because it gets executed the day after it is ordered, while real-time payments are guaranteed and irrevocable. Payment types may therefore feed into risk management practices.

   Some countries have a mandate system‚ where a debit authorization needs to be in place for direct debits. By contrast, in the US, anyone can just debit you, and you can go and complain afterward. You can be debited in real time if we’re employing direct debits. This makes corporates very nervous, because direct debits have no transactional limits. But companies like to set up direct debits for recurring costs, so treasurers can account for them easily with little intervention.

   Some banks have now initiated additional measures to protect clients, where they can automatically deny payments above a given amount. Banks also want to make sure they can settle all the payments that come in daily, so they are interested in limiting payments on the upper end.

   ES: I want us to talk about the liquidity transformation at the heart of the payment system. The first payment stage is often made through credit-based instruments or cash, while the last step happens through the highest quality form of money, i.e., reserves. From a financial stability perspective, how concerned should we be about this transformation?

   TvB: This is more of a concern now with the rise of digital payment providers. We have the proliferation of payment service providers which are not FDIC secured. Instead, in the US, we have “posthumous deposit insurance.” This means that after a firm collapses, government agencies have no option but to extend their clients’ deposit insurance. If I’m a client of a bank, I pass that insurance to my own clients in the US. But this doesn’t exist in Singapore or Australia. It’s on the account holder to have that additional insurance.

   These payment service providers have started to work together to expand their reach and to move money in a cost-efficient way. It does not necessarily reduce transparency, because they still need to report on what’s happening. They are often still required to get a license in the places where they operate, but central banks do have less direct control or visibility over the transactions taking place, especially when the company operates offshore.

   Central banks have responded to this through onshoring regulation, at least on my side of the world. China, Japan, Taiwan, Korea, and Indonesia, among others, created strict rules on who can access data. As I mentioned, they also require the entity to be locally incorporated. This is really the next stage in protecting the consumer. We also see the introduction of local alternatives to global payment methods like Visa or MasterCard. With these local options, central banks have become even more active risk managers in the market.

8. Varieties of Derisking

   June 17, 2023 3:50 am Comments Off on Varieties of Derisking

   In recent years, the debate over climate policy has moved away from the earlier consensus in favor of carbon pricing and towards an investment-focused approach, illustrated by the passage of the Inflation Reduction Act (IRA), along with other similar measures in the US and, to an extent, in Europe. 

   There are good reasons to welcome this shift, both as a more promising response to the challenge of climate change and as a turn away from the neoliberal consensus of previous decades. Industrial policy is better able than carbon pricing to address the real requirements and constraints of decarbonization. It offers the possibility of a more robust political coalition in support of aggressive climate policy, and a way to overcome the long-standing problem of chronically weak demand in the advanced economies.

   At the same time, the specific approach to industrial policy embodied in measures like the IRA raises a number of concerns. Do these policies target the right constraints and the most important barriers to rapid decarbonization? Do the subsidies and incentives impose sufficient discipline on private business to meaningfully redirect investment? Will the direct-pay provisions meaningfully increase the role of public and nonprofit enterprises, or will the IRA further entrench the dominance of for-profit businesses in energy and other sectors—ultimately undermining both climate and broader economic objectives? Does the industrial policy approach risk a zero-sum competition between national governments, and will it exacerbate tensions between the US and China? 

   On Tuesday June 6, Phenomenal World and the Polycrisis hosted a panel around these concerns, thinking about industrial policy, state capacity, macrofinance, and the green transition. The discussion featured Skanda Amarnath (Employ America), Melanie Brusseler (Common Wealth), Daniela Gabor (UWE Economics), and Chirag Lala (Center for Public Enterprise), and was moderated by JW Mason (John Jay College). Watch the full recording of the event here. This transcript has been edited for length and clarity.

   A discussion on industrial policy and decarbonization

   JW Mason: What are the fundamental economic constraints that industrial policy needs to overcome in the climate transition? What are the barriers to the required private investment? Is it just that private returns are too low, making subsidies an insufficient solution? Or are there other problems that require a public sector involvement—problems of finance, coordination, uncertainty, and so on? In other words, what is it that we would like industrial policy to do?

   Skanda Amarnath: The conventional wisdom about carbon taxes was that if you put a certain price on carbon and keep it in place, substitution will happen over time, and therefore it’s the only thing that needs to be done. What’s changed in the thinking is an acknowledgement that decarbonization is an investment challenge. It’s a capital stock challenge. What does it actually take to get the requisite capital stock to support decarbonized consumption? Emissions are both a production and consumption phenomenon. There is demand for oil, gas, and coal across the world, and viable substitutes have to be made available. But those substitutes require investment, which can happen but doesn’t always—hurdle rates and certainties interfere. Then there’s the technological element. There are parts of the transition that aren’t yet fully solved for, especially with regards to commercial scale. 

   While the public balance sheet is a valuable and important tool, it’s not going to solve every problem. Fiscal ambition can lead to success, but there are just as many cases of corporate welfare and corruption. We must be able to learn from how investments are deployed—are we achieving the goals we’re aiming for through investment? How do we use the power of the government purse, at least in advanced economies, to build a more capable government over time? The next five years will see hiccups as the IRA is deployed. There will be unintended consequences, and it’s important that people within government learn from those mistakes to better realign policies towards the goal of lowering carbon emissions.

   JWM: So the question is, why do we need industrial policy at all?

   CHIRAG LALA: I think we have to answer a few questions first. What do we expect investment to do? And why is investment not happening at the requisite speeds or the requisite volume in the areas we would need for decarbonization? We need not just new generation systems, but new heating systems, industrial equipment, transportation equipment, and so on. I want to dig into the work of Alex Williams at Employ America, who notes the difficulties of obtaining a stable cash flow and stable gain over time, which presents a challenge to both private and public enterprises. An example of this in energy projects—if you’re trying to put up a new solar project or a new battery, but you get stuck in an interconnection queue, there’s no risk premium that can compensate you for getting stuck in that queue. If your project doesn’t get built, it doesn’t generate income, which means undertaking that investment in the first place might not be something you even attempt. This is just one barrier for energy generation. 

   We can conceptualize industrial policy and evaluate it for whether it is sparking capital expenditure by asking how it addresses the various barriers to decarbonization across different sectors and projects. Is it opening up new capital investment opportunities for both private and public enterprises? This is industrial policy’s primary purpose. 

   JWM: It’s not simply about prices being wrong, but there are hard barriers that you can’t overcome with a subsidy or by changing prices. You need to identify specific hard constraints and try to remove them. This is a panel on derisking, and in our world, that term is associated with Daniela Gabor more than anybody else. Daniela, you’ve described the “derisking state” in both the US and perhaps even more so in Europe. You’ve identified a number of policy characteristics that fit this model.

   The derisking state focuses on the production of investability; the fundamental problem is enabling or convincing private capital to take ownership of the assets we want them to take ownership of. The derisking state works primarily through price signals, making some investments more attractive. It shifts economic risk from the private sector to public balance sheets, maintains the primacy of the central bank, and does not require any kind of central coordination or planning. That’s just a broad description, but could you explain what distinguishes this “derisking” approach from other forms of economic management? Where does the IRA fit in?

   Daniela gabor: How you frame problems of decarbonization is shaped by your understanding of the political economy of derisking. To me, Chirag framed the question of decarbonization through a derisking logic, where the problems are risks to private investment, and you have to remove them, not just by granting subsidies or tax credits, but also through what the World Bank would describe as “regulatory derisking.” I’ll take a different starting point to describe problems of decarbonization: in our current climate crisis, private capital is engaged in systemic greenwashing. From there, you get a very different diagnosis. 

   I also wanted to make it very clear that although I have spent the last few years theorizing the derisking state, I did not invent the term. Deutsche Bank introduced the term in a 2011 report for the United Nations Development Programme. They argued that private investment into renewables in the global South would require regulatory or financial derisking to escort private capital into those public policy priorities. Derisking was born in Europe as a logic of statecraft. It’s not a particular policy framework or a particular industrial policy approach. It was adopted by the World Bank in 2017 upon the introduction of “maximizing finance for development.” What is interesting now is that we have moved from saying, “We should de-risk private investment, and we need private investment from institutional capital, like BlackRock and other asset managers, to be put towards Sustainable Development Goals (SDGs) in the global South.” Now, we are saying, “We should guide capital towards industrial policy priorities.” That’s the big shift exemplified by the Biden Administration. What are the geopolitical factors that have put derisking at the center of green industrial policy? At its core, derisking sets up a particular type of relationship between the state and private capital. 

   It’s important to resist the temptation to celebrate a paradigm shift. Derisking offers a plausible political compromise to bring together Republicans and Democrats. It doesn’t require fundamental change, it just requires more fiscal resources for bribing private capital to support certain policy priorities. But it does not change the relationship between the central bank and fiscal authorities, and it does not reform institutional capital. 

   The developmentalist literature in the work of Robert Wade or Dani Rodrik emphasizes disciplining private capital. Derisking is not consistent with discipline. This is the difference between derisking and earlier experiments with industrial policy. 

   SA: “Derisking” is a term that’s used quite commonly in a lot of private sector parlance, perhaps less pejoratively than Daniela probably likes to use it. But I think descriptively it’s accurate. Many administration officials use the term “derisking” openly to describe the IRA. But does “derisking” merely entail subsidies or is it something more? Is it bad per se, or are there varieties that actually have legitimacy? 

   What BlackRock wants for their investment products is very different from how the IRA is structured. They are obviously financial beneficiaries, but the IRA is not structured to go through BlackRock. That’s a major contrast with the 2000s US housing bubble and bust, which actively celebrated the derisking of financial products to intermediate more capital towards housing and homeownership. It’s fair to say that the IRA is not trying to change its relationship with the Fed, but it is, in some ways, trying to bypass it. The derisking approaches are different—the difference between derisking a financial product for more financial inflows, leading to more fixed investment, versus subsidizing that fixed investment. 

   cl: One aspect of Daniela’s derisking definition that I really like is the concept of the production of investability. Whatever we end up defining derisking as, it’s important to acknowledge investment as such in certain sectors. What would happen under the right circumstances that often doesn’t happen, and why not? Where I would disagree with Daniela is that I think the production of investability happens both for private and public actors. There are factors that also prevent public actors from undertaking investment, and if those can be mitigated, then in some sense you’ve de-risked public investment as well. In certain cases, the public sector is not dealing with so-called risks—things you can assign probabilities to or try to hedge against, using interest rates or the pricing of capital or subsequent gains from the investment.

   The state is often certifying lines of activity for accumulation by private actors or for possible capital expenditure by public actors. These barriers cannot be compensated for by the price system. I could critique a carbon tax on this basis as well: a carbon tax functions on the idea that a high enough price carbon emissions will spark investment in alternatives, so that substitution effects can take place. The problem with this, of course, is that the carbon tax might not address any of the actual barriers to undertaking certain kinds of capital expenditure in energy. We can talk about planning, we can talk about industrial policy, but we’re ultimately talking about a space where activities are made possible or not. 

   DG: Why do I understand derisking as the intervention in price signals? I would argue that I define derisking through how European technocrats and politicians think about it—steering price signals without fixing them. You don’t have price controls, you don’t deal with inflation with a muscular state. But you steer price signals, even where they don’t exist. For example, the Germans are creating a green hydrogen market where it didn’t exist before, through a series of derisking measures that compensate private investors and reduce the uncertainty of the price signal for private investors. I’m very comfortable standing behind that definition of derisking, because that makes it conceptually clear that derisking is about the relationship between public and private capital, between the state and private capital. The state cannot de-risk itself unless it offers or has companies that operate as market companies. There are examples of the Danish state ownership of 51 percent of companies like Ørsted, who are doing energy infrastructure. 

   I think it confuses things to argue that there is a public derisking. To me, derisking is about shifting risks from the private sector onto the state balance sheet, not just by fiscal measures but also by regulatory measures. The World Bank, the UNDP, and the Deutsche Bank have, from the beginning of this discussion, emphasized the importance of regulatory derisking—removing obstacles to the formation of a price signal and market. I don’t think anybody goes around thinking that the state de-risks itself, though raising the question of the state is important. We can argue whether or not state companies should care about price signals. But there are models of capitalism where state companies do not care about price signals, where they buffer the end users from the consequences of market volatility. 

   This takes me back to Skanda’s point—Why is this a central bank story? You’re correct in the sense that BlackRock is not as important as a political actor, though of course BlackRock sent someone to the Biden administration to write the IRA. But that’s why I would make a distinction with the CHIPS Act, which to me is much better than the IRA. The CHIPS Act moves away significantly from the logic of derisking because it focuses on strategic state priorities. 

   But we have to remember is that the IRA embraces the relationship between the state and private capital—the state steers price signals and makes investability. This isn’t a smooth process, there’s no tried and tested process for this. But what the IRA did is change the European approach—there are many more “sticks” and it disciplines carbon capital. The IRA is not just a question of greening or incentivizing private investment, manufacturing, or clean tech. It’s also a question of shrinking fossil fuels and carbon capital. That’s a very different story from the standard story of industrial policy in the developmental state literature. 

   JWM: Melanie, do the IRA and the CHIPS Act constitute a fundamental shift in the intellectual climate? Is this at least a step in the direction of a broader substitution of public planning for market coordination? Or is that just wishful thinking on the part of those of us who’d like to see a shift? 

   MELANIE BRUSSELER: As several people on this panel have already argued, there’s now a greater shared understanding that decarbonization is a problem of investment and divestment. We need to transform existing capital and infrastructure stocks through investment and divestment very rapidly and at a spectacular volume. It’s important to stress that, when we talk about investment, we’re talking about capital equipment installation, not necessarily financial flows. The policy paradigm for so long has been to let market coordination more or less take over, relying on the constitutive elements of private investment—private profitability and the liquidity preference, which guide private investment but also hinder the multiple criteria that we’re trying to address right now. But market coordination is a fundamental issue for decarbonization. I’m borrowing the language of Yakov Feygin in a very Leontief vein—the fossil system and the renewable system are both very complex integrated machines. You can’t just swap parts from one to the other. They are very incongruous, so you need to synchronize investments to make sure we don’t have mass economic turbulence, in terms of price stability but also in terms of the functioning of our productive systems. 

   How do you build a coherent renewable energy system and an economy on top of that? I don’t think market coordination can do that. What would be different about non-market coordination? Regardless of the decarbonization imperative, economic democracy is an end in itself. But within the decarbonization paradigm, we want to see public coordination take over through institutions of public investment, public asset ownership, public enterprise, and pluralistic decision making, which would deliver investment and divestment directly, by having the state undertake essential activities and investments, and then coordinating amongst public institutions and private actors. There would be a much stronger hand for state bureaucracy. Macrofinancially, the price policies of the transition would move away from monetary dominance. More broadly, we would embrace the risk bearing capacity of the state through public ownership. I would like to provocatively call this the potential for “democratic derisking”—taking whole sectors into public utility models and having systemic public options for capital investment in order to stabilize and expand green production networks, as well as to stabilize green industry. 

   I think of democratic coordination as institutionally moving towards a green mixed ownership economy, with much more systemic public ownership and using equity stakes not just to passively subsidize private investment but to have strong control rights. So where does the IRA stand in this configuration? I agree and disagree with Daniela. The IRA’s passage has ushered in a spectacular volume of subsidies for private capital. That’s both compelling and frustrating, structuring the undertaking of capital expenditure to private actors. I think it’s right to point out that this is a continuation of this logic of producing investability. I love the phrase that Tim Barker revived, “bribing to capital formation,” where the fundamental issue is leaving this to private decision making. 

   At the same time, it’s important to stress that we’ve moved quite strikingly towards concern for capital expenditure. It’s a completely different animal than just worrying about how to get financial actors to do certain things. While there are pitfalls, this is a shared project to manage and coordinate this move—we have subsidies out there that could be undertaken, but it’s subject to further public investment and coordination. This is becoming the shared framework of future policymaking and experimentation, and we need to seize the opportunity. 

   SA: There is a form of derisking in the IRA—even if it doesn’t run through BlackRock, BlackRock surely benefits. But the part that sticks out to me from Melanie’s comments is that there is a certain necessary kind of fixed investment. If left to the private sector, that fixed investment, even once it has social value, tends to be a free cash flow drain—investment tends to only be justified if it overcomes certain hurdle rates in the private sector. That is a risk calculation that I don’t think of as being the same as a price mechanism. I think this will be necessary in areas where investment is subject to a lot of uncertainties. One good example would be Cleveland-Cliffs, a steel producer in the US. It is emissions intensive, and we don’t have scalable, tested solutions for emissions-free steel production. IRA incentives and IRA derisking provide very important tax credits for scaling up. If you can change industry behavior to try things that drain free cash flow in the short run, they of course need potential returns in the longer run. But changed behavior is really important to changing the system itself.

   There are many reasons the IRA looks the way it does—legislative procedure has gone through financial mechanisms, not just regulatory mechanisms, just to get through reconciliation. But we need to focus on substance over form. Sure, it may take the form of carrots that are attractive for the private sector, but the ultimate goal is to change behavior. My biggest concern with painting things with a broad derisking brush is that there are definitely examples where derisking can go wrong, but there are also places where it has a legitimate purpose in the energy transition. How are we going to tackle this challenge? 

   JWM: That was very clarifying. Can we separate derisking as a descriptive term from descriptive derisking as a normative term? Can we imagine a democratic derisking, a derisking paradigm of economic management that is nonetheless serving social needs through a democratic political process?

   DG: I would say the short answer is no. I like the idea of democratic derisking, but I think it’s fundamentally inconsistent with how I understand derisking. There’s a bigger question: Can we or should we expect to tackle the climate crisis through private capital? I’m not sure the answer is yes. Skanda and I agree on trying to change the behavior of private capital. But after living in Europe and following the policies there, I see derisking as a macrofinancial issue, not just an industrial policy issue. For the last five years, the European Commission and European governments have been trying to change behavior through discipline and penalties. You can change the cost of capital and stimulate fixed investment not just by increasing returns, but by making it far more expensive or to invest in dirty assets. There are different kinds of pathways to changing behavior of private capital. My worry is that with the IRA, we are very quickly moving far away from what we had in Europe. 

   These policies in Europe weren’t perfect, and they were open to political contestation and watering down, but the ECB tried to discipline fossil capital and change risk return profiles, changing investability and behavior through penalties on dirty credit. We don’t need democratic derisking. The harsh reality is that you can change behavior in different ways. We are now changing behavior in a way that BlackRock would approve of—adding a lot of carrots and not enough sticks. Why can’t we pursue the European version? 

   MB: On discipline, I think it can be tricky to talk about the role of credit guidance and the greening of the financial system. Credit guidance is a necessary tool in the macrofinancial toolkit, but I think positive and negative credit guidance is often overplayed in terms of driving capital expenditure and divestment. It’s unhelpful to think that penalizing carbon investments through the financial system would lead to an orderly divestment from fossil fuels. Ultimately, the phase out of fossil fuels will have to happen on the state balance sheet, because you have to maintain a certain level of capacity and then phase out. Credit guidance can help that along but it’s not the fundamental mechanism by which it’ll happen. 

   Our conversation on derisking is circling around the question: what should we be publicly invested in? And what will rely on private investment alone as a result of political constraints? The language of derisking can still be quite helpful as we turn from financial market shenanigans to the actual governing of capital expenditure. For example, in the UK, the Contracts for Difference model is a classic form of derisking—it entails backstopping private investment. But there are currently some issues with it, as we face inflation and higher interest rates. Wind turbine developers claim they need to raise their prices to expand capacity because their profits have been eroded, because private generators are fueling the lessening of subsidies through these contract pressure models, also called a reverse auction. They’re fighting for profit share in this space, we’re left with the question: which capacity do we want to be expanding? Do we want to govern the capacity to produce private wind turbines, or do we want public generation that directs that investment and stabilizes that production network? As we move into fixed capital investment, there’s a way to be appropriating this language of derisking. I don’t even know a better term for it.

   SA: Financial investment and fixed investment look very different when it comes to decarbonization. Decarbonization is about the real capital stock, both for divestment and investment purposes. The derisking logic is in the financial context, targeting certain risk financial instruments. Leaving aside the normative aspects, I’m not sure that this is going to be a key lever for how we’ll drive fixed investment. A running theme of the last few decades is that if we just give finance certain conditions, it’ll lead to certain fixed investment conditions, and I’m not convinced that this is true. 

   We need to further parse out the varieties of derisking. I don’t really see how CHIPS is that different from the IRA—industry lobbied for it. There were some Republicans and Democrats who saw the national security benefits of having an industrial base around leading edge and legacy CHIPS, but I think there’s definitely room for public and private sector alignment of interests. But I don’t think it’s actually that different in terms of governance design. Yes, there are some strings attached and some conditions, but CHIPS is largely grants that support the investment and operations of semiconductor manufacturing companies. There may be disciplining of firms, but at best, it’s collaborative, and at worst, it’s a set of conditions to make sure that firms invest a certain amount. It’s larger grants and subsidies, not a new regulatory state around semiconductor manufacturing. Daniela, what does an IRA look like without a pejorative derisking structure? What would the IRA need for fundamental change?

   CL: I want to add onto this concept of discipline. I think of industrial policy more generally as creating the possibility of spaces for investment—public or private—that didn’t exist previously. It reduces the salience of the carrot v. stick differentiation. When you look at how policies end up sparking capital expenditure, you start to miss the point where the policy goes from being an inducement to being a disciplining device on capital. One example is the American Rescue Plan. Firms were pressured to consider certain kinds of capital investment that they might not otherwise have, relative to what they might have done with free cash flow—either discard it in buybacks, return it to shareholders somehow, or just not use it and have it sitting on their balance sheet. In one sense, the ARP was an inducement because it gave firms potential customers and potential profitability opportunities. But it was also a disciplining device—the one aspect of financial capital that would have demanded certain cash flows became relatively less powerful. Other industrial policy devices can also be thought of in this way. Carrots can open a large opportunity for firms to make them consider a space that they hadn’t before. In some sense, the distinction between discipline and carrots is blurred.  

   DG: Chirag, we can play language games in which everything sounds like conditionality or discipline for private capital, but I’m not particularly interested in that. I agree that putting penalties that change risk returns on dirty assets is a necessity that also plays with a price signal. And yes, that doesn’t take us into state control of the pace or nature of credit creation. But the excessive amount of lobbying in Brussels and in London against these measures makes me think that there is something at stake that we should not discard simply because it doesn’t take us into a universe where the state is much more powerful in terms of disciplining private capital. 

   My observations simply have to do with the fact that the derisking logic of statecraft accommodates greenwashing and is inconsistent with Paris targets. I am worried that it doesn’t take us where we want to be, for reasons that Melanie pointed out. When market conditions change, some private actors may change their mind, and we cannot afford this. I use the notion of the close control of credit, which requires the state to do much more work than credit guidance. I’m putting political impossibility aside for a second, but the state must do more to restrict the free flow of capital across and within borders, and this is why decarbonization is fundamentally a macrofinancial issue. We need changes in the structures of finance, in institutions of coercion.

   I was very dismissive of the CHIPS Act at first, but Twitter conversations have persuaded me that there is some level of discipline. The Biden administration is far more ambitious than Europe, in terms of operational milestones like a restraint on share buybacks or prior due diligence. The purpose of disciplining institutions is that strategic industrial policy must ensure that capital doesn’t go in another direction when market conditions change. The state needs to have the capacity to closely steer investment. The CHIPS Act does this more than the IRA. It would require the IRA to say, we can’t shift from small electric cars to electric tanks, because that does not solve the problem of climate change. 

   SA: I think the operational milestones are quite similar in CHIPS and the IRA—the work of the Loans Programs Office, the commercial liftoff reports tied to certain projects, ensuring the goals are achieved. There are places where the Department of Energy and the Department of Commerce look quite similar. It’s a form of indicative planning.

   JWM: Melanie, to what extent is the IRA relevant in the international context, in the UK and the EU in particular? Or would you hope that a future UK Labour government, for example, would support a different kind of model?

   MB: There’s been a lot of European activity on how to respond to the IRA. The EU was certainly concerned about the trade aspects, but there were also internal politics, with some actors wanting more fiscal spending and industrial policy. In the UK, there’s a really exciting development with the potential of a Labour Government, which has pledged to spend upwards of 300 billion pounds across ten years on a “green prosperity plan,” which is still largely undefined. But it does feature a commitment to create British energy—a public renewables generator. They want to be a green energy superpower akin to Électricité de France (EDF) in France. They’ve also proposed creating a sovereign wealth fund with a green mandate, which is quite rare, and closer to the National Investment Authority proposal in the US context. 

   One lesson that the UK could take from the UK experience is to think creatively around fiscal constraints. Discussions around debt and fiscal stability should account for the fact that public assets generate revenue. In the UK, Rachel Reeves and the Labour Party still emphasize maintaining fiscal discipline. The IRA, on the other hand, is made up of uncapped tax credits—for better or for worse. The UK political project could question this fiscal rule.  

   JWM: Daniela, what would be the dangers if the EU were to follow the US example? Was there a more promising model in Europe that is in danger of getting sidelined by the IRA approach?

   DG: I’m not as optimistic as Melanie. I understand the sovereign wealth funds as derisking machines, as opposed to machines for creating public ownership. They are not articulated towards a public or state-driven decarbonization project. While this conversation is about derisking, I’m working in parallel on what I call a big green state. It summarizes a range of approaches, but it does not allow private capital to set the pace and direction of decarbonization, as is currently happening. The dangers in Europe resemble the way that different US states are competing for the IRA money. But in Europe, it’s far more obvious, because the macrofinancial relationship is far more delicate and open to political contestation. With the IRA, we have moved from the EU wanting to decarbonize quickly, even with Chinese clean tech imports. The EU now wants the global market share in clean tech. In other words, it’s industrial policy in the old, traditional way. 

   In the paper, I look through the scenarios where the European Commission uses the term “derisking multiplier,” making some bizarre approximation for the amount of money you need for a percentage of the global market share. But it’s the politics of how to get European capitals to agree on a Europe-level budget. The difficulty of the delicate arrangement, then, is that France, Germany, and countries with more fiscal space are not allowed to promote their own industries through state aid. Since the pandemic, however, the easing of these restrictions which were meant to level the playing field has mainly benefitted France and Germany. It turns back to the same problem that Melanie identified—in the end, the immense challenges we face cannot rely on market coordination. What we need is big state balance sheets and state capacity that do not repeat the mistakes of communist enterprises. My postgrad studies focused on central banks actions in post-communist countries, where they needed to dismantle state-owned companies. Now, I’m going to study how we put them back together.

   SA: I think Daniela’s piece is very provocative—is derisking a race to the bottom or the top? There’s going to be a need for experimentation and overcapacity, erring on the side of redundancy. Many countries and companies will try to figure out how to push down cost structures in a way that leads to more investment and capacity. The developed world must use its fiscal policy space to allow emerging and underdeveloped countries to also pursue decarbonization paths. We have to make that space available, and part of the IRA and derisking is worth rescuing and celebrating.

   CL: The private sector is an existing set of institutions that will continue to exist for the foreseeable future, and we need them to undertake decarbonization activities as well, in many cases against their previously expressed interest and intentions. If our policies succeed in creating a boom in green capital equipment, then we would have the political responsibility for the next steps—the fight doesn’t end there. I think if you’re looking to spark a politics of democratic investment, you have to be prepared for what comes next.

   MB: Ultimately, I think we have to view social transformation as an iterative, uncertain process of transforming institutions, tools, and enterprises. It’s going to be a constant fight. It’s up to us to move the politics towards the socialization of investment, abolition of fossil fuels, and the eventual flourishing of the planetary cooperative commonwealth.

   DG: I think the distinction between financial capital and capital investment is a bit too neat in this panel, but I am a bit more hopeful after this. I’m generally quite skeptical, but I will go with Melanie’s insight that all small political changes might take us somewhere better.

9. Making Markets

   May 25, 2023 8:52 am Comments Off on Making Markets

   The Gamestop bubble of 2021—where the value of the company’s stock increased more than a hundred times over in just a few months—exemplified the rising trend of the meme stock frenzy. This event shed light on the roles of both retail investors and market-makers in contemporary equity markets, and more recently has contributed to the US Securities and Exchange Commission’s (SEC) justifications for its proposals to overhaul how retail investors access and invest in the US markets.

   Douglas Cifu is the co-founder and Chief Executive Officer of Virtu Financial, a major retail and wholesale market-maker. In the following conversation, Cifu and Elham Saeidinezhad discuss the politics and implications of the proposed regulations, as well as the broader dynamics of equity markets. Read Saeidinezhad’s full introduction to the interview and analysis of the new regulations here.

   An interview with Douglas Cifu

   ELHAM SAEIDINEZHAD: Can you summarize the business of market makers? 

   Douglas Cifu: Market making has always been around—we can imagine a subsistence farmer who, thanks to agricultural innovations, ultimately comes to sell her excess harvest at a post in the market. The market maker is the agent who buys corn from the farmer, collects it and holds it in a warehouse, and holds it for sale to buyers looking for corn at a later date. This involves a substantial amount of risk—the market maker accumulates quantities of goods and holds them for an unknown duration of time—during which the price of corn could fluctuate—before securing buyers. 

   In the contemporary equity market, market-makers are willing to purchase and sell securities to investors looking for immediate liquidity. Like the market maker buying the farmer’s corn, today’s market maker assumes the risk of holding the position until it can find an offsetting buyer or seller who wants its inventory. As an incentive to take this risk, market makers attempt to earn a profit by offering to sell shares slightly above the price than they bid to buy shares (the bid-ask spread); however, like the market maker that bought the farmer’s corn, the market for securities can move against a market maker’s position causing it to lose money on some positions. Thus, market makers contribute to market prices through their commitments to purchase and sell all sorts of liquid and illiquid assets. 

   We make markets in 25,000 different financial instruments. At any moment in time, we may be long or short any security. In practice, we aim to bridge the temporal gap between natural buyers and natural sellers. In a perfect world, we would always buy from one person and sell to another person before the market moves against our position. That world doesn’t exist, but by aiming towards this end we facilitate market liquidity overall. Over the past fifteen years, we have invested billions of dollars to build our scaled infrastructure that can access and provide liquidity across hundreds of markets and dozens of asset classes. We are motivated to provide attractive buying and selling prices because, if we don’t, we’re not going to get the business. The farmer should be able to sell her corn for a higher price if she can find a buyer willing to pay more than another buyer. That’s what market making is, and competition among market makers has significantly improved market liquidity and reduced investors’ costs. 

   ES: The SEC’s recent proposals on equity market structure are intended to improve trading execution for retail investors. The proposals distinguish firms which service and often internalize clients’ orders from those which route orders to another market center, with the idea that all orders should be routed to a market center where more competition would help prevent profit incentives on the part of wholesale dealers. What is the SEC missing? 

   DC: The proposal assumes that market-makers have an incentive to internalize every order in order to make a higher profit margin. But, in reality, this is not the case.  

   According to the rules put forward by FINRA (the Financial Industry Regulatory Authority), retail brokers have a duty of best execution which requires them to use reasonable diligence to route orders to the best market. When a broker-dealer that is a market maker receives orders from a broker-dealer client—whether it’s Schwab, Fidelity, Vanguard or any of the 250 clients we service—we have a best execution obligation to execute the client’s order in the best market, regardless of whether that means internalizing the order ourselves or routing to another market center—such as an exchange, alternative trading system (ATS),¹ or another wholesaler—if we expected that doing so would be most likely to result in the best price, immediacy, and overall execution quality for the end client. We have a committee dedicated to monitoring our execution performance and evaluating market centers, including what we internalize and externalize by routing orders to external market centers.

   In addition to the regulatory requirements to deliver best execution, there are intense competitive forces that serve as an immediate check against poor performance. Both to meet our best execution obligations and to compete for order flow, we internalize more orders than we would otherwise want to internalize. However, contrary to urban legends, only about a dozen retail brokers charge payment for order flow (PFOF) and these retail brokers do not route orders to one wholesaler or another based on PFOF amounts; in fact, each broker sets its own PFOF rate and charges that same rate to all wholesalers to avoid potential conflicts. Retail brokers reward wholesalers with more order flow if they deliver better performance than others and send less order flow to wholesalers that deliver lower performance. 

   Importantly, the SEC’s proposed regulations do not recognize that wholesalers service more than just retail brokerage firms such as Robinhood and Schwab. Large firms such as LPL Financial, Stifel, Raymond James, and JP Morgan’s Wealth Management Division also leverage wholesalers to get the best execution for their clients. These brokers and platforms—about 250 in total—and their best execution committees review our performance on an ongoing basis. If we don’t constantly provide exemplary execution service and the best prices, these large wealth management firms would send their orders elsewhere. There are no contracts or long-term agreements that require brokers to route orders to a wholesaler—the brokers are free to (and have an obligation to) make routing changes to send more flow to the marketplaces or wholesalers providing the best execution. After all, execution quality is one the of the key metrics by which retail brokers are measured so they have a commercial incentive to make sure their routing is optimized. So, the competitive market structure already encourages the best execution, and the existing rules by FINRA ensure that this continues.

   Accordingly, wholesalers are incentivized to execute in the best market. While internalizing the order will typically provide the highest probability of being the best market, for a variety of reasons wholesalers frequently obtain shares on other market centers which we refer to as externalizing the order. When we externalize an order by filling it with liquidity obtained from other sources, like an exchange, we often must subsidize the execution quality we obtained by adjusting the order’s fill price to a more favorable price for the client. By providing this supplemental price improvement, we are able to deliver price improving executions to retail investors and remain competitive versus our peers.

   Our view on these proposals is that the SEC is being over-prescriptive in trying to repeal and rewrite the existing understanding, rules, and standard operating procedures that FINRA and the industry have dealt with for the last twenty years. The proposed reforms are vague and subject to substantial uncertainties about the potential benefits, which the SEC itself acknowledges, and there’s a broadly held fear that the proposed rules will have unintended consequences for retail and institutional equity investors. The impression is that the SEC is trying to micromanage, rather than regulate, the marketplace. 

   We believe in data-driven regulatory reform, not pointed rules that pick winners and losers from the outside. But at the moment, there’s no evidence that the proposed rules are objective and data driven, but rather will pointedly harm liquidity in the market and significantly increase investors’ and issuers’ costs. In practice, the best execution rule being put forward will simply ban PFOF—the per-share fee charged by retail brokers to the wholesalers they route orders to. SEC Chair Gary Gensler expressed the desire to ban PFOF a year ago, causing a bipartisan uproar. This is because it is widely recognized that payments (or rebates) to retail brokerage firms order flows don’t impact routing decisions. The rebate that wholesalers pay to the retail broker fosters competition and innovation among brokers, and enables these retail brokers to provide commission-free trading to their clients. 

   The SEC could have opened a debate regarding PFOF. If it had done so, the SEC could have learned about how the market has solved for this already by offering choice to investors. For example, some brokers like Schwab and Robinhood charge PFOF while others like Fidelity and Vanguard do not. Generally, disclosing, quantifying, and regulating financial services and then allowing individuals to make their own decisions is far more effective and useful than prescriptive regulation that limits investors’ choices, such as an outright ban. The latter leads to years of SEC exams, potential fines, and litigation enforcement without improving the markets and would only make our markets less accessible for many first-time investors. 

   Rather than prescribing static rules for a highly dynamic market, the SEC and FINRA’s primary job should be to look for bad players and then go after them. I’m a big believer in a principles-based regulatory regime—where established principles say a broker-dealer has to make reasonable efforts to obtain the best execution for its clients.

   Additionally, we should not confuse best price with best execution. Best execution means using reasonable diligence to execute in a manner that provides a good probability of achieving a price that is at least as good as prices that are reasonably available when comparing competing markets centers under the particular circumstances of the order and market conditions. When a client sends a wholesaler a big block of an illiquid stock, simply executing that order in the marketplace may move market prices overall, which—even if executed at the best posted prices available—may not be the most favorable outcome for investor’s order. Therefore, the best price for a given order should also consider the order size, the investor’s level of urgency, the time the order is received, and what liquidity looks like in the rest of the marketplace. The SEC mistakenly concludes that because the retail broker is charging a rebate, it can’t possibly offer best execution. But this doesn’t recognize the various factors that impact execution quality.

   Finally, investors always have the choice of selecting a retail broker that does not charge PFOF if they dislike PFOF. We service about 250 retail brokers in the United States and abroad, and only about ten of them charge a rebate or PFOF. Regardless of whether a broker charges PFOF, these brokers satisfy their best execution obligations in large measure by sending orders to wholesalers who can provide a better price as academics have demonstrated on many occasions. 

   ES: What is your response to the proposed changes to Regulation National Market System (reg NMS) that would reduce the minimum quoting increment—thus reducing the minimum difference between bid and ask prices for particular stocks, potentially allowing the market to quote closer to an asset’s fundamental value?

   DC: In 2005, reg NMS allowed securities to be traded on more venues than only a security’s primary listing exchange. One of the trade-offs was making everything trade-in “no less than a penny tick.” 

   Nearly twenty years later, there are many exchange-traded funds (ETF) and some stocks that are constantly quoted at a penny. One could make the argument that those names are tick constrained and might benefit by being allowed to quote in half-penny increments, but we should identify these symbols through data rather than arbitrarily regulating tick size. Determining whether a name is tick constrained should be a multi-factor test that also considers quoted size and average trade sizes—not simply determined by the quoted spread. Some exchanges, like the Chicago Board Options Exchange (CBOE), put out a white paper with an objective method for identifying tick-constrained stocks, which seems reasonable and is broadly supported. 

   Additionally, while the SEC’s proposed new tiny pricing increments (tick sizes) of 1/10^th of a penny and 2/10^th of a penny are purportedly aimed at narrowing trading costs for investors, these changes are likely to have the opposite effect and harm displayed liquidity in the market. The SEC’s proposal is meant to encourage tighter quoted spreads on exchanges, but overly narrow ticks will likely push more liquidity away from exchanges.

   For those tick constrained names, I think there is an equilibrium to be found. You may be able to determine that there is sufficient liquidity in sub-penny pricing to narrow the tick from a penny to a half-penny without negatively impacting liquidity. But unilaterally making ticks smaller than they otherwise would-be risks worsening liquidity for everyone—including retail and institutional investors as well as increasing costs for issuers—by removing incentives for participants to display their limit orders on exchanges.

   The net result will be that it will be much more difficult for institutional investors to execute in the market and more expensive for issuers to raise capital. For context, we at Virtu Financial operate retail wholesale market making, our own multi-asset principal market making, and a very large institutional business. In our institutional business, we utilize our technology investments to provide multi-asset execution services (execution algorithms), workflow solutions, and analytics products. We and the majority of comment letters from institutional investors strongly oppose the SEC proposal to reduce quoting increments to 1/10^th or 2/10^th of a penny.²

   ES: One of the most interesting aspects of this is the gap between the SEC’s academic theories on financial markets and what is happening on the ground. Gensler is effectively following academic theories and models, which argue that commission fees and transaction costs should equal zero in a perfectly competitive market. They believe that the price of an asset should only reflect its fundamental value, or risk-adjusted future income, and any service costs should be competed to zero. What do you say to this understanding? 

   dc: I think these tensions are well demonstrated by the auction proposal. The SEC chairman thinks there is too much intermediation in the equity market, and this can be resolved by routing every retail order to an auction. Gensler’s auction proposal mandates that retail equity orders are routed to auctions conducted by exchanges where more market participants would be able to bid (or offer) in the auction. 

   Gensler believes that buyers and sellers would then magically match with each other in the market at more favorable prices, and that wholesalers simply represent “unnecessary friction.” That’s like saying that a grocery store creates “unnecessary friction” because a customer could get a better price if they bought one gallon of milk from the farmer, regardless of the fact that selling milk one gallon at a time would be cost prohibitive for a farmer and there’s a cost to forcing consumers to make time for a separate trip to the farmer. Competition among and between brokers, exchanges, banks, wholesalers, and market makers serves to make the entire ecosystem more efficient and diverse for everyone. 

   To that point, over the years, competition amongst market makers has reduced friction and PFOF payments to retail brokers has enabled commission-free trading for retail investors. Competition has also narrowed the bid-offer spreads quoted in the market and improved execution quality dramatically. Commissions went from $300 when I was a kid to zero today. Quoting increments and trading used to happen in 25 cents, now everything is in penny increments. 

   Wholesalers are able to provide superior executions to retail investors because these are not large orders. By segmenting the typically smaller retail orders from typically larger institutional investor orders, wholesalers can fill the retail orders at a better price than what is available on exchanges. Because the retail order is for, say, a $5,000 and not $100 million, wholesalers can absorb it into inventory, expecting that the individual retail order won’t move the market against us while we’re holding the inventory, which further lowers our cost to provide liquidity. 

   When we have a lower cost of liquidity, we are able to be more competitive and share that savings by providing significant price improvement back to retail investors, often getting close to midpoint execution. That’s what the wholesaler liquidity provision service is—it offers price improvement, price discovery, and immediacy of execution—not “unnecessary friction.”

   It’s also important to go back to the value of wholesalers’ risk taking and its relevance for liquidity provision. As a wholesaler, we assume market risk when we provide immediate executions by absorbing positions from clients. There is a broad swath of securities in the United States with about 10,000 individual companies and ETFs listed on national securities exchanges. In today’s competitive market, retail brokers are able to leverage wholesalers’ investments in technology to service all of their clients’ marketable orders of fewer than 10,000 shares. If a retail investor is buying, we will sell, and if they are selling, we will buy. Retail brokers demand that we be there in every symbol—not just the popular or most active ones. We have a commercial expectation to ensure every order is filled and a regulatory obligation to ensure best execution.

   Now, of those 10,000 stocks and ETFs, there are about 7,000 illiquid securities in which we have little natural interest in being a market maker or wholesaler.³ Providing liquidity in these thinly-traded stocks or ETFs is naturally more expensive due to the lower turnover and higher capital charges—some of these might only trade a million dollars a day or less than 100,000 shares a day. However, when wholesalers receive these orders, we must fulfill them—and we need to do a good job at it to remain competitive and fulfill our regulatory obligations. So, you can see there would be little chance that orders in illiquid symbols would find meaningful liquidity if they were sent to an auction where no one is obligated to provide liquidity. 

   ES: What do you do with such unwanted inventories?

   dc: Well, we fill these orders and often hold positions overnight—or as long as it takes to find the other side. As I mentioned, being a market maker involves taking measured market risk to efficiently bridge the gap in time between when a buyer comes to the market and a seller comes to the market. But under the auction proposal, if market makers don’t want to internalize those unwanted trades at the midpoint price, which we don’t, these orders would be sent to an auction where there’s no obligation for anyone to absorb the orders. 

   This means that under the proposed auction rule, many of these retail orders will not be executed, or if they are, it will be at much worse prices. Wholesalers will send the orders to an auction, where, when no one wants to trade them or if the market is moving quickly, will go unfilled or will be filled at worse prices as compared to when the retail investor entered the order. By removing the competitive forces driving wholesalers to fill every order, we are looking at the potential for massive auction failures, left, right, and center—especially during the most volatile market conditions. This is a risk that the SEC acknowledges, yet unexplainably dismisses, in its auction proposal.

   The head of Trading and Markets, Professor Haoxiang Zhu, seems convinced that the market will fill in that size. That’s why I noted on CNBC that the SEC thinks there’s a liquidity fairy that’s just going to show up and fill these orders. This is not how the markets work. 

   Now, let’s talk about the impacts of this rule on best execution. If you’re a retail broker, such as Schwab, for instance, and you send a sell order to Virtu Financial and Virtu decides not to internalize it at midpoint, then we would send it to an auction. After the 300 millisecond auction period, the order fails to execute because nobody wants to buy the shares. At that point, the retail order’s intentions would have been broadcast to the entire market in the public auction message and the unfilled order would come back to the wholesaler. By now, the markets have moved because the market now has information about the retail order’s intent. 

   Immediately, any natural buyers that might have wanted to buy from the retail seller will stop doing so—or at least lower the price they were willing to buy at to account for the recently published information about the retail sell order. When the quoted spread widens as the best bid price in the market falls below the best bid price at the start of the auction, the auction will fail. After this failed auction, the retail seller would now need to cross a bid/ask spread that is no longer five cents wide but now is ten cents wide—raising the retail investor’s execution costs. Effectively, under the proposed auction regime, wholesalers would no longer be incentivized to compete for order flow as they do now. Wholesalers will selectively provide liquidity to internalize what they want at midpoint and then, as an agent, route the remaining orders to an auction where they have no obligation to provide liquidity.   

   Much of the proposal still needs to be clarified; however, in this scenario, wholesalers—acting as agents—would presumably cross the now wider bid-ask spread and return the order back to the retail broker. From my perspective, as a wholesaler, it’s actually a better result for me because I don’t have to take as much stock into inventory. I’m not using as much capital and I have less risk, but this comes at a cost: retail investors will get a much worse execution and incur higher costs to access the markets. This is bad policy and it’s bad for our capital markets.

   Additionally, regulators fail to appreciate that asset managers don’t typically trade in the same stocks as retail investors and often trade at different times of the day. When an asset manager trades, they are usually only a buyer or a seller—not both—and are typically only active for a few days at a time, so they’re not constantly in the market in every symbol. So, they won’t be acting as a counterparty to every trade and will certainly not follow and fulfill auctions to provide liquidity. Most importantly, by and large, asset managers are liquidity consumers—not liquidity providers—when they want to get into a position or exit the market. Several comment letters from large asset managers go into this in greater detail, but it’s a point worth mentioning. 

   Consequently, if regulators remove the competitive dynamic that obliges wholesalers to execute every order, they are effectively removing a significant amount of liquidity from the market and this change will be most acutely felt in small and mid-cap securities and thinly traded ETFs.

   A market maker provides liquidity that enables investors to immediately trade and assumes the risk of the market moving against its position while it bridges the time between when one investor buys and another sells.  In exchange for offering this immediacy to the investor, market makers attempt to earn the bid-offer spread between the price it buys and sells. Any spread successfully earned is in exchange for the risk the market maker incurred for the service of holding the position in inventory. 

   Under the auction proposal, regulators are attempting to remove the service provider from the market as well as any incentive or requirement to provide liquidity to every order. By removing these incentives for market makers, regulators are harming market liquidity as we know it. It is a monumental change that comes with significant risk to the market structure and capital formation. 

   ES: Now, let us discuss the rules from a market or financial stability perspective. Is there any prospect of a tick size reduction becoming a systemic risk or harming liquidity?

   dc: That’s a great question and the short answer is yes to both. It’s been well documented that reducing quoting increments too much can significantly harm displayed liquidity in the market. This happens for several reasons, but the end result is often counterintuitive: wider spreads and less size displayed at the NBBO.

   Additionally, every time you reduce the minimum quoting increment size, you’re going to have a multiplying effect on the number of quotes going through various systems. From a systemic perspective, you have sixteen national securities exchanges and 40-50 ATSs, all with varying degrees of technology. The physics of every quote that comes through is a certain number of bytes of data, which must be processed. And some exchanges are much better than others regarding the volume of data they can seamlessly receive, process, and then publish. 

   Every order that comes through has to be received by a national securities exchange and reformatted into whatever protocol they use. This all happens in microseconds. Then, it must be reformatted and republished to every subscriber, who absorbs it and translates it into its own system. We do this at Virtu: we digest these giant fire hoses of information and reduce them and process them for consumption by a market making application running in a data center. 

   If you just assumed that everything was in pennies today, and then everything went to tenths of pennies, you’re potentially multiplying everything by ten—or even greater depending on how it changes participants’ behavior. In times of normalcy, like on a typical trading day, that might be manageable. But at two o’clock today, when the Fed Chairman puts out a statement, and, depending on whether or not the Fed stops increasing rates by 25 or 50 basis points, I’m telling you, there will be a burst of activity in terms of information and bytes that you couldn’t even begin to understand how voluminous it is. The systemic implications of the additional technological burden created across the market would be significant if we had ten times as much messaging due to the proposed changes because now people are sending not just one order at a penny, but sending separate orders at different fractions of penny increments to all of these other exchanges. 

   Then, on top of that, if the regulations are fully implemented as they are proposed, there are going to be millions of these little retail auctions going off every day, and the volume and costs associated with the additional overhead or how millions of intraday auctions would disrupt continuous trading haven’t been considered. There will be system capacity concerns, and some exchanges may not be able to deal with the spikes in message activity. That’s when you start to have systemic problems because people’s systems could fail under the excessive load, and there will be operational and technological issues everywhere. 

   That, to me, is a systemic risk because the entire market is beholden to this change.  

10. Emergency Prices

    January 12, 2023 6:24 pm Comments Off on Emergency Prices

    In How China Escaped Shock Therapy (2021), Isabella Weber analyzes how China applied market reforms selectively, avoiding the broad agenda of liberalization advocated for in the West. Retaining oversight of prices for critical goods was key to this strategy. 

    Recently, Weber served on Germany’s gas price commission, whose recommendations are a pillar of the country’s €200 billion response to the energy price crisis. Her new paper with co-authors Jesus Lara Jauregui, Lucas Teixeira, and Luiza Nassif Pires provides another challenge to prevailing orthodoxy by examining which prices have the greatest impact on inflation. The authors created an input-output model to identify the sectors, goods, and services that more significant drivers of inflation. They also determined three characteristics of systemically-important prices, including their weightage as inputs. 

    In December, Weber spoke to Kate Mackenzie about the links between energy sectors, inflation, and the green transition. The following conversation has been lightly edited for length and clarity.

    An interview with Isabella Weber

    Kate mackenzie: You were on the German gas price commission. Have you been involved in a policy process like that before? 

    ISabella weber: In rich countries there hasn’t been this kind of emergency management in quite some time—there have been Covid-19 measures, but they took a different form. So it was a totally new experience. In Germany, previous government commissions had been set up to address very contentious policy issues, but those were focused on, let’s say, transitioning out of coal. These were big, long-run strategy questions, and the commissions working on them met regularly over a longer period. 

    The gas price commission, by contrast, was set up on extremely short notice and it was very intense. This speaks to the question of how best to govern economic emergencies, in real time, when relevant institutions do not exist. It’s been tough trying to develop institutional innovations to deal with this extreme situation in energy prices.

    One can question whether such commissions are a good way of doing this, or whether they are democratic. But the government did try to come up with a solution, after having waited a long time, and after not having fully appreciated the severity of the situation before. 

    KM: That seems relevant to some of your earlier research about the institutional muscle that the state needs to have for critical industries.

    IW: I think part of the reason it took so long to react in the German case was because there was no mindset that these specific prices can really matter, that they have the potential to undermine not only monetary stability, but even economic and social stability. If you have a central bank that does interest rates but cannot target specific prices, then that limits people’s thinking. 

    We are living in this age of overlapping emergencies where shocks to essentials are becoming more common, possibly even systemic. It seems likely that more shocks are to come, and they’re going to be more regular than before because of climate disasters, geopolitical tensions and the unraveling of global economic order, the whole disease environment, and so on. If this is the case, we might need a mindset of disaster preparedness in economic policymaking. This requires the state to have monitoring capacity and a policy toolbox for systemically significant sectors. 

    This is not to say that we want to have constant regimes of price controls, but we do want to be able to intervene if we need to. Ideally we’d be stabilizing prices well before the point where we have a price explosion. 

    KM: You mentioned a lot of that specific capacity exists, but it isn’t coordinated. Is there an unwillingness from the macroeconomics field to engage with other areas? 

    IW: For the most part, our economic training does not include a strong education in institutional economics, or even the basic institutions that govern our economic reality, starting from our corporations to the basic government agencies that actually do economic policy. Of course you can be an energy economist, which has become more common because of climate change, or an agricultural economist, and so on. But generally speaking, the assumption behind macroeconomics is that you can talk about the economy without sectoral knowledge, which often leads to a situation where we don’t have these links between disciplines. 

    Let’s say the energy economists on the commission do not care about inflation—it’s not something they’re worried about, and they’re just concerned about the price of gas and the efficiency of corporations and households using it. The macroeconomists care about inflation but not about the specific situation in the gas market. Now, unsurprisingly, we find that the two areas are actually deeply related. What’s happening in energy markets is extremely relevant to what’s happening in inflation. It’s just that the energy experts don’t care about inflation and the macroeconomists don’t care for the energy markets. We are missing the links between sectoral developments and macro trends. 

    I think the business analysis and business literature—even business news—are probably the best on this. But in economics, we lack the expertise or theories or ways to study how these two levers are interlinked. 

    IW: In the paper on overlapping emergencies and inflation, we try to identify systemically important prices for overall price stability. The aim is to create a framework to link sectoral development with the macro level, but we of course also fall short of understanding all the critical sectors we identify in sufficient detail to come up with policy recommendations for each sector. 

    I’m thinking of this as creating a framework for a platform to bring together the people who understand all these sectors, and the literature on these sectors, with those who understand questions of macroeconomic stability, outlook, and growth. 

    KM: It seems important to identify what those sectors are. I assume it was also a very difficult modeling exercise, but it seems surprising that this hadn’t been attempted before. 

    IW: There are contributions by Saule Omarova—we are taking the terminology of systemically important prices from her work. She has been talking about many prices that also show up in our analysis. 

    In contrast to Saule’s inductive approach or the general discourse around specific inflation drivers, we’re taking a more structuralist and systemic view. This means that we run these shocks through an input/output framework, which captures all the input/output relationships in the economy, and we make use of sectoral price volatilities before the pandemic. We compare what we’d have expected to be “systemic” before the pandemic with the post-shutdown economy, and also to the war in Ukraine. We find that basically the same sectors mattered before the pandemic that also matter more recently. 

    I’d add that the inflation commentary over the last couple of months has become commonplace in all sorts of policy reports—from BIS to OECD to the Fed to the European Central Bank. Now it’s more commonplace to read that supply shocks in energy matter for inflation, that food has been a big driver of inflation, that housing has played a role, and so on. So from that perspective it’s not surprising to find these prices matter. 

    We captured three dimensions, or channels, that can render a price systemically significant for inflation:

    • Position of sector in relation to all other sectors: Upstream oil and gas—which was the second-most important sector identified in the modeling, with a particularly high “indirect” component—are an important input to all other sectors.
    • Price volatility: The price of oil is very volatile whereas the price of administrative services in companies is very stable, because it’s basically just wages which tend not to fluctuate. 
    • The weight of goods in consumer baskets: Residential housing may not appear to be hugely volatile. Compared to oil prices, housing is relatively stable. It’s also not an important input into industrial production, but it shows up as a systemically significant price because it has such a large impact on people’s consumption baskets. 

    KM: How did energy sectors show up in the analysis?

    IW: In contrast to the Consumer Price Index (CPI), our simulation is capable of capturing indirect effects. If you look at the CPI, you only see the first layer—you don’t see that the price of oil is important because it’s important for plastic or all the things that people consume made of plastic. We show a large number of indirect effects. For example, in our analysis, oil and gas extraction shows up as the second most important category for price stability, which is basically because of an indirect effect. If you think about consumer inflation, you think about gasoline at the pump, or gas for heating, but you don’t think about oil and gas extraction as a sector that matters for consumption. Even something like chemical products have a fairly large indirect component which would come through things like fertilizer—or inputs into industrial processes—which then reside in goods that people buy which affect consumer prices. 

    This all becomes important with regard to the question of how we’re going to deal with price stability in a green transition. A key finding in our paper is the fundamental importance of fossil-fuel dependence. Trying to overcome this dependence underscores the challenges for monetary stability. This is not to say that we shouldn’t try, but we should take these challenges very seriously rather than hand-waving and saying everything will be fine.

    KM: Capital investment in upstream fossil fuels is particularly lumpy, and other aspects of fossil fuels, such as their traded nature and their vulnerability to geopolitics, are volatile. Does your work also point to the possibility of a more stable future? 

    IW: I think there is potential for it to become more stable, but we should think carefully about how these systems are designed to achieve price stability instead of just assuming the new energy systems will deliver more stable prices. We should still think of our ability to avoid and manage energy shocks. If you look at what happened with China with hydro—if you have a drought you can lose a very large source of your energy supply. 

    The question is: When were design new systems, which we will have to do, how do we ensure that they don’t build in the same price volatility that we have been struggling with these last hundred years?

    KM: What does it mean for the big energy transition scenarios which smoothly swap out one part of the energy system for another? 

    IW: I think that we will need a lot of redundancy in the transition. We need to build the new stuff before we shut off the old stuff. And you even need the old capacity to build the new capacity. 

    It’s not as though you have a given amount of energy and you smoothly transition from one system to another. It’s more like first you have an oversupply, and then you shut down the system you want to get rid of. There will be a moment in which you have both, so it’s not a gradually changing composition. This also means that there will be bumps, but maybe fewer bumps than if you were to try to mimic the straight transition path. 

    KM: What are the implications of this research?

    IW: We could imagine performing these exercises for goals other than price stability, by the way. But the specific policy that follows from this would need to be informed by the insights of people working on these specific sectors. It could bring together people who’ve been arguing for specific policies—anti-trust legislation, windfall profits, public investment, price stabilization, and so on. The idea here is not to say we need these specific policies, but to say that these are the sectors that matter and here’s a set of policies that we’ve been talking about.