The Thucydides Trap is a theory proposed by Graham Allison who postulates that war between a rising power and an established power is inevitable: “It was the rise of Athens and the fear that this instilled in Sparta that made war inevitable.” Thucydides from “The History of the Peloponnesian War”. Joachim Fels, Global Economic Advisor, Managing Director at PIMCO analyses the commercial war between the two super-powers under the light of Thucydides theory.
I find it hard to get overly excited about the outlook for the economy and markets, especially after the sizeable rally in risk assets and the back-up in global rates. As I see it, apart from concerns about stretched valuations across many assets classes, there are three reasons for caution.
First, my cyclical concern is that the U.S. economy keeps slowing, with both the Atlanta Fed’s and the New York Fed’s Q4 GDP trackers pointing to less than 1% growth, while the signs of stabilization in China and Europe are tentative at best and the data flow in both regions is very mixed. It is worth re-emphasizing that global growth is close to stall speed and hence more vulnerable than usual to adverse shocks, whatever may cause these.
Second, it is possible that Fed policy, even after the three rate cuts that took the fed funds rate to 1.5% – 1.75%, remains restrictive. Consider that estimates of the neutral or equilibrium interest rate are very imprecise. Moreover, most of these estimates have, until recently, not sufficiently accounted for global factors that may have dragged the neutral rate even lower. In fact, a new paper by Fed researcher Michael Kiley argues that incorporating global factors explicitly into the estimation yields estimates of the U.S. equilibrium interest rates rate that are considerably lower than the traditional ones that only incorporate national factors. On Kiley’s estimate, the neutral rate of interest in the U.S. incorporating global factors may be in the vicinity of -1% real, or +1% nominal. If so, Fed policy, while less restrictive than before the 75 basis points reduction in the Fed funds rate since the summer, remains restrictive even at an effective Fed funds rate of just above 1.5% and hopes for a recovery of U.S. growth in the course of next years could be disappointed.
Third, but not least, the trade truce between the U.S. and China remains fragile. Even if a “phase one” deal gets signed later this year, “phase two” negotiations will be much more contentious. Moreover, the underlying conflict between the U.S. as the status quo global hegemon that is challenged by the rising power China is unlikely to be resolved by a trade deal, but will likely shape geopolitics for decades to come. History teaches us that these conflicts are usually very disruptive and have often led to outright war. Earlier this week, a colleague pointed me to a fascinating 2018 paper by Markus Brunnermeier, Rush Doshi and Harold James, “Beijing’s Bismarckian Ghosts: How Great Powers Compete Economically”, which draws out the parallels between the current China-U.S. power struggle and the late 19th century/early 20th century struggle between the rising power Germany and Great Britain, then the dominant global power. While history never repeats itself, it rhymes, and the struggle between Germany and Great Britain didn’t end well.