The Clash of Civilizations

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Thomas Cole, “The Course of Empire: Destruction” (1836)

In the emerging world of ethnic conflict and civilizational clash, Western belief in the universality of Western culture suffers three problems: it is false; it is immoral; and it is dangerous.

– Samuel P. Huntington, “The Clash of Civilizations and the Remaking of World Order” (1996)

The West won the world not by the superiority of its ideas or values or religion … but rather by its superiority in applying organized violence. Westerners often forget this fact; non-Westerners never do.

– Samuel P. Huntington (1927 – 2008)

The argument now that the spread of pop culture and consumer goods around the world represents the triumph of Western civilization trivializes Western culture. The essence of Western civilization is the Magna Carta, not the Magna Mac. The fact that non-Westerners may bite into the latter has no implications for their accepting the former.

– Samuel P. Huntington (1927 – 2008)

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Islam’s borders are bloody and so are its innards. The fundamental problem for the West is not Islamic fundamentalism. It is Islam, a different civilization whose people are convinced of the superiority of their culture and are obsessed with the inferiority of their power. 

– Samuel P. Huntington (1927 – 2008)

Q:     What do you think of Western civilization?
A:     I think it would be a good idea. 

– Mahatma Gandhi (1869 – 1948)

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Adrian Veidt: It doesn’t take a genius to see that the world has problems.
Edward Blake: No, but it takes a room full of morons to think they’re small enough for you to handle.

– “Watchmen” (2009)

Our civilization is flinging itself to pieces. Stand back from the centrifuge.

– Ray Bradbury, “Fahrenheit 451” (1953)

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Upon learning of Cardinal Richelieu’s death, Pope Urban VIII is alleged to have said, “If there is a God, then Cardinal de Richelieu will have much to answer for. If not … well, he had a successful life.”
Henry Kissinger, “Diplomacy” (1994)

Corrupt politicians make the remaining ten percent look bad.

– Henry Kissinger (b. 1923)

Poor old Germany. Too big for Europe, too small for the world. 

– Henry Kissinger (b. 1923)

The most fundamental problem of politics is not the control of wickedness but the limitation of righteousness. 

– Henry Kissinger, “A World Restored: Metternich, Castlereagh and the Problems of Peace, 1812-22” (1957)

Order should not have priority over freedom. But the affirmation of freedom should be elevated from a mood to a strategy. 

– Henry Kissinger, “World Order: Reflections on the Character of Nations and the Course of History” (2014)

A more immediate issue concerns North Korea, to which Bismarck’s nineteenth-century aphorism surely applies: “We live in a wondrous time, in which the strong is weak because of his scruples and the weak grows strong because of his audacity.” 

– Henry Kissinger, “World Order: Reflections on the Character of Nations and the Course of History” (2014)

In the end, peace can be achieved only by hegemony or by balance of power.

– Henry Kissinger (b. 1923)

Isaac: Has anybody read that Nazis are gonna march in New Jersey? Ya know? I read it in the newspaper. We should go down there, get some guys together, ya know, get some bricks and baseball bats, and really explain things to ’em.
Party Guest: There was this devastating satirical piece on that on the op-ed page of the Times, just devastating.
Isaac: Whoa, whoa. A satirical piece in the Times is one thing, but bricks and baseball bats really gets right to the point of it.
Party Guest: Oh, but really biting satire is always better than physical force.
Isaac: No, physical force is always better with Nazis.

– “Manhattan” (1979)

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Lots of quotes this week, particularly from my two favorite war criminals – Sam Huntington and Henry Kissinger. Everyone has heard of Kissinger, fewer of Huntington, who may have been even more of a hawk and law-and-order fetishist than Kissinger but never sufficiently escaped the ivory towers of Harvard to make a difference in Washington. Like me, Kissinger bolted academia at his first real opportunity for a better gig and never looked back, which is probably why I always found him to be so personally engaging and fun to be around. Sam Huntington … not so much.

But Huntington’s “Clash of Civilizations” argument is not just provocative, curmudgeonly, and hawkish. It is, I think, demonstrably more useful in making sense of the world than any competing theory, which is the highest praise any academic work can receive. Supplement Huntington’s work with a healthy dose of Kissinger’s writings on “the character of nations” and you’ve got a cogent and predictive intellectual framework for understanding the Big Picture of international politics. It’s a lens for seeing the world differently – a lens constructed from history and, yes, game theory – and that’s what makes this a foundational topic for Epsilon Theory.

Huntington and Kissinger were both realists (in the Thucydides and Bismarck sense of the word), as opposed to liberals (in the John Stuart Mill and Woodrow Wilson sense of the word), which basically just means that they saw human political history as essentially cyclical and the human experience as essentially constant. Life is fundamentally “nasty, brutish, and short”, to quote Thomas Hobbes, and people band together in tribes, societies, and nation-states to do something about that. As such, we are constantly competing with other tribes, societies, and nation-states, and the patterns of that competition – patterns with names like “balance of power” and “empire” and “hegemony” – never really change across the centuries or from one continent to another. Sure, technology might provide some “progress” in creature comforts and quality of life (thank goodness for modern dentistry!), but basically technology just provides mechanisms for these political patterns to occur faster and with more devastating effect than before.

The central point of “Clash of Civilizations” is that it’s far more useful to think of the human world as divided into 9 great cultures (Huntington calls them civilizations, but I’ll use the words interchangeably here) rather than as 200 or so sovereign nations. Those cultures – Western, Orthodox (Russian), Islamic, African, Latin American, Sinic (Chinese), Hindu, Buddhist, and Japonic – are persistent and profoundly influential in ways that national borders and national institutions aren’t. Huntington argues that these 9 cultures are the most meaningful current expressions of the human animal’s inherent social imperatives, and that the logic of competition between these cultures explains and illuminates human history far better than competing notions, particularly those (like Marxism and liberalism) that assume an up-and-to-the-right direction to the arrow of history.

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Marxism and liberalism are inherently optimistic visions of human society. Things are always getting better … or they will be better just as soon as people wake up and recognize their enlightened self-interest … as ideas of proletariat empowerment (Marxism) or individual rights as instantiated by free markets and free elections (liberalism) inexorably spread throughout the world. For realists like Huntington and Kissinger, on the other hand, this is nonsense. Free markets and free elections are good things (as is proletariat empowerment, frankly), but these central concepts of liberalism only mean what we Westerners think they mean if they exist within the entire context of Western culture. To insert the practices and institutions of liberalism into the Sinic culture, for example, might look awfully pretty to the Western eye and fill us with righteous pride, but it’s just a veneer. It won’t stick. The West may very well want to impose the practices and institutions of free markets and free elections for its own self-interest, and China may want to adopt the practices and institutions of free markets (but not free elections) for its own self-interest, but the logic of self-interest is a VERY different thing than the triumphalist claim that the liberal ideas of Western free markets and free elections are “naturally” spreading throughout the world.

A brief aside here on the distinction between personal beliefs and useful models. I’m not saying that I believe that authoritarian regimes and jihadist despots have some sort of moral equivalence to liberal governments, or that human rights don’t matter, or any of the other tired bromides used to tar realists. On the contrary, I personally believe that everyone in the non-Western world would be better off … MUCH better off … if their governing regimes gave a damn about individual rights and liberties in the same way that ANY governing regime in the West does. I believe that the principles of liberalism are the best ideas on social organization that the human animal has ever devised, and I’d like to spread these ideals into every corner of the globe. And you know what? On a personal level, Sam Huntington and Henry Kissinger believed exactly the same thing. Kissinger fought in the Battle of the Bulge. He won the freakin’ Bronze Star for his work tracking down Gestapo agents in Hanover. Does that sound like a moral relativist? Huntington served in the Jimmy Carter administration, for god’s sake. Talk about personal sacrifices …

But what a realist recognizes is that our personal vision of how we would like the world to be is not an accurate representation of The World As It Is, and – as Huntington wrote – it’s false, immoral, and dangerous to pretend otherwise. The World As It Is today includes the birth of an Islamic Caliphate, effectively erasing Western colonialist borders from Iraq to Syria to Libya as it spews anti-modern carnage. The World As It Is today includes the violent sundering of Ukraine along Orthodox/Western cultural lines. The World As It Is today includes an insane Sinic theocracy in North Korea with nuclear weapons. The World As It Is today includes a Japonic culture that is, in a very real sense, dying. Is a realist happy about any of this? Is a realist satisfied to shrug his shoulders and retreat into some isolationist shell? No, of course not. But a realist does not assume that there are solutions to these problems. Certainly a realist does not assume that there are universal principles like “free and fair elections” that can or should be applied as solutions to these problems. Some problems are intractable because they have been around for hundreds or thousands of years and are part and parcel of the Clash of Civilizations. They’re not going away no matter how hard some American President stomps his feet or how many drones he releases or how stern an op-ed piece is printed in the New York Times or how warm and fuzzy we feel when we see a picture of an Iraqi woman proudly displaying her finger freshly inked from voting. Yes, I know I’m an a-hole for criticizing the whole “purple revolution” thing. Doesn’t mean I’m wrong.

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Kissinger wasn’t kidding when he said that there were two and exactly two solutions to international problems: 1) hegemony (i.e., empire) over the opposing Civilization, or 2) balance of power with the opposing Civilization. The problem, of course, is that Door #1 is awfully expensive. For example, if you’re not prepared to push Germany into recession and risk a lot of lives – and I mean a LOT of lives – by expanding the NATO umbrella over Ukraine, then there’s no way you’re going to reverse a basic balance of power reality like “Russia gets a warm water port on the Black Sea, no matter what the petty satraps in Kiev think about that”. Sorry, but that’s the “solution” if you’re not happy with Russia’s annexation of the Crimea and Eastern Ukraine, and I have yet to meet anyone who’s willing to pay that price. Are there aspects of The World As It Is where you ARE prepared to pay the high price of empire to prevent a balance of power equilibrium? It’s a short list for me, but yes, there is a list, headed by the preservation of Israel and South Korea as (largely) Western outposts in the middle of non-Western cultures. Is nation-building in Afghanistan on the list? Don’t make me laugh.

I think the crucial issue here (as it is with so many things in life) is to call things by their proper name. We’ve mistaken the self-interested imposition and adoption of so many Western artifices – the borders between Syria and Iraq are a perfect example, but you can substitute “democracy in Afghanistan” if you like, or “capital markets in China” if you want something a bit more contentious – for the inevitable and righteous spread of Western ideals on their own merits. This is a problem for one simple reason: if you think Something happened because of Reason A (ideals spreading “naturally” and “inevitably” within an environment of growing global cooperation), but it really happened because of Reason B (practices imposed or adopted out of regime self-interest within an environment of constant global competition), then you will fail to anticipate or react appropriately when that Something changes.

And here’s the kicker: change is coming. The Clash of Civilizations is not going to get better in 2015. It’s going to get worse. Why? Because for the past five years we have had a US government that was willing to pay the high price of empire to extend its monetary policy hegemony over the entire world to save the infrastructure of modern Western civilization: the US banking system and its collateral assets. Five trillion dollars later, the Fed has now declared victory and is demobilizing the QE troops. Is it a lasting victory? I don’t know and it doesn’t really matter. It’s a useless question. In the immortal words of Bill Parcells, you are what your record says you are, and the Fed’s record looks pretty darn good. So they’re declaring victory and that’s how it will go down in the history books. The better question is: what now? What happens in the rest of the world now that the peace-keeping and price-raising and prosperity-bringing delivered by five trillion dollars in asset purchases … stops?

Part of the answer – a small part of the answer – is that other central banks with printing presses will try to take up some of the slack. The BOJ will continue to weaken the yen and monetize the government’s debt, and the ECB will do the same thing, although they will do less and will be forced to jump through bizarre hoops to preserve the pleasant fiction that they’re not monetizing government debt. I say that this is a small part of the answer to the question of “what now?” – even though if you listen to the prognosticators in financial media you would think that this is the entire answer – because monetary policy divergence, as important as it is, pales in comparison to political divergence. I don’t think it’s an accident that Ukraine starts ripping itself apart as the largest monetary experiment in the history of man starts to wind down. Or that ISIS starts to remap the entire Middle East. Or that North Korea attacks Sony. Or that the price of oil drops by half as OPEC faces its greatest existential threat. Did the Fed cause these events? Of course not. But they’re not unrelated. They’re all part of the fabric of global deleveraging. This is what happens when you have a global debt crisis and politicians respond to maintain the status quo by any means necessary – the political center does not hold. Whether you’re talking about the 1870’s or the 1930’s or today, it’s always the same story … domestic coalitions and sovereign nations and international alliances that were held together by mutual absolute gains in the good times are driven apart by relative gains and losses in the bad times, and those domestic coalitions and sovereign nations and international alliances that bridge two ancient civilizations are thrown into the centrifuge most of all.

The market flash points for 2015 are not limited to the obvious suspects, like Ukraine and ISIS. In fact, most of the obvious suspects are not terribly impactful on major markets, and some have the perverse effect of providing “good news” for markets the worse their situation becomes. For example, to the degree that Ukraine-related sanctions on Russia damage German growth rates, the market believes that this forces still greater ECB market accommodation and direct propping-up of financial asset prices in the Eurozone. The non-obvious suspects I’m looking at are countries that, like Ukraine, find themselves with one foot in one civilization and one foot in another but, unlike Ukraine, are much more central to global markets. Those countries are Greece, Turkey, Iran, Egypt, and South Korea. I wrote about Greece two weeks ago, so won’t repeat all that here. Turkey, Iran, and Egypt are all the same basic story – ancient civilizations that had their day in the sun many centuries ago and are now being consumed by the Borg-like entity that is Islam. Persia, the most potent of the three cultures, is completely lost. Egypt is lost but hasn’t realized it yet, like a chicken running around with its head cut off. Turkey, the least of the three, has adopted enough Western antibodies to provide some resistance, but it’s just a matter of time before it becomes the Sick Man of Europe once again. South Korea … judging from how little it is discussed in the Western press it sometimes seems like no one cares about South Korea, and that’s a mistake. No country on earth is split between more civilizations, and no country is as sensitive AND vulnerable to the clashes that are coming down the pike.

So … am I terrified by the Clash of Civilizations? Am I getting out of the market and running for the hills? No. Not yet, anyway. So long as the market is dominated by the Narrative of Central Bank Omnipotence, any of these flash points that I’ve mentioned will inevitably be seen through the lens of monetary policy accommodation, making bad news in the real world good news for major stock markets, particularly here in the US. Global growth will get even more pathetic, of course, but that’s positive for major government bonds. Of all the flash points above I’m probably most concerned about Greece, but even then the concern is more for what Greece ultimately means for Italian politics than for what it means to Europe or major global markets directly.

What scares me about the Clash of Civilizations is that the three leaders of the three biggest civilizations – the US (Western), China (Sinic), and Russia (Orthodox) – will misplay their hands and take on another civilization directly or, worse, take on each other, and that will vaporize the Narrative of Central Bank Omnipotence in a nanosecond. The existential risk here for markets is not that China/Russia/Europe/America might “collapse”, whatever that means. No, the existential risk is that the great civilizations of the world will be “hollowed out” internally, so that the process of managing the ten thousand year old competition between civilizations devolves into an unstable game of pandering to domestic crowds rather than a stable equilibrium of balance of power. Don’t take my word for it. Take the word of America’s finest diplomat since Benjamin Franklin, writing in his final book and delivering his most important warning.

Side by side with the limitless possibilities opened up by the new technologies, reflection about international order must include the internal dangers of societies driven by mass consensus, deprived of the context and foresight needed on terms compatible with their historical character. As diplomacy is transformed into gestures geared toward passions, the search for equilibrium risks giving way to a testing of limits. … 

Because information is so accessible and communication instantaneous, there is a diminution of focus on its significance, or even on the definition of what is significant. This dynamic may encourage policymakers to wait for an issue to arise rather than anticipate it, and to regard moments of decision as a series of isolated events rather than part of a historical continuum. When this happens, manipulation of information replaces reflection as the principal policy tool. 

– Henry Kissinger, “World Order: Reflections on the Character of Nations and the Course of History” (2014)

I can’t over-emphasize how important I think this passage is, and I’ll be returning to it again in future Epsilon Theory notes. For now, though, I’ll just introduce two key game theoretic concepts at the core of Kissinger’s warning.

First, the proliferation of the most dangerous game of all – Chicken. When Kissinger writes about how “the search for equilibrium risks giving way to a testing of limits”, he’s talking about how ordinary diplomatic maneuvers can deteriorate into brinksmanship, the hallmark of the game of Chicken. I’ve written a little bit about this game in the context of the Fed-inspired “Taper Tantrum” in the summer of 2013, when Bernanke et al misread the market impact of a change in the acceleration of monetary easing, but that little episode will look like a gentle spring shower compared to the market storm that could result from a full-scale game of Chicken between, say, China and Japan over trade, exchange rates, and offshore oil and gas reserves in the South China Sea. Chicken is such a dangerous game because it has no equilibrium, no outcome where all parties prefer where they are to where they might be. This constant cycling of one unstable outcome to another typically ends in disaster because the least worst outcome for each player – the “move” that each player makes to respond strategically to the other player’s most recent limit-testing actions – doesn’t remain constant but gets progressively worse over time. The game of Chicken is a mutual spiral into oblivion, and once you start down this road it’s really hard to stop because stopping means admitting defeat.

Second, the dumbing-down of all political games into their most unstable form – the single-play game. When Kissinger writes about how political leaders come to see “moments of decision as a series of isolated events”, he’s talking about the elimination of repeated-play games and shrinking the shadow of the future. Most games seem really daunting at first glance. For example, the Prisoner’s Dilemma is famous for having a very stable equilibrium where everyone is worse off than they easily could have been with some very basic cooperation. But there’s a secret to solving the Prisoner’s Dilemma – play it lots of times with the same players. Cooperation and mutually advantageous equilibria are far easier to achieve within a repeated-play game because reputation matters. The shadow of the future looms large if you’re thinking not only about this iteration of the game and the moves ahead, but also about the next time you have to play the game, perhaps for larger stakes, and the next, and the next. Imagine if you sat down at a poker table, were dealt one hand, and were then informed that everyone would have to get up and find another table with new players, at which point only one hand would be dealt there, too. That’s a series of single-play games, and it’s just as unpleasant as it sounds, whether you’re playing poker or you’re playing politics.

It won’t surprise many regular readers of Epsilon Theory if I say that I think much of what Kissinger warns about – “societies driven by mass consensus”, “gestures geared towards passions”, “manipulation of information” – has now reached, if not its full fruition, then at least a new quantum level of advanced and ubiquitous practice. And not just in the US, but also Russia and China and everywhere in between. Twenty-three years after Sam Huntington first presented his “Clash of Civilizations” argument, the conditions for that realist confrontation to be terribly severe are finally met. 2014 wrote an unpleasant story of nascent international splintering and conflict. Unfortunately, I think it was just an introductory chapter in a much longer book.

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Now There’s Something You Don’t See Every Day, Chauncey

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Narrator: Well, today we find our heroes flying along smoothly…
Rocket J. Squirrel: Flying along smoothly?
Bullwinkle J. Moose: You’re just looking at the picture sideways!
Rocket J. Squirrel: Actually it’s like this!
Narrator: Oh… OH GOOD HEAVENS! Today we find our heroes plunging straight down toward disaster at supersonic speed!
Bullwinkle J. Moose: That’s better.

The Rocky and Bullwinkle Show (1959 – 1964)

There are decades where nothing happens; and there are weeks where decades happen.

― Vladimir Lenin (1870 – 1924)

I have always thought that in revolutions, especially democratic revolutions, madmen, not those so called by courtesy, but genuine madmen, have played a very considerable political part. One thing is certain, and that is that a condition of semi-madness is not unbecoming at such times, and often even leads to success. 

― Alexis de Tocqueville (1805 – 1859)

A match as a pen
Blood on the floor as ink
The forgotten gauze cover as paper
But what should I write?
I might just manage my address
This ink is strange; it clots
I write you from a prison
in Greece.
― Alexanderos Panagoulis (1939 – 1976) 

The revolution is now just a sentiment.
― Pier Paolo Pasolini (1922 – 1975)

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Pedro: Vote for me, and all your wildest dreams will come true. 

― “Napoleon Dynamite” (2004)

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Tammy Metzler: [her campaign speech] Who cares about this stupid election? We all know it doesn’t matter who gets elected president of Carver. Do you really think it’s going to change anything around here? Make one single person smarter or happier or nicer? The only person it does matter to is the one who gets elected.
― “Election” (1999)

So inscrutable is the arrangement of causes and consequences in this world, that a two-penny duty on tea, unjustly imposed in a sequestered part of it, changes the condition of all its inhabitants.
― Thomas Jefferson, “Autobiography” (1821)

Like every other male homo sapiens I know, I watch a lot of sports. There’s only one team that I watch as a fan – the University of Alabama football team (my grandfather and uncle played there, and I was raised in the Church of Bear Bryant) – by which I mean that these are the only games I watch where I could not care less about the quality of the gameplay, but only care about winning in as lopsided a fashion as possible. For example, while the rest of the world thought the 2011 Championship game where Alabama beat LSU 21-0 was a miserably boring affair, a Bama fan like myself thought it was a performance of absolute beauty. Roll Tide.

Fans and gamblers care about outcomes. For everyone else watching a game, we’re there for something else. One of those things – and for me the centerpiece of any non-Bama, non-Hunt-participant sporting event – is the chance that we might see something we’ve never seen before. For example, a few weeks back I was watching the Sunday night Giants-Cowboys game on television even though I don’t really care about the New York Giants and the last time I rooted for the Dallas Cowboys was when I was 6 years old and wearing footie pajamas with a big blue star on them. A year from now I will no longer remember (and don’t care today) who won that game. But I will never forget the greatest catch I have ever seen – Odell Beckham, Jr. throwing himself backwards, reaching out behind his head, and cleanly catching the long pass with 3 fingers of one hand for a touchdown. That’s why I watch the games – for moments like this where something happens that I’ve never seen before and almost certainly never will again.

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I spend a lot of my time watching politics, too, which is just another type of game. And as with my sports-watching, I care deeply about the outcome in only a small fraction of the political events that I follow, mostly local elections, but occasionally broader elections that impact my personal notions of political identity or justice. For the vast majority of political events, though, I’m really just watching in hopes that something exciting will happen.

Last weekend’s election in Japan was the opposite of exciting. It was a foregone conclusion – roughly the equivalent of Alabama playing a Division III team – because Abe scheduled the vote in precisely the same way that powerhouse college football teams schedule creampuffs. Abe announced the election on November 18, giving the opposition parties less than a month to field candidates in the various prefectures (they don’t call them “snap elections” for nothing), which allowed many of his LDP candidates to run either unopposed or with token opposition. This sort of political ploy is impossible in the American electoral system and too risky in a system that requires the head of government to submit to a national vote or referendum, but it’s a smart play in Parliamentary systems where the Prime Minister is selected by virtue of his bureaucratic leadership of the political party with the most locally elected representatives. Abe has to win a seat in the Japanese Diet, just like John Boehner must be elected to Congress from his local Ohio district every two years, but Abe’s position as head of government stems from the same source as John Boehner’s House Speakership – the support of fellow party members and allied coalition party members – not some national vote on Abe himself. It allows a Prime Minister to reset the clock on his tenure as national leader by simply resetting the clock on the locally elected representatives who support him, and that’s a very powerful tool.

What it doesn’t mean, of course, is that Abe is a nationally elected leader or that his policies enjoy some sort of “mandate” from the Japanese electorate, even though this is naturally what Abe will claim. As Speaker of the House Tip O’Neill famously said, “all politics is local”, and that holds true for Japan (in fact, is probably more true) than for the US. The backbone of Abe’s majority in the Japanese Diet comes from single-member districts (as opposed to the larger multi-member and “block” districts), where it’s American-style plurality that elects one person to the House of Representatives (yes, same name for the lower House in both Japan and the US). So in a multi-party system like Japan with many competing parties and candidates, you can often win these single-member districts without a majority of votes even in the local district, much less on a national scale. And in fact Abe’s party – the LDP – won 78% of these single-member district seats with an aggregate vote of less than 50% of the single-member district voters. Combine this structurally-biased vote outcome with a record low voter turnout (about 52%), and it’s really hard to read this election as a full-throated popular vindication for Abenomics. But it was certainly the smart play for Abe to call for the election – because the outcome was never in doubt – and you can already read non-Japanese financial media like the Wall Street Journal talking about his “mandate”. It’s ridiculous and misleading, of course, but no more ridiculous or misleading than the Narrative creation that takes place constantly in The Hollow Market, most recently on oil prices.

The upcoming elections in Greece, however, are another matter entirely.

These snap elections are not a carefully planned tool of Narrative creation and status quo regime support as we just saw in Japan, but are … potentially … a keg of dynamite that could spark revolutionary change within the status quo European system. I use that word “revolution” cautiously, because it just doesn’t mean what it used to in the West, not even in Greece where as recently as 40 years ago revolution meant coups and armed insurrections and political prisoners. Revolution today is sentiment, a narrowly constrained concept where we talk about a return to a sovereign monetary policy as if it were the equivalent of storming the Bastille. Such is life in the Golden Age of the Central Banker. 

I know, I know … we’ve heard this song before, most recently in the late spring and early summer of 2012 when the threat of a Syriza-led coalition government and a Greek exit from the Euro threw global markets for a loop. New Democracy and its allies won enough seats to form a stable coalition, and just like that the Greek problem was “solved”. What’s different today? Not much. Time has passed. The real economy of Greece is just as broken as it was 3 years ago, but there’s been progress on the structural deficit (which makes an exit from the Euro more feasible) and there certainly doesn’t seem to be the same fear of the abyss (in Greece or the rest of the EU) as in 2012.

What’s really different about the Greek elections now and the Greek elections in 2012 is the lack of a Oh-My-God-Look-At-Greece media Narrative today, particularly in the US. You’ve got the occasional headline in the European press about what a Syriza-led government might mean for the Euro system, and certainly Greek equity markets (and in a reverberating sense Italian and Spanish markets) and Greek sovereign debt have taken it on the chin since the snap elections were announced. But US financial media has been almost totally AWOL on this story. Here it’s all oil, all the time, which means that any power transition in Greece will come as a big negative “surprise” to US investors and US markets. Certainly it will come as a negative surprise to all those US investors who have been loading up on European equities over the past two months in anticipation of Draghi launching a “dramatic” acceleration of ECB-flavored QE.

Now maybe we’ll see a repeat of June 2012 tomorrow and over the next few weeks. Maybe this will end up being a boring game where the two teams basically agree to a draw, to postpone the knock-down drag-out fight for another day. But there’s a decent chance that we’re going to see something in Greece that we’ve never seen before. There’s a bit of madness to the Greek electoral saga of the past 3 years that, as de Tocqueville pointed out, is the hallmark of democratic revolutions. And just as the somewhat mad IDEA of small-l liberalism spread like wildfire through Europe in 1848, deposing old-school aristocracies across the Continent, so, too, do I think that the somewhat mad idea of growth-oriented nationalism can depose the new-school aristocracies of the Troika. As Thomas Jefferson wrote in his autobiography, it’s amazing how a seemingly small event combined with a powerful idea – say a two-penny tax on tea in some far-off colony, combined with a determination by said colonists to demand representation – can change the entire world. The mandarins in Brussels and the apparatchiks in Frankfurt will speak of the events in Greece as “contagion”, a modern version of the same “scientific” language that royalists and their flunkies used in 1848 to condemn “the mob”. Good luck with that.

What’s the market impact of all this? Look, first of all this may be a false alarm and the Red King will simply return to his tranquil slumber. Second, even if Syriza takes control of the government they may ultimately prove to be just as status quo-oriented as New Democracy. That latter bit happens more often than you’d think. Second Republics can turn into Second Empires in the blink of an eye. But what I can tell you with confidence is that the Common Knowledge of the market today is that Greece is “fixed”, which means that any un-fixing will hit markets like a ton of bricks. It’s an asymmetric risk/reward profile – in a bad way – for global markets in general and European markets in particular from an Epsilon Theory perspective.

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Narrative Uber Alles

Yesterday the Wall Street Journal ran a front page story titled “OPEC Sees Less Demand for Its Oil in 2015”, as well as another article with the following quote: “OPEC’s output exceeded its quota by 50,000 barrels a day in November, the group said.”

That’s all true, and all supportive of today’s dominant Narrative that OPEC is broken and oil is now in free fall.

Wanna know what else is true? November OPEC production was down 390,000 bbls/day from October and down 510,000 bbls/day from September. But, hey, we can’t have crucial facts get in the way of a dominant Narrative, now can we?

And here’s another thing that’s true. That horrific “demand reduction” that OPEC is forecasting for 2015? If you’re talking about global demand for crude oil, OPEC reduced its 2015 forecast by 120,000 bbls/day on an aggregate forecast of 91.1 million bbls/day, which is all of a 13 basis points reduction and still includes demand growth of close to 1 million bbls/day. Yes, OPEC reduced projected 2015 demand for its oil by 300,000 bbls/day (about 1% of current production targets), but that’s a good thing for oil prices if it’s the rationale required for further production cuts within OPEC.

And because I can’t help myself, here’s one more thing that’s true. You won’t find that sentence about exceeding the quota – which was a main thrust of the original story – because it’s been eliminated in the afternoon revisions. Flushed down the memory hole. After the markets close. After the Narrative damage is done.

Not trying to pick on the WSJ here, as every media mouthpiece is doing exactly the same thing. Reuters report on the monthly OPEC news release spoke only to the reduced demand forecast and “hefty oversupply” with zero mention of the production cuts. Bloomberg did the same, with a 1,000 word article on the oversupply “paradigm shift” and a tacked-on sentence noting the production cuts in passing. Some of the media headlines were downright schizophrenic. My personal fave was from USA Today, with an article titled “OPEC Slashes Oil Production Estimate” – as if that were a bad thing for oil prices! – and that this is why crude was down because … well … because … you know … if we use the word “slash” it must be a bad thing.

Sigh. After a 25-year professional career of studying media Narratives and their amazingly powerful impact on investor and voter behavior alike, you’d think that I’d be numb to this stuff. But it never ceases to amaze me.

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We Now Return to Our Regularly Scheduled Programming

epsilon-theory-we-now-return-to-our-regularly-scheduled-programming-december-5-2014-stand-by

Hilsenrath Analysis: Friday’s Jobs Report Assures Global Central Banks Going in Two Directions ― Wall Street Journal, December 5th, 9:59a ET

Earlier today I tweeted that “I should write a note on Draghi today, but after 2.5 yrs of reviewing the same song and dance I’d rather put out my eye with a rusty spoon.” I feel the same way about writing a note on Jon Hilsenrath’s Missionary statements on monetary policy, but the potential ramifications of today’s jobs report and how the Narrative is being shaped around that report are just too important – particularly for the price of oil and the energy complex – to leave it alone. Over the past two weeks I’ve tried to provide an Epsilon Theory perspective on both the price of oil (“The Unbearable Over-Determination of Oil”) and the signaling role of the price of oil on energy stocks (“Signs and Portents”), and here’s the skinny: so long as the dominant Narrative around oil prices is based on global supply/demand fundamentals – even if those fundamentals are somewhat negative – that is far more constructive for oil prices and energy stocks than if the dominant Narrative around oil prices is based on monetary policy. When Saudi Arabia said, “we’re happy with oil in the 60’s”, here’s what value investors heard: “we’re not happy with oil in the 50’s”. So long as there is a perception of a floor … so long as value investors do not fear catching a free-falling knife … they will buy stuff that looks cheap. That’s what value investors DO.

The dominance of the OPEC meeting-inspired supply/demand Narrative is, I fear, short-lived, as we appear today to be returning to the regularly scheduled programming of all central banks, all the time. The dollar is starkly higher today, as the yen and euro plumb new depths. That’s on the back of the much stronger than expected jobs report today, which – as Fed amanuensis Hilsenrath “reports” – means that the Fed will be still more resolute in tightening even as the BOJ and ECB double-down on extraordinary liquidity operations. Oil is down a bit … less than I’d expect from a currency move of this magnitude … which I think is indicative that the fundamentals-driven Narrative still narrowly holds sway. How narrow? Can’t tell yet. I’ll be watching Narrative development closely next week, but there’s a non-trivial chance that the monetary policy “explanation” for oil prices will resume its pole position, and that’s problematic for the energy sector. Sorry, but I gotta call ‘em like I see ‘em.

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Signs and Portents

epsilon-theory-signs-and-portents-december-1-2014-the-omen

Young nanny: Look at me, Damien! It’s all for you.  

[she jumps off a roof, hanging herself] 
– “The Omen” (1976)  

epsilon-theory-signs-and-portents-december-1-2014-bag-of-bones

When one has little faith, one must survive from day to day signs.

– Stephen King, “Bag of Bones” (1998)

epsilon-theory-signs-and-portents-december-1-2014-batman

Criminals are a superstitious cowardly lot, so my disguise must be able to strike terror into their hearts. I must be a creature of the night, black,  terrible … a … a …  


– Bob Kane and Bill Finger, “Batman” (1939)

When clouds appear, wise men put on their cloaks;

When great leaves fall, the winter is at hand;
When the sun sets, who doth not look for night?

― William Shakespeare, “Richard II” (1595)

Alas, why gnaw you so your nether lip?

Some bloody passion shakes your very frame:

These are portents; but yet I hope, I hope,

They do not point at me.

― William Shakespeare, “Othello” (1603)

Destiny does not send us heralds. She is too wise or too cruel for that.

― Oscar Wilde (1854 – 1900)

Like the criminals that Bruce Wayne fought as Batman, we investors are a superstitious, cowardly lot. We are constantly ascribing way too much import to this sign or that sign, constantly freaking out over the meaning and significance of this market event or that market event. It doesn’t help that the financial media world has devolved into fiefdoms of rah-rah soothsayers on the one hand and doom-seeing end-timers on the other, so that whatever our predispositions might be we can easily find Voices of Authority to read the entrails to our liking. And it really doesn’t help that we are in the midst of the greatest crisis of faith in the markets since the 1930’s, so that – as Stephen King wrote – we survive by looking for day-to-day signs to show us what to do.

And yet sometimes a little freaking out over the signs and portents is clearly the right thing to do. Sure, if your nanny declares her loyalty to your adopted-under-mysterious-circumstances devil-child as she hangs herself outside the nursery window it’s probably a case of mental illness, but I’d also listen a little more closely to what that pesky priest says. If you’re Pierce Brosnan in the “Bag of Bones” mini-series and you think that your dead wife is sending you cryptic messages via a handful of refrigerator magnets … well, maybe you should drive into town and buy more refrigerator magnets, see if she’s got anything interesting to say. If you’re Desdemona and you’re worried that Othello’s lip-biting is a sign that he’s about to fall into a jealous, murderous rage … well, maybe you should run out of the room instead of hanging around to see if you’re right.

It’s a tough call, evaluating what’s a “true” sign and what’s a “false” sign. Are we being foolish to sell our energy stocks after oil prices took another big hit, or are we reading the market’s tea leaves correctly and saving ourselves a lot of future pain? Are we acting as Shakespeare says any wise person would in a knowable and deterministic world, by putting on our cloaks as clouds appear and looking for the night as the sun sets? Or are we mistaking our play-acting market world for the real world, putting on our cloaks as the projectionist shows us a picture of clouds and looking for the night as the stage lights dim?

Here’s the Epsilon Theory answer: the latter mistake is 1,000 times more common than the former wisdom, and the vast majority of investors would be better off if they never read the newspaper and never turned on the TV. Why? Because what they think is a “sign” is actually a signal, neither true nor false in and of itself but only more or less influential in changing their mind and other investors’ minds about the world. (for more on signals and Information Theory, see “Through the Looking Glass” and “The Music of the Spheres”) Signals are constructed. Signals are malleable. And unless you are focused on how and why signals are constructed and shaped, you will be whipsawed. You will be shaken out. You will be roped in. You will catch a falling knife. Pick your own analogy or metaphor … there are a million to choose from and anyone who has spent any time at all in the market has experienced most of them. We’ve all been there.

Case in point: why are many investors puking energy sector stocks today? It’s not because they have a detailed cash flow model of the specific companies they’re selling and have calculated the incremental earnings impact of oil prices moving from a $70 handle to a $60 handle. It’s also not because there’s some credit freeze roiling financial markets and a careful balance sheet analysis shows imminent dividend cuts or debt stress throughout the sector. Will lower oil prices over a long period of time hurt earnings and crimp growth for the entire sector? Well, sure. That’s kinda what it means to invest in a cyclical stock, and if this comes as a surprise to you then I really don’t know what to say. Will lower oil prices over a long period of time create balance sheet distress in the energy sector’s more levered, go-go stocks? Absolutely. If you’re not stress testing the balance sheet, capital allocation, and distribution coverage models of the energy stocks you own, then you’re not doing your job as a risk manager. But neither earnings risk nor balance sheet risk explains why you see a spasm of energy sector selling today or back in October.

No, the selling is because the dominant Common Knowledge regarding energy sector stocks is that they move up and down with the price of oil. Common Knowledge is not what everyone knows; that’s the consensus. Common Knowledge is what everyone knows that everyone knows, and it’s the driving force behind the Game of Sentiment. Everyone knows that everyone knows energy stocks are tied to oil prices, we just took another sharp leg down in oil prices, and so energy stocks must be sold. The fact that energy stocks are down “proves” the relationship (a wonderful example of Soros’s concept of reflexivity), which adds to the selling. And “Even After Selloff, Energy Stocks Attract Few Buyers” because, as the WSJ breathlessly announces, “prices could soon plumb new depths.” Or not, but … hey, all the better to set-up that “rebound that no one was expecting” story. Until that story is written, any oil price increases are merely because “traders who had bet on lower prices locked in gains.” I find it awfully telling that this WSJ article now titled “U.S. Oil Prices Trade Higher After Selloff” was originally titled and archived as “Oil Slides as Market Struggles To Get Grip” (you can track URL’s to identify this stuff), but then the market failed to cooperate and they had to change the title!

A couple of Epsilon Theory points on all this.

The reality (not that it matters) is that energy stocks are barely correlated with the price of oil, and their correlation with each other is barely driven by oil prices. We’ve run some basic regression analyses on MLP portfolios, and since 2012 only about 7% of the total return profile of MLP’s can be “explained” (statistically speaking) by change in oil prices. The largest explanatory factor is just the S&P 500, with about 4 times the “power” of oil prices to predict MLP prices. My interpretation is not that a rising overall market is “causing” MLP stocks to work, but that the same non-fundamental monetary policy-driven forces that are driving up the overall market are also at work in the MLP space. MLP’s have both growth and yield – the two rarest things in a Fed-dominated world – so whatever market dynamics work for stocks overall have really worked for MLP’s.

For another perspective, take a look at this recent piece by Ed Tom and the Credit Suisse Equity Trading Strategy team, titled “What’s Driving Energy Sector Correlation? (Hint: It’s NOT Oil)”. Ed and his team do stellar econometric analysis of equity market derivative contracts, which means that their papers typically need some translation into plain English. Here’s the skinny: most investors think that energy stocks traded off in unison in October because they’re highly correlated to the decline in oil prices. Not true. Yes, there’s some correlation to oil, but what’s really driving this across-the-board decline is the fact that “long energy” has become a very crowded trade. So if you get a signal that spooks the long energy crowd, you’re going to get a mad rush of investors heading for the exit even if the signal isn’t truly that relevant for the fundamentals or the historical beta of energy stocks. When a trade is crowded on the long side, everyone has an itchy trigger finger to sell.

So what does matter? How can we improve our investing around energy sector stocks by thinking about oil prices as a malleable signal that drives sentiment dynamics (at least in the short and medium term) rather than as a deterministic and inexorable sign of things to come? I think what happens from here depends on the strategic interaction of four factors:

  1. How crowded is the trade (still)? The good news here is that the Credit Suisse team believes a lot of the air was let out of the long-energy crowded trade balloon in October. I think that’s probably true, although I certainly wouldn’t call it un-crowded. I also think there’s a tremendous amount of air in the more general “the Fed has got your back” crowded trade balloon, which is worrisome for all equity market sectors, including energy.
  2. What’s the investing DNA – value or growth – of the majority of energy sector holders? The notion of population dynamics and evolutionary theory is something I explored earlier this year in Epsilon Theory (here and here), and it’s a topic that I’m going to refocus on in 2015. The basic idea is that different investors have different linguistic grammars (value investors possess a mean-reversion grammar, while growth investors possess a momentum grammar), and that for a stock or sector to “work” you need the dominant Narrative grammar to fit the dominant investor type.
  3. How is the oil price Narrative framed – supply/demand fundamentals or monetary policy? I wrote about this at length in last week’s Epsilon Theory note, so won’t repeat all that here. Everything I wrote then remains true: the supply/demand fundamentals Narrative is now ascendant and I suspect will remain so for at least a couple of weeks, maybe longer. That’s important because at current supply/demand projections it’s hard (not impossible, but hard) for oil prices to get much below $70 and stay there for a long time if you believe in this Narrative. A fundamentals-driven “explanation” places a martingale on oil prices that does not exist with monetary policy-driven “explanations”.
  4. What will China and the US do with their monetary policy, and what will Saudi Arabia and Russia do with their foreign policy? Hey, your guess is as good as mine. I don’t have a crystal ball on outcomes or timing, but this is where my risk antennae are focused 99% of the time.

I don’t have settled answers to any of these questions. And I don’t have a predictive model (a risk-based econometric analysis), because not only don’t I have settled answers, but I don’t even have a sense of potential outcomes or rough probability distributions for #4. I know that’s unsatisfying to many readers (certainly it’s unsatisfying to me!), but you have to take what the market gives you, not what you wish were there. My goal is not to be a hero and make bold predictions in the Golden Age of the Central Banker. My goal is to be a survivor. My goal is to play the game a bit better than the crowd by paying attention to the construction and shaping of market signals, all the while keeping my attention focused on how politicians and bankers wrestle with a global debt crisis. Call it being reactive if you like. I prefer to call it Adaptive Investing, and that’s what I want to communicate with Epsilon Theory.

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