The Evolution of Competition

Death inspires me
Like a dog inspires a rabbit.
― Twenty One Pilots, “Heavydirtysoul” (2017)

Sometimes a cigar is just a cigar.
― Sigmund Freud, who probably never actually said this (but should have)

Over the past few weeks, I’ve had a fight with my wife, spoiling an otherwise wonderful night out, and email spats with two of my best and oldest friends. It was about Trump, of course. Not directly, but always on some silly tangential issue like “Should Sally Yates have resigned instead of countermanded an executive order on the basis of her personal beliefs?” or, better yet, “Is Lady Gaga authentic?” In each case, I didn’t recognize that we weren’t really talking about what I thought we were talking about, and by the time I did recognize the real issues, I was already too far down the path of combative Ben (think Bruce Banner but without the green skin) to care. Not my finest moments.

I suspect a lot of Epsilon Theory readers have had similar individual experiences of late. Certainly it seems that our collective experience as a nation and political society is breaking down this way.

What I want to write about today is not the specifics of this policy or that policy. It’s not to make an argument of any sort. It’s to write about argumentation itself, and the way in which the GAME of our politics and our society has shifted. Yeah, I know this is all very meta and has zero direct impact on your investing or portfolio decisions. But it’s actually the only thing that I think really matters for our social lives, including our lives as citizens and as investors, because it’s only by recognizing the game that we’re playing that we can survive it. Together. Maybe.

The most widely read Epsilon Theory note ever was “Virtue Signaling: Or Why Clinton is in Trouble”, published last September, where I wrote about why I thought Hillary could lose the election. The argument was that this was a turn-out election for a handful of swing states, and Democrats were all too keen to proclaim their political virtue by being anti-Trump in easy places like the Huffington Post or California metro advertising markets, where lots of like-minded Democrats would see them, rather than to barnstorm FOR Clinton in places where unlike-minded Democrats would see them, like Pennsylvania or Michigan or Wisconsin. Hubris, thy name is Debbie Wasserman Schultz and the rest of the DNC cartel.

But here’s what I wrote about Trump in that note:

Trump, on the other hand … I think he breaks us. Maybe he already has. He breaks us because he transforms every game we play as a country — from our domestic social games to our international security games — from a Coordination Game to a Competition Game.

Blowing up our international trade and security games with Europe, Japan, and China for the sheer hell of it, turning them into full-blown Competition Games … that’s really stupid. But we have a nasty recession and maybe a nasty war. Maybe it would have happened anyway. We get over it. Blowing up our American political game with citizens, institutions, and identities for the sheer hell of it, turning it into a full-blown Competition Game … that’s a historic tragedy. We don’t get over that.

Geez. Like anyone else with a public persona, I loooove being right. But I didn’t expect to be this right, this quickly. The election of Trump IS breaking us, and not because of the specifics of his policies or whether they’re right or wrong or anything like that. It’s breaking us because of the nature of repeated-play competitive games and the shifting meaning of cooperation.

That first bit — the nature of repeated-play competitive games — is a mouthful. All it really means, though, is that our real-life social interactions, whether in politics or markets or everyday life with our family and friends, are never a single, solitary game. We play the same core game over and over and over, each single interaction setting the stage for the next, and what we really should be concerned about is the overall pattern of the entire set of interactions. That’s real life, as opposed to some 2×2 matrix of Cooperate/Defect like you’d see in a game theory textbook.

And famously, repeated plays can help improve competitive games that otherwise end up in a sad equilibrium, like the Prisoner’s Dilemma. A political scientist named Robert Axelrod (not to be confused with David Axelrod of Obama campaign and CNN fame … this is a different guy) wrote a really influential book back in 1984 called The Evolution of Cooperation, where he showed that a cooperative but non-patsy player (i.e., willing to cooperate first and reluctantly forgive an opponent’s occasional defection) would, over time, find enough similarly “nice” players to create an ecosystem of cooperators and dominate, over time, those not-so-nice players who were looking to WIN BIGLY in every single interaction. Axelrod’s book was one of the most popular political science books of the past 40 years, and it spawned a cottage industry of academics looking to expand this insight in theory and practice. It’s a powerful idea because it’s a hopeful idea for nice people. If only us nice people can signal each other and band together, why golly, this proves that there’s nothing we can’t overcome together in this mean old world.

Unfortunately, the evolution of cooperation through adopting “nice” strategies is not a particularly robust finding. Or rather, it’s robust, but only in a particular subset of competitive games and only if the players agree on the meaning of cooperation. For example, if you’re playing a game of Chicken over and over again rather than a game of Prisoner’s Dilemma over and over again, being nice and forgiving doesn’t work very well. At all. Google “Sudetenland 1938” if you don’t believe me. In fact, the entire concept of repeated-play doesn’t fit neatly with the competitive game of Chicken, which is a problem because it’s the dominant competitive game form in the modern world, both internationally and domestically. It wasn’t always this way, particularly in our domestic politics. But it sure is now.

The fundamental reason that a repeated-play cooperative strategy doesn’t work in a game of Chicken is that the meaning of cooperation is different in this class of games. You see it in the title of the game itself. If you cooperate in a game of Chicken — i.e., you’re driving your tractor straight on at Kevin Bacon’s pick-up truck and you veer off from the looming crash, or you and James Dean are racing towards a cliff and you put on your brakes first — you are the LOSER. You are the COWARD. That becomes your identity and your reputation, which means that others will now treat you like a loser and a coward in the games that they play with you in the future. Compare that to the meaning of cooperation in a game of Prisoner’s Dilemma, where cooperation — i.e., you refuse to rat out your partner and cut a deal for yourself at his expense — means that you are STRONG and LOYAL. The words and the examples used to illustrate bloodless, mathematical game theoretic matrices are not accidental! If we believe that our identity is at risk in a repeated-play competitive game, we behave very differently than if it’s not. More to the point, we should behave differently if our identity is at stake. It’s the rational thing to do. If Trump inspires you like a dog inspires a rabbit, then you should never cooperate if it’s a game of Chicken with his tribe and you should always cooperate if it’s a Prisoner’s Dilemma game with your tribe. Maybe you’ll crash the car in this particular game of Chicken and maybe your partner will rat you out in this particular game of Prisoner’s Dilemma. But your identity and reputation will be strengthened, not damaged, for the next game you play with the other tribe or within your own tribe. And there’s always another game.

Okay, Ben, fair enough. We don’t want to be cowards but we still want to think of ourselves as nice. For the big identity-is-at-stake games, we should play nice strategies within our own mob and play mean strategies with the other guys. Got it. But how do we avoid crashing the car in our everyday lives? How do we avoid talking past or yelling at our friends, family, and fellow citizens with whom we share so much common ground on the really big ideas of what it means to be Americans or, more fundamentally still, a good human being?

Well … first off I’m going to suggest that we should all prepare for impact. The evolution of competition and the success of “mean” strategies in games like Chicken is at least as robust as the evolution of cooperation and the success of “nice” strategies in games like Prisoner’s Dilemma. Once you introduce, say, mustard gas into the trench warfare game, it doesn’t just un-introduce itself on its own. These bells are really hard to un-ring, and it typically takes a lot of car crashes on both sides before you get a peace treaty and a chance to rebuild a cooperative game structure. That’s at least four mixed metaphors, but you get what I mean. And unfortunately, all of these metaphors apply just as aptly to a social structure of family and friends as to a social structure of a political party or an entire nation. The evolution of competition is a powerfully contagious virus, and it hops easily from a big tribe like a nation to a small tribe like a family.

But I do have two suggestions to limit the damage that the evolution of competition inevitably spews in its wake.

First, whatever competitive social interaction we’re having, at whatever level we’re having it, the most important thing in that interaction is to figure out the meaning of cooperation for yourself and whoever you’re dealing with. Otherwise you’re going to find yourself playing a different game from the other person, and that never ends well. This is a tough piece of advice to follow (myself included!) because we assume that whatever our “identity weighting” might be for a given issue, the person or group we’re interacting with attaches that same meaning. So, for example, if you voted for Clinton as an affirmation of a personal identity that rejects the racism and sexism you see in Trump, your natural assumption is going to be that anyone who voted for Trump similarly did so as an affirmation of a personal identity, but one that accepts racism and sexism. Or vice versa. Or whatever. We’ve all seen a dozen variations of this theme over the past eight weeks, and we’ve all (yes, every single one of us) engaged in it, as well. This sort of projection is an innate behavioral bias of the human animal. I get it. But it is also entirely wrong-headed when it comes to complex and over-determined social behaviors like voting. Or buying a stock. Believe it or not (and many people reading this note won’t), behaviors like voting or purchasing or speaking or tweeting are not necessarily markers of personal identity. Maybe they are, and when they are they MUST be respected if you care about having a peaceful social interaction. But maybe they aren’t. And that must be respected, too.

Second, it’s crucial to recognize that not all political arguments or competitive games are really existential in nature or fraught with questions of identity. Not every tweet is a constitutional crisis. Sometimes a cigar is just a cigar. This is also a tough piece of advice to follow (also myself included!) because the ringleaders of the various Team Elite cabals, whether it’s the Trump Plutocrats or the Davos Globalists or the Central Bank Mandarins or the NeoCon Spymasters or whoever, are working diligently day in and day out to convince you that it is. That every action or statement by the other ringleaders is an OUTRAGE. That this is how Hitler got started or how liberty is lost.

Of course, the really scary thing is that this IS how Hitler got started and it IS how liberty is lost, it’s just not clear to me which of our contending factions or geographies is supplying the 21st century version. History rhymes roughly; it doesn’t repeat neatly.

Meanwhile the barrage of fiat news and alternative facts continues from all sides unabated. We are caught in the crossfire of the “mean” strategies implemented by the various factions as they quite rationally engage in a massive repeated-play game of Chicken, where winning means mobilizing the hearts and minds of the cannon fodder. And by cannon fodder I mean us.

It’s the oldest saying in poker, and one I can’t repeat often enough. If you’ve been playing poker for 30 minutes and you don’t know who the sucker is … it’s you. We are — all of us, without exception — being played. That doesn’t mean we stop playing the game, whether it’s the game of markets or the game of citizenship. It means, though, that we resolve not to be the sucker. That we turn a clear eye to the stories that others tell us and the stories that we tell ourselves. That we demand to be treated as the rightful, autonomous owners of our identities, and we extend that right to others.

Know thyself.

Treat others as you would have them treat you.  

Pretty good advice 2,000 years ago in some pretty hard times. Pretty good advice today.

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1914 is (still) the New Black

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

Vladimir Lenin (1870 – 1924) 

In 1914, Europe had arrived at a point in which every country except Germany was afraid of the present, and Germany was afraid of the future. 

Sir Edward Grey (1862 – 1933) 

Last week’s email, “1914 is the New Black”, was the most widely read Epsilon Theory note to date, and given yesterday’s events it bears repeating, as the echoes of 1914 are growing louder and louder. We are, I think, likely embarked on the death spiral phase of a game of Chicken, just as in the summer of 1914. The stakes are, for now at least, not nearly as cataclysmic today as they were a century ago, but the social and political dynamics are eerily alike.

I’m often asked how to get a better take on a historical event like the lead-up to World War I, and the answer is that there’s no substitute for immersing yourself in what people were actually saying and writing at the time the events transpired. If you’re lucky, perhaps you’ll pick a period that also attracted the attention of a gifted historian like a Robert Caro or a David McCullough. Second best, I’ve found, is to find a gifted editor or anthologist to smooth the path a bit. One such anthologist is Peter Vansittart, who collected a wide range of original texts in his classic books, “Voices: 1870 – 1914” and “Voices from the Great War”. I’ve taken some of those texts and appended them below. They speak for themselves, I hope, to illustrate the defining characteristic of a spiraling game of Chicken – all sides begin to speak in terms of “having no choice” but to take aggressive actions to defend their own interests.

Before the quotes, though, three other historical observations:

  1. The Austrian ultimatum to Serbia – long seen as the proximate cause of World War I – was accepted by the Serbian government almost in its entirety. Unfortunately, that “almost” part made all the difference. An important anecdote to remember the next time someone calls your attention to Tsipras’s acceptance of 90% of the Eurogroup reform ultimatum.
  2. Anti-establishment voters are always underrepresented in establishment polls. Noted segregationist and Alabama governor George Wallace won the 1972 Democratic Party primary in Michigan despite showing third in polls. Daniel Ortega and his Sandinista regime lost the 1990 Nicaraguan election by 10 percentage points to Violeta Chamorro despite leading by more than 10 points in every pre-election poll. The Syriza NO landslide was no surprise here, and this is an important phenomenon to keep in mind when you start to see opinion polls from Italy and France published over the next few days.
  3. Politics always trumps economics. My favorite 1914 quote in this regard is from Lord Cunliffe, governor of the Bank of England from 1913 – 1918, who famously declared that war was impossible because “The Germans haven’t the credits.” So what if Greek banks run out of euros? The Greek government will make their own, or maybe issue California-style IOUs and dare the Eurogroup to boot them out of the currency. If you think that an ECB squeeze can put this political genie back in the bottle, you’re making the same classic error as Walter Cunliffe did.

And now the quotes.

I held a council at 10:45 to declare war with Germany. It is a terrible catastrophe but it is not our fault. An enormous crowd collected outside the palace; we went on the balcony both before and after dinner. When they learned that war had been declared, the excitement increased and May and I with David went on to the balcony; the cheering was terrific

King George V (1865 – 1936) 

England alone carries the responsibility for peace or war, no longer us.

Kaiser Wilhelm II (1859 – 1941) 

In this most serious moment I appeal to you to help me. An ignoble war has been declared to a weak country. The indignation in Russia shared fully by me is enormous. I foresee that very soon I shall be overwhelmed by the pressure brought upon me and be forced to take extreme measures which will lead to war. To try and avoid such a calamity as a European war, I beg you in the name of our old friendship to do what you can to stop your allies from going too far. — Nicky

Tsar “Nicky” Nicholas II (1868 – 1918) in a letter to his cousin, Kaiser “Willy” Wilhelm II 

Now Tsarism has attacked Germany, now we have no choice, now there is no looking back. 

Kurt Eisner (1867 – 1919) 

Necessity knows no law; we must hack our way through. 

Theobald von Bethmann-Hollweg (1856 – 1921) in a speech to German Reichstag 

The few neutral states are not sympathetic toward us. Germany has not a friend in the world, she stands utterly alone and has only herself to depend on. … How different it all was a few weeks ago, when we launched so brilliant a campaign – now a bitter disillusionment is setting in. And how much we shall have to pay for all that is being destroyed! 

Helmuth von Moltke the Younger (1848 – 1916) in a letter to his wife 

In this war it is a question … of German civilization against barbarous Slavdom. 

Helmuth von Moltke the Younger (1848 – 1916)

The year 1914 in America seemed the crest of a wave of passionate idealism among young people, and of passionate selfishness among middle-aged people. 

John Cowper Powys (1872 – 1963)

July 25: Unbelievably large crowds are waiting outside the newspaper offices. News arrives in the evening that Serbia is rejecting the ultimatum. General excitement and enthusiasm, and all eyes turn towards Russia – is she going to support Serbia? The days pass from 25 to 31 July. Incredibly exciting; the whole world is agog to see whether Germany is now going to mobilize.

July 31: Try as I may I simply can’t convey the splendid spirit and wild enthusiasm that has come over us all. We feel we’ve been attacked, and the idea that we have to defend ourselves gives us unbelievable strength … You still can’t imagine what it’s going to be like. Is it all real, or just a dream?
diary of Herbert Sulzbach, “With the German Guns” (1935) 

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1914 is the New Black

Man in Black: All right. Where is the poison? The battle of wits has begun. It ends when you decide and we both drink, and find out who is right … and who is dead.

“The Princess Bride” (1987) 

Time is a game played beautifully by children.

Heraclitus of Ephesus (535 – 475 BC) 

How can you hide from what never goes away?

Heraclitus of Ephesus (535 – 475 BC)

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Whoever cannot seek the unforeseen sees nothing, for the known way is an impasse.

– Heraclitus of Ephesus (535 – 475 BC)

Let me just say that I am very negatively surprised by today’s decisions by the Greek government. That is a sad decision for Greece because it has closed the door on further talks, where the door was still open in my mind.

Jeroen Dijsselbloem, head of Eurogroup finance ministers

The judge smiled. Men are born for games. Nothing else. Every child knows that play is nobler than work. He knows too that the worth or merit of a game is not inherent in the game itself but rather in the value of that which is put at hazard. Games of chance require a wager to have meaning at all. Games of sport involve the skill and strength of the opponents and the humiliation of defeat and the pride of victory are in themselves sufficient stake because they inhere in the worth of the principals and define them. But trial of chance or trial of worth all games aspire to the condition of war for here that which is wagered swallows up game, player, all.

Cormac McCarthy, “Blood Meridian, or The Evening Redness in the West” (1985) 

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) 

Children and lunatics cut the Gordian knot which the poet spends his life patiently trying to untie.

Jean Cocteau (1889 – 1963) 

epsilon-theory-1914-is-the-new-black-june-29-2015-power

If you don’t like how the table is set, turn over the table.

– Frank Underwood, “House of Cards” (2013)

Nothing like a good Friday-after-the-close blockbuster to set the stage for an interesting week.

At 1am Saturday morning Athens time, the Greek government called for a nationwide referendum to vote the Eurogroup’s reform + bailout proposal up or down. The vote will happen on Sunday, July 5th, but Greece will default on its IMF debt this Wednesday, and as a result the slow motion run on Greek banks is about to get a lot more fast motion unless capital controls are imposed. If you want to get into the weeds, Deutsche Bank put out a note, available here, that I think is both a well-written and comprehensive take on the facts at hand. As for the big picture, I’ve attached last week’s Epsilon Theory note (“Inherent Vice“), as this referendum is EXACTLY the sort of self-binding, “rip your brakes and steering wheel out of the car” strategy I wrote about as a highly effective way to play the game of Chicken.

Look, I have no idea whether or not Tsipras will be successful with this gambit. But I admire it. It’s a really smart move. It’s a wonderful display of what de Tocqueville praised as the “condition of semi-madness” that was so politically effective in 1848, and I suspect will be today. Plus, you can’t deny the sheer entertainment value of hearing Dijsselbloem splutter about how he was open to a revised, revised, Plan X from Greece all along, if only Tsipras would continue with this interminable charade. “The door was still open, in my mind.” Priceless.

So long as Tsipras can avoid market anarchy and TV coverage of violent ATM mobs this week, I think the NO vote is likely to win. The referendum is worded and timed in a way that allows very little room for Antonio Samaras and other Syriza opponents to turn the vote into a referendum on the Euro itself, which has proven to be a successful approach in the past. Particularly as the Eurogroup rather ham-handedly denied the request for a one-week extension in the default deadline, the referendum is being framed by Syriza as what Cormac McCarthy called a “condition of war”, an over-arching game where “that which is wagered swallows up game, player, all.” It may well be a close vote, but it’s hard to vote YES for a public humiliation of your own country under any circumstances, much less when that YES vote is being portrayed as giving aid and comfort to the enemy.

Here’s how I see the game playing out after the vote.

If Greece votes to accept the Eurogroup reform proposal after all, then the game of Chicken resolves itself within the stable Nash equilibrium of a shamed Greece and a triumphant Euro status quo. I would expect an enormous risk-on rally in equities and credit, particularly in Euro-area financials. Hard to say about rates … peripheral Euro debt (Italy, Spain) should rally, and German Bunds might, too, as the Narrative will be that Germany “won”. But reduction of systemic risk is a negative for any flight-to-safety trade, so this outcome is probably not good for Bunds in the long term, or US Treasuries over any term.

If Greece votes to reject the proposal, then either the game resolves itself within the stable Nash equilibrium of a shamed Euro status quo and a triumphant Greece (if the ECB and EU decide to cave to some form of the original Greek proposal), or we enter the death spiral phase of a game of Chicken, as all parties start to talk about how they “have no choice” but to crash their cars. That latter course is the far more likely path, I think, given how the various Euro Powers That Be are already positioning themselves. It’s all so very 1914-ish. Draghi’s cap on bank-supporting Emergency Liquidity Assistance (ELA) is the modern day equivalent of Czar Nicholas II’s troop mobilization. Good luck walking that back.

If we go down the death spiral path and some form of Greek exit from the Euro-system, I expect the dominant market Narrative to be that Greece committed economic suicide and that the rest of Europe will be just fine, thank you very much. That should prevent a big risk-off market move down, or at least keep it short-lived (although you should expect Bunds and USTs to do their risk-off thing here). Unless you’re a hedge fund trying to make a killing on those really cheap Greek bonds you bought two years ago, there’s no reason to panic even if we’re on the death spiral.

Over time, however, I expect that dominant Narrative to be flipped on its head. Greece will quickly do some sort of deal with Russia (hard currency for port access?), and then the IMF will strike a deal because that’s what the IMF does. More and more people will start to say, “Hey, this isn’t so bad”, which is actually the worst possible outcome for Draghi and Merkel. At that point, you’ll start to see the Narrative focus on the ECB balance sheet and credibility, and as Italian and Spanish rates start to creep up and as the spread to Bunds starts to widen, people will recall that ECB QE only has national banks buying their own debt … the Bundesbank ain’t propping up Italian sovereign debt. I suspect it will be a slow motion contagion, all taking place in the Narrative and expressed in Italian, Spanish, and French politics over the next 12 months or so. The Red King will start to wake.

One last point on how the market Narrative will shift if we go down the death spiral path, and that’s the dog that will stop barking. The incessant and often silly focus on Fed “lift-off” is about to go on summer hiatus, which can’t happen soon enough for me. 

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Inherent Vice

epsilon-theory-inherent-vice-june-22-2015-nash

Nash: See, if I derive an equilibrium where prevalance is a non-singular event where nobody loses, can you imagine the effect that would have on conflict scenarios, arms negotiations …
Charles: When did you last eat?
Nash: … currency exchange …
Charles: When did you last eat? You know, food.
Nash: You have no respect for cognitive reverie, you know that?
Charles: Yes. But pizza – now pizza I have enormous respect for. And of course beer. [leaves]
Nash: [throws stuff down and follows] I have respect for beer. I have respect for beer!

“A Beautiful Mind” (2001), biopic of game theorist John Nash (1928 – 2015).

epsilon-theory-inherent-vice-june-22-2015-neumann

  1. If people do not believe that mathematics is simple, it is only because they do not realize how complicated life is.
  2. Young man, in mathematics you don’t understand things. You just get used to them.
  3. There’s no sense in being precise when you don’t even know what you’re talking about.
  4. It is just as foolish to complain that people are selfish and treacherous as it is to complain that the magnetic field does not increase unless the electric field has a curl. Both are laws of nature.

– Four from John von Neumann(1903 – 1957), the father of modern game theory.

I’m interested in the fact that the less secure a man is, the more likely he is to have extreme prejudice.
– Clint Eastwood (b. 1930) 

Insecurity is the worst sense that lovers feel; sometimes the most humdrum desireless marriage seems better. Insecurity twists meanings and poisons trust.
Graham Greene, “The End of the Affair” (1951) 

epsilon-theory-inherent-vice-june-22-2015-hitler

If freedom is short of weapons, we must compensate with willpower.

– Adolph Hitler (1889 – 1945)

One constant among the elements of 1914 – as of any era – was the disposition of everyone on all sides not to prepare for the harder alternative, not to act upon what they suspected to be true.

– Barbara Tuchman, “The Guns of August” (1962)

In a significant move to deter possible Russian aggression in Europe, the Pentagon is poised to store battle tanks, infantry fighting vehicles and other heavy weapons for as many as 5,000 American troops in several Baltic and Eastern European countries, American and allied officials say.

New York Times, “US Is Poised to Put Heavy Weaponry in Eastern Europe“, June 13, 2015

Be careful who you call your friends. I’d rather have four quarters than one hundred pennies.
Al Capone (1899 – 1947) 

epsilon-theory-inherent-vice-june-22-2015-james-dean

We are all impaled on the crook of conditioning.

– James Dean (1931 – 1955)

epsilon-theory-inherent-vice-june-22-2015-keats

There’s nothing stable in the world; uproar’s your only music.

– John Keats (1795 – 1821)

Shasta Fay: I went on a boat ride.
Doc: A three hour tour.
Shasta Fay: They told me I was precious cargo that couldn’t be insured because of inherent vice.
Doc: What does that mean?
Shasta Fay: I don’t know.
Doc: Inherent vice in a maritime insurance policy is anything that you can’t avoid. Eggs break, chocolate melts, glass shatters, and Doc wondered what that meant when it applied to ex old ladies.

“Inherent Vice” (2014)

I was at a conference, on deck for a presentation, and I had the chance to listen to the Q&A for the speaker ahead of me.

“Assuming no external shock, how much longer can this bull market run?”

The speaker, not exactly the most sparkling of raconteurs under the best of circumstances, first replied with the obligatory, “well, that’s a very good question”, and then proceeded to give a detailed, bone-dry explication of exactly how long he thought this market would run, the likely level of the S&P 500 top, and a few winning sectors and stock picks for good measure. It all sounded very smart, and I’m sure he was … smart, that is. But boy oh boy, if there were ever a living embodiment of von Neumann’s dictum that being precise is all too often a waste of time, this was it.

Because this wasn’t “a very good question”. It was, in fact, a pretty useless question, the functional equivalent of asking a botanist how big a tree can grow in the absence of storms, droughts, fires, blights, lightning, insects, or whatever. Answer: pretty darn big. Better answer: who cares? You don’t need my help with an investment strategy for a paradise scenario, any more than you need my help with an investment strategy for a doomsday scenario. But where we could all use some help is with an investment strategy for the Real World in-between paradise and doomsday. What we all need is a good perspective or vantage point for differentiating between this potential shock and that potential shock, for evaluating what signals to press and what signals to fade. It’s not a matter of predicting shocks, but rather a matter of reacting to incipient shocks smartly and strategically, of knowing, in the immortal words of Kenny Rogers, when to hold ‘em and when to fold ‘em. Now that’s a good question, and it’s one that Epsilon Theory is well suited to take on.

There’s a specific sort of instability in the world today – a game theoretic instability – which means that it has an identifiable pattern and rhythm you can understand in order to improve your investment strategy. It’s the instability of the game of Chicken, and once you start looking for it, you will see it everywhere here in the Golden Age of the Central Banker. Greece vs. the Troika? Chicken. Western sanctions on Russia over the Ukraine? Chicken. OPEC vs. US energy producers? Chicken. ECB vs. the Swiss National Bank? Chicken. Fed monetary policy communications to markets? Chicken. Abenomics? Chicken. US policy towards China? Chicken. ISIS vs. the world? Chicken.

Let me take a minute to describe why a game of Chicken is particularly and peculiarly unstable, because understanding the game’s dynamics is crucial for understanding how and why Chicken has become the defining strategic interaction of nations and institutions today, just as it was in the 1930s, the 1910s, and the 1870s. To make that description, I’ll be drawing on the concept of the Nash equilibrium, the most influential insight of mathematician John Nash, whose early career and lifelong struggle with mental illness was portrayed in the great movie “A Beautiful Mind”, and who was killed last month in a car accident at the age of 87 (I’d like to think that his not wearing a seatbelt while traveling on the New Jersey Turnpike was a game theoretic exercise, but that’s the Keats-ian Romantic in me talking).

The central idea of the Nash equilibrium is that a non-cooperative strategic interaction between players (for simplicity’s sake we’ll just talk about two player games, although the concept is applicable for any number of independent players) is in balance, i.e. in equilibrium, if neither player prefers to “move” from the current game position after consideration of both his preferences and potential moves AND his opponent’s preferences and potential moves AND the knowledge that both of you are thinking about the other in this manner. The Nash equilibrium takes seriously the notion that the other player is just as smart as you are and, as importantly, just as strategic as you are – meaning that both of you can look several moves ahead, and both of you are making moves that are contingent on the other player’s moves. Like all great ideas the Nash equilibrium seems simple at first blush, but it’s a deceptive simplicity, one that when applied rigorously can shed light on a raft of social interactions that otherwise seem irrational or unpredictable.

I’ll start with a common game that has a straightforward Nash equilibrium, the Prisoner’s Dilemma. I’ve written about this game in several prior notes, so I won’t go into detail here about its meaning. It’s just an example to explain the nomenclature. Below is the standard way of depicting a game between two players – in this case you and Al Capone – with each player having two behavioral choices – in this case Silence or Rat – and with the game payoffs in red for you and green for Al. The infamous Prisoner’s Dilemma outcome, where both you and Al rat on each other even though you both suffer more than you have to, is marked with the light blue oval and is the stable Nash equilibrium.

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The Rat-Rat outcome is a Nash equilibrium because you don’t want to change from Rat behavior to Silence behavior (moving from the bottom right quadrant to the upper right quadrant) because your red payoff declines from -5 to -10. Ditto for Al Capone. He’s not changing his behavior from Rat to Silence (moving from the bottom right quadrant to the bottom left quadrant), as his green payoff would be worse for making the move. More interestingly, the Rat-Rat outcome is a highly predictable Nash equilibrium because no matter what quadrant or combination of behaviors you and Al start with, the game always ends up in the bottom right quadrant. Why? Because this is a non-cooperative game. Even if you and Al start in the happy upper left quadrant of Silence-Silence, where there is a +10 total utility to the shared outcome, there’s no way for Al to prevent you from choosing Rat behavior and boosting your personal payoff from +5 to +10. That wouldn’t be so bad in and of itself, but your choice to move from Silence to Rat is accompanied by Al’s payoff changing from +5 to -10, and that’s intolerable for him. So he decides to switch his behavior from Silence to Rat, to get out of what’s called the “sucker payoff” of the bottom left quadrant if that’s where you were planning to put him, or to put the sucker payoff of the upper right quadrant onto you if you were keeping your mouth shut after all. Of course, you are thinking about Al Capone in exactly the same way, and both of you know that both of you are thinking in this manner. All this combines to make the Rat-Rat outcome a very speedy equilibrium solution to the Prisoner’s Dilemma.

Now here’s the layout for the game of Chicken.

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You and James Dean are each driving your car towards the cliff’s edge, but unfortunately for both you and James there isn’t a single Nash equilibrium for this game. Obviously it’s disastrous for both of you to stay in the lower right quadrant where you’re both dead and leaving behind pretty corpses. But why should you stop your car and enter the stable but embarrassing Nash equilibrium of the upper right quadrant (-10 for you, +10 for him) when it would be just as easy for James Dean to stop his car and move both of you into the far more enjoyable and just as stable Nash equilibrium of the lower left quadrant? A game of Chicken has two Nash equilibria, each just as likely as the other, each just as “natural” an outcome as the other. This is the inherent vice of the game of Chicken – it is impossible to predict the outcome of the game by looking at the fundamentals of the game. It is inherently unpredictable – not because we don’t know enough facts about the situation or because we’re not smart enough to analyze the situation – but because it is the mathematical nature of this particular beast.

I’m often asked what I think the outcome of the negotiations between Greece and the Troika will turn out to be. Will Greece leave the Euro and default on its debt? Will Germany blink? And when I answer the question by saying that I don’t know, I can feel the disappointment. Don’t you even have an opinion, Ben? You seem to know a lot of the facts here, or at least you talk a good game about domestic Greek politics and multi-level game-playing. What good is game theory and all your knowledge if you can’t even handicap the odds of a Greek default?

Game theory is useful precisely because it tells me that there is no fundamentals-based or structural methodology to handicap the odds of a Greek default! Sometimes the answer to a mathematical question is the same as the answer to a prayer or the answer to a Magic 8 Ball: NO. There is no greater understanding possible here through the use of science and mathematics. To paraphrase Von Neumann again, get used to it.

In my stump speech about investing in the Golden Age of the Central Banker, I always start by making the distinction between decisions under risk and decisions under uncertainty. In a decision under risk, you know the possible outcomes of a decision and you have a rough sense of the probabilities to associate with those outcomes. In a decision under uncertainty, you either don’t know the possible outcomes or it’s impossible to assign meaningful probability distributions to those outcomes. What’s at stake in the distinction between the two? All of modern portfolio theory and all of mainstream macroeconomic theory and all of econometric modeling – ALL of it – is based on the assumption that everyone in the world is making decisions under risk. Violate that assumption – an assumption that is as deeply buried and indecipherably written within the edifice of academic economics today as the assumption that “a nationwide decline in home prices is impossible” was deeply buried and indecipherably written within the edifice of $10 trillion worth of residential mortgage-backed securities in 2008 – and your portfolio risk analysis suddenly has a hole big enough to drive a truck through. Game theory provides a perspective and a toolkit to distinguish between decisions under risk and decisions under uncertainty. It can’t work miracles by predicting the outcome of something that’s inherently unpredictable, but it can identify the situations that are unpredictable and suggest coping mechanisms for dealing with them. And that’s a lot. It can also highlight the situations where you have made a category error, where you have a misplaced confidence in your existing risk management toolkit or perspective. And that’s a lot, too.

So what does determine the outcome of a game of Chicken? Surely it’s not just a random outcome? Well, no, it’s not random, but you’re not going to like the answer I have for you any better. The game of Chicken is not a test of power and capabilities. It is a test of will. It is governed by constructed signals of resolve, control, and – occasionally – lack of control. It is governed by Narratives, particularly by political Narratives when the game is played on an international stage. Cooler heads rarely prevail in a game of Chicken, even if they’re objectively the stronger player. Because we’re all smart enough to know how to play the game, and because we know that the other players are going around and around in their heads trying to figure it out just like we are, the game of Chicken breeds insecurity, doubt, and miscalculation like no other. Play the game enough times and it will break you. It’s un-insurable, plagued by inherent vice, and that means that it’s un-investable, too.

I promised that game theory could provide some coping mechanisms for dealing with technically uncertain (as opposed to merely risky) investment or policy environments, and I’ll write briefly about three in this note. The first two are methods for gauging which equilibrium the game of Chicken is moving towards by evaluating the relative strength of the competing player Narratives. The third is a more general observation about gameplay and timing.

First, watch for acceleration and deceleration in behaviors, not absolute levels of speed. Technically speaking, second derivatives are always more influential than first derivatives as signaling devices because they contain more information (data that makes you change your mind; see “Sometimes A Cigar is Just a Cigar” for a primer on Information Theory), and third derivatives are even more powerful. More colloquially, it’s not whether your car is going faster than James Dean’s, it’s whether you are accelerating your speed more than James is accelerating his speed. Better yet, it’s whether you start to accelerate at a faster rate than you were a second ago. Remember, the game of Chicken is all about intentions and willpower, not capabilities and structure, and pressing down on the gas pedal is the only structural (or to use a $10 word, endogenous) method of communicating those intentions.

Three quick examples of the primacy of change (and change of change) in determining market outcomes in Chicken environments:

What was the Fed Narrative that brought markets back from the abyss in the spring and summer of 2009? Answer: “green shoots” – the notion that even though the US and global economy were still declining, they were getting worse at a decelerating rate.

What was the market reaction to Bernanke’s summer of 2013 Narrative that the Fed was not going to put on the brakes, but they were going to “ease off the accelerator” a bit? Answer: Taper Tantrum – a sharp decline in almost all asset classes in almost every market around the world, as investors reacted to the change in intentions signaled by the Fed (for more on this, see one of my first Epsilon Theory notes, “2 Fast 2 Furious”).

Now fast forward to today and ask yourself why we are NOT seeing a similar sell-off in global markets as the Fed very publicly goes about its business of preparing to raise short rates. Answer: because from a second derivative perspective putting on the brakes is the same thing as taking your foot off the accelerator. Deceleration is deceleration; you’re just crossing the zero-line when you put your foot on the brake. There is no essential change in intentions from the Taper Tantrum to today, and that’s why this Narrative-dominated market continues to set new highs.

Second, watch for self-binding behaviors, particularly suicidal self-binding behaviors. These are very powerful Narratives for signaling intentions, and they are variations of the classic Chicken-winning strategies of ripping your brakes or steering wheel out of the car, or acting so crazy that your opponent believes that you prefer death to defeat.

By suicidal self-binding behaviors I mean politically suicidal, like John Boehner’s go-to move in negotiations with the White House, where he “has no choice” but to take a hard line or else face a revolt from the Republican caucus, but I also mean physically suicidal. And before you say that this is only something that ISIS jihadists would do, consider that last week the US Defense Department floated a trial balloon in The New York Times saying that they were considering moving up to 5,000 US troops into Baltic and Eastern European countries. Now the press articles emphasized all the tanks and equipment that would be pre-positioned there, making it seem as if this would be a very potent fighting force, ready to take on a new Evil Empire if one materialized from Moscow. Please. These soldiers would be in Eastern Europe for exactly the same reason we stationed US soldiers in West Berlin during the Cold War: they are there to die. In the event of a Russian attack, their job is to be killed so that the resulting hue and cry would guarantee an all-out NATO military response. Sorry, but it’s true. It’s a classic “tripwire” strategy, and the thing about tripwires is that they have to be broken in order to work. Of course, the Russians know exactly what the moves are here, which makes them less likely to engage in full-frontal military actions in the first place, which is exactly the Pentagon’s goal. It’s an effective way of playing the game of deterrence, which is a form of Chicken, but less effective and more risky the deeper you place the tripwire into Russia’s sphere of influence. Color me nervous. Really, I don’t see how the game is worth the candle here.

On the flip side of the self-binding spectrum, intentional ambiguity can also be a very effective strategy for playing Chicken, particularly if you’re starting from a structurally stronger position than your opponent. What is not effective at all, however, is to switch back and forth between ambiguity and self-binding, as we have seen from time to time with the Fed (data dependence versus strong forward guidance) and constantly with this White House, particularly in its foreign policy.

Third, there is one redeeming quality about the game of Chicken – it takes a long time to play. Unlike the Prisoner’s Dilemma, where you typically get to the single Nash equilibrium so fast it makes your head spin (and usually too quickly to react effectively in your portfolio), Chicken players tend to have a mutual interest in pushing back the day of reckoning as much as they can. That’s because no matter how confident you are that you’re “winning” with your clever signals and Narratives, neither your true will nor your opponent’s true will are knowable or observable directly. Chicken is a game played through a glass, darkly. It’s ultimately as unpredictable for the players as it is for investors, and if there’s one group that hates unpredictability even more than professional investors it’s professional politicians.

The upshot of all this for investors is two-fold:

Take your time in dis-engaging from the game. Yes, a game of Chicken is inherently unpredictable and hence inherently un-investable, but you have plenty of time to exit. Moreover, the passage of time can often make the ultimate car crash much less painful. For example, while a Greek default and Euro exit will spark trouble no matter when it occurs, it’s absolutely less destabilizing today with most of the debt in the hands of the Troika than three years ago when that debt was spread all over the private banking sector.

Don’t freak out on any individual signal or Missionary statement, but don’t ring the all-clear bell, either. Because Chicken is a game of constructed signals and Narratives signifying hidden will and intentions, there’s almost always “room” for players to volley market-moving statements back and forth, regardless of the objective or structural characteristics at hand. In other words, it is virtually impossible for a single signal to push the outcome into either Nash equilibrium. When does time run out in a game of Chicken? When you see competing Narratives of “we have no choice” you’ve entered the death spiral phase of the game. That’s when it’s time to head for the hills, and quickly.

I’ll close this note with the same line that I find myself using over and over again. The Golden Age of the Central Banker is a time for investment survivors, not investment heroes, and the ubiquity of inherently unstable games of Chicken is a big reason for that advice. There’s no shame in picking your battles, in recognizing what’s investable and what’s not. There’s also no reason to panic. But it’s not easy to make that differentiation if you’re looking at an uncertain world through risk-colored glasses. Time for a new set of lenses, one that takes seriously the patterns of strategic interaction and behavioral dynamics that rocked the world in the 1870s, the 1910s, the 1930s, and … I suspect … the years immediately ahead of us.

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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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