If you are new, welcome. You can read what I am up to and my background here. I encourage you to share this with others, that’s how this grows. If you were forwarded this, you can sign up (either free or paid versions), here:
Ukraine is bringing back to life images that once seemed frozen in 1940s Europe—trenches filled with bodies, burnt out husks of cities, terrified civilians on crammed train platforms. Putin’s fantastical lies, targeting of civilians and threats of using chemical and nuclear weapons suggest someone who will fight to the end. In pursuing this path, he has closed a chapter in history and taken the mask off authoritarianism.
The two great debates of the 20th century, or at least 1917-1989, were a) what type of economic system confers the best benefits and b) what type of government does the same. Every system has flaws. The question is what is the least-worst system. The collapse of the Berlin wall ended the first debate, Communism created poverty. As one of my Russian friends quipped: “you know what happened when they built Socialism in a desert? They ran out of sand.”
From 1989 until three weeks ago, the West’s assumption—and mine—was that economic self-interest would prevent an authoritarian leader, particularly an avaricious one like Putin, from ruining an increasingly prosperous economy in exchange for more land. That assumption was wrong. In response, I suspect a new era is beginning. Now it is clear that to enjoy the enormous, almost magical benefits of the modern economic system one must adhere to certain rules.
The rules are not yet rigidly defined. But for the US, Europe, Japan, Australia and the other 141 countries who voted in the UN to condemn the attack, invading a neighbor clearly violates one of them. The most influential country that either abstained or voted against the UN resolution is China, which is noteworthy.1
The Design Flaw of Authoritarianism
In recent years, leaders in Russia and China increasingly looked at the West, particularly the US, and concluded it was in self-reinforcing decline. I recall being told over a Beijing dinner by a thoughtful, bookish person that US collapse was imminent. Attacking Iraq (2003) based on false intelligence, economic instability (2008) and Trumpism (2016) against the backdrop of crumbling infrastructure, income disparity and racial tension all fed this view.
Despite this critique, the attractiveness of open systems endured. The oligarchs bought villas in Europe, not the other way around. Ukrainian refugees flee toward Poland not Russia and that instinct has been mimicked in longer-term data tracking the flow of people.
Both open and closed (authoritarian) systems get wildly off course. The structural difference is that as long as rule of law holds, the open system has more self-correcting features. True, these can take a long time to work. Ending slavery and giving Black Americans meaningful legal rights took well over 100 years, depending on how you count. But closed authoritarian systems concentrate so much power with the leader that they can get much further off course.
The obvious 20th century examples are Stalin and Mao. While precise calculations are difficult, in both cases each leader killed roughly 10% of their population, 15-20 million in Russia and 50 million in China. In both cases, others—Khrushchev and Deng—were aware of what was going on but unable to constrain the supreme leader while the leader was alive, possibly a precedent for Putin.
Open systems can become authoritarian, which is what happened in 1930s Germany and risks occurring in the US, particularly if Trump returns to power. One rough way of seeing the difference is by looking at how often and how deep the economy contracts under different systems. As the chart below shows from Rose Technology, these “drawdowns,” or contractions in economic activity, are far more severe in authoritarian countries.2 Russian data will look even worse pretty soon.
Key Structural Supports of a Modern Open Society
While the modern economic/financial system is complex, the pillars are (fiat) money, credit, energy and technology, particularly semiconductors. These pillars once seemed boring and technical. Now it is clear both that access to any single pillar is contingent on adhering to certain rules and that modern open societies that are dependent on authoritarian ones do so at their peril.
(Fiat) Money. Money—dollars or euros—is backed by nothing but a central bank monopoly on printing. Having a currency whose supply is flexible (it can expand and contract), run by apolitical technocrats, widely accepted and issued in a jurisdiction with enforceable laws is rare. By dropping a financial bomb on Russia, Western countries both destroyed the value of the ruble and turned what had been a relatively flimsy deterrent—sanctions—into a powerful weapon.
Credit. Credit allows you to spend today what you will earn tomorrow. Part of the reason Soviet apartments like the one my wife grew up in were so awful was because there was not a functioning mortgage market in Russia. Global markets for capital drive down borrowing cost and allow capital formation, like home building. Despite being flush with capital, Russia will likely default on debt Wednesday, suggesting that lending to authoritarian countries is far more risky than it might once have appeared.
Semiconductors. We are in the midst of an important technology shift including artificial intelligence and the internet of things. In the Enlightenment, human logic challenged the church’s authority; AI devises solutions to problems (like gene sequencing) that are beyond human logic. But this “thinking,” is dependent on fast semi-conductors, so having a safe supply is paramount and choking off supply can punish rule-breakers.
Energy. The difference between 21st century and 19th century standards of living are significantly due to energy use, particularly widespread, safe electricity. But Europe’s dependence on Russia prevents more impactful sanctions. This reality (higher prices actually make it easier for Russia to fund conflict) will almost certainly instigate a push away from cheap natural gas toward nuclear, liquid natural gas and alternative energy. While typically these shifts are slow, during war they can accelerate very quickly. (US power output rose by over 40% in WW2).3
China and the West
China is authoritarian, the second biggest economy in the world and on track (assuming it grows faster than the US) to become the biggest economy. Xi hasn’t condemned the invasion, possibly offered to provide Russia arms, is green-lighting pro-Putin propaganda and wants to absorb Taiwan. Given this and the financial bomb that has been dropped on Russia, it seems reasonable China will sell (either quickly or slowly) $3 trillion of US treasuries, buy more energy from Russia at discounted prices and gain a domestic source of semi-conductors either by dint of hard work or invading Taiwan and seizing TSMC, the cutting-edge manufacturer. For the West, a less globalized world likely equals lower productivity, slower growth, higher inflation, lower asset prices and, of course, a re-examination of the false assumptions held in the 1989-2022 era.
Investment Implications
Keep reading with a 7-day free trial
Subscribe to Things I Didn't Learn in School to keep reading this post and get 7 days of free access to the full post archives.