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Risk Over Reward

Thinking About Investing

Geopolitics Part 2 - Poland, Turkey, China, and Culture

by Alpha and Vega, an Investor and a Trader
September 9th, 2010

In this issue:
1) Geopolitics Revisited
2) The Rise of Poland and Turkey
3) The Fall of China
4) Culture Wars and the End of Family Values
5) Six Impossible Things Before Breakfast

For a PDF version of this newsletter, please look here:

Dear Friends, Colleagues, and Investors,

In Geopolitics part 1, available here:

access_key=key-5s6nkynmcjh04k5n1zn, I introduced a way of looking at the world
that defines states as rational actors and explores the impact of geography and
demography on global affairs. I then argued that the US' global domination will
continue for at least another 30 years and I explored Russia's machinations in
central Eurasia. In this newsletter, I'll apply the same lens to other regions. I'll
argue that Turkey and Poland may become regional superpowers and that
China could fracture into weak sovereign territories.

1. Geopolitics Revisited
As with part 1, this edition of Risk over Reward owes a debt of gratitude to George
Friedman of Stratfor. Many of the ideas below are from his book, "The Next 100 Years."

In Part 1, I established that the US will remain the sole global superpower for the next
30 years. Through complete domination of the world's oceans and therefore the global
economy, the US decides the economic winners and losers. To identify which countries are
likely to outperform over the next 30 years, we want to look at which countries will be favored
by US technology transfers and favorable terms of trade. The US provides technology and
favorable terms of trade with realpolitik goals in mind. For example, the US provides aid to
Israel because a strong Israel serves as our giant military base in the Middle East. We follow
a strategy of "the enemy of my enemy is my friend." That was why we funded the Taliban in
Afghanistan in the 80s and why we are likely to provide increasing support to Poland and
Turkey. A strong Poland can contain Russia. A strong Turkey serves both to contain Russia to
the south and also to contain the more radical Islamic States.

2. The Rise of Poland and Turkey

Poland dodged the 2008 financial crisis and averaged over 1% real GDP growth over the
last 4 years. This is about the same as Brazil, and far better than France at 0%, and Germany
at 0.25%. Poland’s future finances look similarly strong with a debt to GDP ratio of about 47%
that is projected to stay under 60% for the next 6 years. In Europe, Poland is a dynamic up
and comer. If Poland becomes a regional superpower though, it will be primarily because the
US will bless them with increasing technology transfers, monetary aid, and favorable terms of
trade. The US will do this to strengthen Poland as a buffer to Russia. Conservatively, the
"region" in which Poland will gain prominence is Eastern Europe. Over a longer time frame
and with some luck, it's conceivable that Poland could gain prominence throughout all of
Europe as Germany and France shrink demographically and stagnate economically.

Turkey is a more obvious choice as a regional superpower; they held that title several
times in history, most recently as the seat of the Ottoman Empire. Turkey is geographically
well positioned to integrate the European and Middle Eastern economies. Turkey is the 17th
largest economy in the world, and one of the few developed economies in the Muslim world.
As a US favorite, it only takes a little imagination to see Turkey playing a dominant role in the
Middle East. The new leadership of Turkey has been rattling their sabers against Israel and
the US, but to me this looks like temporary and expedient political maneuvering. Turkey has
a well developed middle class that will continue to place materialism before ideology.

3. The Fall of China

China's strengths are well heralded. The citizens emphasize education and have a strong
work ethic, the government has been guiding growth to minimize asset bubbles (relatively)
well. As a result, their growth over the last 20 years has been extraordinary. However, there
are reasons to believe that China may unravel into weak sovereign states in the not too
distant future. This is not a prediction, but one possible scenario among several.

First, I need to identify the economic weaknesses. Like Japan in the 1980s, China has
been subsidizing corporate growth by keeping interest rates artificially low. Effectively this
transfers wealth from individual savers to corporations. As with Japan, this results in
companies looking more competitive and more profitable than they are really. Another effect
of keeping interest rates artificially low is that companies borrow more than they should.
Some smart analysts estimate that 30% of China's GDP is actually just bad bank loans that
will come crashing down in the near future. Finally, much of China's growth has come from
exports to the US. China has kept their exchange rate pegged at an artificially low rate. This
has increased their exports (and GDP), and resulted in the government accumulating about
$4 trillion US dollars. Unfortunately for China, that $4 trillion isn't worth what it seems. China
can't spend that money because that would require reversing the trade deficit and would
cause a sharp drop in Chinese exports. In other words, China is collecting IOUs worth
pennies on the dollar in exchange for increasing their exports. For China, this may have been
a good bet since it allowed them to quickly develop an industrial sector and minimize
unemployment. Their fiscal situation is less attractive than it looks on paper though, and the
eventual elimination of the trade deficit will be very painful.
If China fractures however, it will be for political reasons. Throughout history, China has
gone through a common cycle. China opens its borders, the coastal regions prosper while the
rest of the country remains poor, and revolutionaries arise to equalize the wealth and close
the borders. Today, some 400 million Chinese live on less than $1500 a year. As the graph
above shows, nearly the entire middle and upper class reside on the coasts. The coastal
businessmen feel far more allegiance too their trading partners in the US, Europe, and Japan,
than to politicians in Beijing. The Chinese leadership know that to maintain unity, they must
constantly redistribute wealth from the coasts to the poor interior, but obviously this is a bad
deal for the coasts.

I've already mentioned the frequent historical outcome of this tension - there may be a
revolutionary uprising that closes China's borders. I think a more likely outcome is for Beijing
to weaken. The coastal regions could ally closely with other countries to resist having their
wealth redistributed and China could look like a weak federation.

4. Culture Wars and The End Of Family Values

In 1800, women had an average of 9 children. A woman basically entered adolescence,
carried and raised children, and then died. Today the average woman in the western world
has about 2 children and lives twice as long. Only a small fraction of her life is spent raising
children, so women have fought for the right to do other things with their lives.

Before the industrial revolution, a woman needed to give birth to 9 children so that 3 would
survive. Those 3 children were both valuable labor on a farm and the mother's social security
if she was fortunate to live past menopause. Today, children don't produce wealth. In
advanced economies, the most desirable jobs require graduate level education. Children
aren't productive until their mid to late twenties and even then, they are frequently burdened
with school loans. Also, most societies have some form of social security so parents are less
reliant on their children. For these rational reasons, parents are having far fewer children.

The fundamentalist forms of most religions emphasize "traditional family values." At its
core, this means a large family, which usually entails a wife committed to child-rearing. The
economics of modern society make the large family an expensive anachronism. Sending 8
children to college is a luxury for the wealthy, yet it is generally the poorest people who have
the most children. Over time, people are recognizing the new economics and abandoning the
large family and single worker household. Society is moving inexorably towards longer
lifespans, more education, and therefore fewer children.

As investors, this is important to us because demographics impact every industry and the
political power of countries. Fewer people mean less demand for commodities and products
of all kinds, although some goods are more tied to population numbers than others. For
example, once everyone has a full belly, the demand for rice doesn't rise with higher incomes;
the demand for yachts however, can climb much higher. By understanding that large families
are a severe economic burden, we can predict that religious countries that emphasize
traditional family values are likely to underperform economically.

5. Six Impossible Things Before Breakfast

One of my favorite investment quotes comes from the Queen in Alice in Wonderland: "Why,
sometimes I've believed as many as six impossible things before breakfast." In trying to
predict the future, it's helpful to start with the impossible. As a thought experiment, I like to
pick an outcome and then try to imagine a path that would make it a reality. For example, let's
assume that we wake up in 2050 and Mexico is a leading economic power. How did it
happen? We can work backwards and imagine that Mexico cured its drug cartel problems and
established itself as a central hub of trade for North and South America. While most
developed economies were shrinking, Mexico's growing population gave it great dynamism.
As we paint a scenario, we may find it's less absurd than it originally sounded. The idea of
Turkey and Poland becoming regional superpowers and China fracturing into weak states
may sound impossible at first, but hopefully I've made that scenario sound just improbable or
even possible.

Your "Through the Looking Glass" trader,


Risk over Reward: A conversation about intelligent investing – we discuss the nature of risk
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