2025 is the year that “kicking the can” encounters a brick wall, not just in the US but worldwide. China and Europe are in the vanguard among the larger economies along with most emerging regions. Japan and the US are among the relatively healthiest but both are looking at substantial difficulty in the coming year.
When we get to the final analysis of this period, I expect that we will find that government involvement in all these economies produced disincentive for prudent financial decision-making. In particular, I expect that we will find that the principle-agent problem has been duplicated millions of times across the globe, leading to extraordinary inefficiencies in the global economy even as technological innovation suggests otherwise.
During good times, there is little incentive to actively audit public agencies which allows the principle-agent problem to grow such that agencies expand far beyond their intended purpose, finding or creating new issues to solve. Over time, this often becomes a regulatory capture issue as regulators and industry participants realize they have complimentary incentives. Unchecked by decades of stability, regulators and industry participants accumulate significant capital and power creating difficult barriers to exit, especially when legislatures support such activity. It’s in this way that multiple acts of passivity become collective acts of agency.
In the first piece of this series, I wrote about how socialism and fascism somehow coexist in the US; this is how it happened. It is not limited to the US because Europe and Japan have their own blends of socialism/fascism. In China, it’s known as “Socialism with Chinese Characteristics.”
In common, all experienced the positive expansion phase where the models looked unbeatable, much like the Soviet Union of the early 1960’s, but like the USSR, these systems suffer from mis-allocation of capital on a grand scale. 2025 is the year the system breaks.
China is the Worst
We cannot solve our problems with the same thinking that created them – Albert Einstein
Deng Xiaoping’s liberal policies brought China into the 21st century; he simply allowed people to enjoy much of the fruit from their labor. We all know the story from there but over time, the fruits of labor came to be dominated by Chinese “princelings” or families who supported Mao during the revolution. Ultimately, the system morphed into one that now protects the profits of the princelings as well as the CCP as a whole – a 21st century form of feudalism. Xi shuttered all pretenses of freedom by re-instituting Marxism as the guiding principle. Now, it’s all over.
Xi knocked off China’s successful multinational companies like Ant Group because they posed a risk to his leadership. That was the end of their stock market because they were the only companies creating value.
When the money ran out, like it always does with Marxism, the government turned to extracting wealth from citizens through onerous taxes, fees, assessments, fines, and now forced upgrades on appliances and vehicles. This is a problem because 80% of the Chinese workforce is employed by small businesses. Government and trade restrictions are bleeding them dry and I expect this will reach a breaking point in 2025.
I use this chart almost exclusively these days because nothing else is trustworthy in China. Once China breaks decisively below these levels, their ability to import vital natural resources will fall which should mark the start of a global deflationary cycle for the world.
Europe
All things are subject to interpretation whichever interpretation prevails at a given time is a function of power and not truth – Friedrich Nietzsche
It’s only been around 100 years or so that Europe has embraced democracy. Prior to the Great War, the Continent was largely governed by monarchies, particularly relatively centralized monarchies. People are comfortable operating by rules created by a centralized power. I suppose this is the biggest difference between Americans and Europeans, despite common ancestry.
The devastation of WWI and II has bred a desire to limit competition, understandably so, yet the population still expects to remain at the forefront of human endeavors. As a result, we get a large dose of socialism, combined with a smattering of capitalism. It’s good to succeed as long as you socialize the benefits. It’s why Europe is a nice place to visit but a difficult place to operate a firm in a competitive global industry.
As a result of this restrictive environment, Europe has become something of a pilot fish, operating on the shark that is the US economy.
Perhaps it’s rude of me to point this out but my goal is to have a clear look at the challenges in front of us, not to be a pleasant read. Besides, Europe is full of potential sharks but the restrictions of their system make it difficult to accumulate the necessary capital to be dominant – with some obvious exceptions such as ASML.
The European system prevents global companies from competing on price thanks to very high frictional costs which is why they predominantly compete in value-added industries. Until recently, they enjoyed the benefits of relatively low-cost natural gas from Russia which allowed their primary industries to make the feedstock that is later turned into value-added chemicals and metals.
The “special operation” in Ukraine changed all that and while European companies were able to manage for a couple of years, time has run out. Solid employers like Volkswagen, Daimler and BASF have slashed employment levels thanks to the higher costs of industrial inputs.
The chart below tells the ugly story.
German industries are paying $11 per million British thermal units versus roughly $3 mmbtu in the US. Formerly viable industrial plants across Europe have been forced to close, shrinking employment, consumer spending, and tax revenues. This economic activity won’t return until cheap Russian gas starts to flow again.
The Continent is also hurt by a rapidly aging workforce, high costs for climate change initiatives, and high interest rates as shown below.
There is no need to spend more space on Europe because we simply need to look at their political situation where the two most powerful nations in the bloc are facing voter rebellion. Both Emmanuel Macron and Olaf Scholz are fighting for their political lives in France and Germany, respectively and it’s going to get worse with a new US Administration. Trump is going to force them to compete with the US on a level playing field.
I expect the euro to trade far below parity against the dollar at some point in 2025. When their currency breaks, we’ll get to find out how many Eurodollar banks are short the dollar and need a bailout.
Before long, the European Central Bank will need to cut interest rates to 0%. The Swiss National Bank has already warned of this when they cut their rates in half last week to 0.5%. Deflation is rapidly taking hold of Europe where the Continent lacks the political and social cohesion to act aggressively. Might this be the end of the European Union?
I’ll skip Japan because they are suffering from many of the same ills as Europe with a rapidly aging workforce and a high cost of energy. The difference is that Japan enjoys a large degree of social cohesion which they will need when they are forced to turn their nuclear plants back on.
United States
The Bismark quote is one of my all-time favorites and I use it often when I write because the US has been blessed by Providence. It’s why I stopped getting angry over political elections because somehow, over the long run, we seem to get things right, even if it takes a couple of decades to see the benefits.
Socialism is a terrible choice for society in the long run because it breeds complacency by allowing the people at the top to remain in place. That may be fine for Europe but the US was built on meritocracy, not landed titles. The folks at the top rotate in and out largely based on their individual efforts – over the long term.
Taking a longer view, our flirtation with socialism allowed different kinds of people to showcase their skills and integrate more fully into society. In short, this period has allowed us to turn up the heat on the melting pot, hopefully producing better future outcomes for society. The long term looks very good for the US; the problem is the short term.
Just like crooked bank execs capitalizing missed interest payments on loans to produce phantom profits, the US government has used its balance sheet to create fictitious GDP growth since 2008. Borrowing money and spending it creates liabilities, not prosperity and the new Administration has promised politique de rigueur and not more of the same.
How can you break the addiction to government spending that has been the hallmark of the US economy for 15 years? How can we break our addiction to junk economic activity without a major stint in economic rehab? At a time when the rest of the world is headed for economic rehab? Without trashing the capital markets?
This is my favorite economic chart because it shows US GDP minus US government debt. Since 2008, we’ve been buying our GDP growth with debt. I don’t think I can explain it more simply.
The stock market is supposed to be a measure of economic activity and taken at face-value, it tells us that our economy has been spectacular over the past 30 years. But if this truly is the case, people wouldn’t have voted for change. As they say, “the proof is in the pudding.”
I believe the new Administration is running into a buzzsaw with good intentions but strategies that may be out of step with the economic cycle. As such, I expect economic conditions to get really bad over the next year and I believe this will likely hurt most companies in the stock market.
Whatever strength we see in the economy today is a function of election year spending. It’s also the reason why inflation is still fairly strong and why the Fed is hesitant to cut interest rates faster, even though the Fed is behind the curve already. Such is the price of relying on models and not experience. The result will be weaker economic activity in the first half of 2025 which will be exacerbated by Trump’s first round of changes.
Conclusion
You cannot run away from weakness; you must sometime fight it out or perish; and if that be so, why not now, and where you stand – Robert Louis Stevenson
Fifteen years ago, world leaders took a handful of Prozac and decided to attempt to grow their way out of the debt problem despite declining birth-rates in the West. They put their hope for growth in China and other emerging nations as well as creating wealth-effects at home. Big mistake.
China bet the money on long odds that they would be able to convert the West to Marxism with China muscling the US out as global leader. The bet went sour on empty cities, bloated regional governments, redundant capacity, and resistant westerners. The whole country is facing an economic Black Hole and is threatening to drag the rest of the emerging nations with it.
The US bet the ranch on a wealth-effect that favored luxury over utility. Today we have hundreds of billions of dollars tied up in housing in flood zones or hundreds of miles away from formerly productive regions.
In part III of this series, I’ll look at the bloated bureaucracy that will resist reinvestment in productive assets along with the market troubles that will follow such a path.
