Substack Library


The Cost of Conflict

Likely all of us registered, perhaps out of our peripheral vision, that Chinese and Americans sat down last week at a hotel in Anchorage, Alaska and that there was a “clash” and “posturing.”

Regular Chinese and Americans, unlike the people at the table, barely know each other. About 42% of Americans hold a foreign passport and only a fraction of them have been to China, perhaps one or two percent based on tourism data. About 9% of Chinese hold a foreign passport. I suspect the vast majority of people on both sides want similar things––a cozy place to live, decent grub, some scratch and connection to close friends and family. Yet, we appear to be gearing up for a duel, possibly over Taiwan, maybe over islands almost no one can find on a map.

In this context, I tried to calculate for the cost of conflict. The true cost of conflict, which I will define as efforts to forcibly shift borders or ideology, is incredibly high. The cost is much higher than a direct calculation like military expenditure or lives lost; an accurate measure must include all the things that might have been had that violence been avoided in the first place.

I am not the only one who feels a vague sense of impending doom. Google searches on “US China Conflict” are at highs (credit this chart and an additional one further down goes to Rose, a company founded by Alex Campbell).

Over the long-term, economic growth is driven by how inventive we are. In econ speak, this is called productivity. In plain English it means getting more done for less, like plowing a field with a tractor versus a horse. What are tomorrow’s “tractors” in terms of transformative technology? No one knows for sure. What we do know is that we are in the midst of a disruptive, transformative wave of productivity and that there will probably be great inventions in both China and the US.

We interact with the outlines of this futuristic world every day. I write this overlooking Long Island Sound, having just spoken over video conference with a Google employee in Delhi about a book advertising campaign (shameless plug: buy, review or recommend Raising a Thief). The video somehow flowed through my telephone hotspot. We chatted about the relative speed of vaccine distribution in Delhi and Connecticut, a vaccine created in record time. The list of such innovative moments goes on and on. 

Amid such wonders, fighting over land seems anachronistic, yet that is where we are. Nationalism blooms despite how dated the concept. The primitive parts in all our brains that instinctively fear change, doubt people who don’t look or talk like us and sympathize to those that do remains intact. Calculating politicians tap into those primitive urges. Also true: the cultural collisions this new technology accelerates are real. China has had an emperor of some form for thousands of years, the United States was founded on the idea that living without an emperor was enormously preferable.

When tension spills over to violence, productivity plummets and wealth is destroyed. The US invasions of Iraq and Afghanistan cost around $6 trillion. This money could have been used to do many things, like fully upgrade the US’s creaky infrastructure. The untapped contributions of those that die in these conflicts is of course unfathomable.

The “track record,” in trading parlance, of poorly conceived military ventures is long. German wealth was wiped out (twice) in the first half of the 20th century.  Because we tend to measure wealth in our own currencies, an external reference point is required. The chart below shows gold measured against the Deustche mark. The 1923 hyper-inflation triggered by efforts to pay war reparations followed by the second world war eviscerated German wealth. The step change up in the chart is when the Deustche mark collapsed. (Geeky point, this chart is in log terms and the axis is 0 to 1).

Yet, the scars from conflict run far deeper. The true cost was the enormous productivity to be gained had Germany chosen another path. For instance, German mathematics has yet to recover because the top talent left. 

The closest recent parallel to a potential US-China clash is Crimea. Russia invaded Crimea in 2014, a decision enthusiastically supported by many Russians and one the Kremlin deemed in its interests. In response, the UN general assembly passed a resolution by a 100-11 affirming Ukraine’s territorial integrity. The US and Europe applied sanctions.  

Prior to the invasion, the Russian ruble was trading at 35 to the dollar. In the wake of the invasion, the ruble fell to 80 and has yet to meaningfully recover. (An important footnote: concurrent with the 2014 invasion, Saudi Arabia increased oil production, leading to a collapse in the price of oil, Russia’s key export). 

Just as German mathematics suffered after WWII, the Crimea invasion also left a lasting scar on Russia. This is most clearly evidence is how much it costs to borrow money. Without getting into all the nitty gritty, this cost is much higher in Russia. (Ten-year government interest rates are below 2% in the US, around 3% in China and closer to 7% in Russia).

A high cost of capital impairs investment, which directly relates to economic growth. Russian household debt is around 20% of GDP. By contrast, the US is closer to 80% and China 60%. Russian GDP is around $1.7 trillion dollars. If their household debt levels were closer to China’s, since 2014 Russia would have produced another $600 billion of spending. In other words, China-like growth rates.

Bad foreign policy decisions directly tie to things we can see and touch. The aging bridges I drive over every day are in some sense tied to the decision to spend US treasure abroad. When Chinese visited the US in the 1980s they say (see my podcast with Gao Xiqing) that America seemed impossibly bright and clean. Today’s Chinese students, I am told, are shocked by how decrepit the US is. And Russia’s decision to invade Crimea, a decision that most of the world sees as a violation of international law, directly relates to Russians living in small apartments.

I am so far betting the odds under Biden of such a conflict turning truly violent are low. I am long stocks and bonds in the US, China and even, a bit, in Russia. (I had been short US bonds, but I no longer am). I wonder if I am too optimistic on the likelihood of avoiding a clash. Negative views of China have exploded. According to Pew polling, a majority of people in the US, Europe and much of Asia hold negative views of China and President Xi. If the status quo around either Taiwan or the South China Sea shifts from posturing to actual conflict, not only will my asset allocation be in danger, the hit to productivity will last for decades to come.