As we reach the last Geopolitics & the Day After newsletter of the year, we examine some of the larger trends and recent news items that we believe warrant consideration for the future. We begin with a discussion about the shifting nature of the global economic order. Then, we look at the recent attacks on maritime shipping off the coast of Yemen in the Red Sea. Next, we move to consider the ramifications of a potential war over the Taiwan Strait. Finally, we end on an outlook for the Federal Reserve’s possible interest rate cuts in the New Year.

The Global Economic Order is Changing

The Global Economy’s Unsolved Problems

José Antonio Ocampo, Project Syndicate

The Debt Problem Is Enormous. Experts Say the System for Fixing It Is Broken.

Patricia Cohen, The New York Times

The Era of Big Taxes Is Upon Us

Tom Fairless, The Wall Street Journal

The global economic landscape is undergoing a profound transformation. Developing countries are feeling the economic pain from the pandemic, while the high energy and food prices from the war in Ukraine and the high global interest rates are all adding to the increasingly debt-distressed Global South. Proposed measures to global financial institutions such as the International Monetary Fund (IMF) highlight the need for debt forgiveness, restructuring programs, and increased support for developing countries to act against the effects of climate change. Historical approaches, such as unhindered trade and the promotion of private investment, seem inadequate to address the issues the world is facing, especially in the face of rising geopolitical tensions.

Meanwhile, rich countries face a different set of challenges. Higher interest rates have made government borrowing more expensive, which has led to an increase in tax revenue in some of the richest countries in the world, including the US, Europe, and Asia. The trend towards big government – exacerbated by the pandemic, aging populations, climate change policies, and security concerns driven by a volatile geopolitical landscape – is evident. Wealthy governments are also grappling with a heavier burden from interest payments, further complicating the economic landscape for rich countries. The traditional norms of the global economy have given way to an ever-changing world as governments around the globe struggle to make sense of this new era.

The Shipping Crisis in the Red Sea

A new Suez crisis threatens the world economy

The Economist

Shipping companies avoid Red Sea after Houthi attacks

Lukanya Mnyanda, Robert Wright, David Sheppard, & Oliver Telling, Financial Times

The war between Israel and Hamas has expanded over a thousand miles away from the Gaza Strip in the Red Sea. Iran-backed Houthi militants based in Yemen have begun to attack global shipping flows through the waterway, a vital route through which 12% of global trade by volume flows. The rebel group, which is in conflict with the internationally-recognized government of Yemen, has stockpiled massive amounts of anti-ship weapons and poses a very real threat to vessels in the area. The Houthis claim these attacks are in support of Palestinians in Gaza, but they have not made a clear connection between the plight of the Palestinians and the multinational cargo ships that have little to do with Israel. Four of the five top shipping companies have suspended trade along the route, opting instead to travel the long way around Africa via the Cape of Good Hope. This increases the costs of shipping, which compounds the already rising insurance premiums. If the area of risk is expanded to the wider region near the Arabian peninsula, around which about a third of global oil shipments pass, energy prices could be affected. Already, US officials have announced a multinational naval mission to protect commercial shipping in the Red Sea.

The Big One

Andrew F. Krepinevich, Jr., Foreign Affairs

Chinese expansionism in the Taiwan Strait and South China Sea is increasing the likelihood of an outright great power conflict between the US and China. Such a war – potentially triggered by disputed Chinese claims and activities within the first island chain running from islands near Japan, through Taiwan, and extending through islands as east and south as Indonesia – would be the first great power conflict since World War II and the first conflict ever between nuclear states. While the conflict may go nuclear, the odds of a drawn-out conventional conflict are significant.

As such, the US and its allies must prepare for a long conflict that risks expanding outside of the Asia-Pacific into other areas such as the Horn of Africa, where both the US and China maintain military presences. In order to achieve success, then, the US will need to prepare for the management of such a conflict, including preparations to produce sufficient military equipment, to keep allies such as Japan and the Philippines engaged in the war effort, and to maintain a doctrine that would keep the conflict sub-nuclear on both sides. Ultimately, such a conflict would be devastating to both the US, China, and the global economy, therefore it is in the US’ interest to deter China from taking any action that would result in war ever breaking out.

Fed 2024: A Look Ahead

Fed Official Says Rate Cuts Could Be Needed Next Year to Prevent Overtightening

Nick Timiraos, The Wall Street Journal

The Fed’s Shrinking Balance Sheet Is Worrying a Key Corner of US Financial Markets

Alex Harris, Bloomberg

San Francisco Fed Reserve President Mary Daly has stated that the central bank can look forward to as many as 3 rate cuts penciled in for 2024, which is in line with 19 other Fed officials. The pivot comes as the Fed sees inflation softening and the mandate to maintain employment comes back into focus, with concerns of overtightening leading to unemployment. Nonetheless, expectations for higher-for-longer rates are still in place as the Fed maintains its 2% annual inflation target. In the meantime, the Fed will continue to offload its balance sheet through quantitative tightening (QT), as Fed Chair Powell still sees “ample” reserves available to do so. While QT has sparked some concern in the overnight funding market, which is a key conduit for bank borrowing, there is no evidence as of yet that the Fed has reached overtightening.