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The Industrial Revolution Will Outlive the Liquidity Bubble

The Nasdaq has increased tenfold between the beginning of 2009 and the end of 2021, the S&P 500 a little more than five-fold. It was difficult to imagine, when the Fed started its ultra monetary stimulus (followed more or less belatedly by its various counterparts in the developed economies) that the world would go from one crisis management policy to another for more than a decade. The method of massive monetary stimulus has become, over the years, monolithic, inflating huge bubbles.

With the surge in inflation, these same central banks are suddenly being blamed, whereas the factors are, on this particular issue, more varied, starting with the global logistical chaos, aggravated by the war in Ukraine in the midst of a pandemic. If one can discuss endlessly the causes of the current inflation, the situation is clearer as far as the markets are concerned. Before inflation recently brought the demise of ultra-expansionary monetary policies, the major central banks guaranteed the surge in capital markets with a mountain of liquidity, supposedly to support the financing conditions of the real economy. A few years ago, fanciful economic theories emerged according to which central banks were supposed to use unlimited quantitative easing to target a certain level of GDP… In reality, these flows were mainly directed towards the financial and real estate sectors.

Liquidity Has Pushed the “Growth” Logic to the Extreme

Technology stocks have unsurprisingly overreacted in one direction, for a long time, and now in the other. These are typically so-called growth stocks, whose prices are overly dependent on the presumed expansion of business, in times of euphoria, with little concern for current profitability. It is quite normal for technology investors to be forward-looking, especially in a period of industrial revolution like ours. But this logic is pushed to the extreme in bubbles, to the point of losing touch with reality, as was the case with the internet bubble at the turn of the century. In recent years, it is monetary action most notably that has radically distorted market representations and the relation to time in the evaluation of asset prices.

The panic linked to the pandemic led to a reaction equal to the shock caused by the confinements, both monetary and fiscal. The markets then entered a parallel dimension where the notion of valuation was almost ridiculed. At the very beginning of the pandemic, the Nasdaq lost about a quarter of its value, and then doubled as a result of the rebound and, more importantly, the massive stimulus policies. The crypto bubble, with its countless shades of Ponzi schemes, from NFTs to collateral-free “stablecoins”, was simply the last straw ….

The Real Economy Is Weaker than When the Dot-Com Bubble Burst

The bubbles we are experiencing are intimately linked to the quasi-permanent crisis monetary policy, and the surge in inflation is very heavily neutralizing this arsenal of stimulus, despite the prospects of recession, which are becoming clearer. At the time of the dot com bubble, as spectacular as it was when it burst, interest rates were much higher, inflation was under control, the world economy was less unbalanced, real estate was at levels much more in line with household incomes. And Europe was not at war…

The combination of bubbles all over the world and monetary tightening (doomed, in the face of inflation, to aggravate market corrections and the dynamics of recession), creates a more formidable situation than two decades ago. The environment of zero interest rates – largely negative in real terms – and of mountains of liquidity, over time, has precipitated the most explosive trends in our financial model.

The Good Old Notions of Valuation Are Coming Back into Play

The dividend yield of S&P 500 companies is below 1.5%, while the 10-year yield on US government bonds is around 2.8%. With the prospect of a recession and central banks neutralized by inflation, we are moving away from a logic based on corporate growth expectations (and the inflation of bubbles). The good old notions of valuation (and yield) are starting to come back into play. The situation is simply more extreme for technology companies, because of their propensity, which is legitimate in this area, to focus on future prospects. Moreover, the monetary environment, as much as it has allowed the survival of zombie companies, has also shaped the technology sector, with the excesses we have seen in recent years, from Elon Musk’s stock market blows to the most dubious crypto constructions. However, we are indeed in a period of industrial and technological revolution, especially with the expansion of artificial intelligence in all its forms. The market correction, as severe as it is, can also be an opportunity to rethink our technological development, and its financing, in the long term.

This piece was originally published as an interview by Atlantico in French.

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Crypto-Bubbles and the Decentralized Eldorado

The crypto rollercoaster has consequences beyond the realm of mass speculation. It shapes key discussions on the future of money and the Internet, which revolve around notions of decentralization and economic power.

Web3: The Quest of Decentralization, and the Market Hype

The idea of Web3, with blockchain at its core, is meant as a promise of decentralization, a return to the spirit of web1 (whose early protocols still underpin the Internet). It aims to supersede Web2, marked by the rise of social media giants. They filled the void left by the absence of an identification protocol in the original Internet, in order to expand their control over personal data, for advertising purposes. Giving users back control of their data, through the blockchain, and ensuring interoperability across services is the key rationale behind web3. The idea that artists could use NFTs – usually defined as digital property certificates – to directly market their creations and cut the middleman is undeniably appealing. Similarly, programmable blockchains like Ethereum, with decentralized apps (dApps), could offer a prospect to overcome the exorbitant privilege wielded by app stores.

However, the main promise of web3 clashes with the reality of blockchains, caught up in the centralization of large exchanges and key venture capital firms. Besides, the massive crypto bubbles – fueled by herd behavior, shaky digital constructs and (central) monetary policy – do not quite fit with the common vision of financial and digital decentralization… A bubble is generally defined as a mismatch between the trend of an asset price and some underlying value. In the crypto bubble, the very idea of an underlying asset – or reality – has been derided. Some NFTs have pushed that logic with undeniable humor, like those based on drawings of adorable monkeys and their ApeCoin…

The global financial landscape – with inflation-driven monetary tightening – is throwing many asset classes into trouble, drying up the liquidity flows that have fueled the rally. Extreme volatility has been a hallmark of cryptos since their inception, but the last few years have seen a considerable drift, based on authentic Ponzi schemes, with concepts as far-fetched as that of virtual land. The most recent projects rarely show the kind of monetary thinking that underpinned the (very experimental) creation of bitcoin in 2008, using the cryptographic concept of Merkle tree, developed as early as the 1970s.

Most of the confusion this time came from stablecoins, which aspired to be the poster child of cryptos by offering a fixed exchange rate with a currency, like the dollar. Some, however, operate without collateral… This is the case with TerraUSD, which relies on a highly vulnerable system of rebalancing, using a floating crypto named Luna. TerraUSD has seen its peg to the dollar collapse as result of massive outflows. Collateral-based, centralized stablecoins like Tether already show more resilience. Beyond reports of destabilizing movements by large investment funds betting on the downside, the rout has, in any case, occurred against a background of severe fragility.

Blockchain Is Still an Experiment, However Fascinating

The concept of monetary decentralization, using cryptography, remains exciting. It is a substantial contribution to the discussion on the nature of our monetary and banking system, and its reform. This system is said to be centralized in the sense that it relies on central banks, but also on the privilege of massive money creation by commercial banks (through loan issuance out of thin air) – centralized institutions indeed. On the other hand, the concept of decentralization is also relevant in the face of Big Tech’s concentration in the digital sector and its control over user data. This control is likely to increase exponentially with the level of immersion, as will be the case with the metaverse.

Overall, the crypto world needs to further question the purpose, stability and legal status of its constructs. The crypto-currencies and assets that have only capitalized on the bubble of the past few years are unlikely to thrive. The (few) true pioneers of blockchain keep insisting on its experimental nature. For example, a crucial discussion centers on overcoming proof of work (a mining mechanism based on a cryptographic contest between blockchain nodes), which comes at an exorbitant energy cost. Considerable effort is being made in this direction in the case of Ethereum, to move towards the more reasonable concept of proof of stake – which accredits the nodes on the basis of their proven involvement, like a substantial holding of the cryptocurrency. It is hard to see how bitcoin could reform in this direction. If web3 is to bear fruit in favor of any kind of decentralization, the crypto ecosystem will first have to refocus.

Regulation and Central Bank Digital Currencies Will Redefine the Landscape

Emerging and updated regulations – like MiCA and TFR in the European Union – focus mainly on the issue of anonymity and trafficking. This type of rules may indeed disrupt the model of crypto platforms and can be expected to spread worldwide. At the same time, other important pieces of regulation target Big Tech, like the twin Digital Services and Digital Markets acts, which the EU is in the process of ratifying. Competition policy is waking up to the challenges of the digital age. However, governments will have to find a balance between tackling Big Tech monopolies and regulating decentralized players, which present major risks but also opportunities to restore a healthier level of competition.

Public digital projects, especially on the monetary stage, are also crucial to seize the opportunity for reform. Central bank digital currencies are not crypto currencies as such but official currencies in their own right. They will be backed by their respective central bank (rather than a cryptographic creation mechanism) and enjoy full equivalence with other forms – digital or physical – of the currency. The development of CBDCs must be pursued in a more ambitious way to give more meaning and stability to money, with a more direct link between monetary authorities and economic players. This brings us back to discussions that have endured underground since the Great Depression (on the fractional reserve system). Admittedly, the emergence of crypto-currencies helped to revive the interest in these ideas, after the great recession. The crypto rout could undermine the interest in digital currencies as a whole. On the contrary, we should engage in a broad political reflection on the use of digital innovation to stabilize our monetary system.

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Failing to Diversify Gas: Europe’s Decades-Long Renouncement Toward Russia

The failure to diversify natural gas sources leaves Europe without a convincing solution to such a premeditated Russian invasion of Ukraine. We find ourselves playing poker against chess players. Europe imports more than a third of its natural gas from Russia, and has given up most of its strategic leeway in this sector. Even though Europe’s political rhetoric was intended to be increasingly firm toward Russia, particularly with the idea of NATO expansion, in reality our dependence on Russia has increased year after year. This gap is exemplified by the major German-Russian agreements around Nord Stream 1, opened in 2011, then Nord Stream 2, just suspended before going into operation. The major diversification routes that Europe had been planning for since the early 2000s have been abandoned or reduced to a fraction of their original scope. The idea of a Southern Corridor from the Azeri Caspian fields as an alternative has been replaced by a gigantic northern, maritime route bypassing Ukraine, directly from Russia to Germany.

Turning Germany into a Major Hub for Russian Gas… and Bypassing Ukraine

In Germany, the share of gas imports from Russia is estimated at nearly half. The relative weight of Russian gas imports can vary significantly from one year to the next, and from one month to the next, but the trend has clearly been upwards over the last ten years, by more than 20% in Europe, while Norwegian production was beginning to stagnate overall. With Nord Stream 2, Germany’s dependence could have reached 70%. Nord Stream 1 has an annual capacity of 55 billion cubic meters (bcm). Nord Stream 2 was to double this capacity. 110 bcm is more than all of Germany’s natural gas consumption (about 100 bcm)! At the same time, the country has strongly developed its storage capacities. The aim was clearly to turn it into a major import-export platform for Russian natural gas, in addition to guaranteeing the country’s energy security after the end of nuclear power and satisfying Russian requirements to bypass Ukraine.

The Southern Corridor: A Missed Opportunity for Diversification

Alternative projects developed under the Southern Corridor framework were rightly presented as major diversification initiatives for Europe from the early 2000s until just under a decade ago. European countries, like Italy, Greece or Austria, each projected themselves, depending on the route options, as the hub of this southern route for distribution to the rest of Europe or at least its southern half.

On the one hand, Nord Stream, this gigantic northern route, has taken its place. On the other hand, while gas from the Azeri fields in the Caspian remained an alternative, the various secondary branches to Iran and Iraq have obviously disappeared in the wake of political ruptures and security crises. It would not be surprising, however, if a new commitment to diversification quickly led to improved relations with gas giant Iran and to new agreements.

In the end, instead of a major diversification route for Europe, the Caspian gas route has only into developed a modest interlocking of much smaller projects in Azerbaijan and Turkey, in particular, to Europe.

Russia has sought to bypass Ukraine for a long time. Already in the days of pro-Russian Yanukovych, there were incessant disputes about the fees charged by Ukraine and even more about the share of gas taken, with Moscow regularly accusing Kiev of siphoning off Russian gas flows to Europe. While various diversification projects were on the table in Europe, this Russian plan to bypass Ukraine resonated with the German objective of guaranteeing direct access to Russian gas, even if this meant considerably weakening Ukraine.

Energy Diversification Would Have Been More Effective than Banking Sanctions

This long drift has resulted in a loss of strategic room for maneuver. We therefore have to focus on financial sanctions with international repercussions that are difficult to anticipate and contain, such as banning some Russian banks from the SWIFT protocol. This type of measures was designed for Iran, which was already much less inserted in world trade. Above all, these measures of financial blockade were accompanied by the equivalent isolation in trade, and energy in particular. With heavy financial sanctions against Russia, there are still channels left, if only to be able to pay for our gas imports and receive payments from Russia. These sanctions are massive as such, but because of the extent of the dependence on energy flows, they are necessarily fragmented and unevenly applied.

The alternatives are limited in the short term. Liquefied natural gas is one of them, already accounting for slightly more than a quarter of European imports. However, the infrastructure is still quite limited, and non-existent in Germany, for example, which relies on the infrastructure of neighboring Netherlands. These take less time to build than large gas pipelines, of course, but they cannot be erected overnight. Flexible US supply has helped to increase European LNG imports. However, it is extremely difficult to overcome a tendency towards ultra-dependence in gas pipeline imports, which has developed over decades, since the days of the USSR, following long-term contracts with often opaque financial commitments. It should also be noted that Russia still accounts for 20% of the LNG imported by Europe, just behind the 26% share of the United States and 24% of Qatar…

This piece has initially been published as an interview by Atlantico in French.