The Recession That Didn’t Bark

>> Becky: You think a recession is more likely now than maybe you would have said six months ago?

>> Warren: Well, I think most of our manager would say that they are surprised at where they are now compared to how they thought they were going to feel six months ago at this point in a lot of businesses.

 

>> Niall: It's Wednesday, July 12, 2023, and welcome back to GoodFellows, a Hoover Institution broadcast that examines social, economic, political, and geopolitical issues. My name is Niall Ferguson, and I am an historian and the Milbanke family senior fellow here at the Hoover Institution, I'll be moderating today's show, standing in for Bill Whelan, who is off this week.

And joining me, as usual, are my fellow GoodFellows, please welcome the noted economist John Cochran, author of the monumental new book the Fiscal Theory of the Price Level, which we're going to be talking about. And sitting next to him in Zoom Land, the host of Hoover's Battleground series and author of the book of that same title, the historian and strategist lieutenant general HR McMaster, who served as national security advisor from 2017 to 2018.

John and HR are also Hoover senior fellows. By the way, if you like this show and are watching us on YouTube, just take a minute to hit the like button and the subscribe button. It really helps us with the all powerful, all knowing YouTube algorithm and probably our AI overlords, too.

Okay, we're gonna do some economics this week. Today was inflation number day, and it's a great time, I think, to catch up with John and how he's thinking about the current state of the us economy. We've been warned for what it feels like at least a year by many economists.

The recession was imminent here in the United States and yet, according to the most recent jobs report, the economy added nearly 340,000 jobs in May. The unemployment rate remains at a pretty low level, by historical standards, at just 3.7%. And let's just say this isn't what you'd expect after more than a year of interest rate hikes and some quantitative tightening by the Federal Reserve.

Now this brings to mind a famous observation unconnected to economics. In adventures in the screen trade, his seminal book about Hollywood, the screenwriter William Goldman famously coined the phrase, nobody knows anything. John does Goldmans Hollywood dictum apply to economists today? I mean, where did that recession go?

>> John: It does, actually, we actually know a whole lot less than we like to pretend in public, and certainly than our policy making colleagues at the Federal Reserve like to pretend in public.

Just what is a recession is a little mysterious, where they come from is a little mysterious. How and if monetary policy has anything to do with them is a little mysterious, and they're always going to be hard to forecast. I mean, this is one thing I think we do know.

We know the limits of our knowledge. If you knew that the stock market would go down tomorrow, you'd go sell today and it would go down today. And so that fundamental logic applies, I think, to inflation. If you knew prices were gonna go up tomorrow, you'd raise them today and applies a little bit to recession, certainly applies to bank runs.

If you knew there'd be a bank run tomorrow, you would go get your money today. So, I think there's good reasons why recessions will always be hard to forecast. But this is really an interesting one that so many people said, here comes the recession, and it didn't come.

 

>> Niall: Is it just a matter of wait and see? I mean, are we just getting impatient? I've read somewhere that the average time between the Fed hiking and a recession is nine months, and there's quite a lot of variance there. I mean, are people just getting impatient? Do you sense that this recession is just a few months out and at some point we'll be having a very different conversation?

 

>> John: Well, the last thing I'm going to do with a year of economist failures to predict recession is stand up on my chair and say, here comes the recession, I'm wise enough not to do that here. I think we can put our economist and historian heads together and try to see what's going on, especially thinking about the history of past recessions.

Now there's excuses, there's sort of the dog ate my homework excuses is one. The Federal Reserve has raised interest rates, but not yet much above current inflation. When you think of the classic story for interest rates causing recessions, the early 1980s, when inflation was about 10% and interest rates went to 20%.

So there's a lot of classic wisdom that thinks you have to get interest rates substantially above inflation to cause a recession or to bring inflation down. The real interest rate, the interest rate net of what people think will happen to inflation, is who knows where it is, because who knows what people expect of inflation, but it's not strikingly high.

So one answer may be the Fed simply, it's raised interest rates a lot, but has not substantially raised them above inflation yet. And so we may not really be in a restrictive policy yet, higher relative rate of inflation. Another possibility which especially, I turn to you as the author of great books on financial catastrophes.

Past recessions didn't just involve interest rates they involved a tightening down of the financial system, a financial crisis, a contraction, and credit, something of the sort. In the past, the Fed didn't pay interest on reserves, so raising interest rates was part of a clamp down on the monetary and financial system.

Now, we have immense amounts of reserves still interest on reserves, raising interest rates alone may simply not have those effects, at least until it does something to collapse the financial system. How am I doing on dog ate my homework excuses so far?

>> Niall: Well, there's another way of thinking about this.

It's only a few months ago that we were talking about a potential banking crisis when banks like Silicon Valley bank were blowing up. That seems to have gone away. Or is it just the quiet before the next phase of the banking crisis? Because I'm sure I've heard from some of our colleagues at the recent monetary policy conference that our friend John Taylor organized, that there's still a lot of problems out there, a lot of banking losses, particularly on portfolios of bonds.

I mean, do you sense that the banking crisis has gone away, or is it a little bit like the recession just waiting to come back, maybe after Labor Day?

>> John: Well, definitely, what I see in the course of history is recessions need a shock, they need something to go wrong, and not just a steady increase in the overnight federal funds rate.

And a banking crisis is certainly the kind of thing that can go wrong, cause that contraction in credit, that unwillingness of people to take risks, that unwillingness to invest, that's really where recessions show up. And if this turns into a banking crisis, that could be the shock that we want, and there's certainly danger there.

So lots of banks are still underwater just on their plain interest rate risks. And we're waiting and hoping that problems go away, as often happens with banks, is necessary. I worry a little about commercial real estate. There's a lot of businesses, there's a lot of buildings in San Francisco that aren't paying rent and the rents aren't paying loans.

Those loans eventually turn over, that turns into problems for the banks. I would think that our great bank regulators had an eye on this, but they didn't have an eye on interest rate risks, or who knows? And something could blow up around the world, HR's territory, and that could be the next shock as well.

 

>> Niall: Yeah, I want to bring HR in at this point. We kind of forget what a big shock the Russian invasion of Ukraine was last year, and it was. Let's say, only three months later or four months later that inflation hit its high in the US at 9% and we just got this new inflation numbers.

As we were preparing to go on the air, which saw headline inflation came in at 3% core, down below 5 to 4.8%. I mean, those are, I think, pretty good numbers from the vantage point of the Fed. But before we go to that, HR, could there be some other geopolitical shock, some other war that we're not expecting that could create a whole set of new supply side shocks?

Anything out there that could be a little Russia's invasion of Ukraine or is it all quiet on all fronts?

>> H.R.: Well, it's unquiet on all fronts, Neil. I mean, I think that there could be a number of shocks that could really generate a great deal of inflationary pressure associated with constrained supply lines, associated with energy or food.

We've been talking with our colleagues about the dangers associated with the Zaporizhzia nuclear plant, for example, and the effect that that would have on food supply, for example, internationally. And then, of course, Iran has been quite active in the Middle east, and we just saw them taking another tanker, even while they were contested by a us naval vessel.

So you could see the constraint and an interruption of energy supplies coming out of the Straits of Hormuz or the Bob el Mendeb. And we are also very cognizant, obviously, of the threat from the People's Liberation army in the South China Sea and vis a vis Taiwan. The effect that that could have on, which something we've been talking about for quite some time.

And Hoover will have an excellent report coming out next week on semiconductors and the threat associated with the interruption of semiconductor supplies associated with an attack on Taiwan in particular. And that could actually bring us into a global depression, I think, in terms of that effect. And then Kim Jong Un in North Korea just released a string of threats last week, and nobody really paid attention to it.

And then, of course, fired a missile recently, another long range missile. So I think that its important for us to continue to highlight the theme of supply chain resilience and to recognize that these growing geostrategic threats could interrupt any number of critical supply chains. And then id just like to ask John as well, with this idea of reduced inflation rates.

Is that something we should be super happy about, or do you think there are other indicators we should look for to help us understand better maybe that this crisis is behind us? I mean, I know you have some thoughts on what really caused inflation to begin with, and are those causes now in the past, or do you think they still exist?

 

>> John: I want to take a little victory lap for fiscal theory of the price level, cuz it tells us why we got inflation in the first place, the huge COVID blowouts. It also says that inflation goes away largely on its own without aggressive Federal Reserve action, because you basically inflate away the debt that you printed up in the first place.

But then it's over as long as nothing bad happens, all forecasts are about here's the way things play out. If nothing bad happens, and then we listen to HR for all the bad things that might happen. But it is remarkable within the monetary doctrines that inflation did peak and seems to be easing even with interest rates substantially below the current inflation rate.

So conventional theories don`t say inflation goes away until you really get high interest rates. And that didn`t happen and that is how fiscal theory understands the world. So I kind of see an easing of inflation, but quite possibly it gets stuck substantially above 2% and then we're not out of the fiscal, we've talked about our fiscal problems and I would say also it's not just supply chains.

When the next bad shock happens, that causes a recession, when it causes people just to pull back and be worried about making new investments, taking new risks, not just little problems or even big problems in the supply chain. And also next stock comes, what are our governments gonna do?

They're gonna print up a lot of money, borrow a lot more and we just saw that we're at our limit for that. So inflation could, I think the current thing is it kind of eases off slowly on its own, but then it could come back with the next shock.

 

>> Niall: So I hate to cause trouble and risk provoking you, but there was our old friend Paul Krugman, and I use the term friend advisedly on twitter today. Got to say it, the original team transitory proposition was that inflation would subside without the need for a big rise in unemployment.

Not looking so wrong now. So John, are today's inflation numbers enough to permit a victory lap by team transitory? That's the economists like Paul Krugman, who said that the inflation would be transitory. They never quite specified how long transitory was, but are they entitled to a victory lap too?

 

>> John: Even the German hyperinflation after World War I was transitory, it went away sooner or later. Krugman is right for the wrong reasons, his team transitory. First of all, he was talking about months, not years earlier. But the story was the supply chain story, that there's a supply shock which then goes away and the inflation goes away.

Now that's fundamentally a story about relative prices, not overall inflation. So, that's why I think it was wrong. And it also is a story that says the price level should come back to where it was. Strawberries get more expensive in the winter cuz there's a supply shock, and then the price of strawberries comes back down again in the summer.

We don't have a permanently higher price level, so we had inflation that went up but left us a permanently higher price level. And the price of everything went up, not just the things that were under supply shocks. The wages went up, houses went up, everything went up. So that is just, although it did eventually go away, it's a completely, what we've seen is, does not conform to that supply shock.

Don't worry about it, relative price story.

>> Niall: And the reason that I brought HR in at this juncture is just to remind people of some history. In the 70s, the Fed would periodically raise rates in response to inflation, then look like it had succeeded. Inflation would come down and then boom, something would happen, like a war in October 1973 or the Iranian revolution in 79.

And so these different worlds of geopolitics, economics and history, they interact in important ways. I still think the Fed is probably gonna say Q it's working. Does that mean they're gonna not do those additional interest rate hikes that they were talking about at Jay Powell's last press conference?

Is this good enough for them to skip again? Skip is the new word for pausing, I gather.

>> John: Well, I don't know about the next meeting, but I do think everything I know about the Fed, as long as inflation is above 2%, you're in for rate hikes. Now they might skip, they might pause, they might long and variable lag.

They might the dog eat my homework and wait a while. But they are not going to go back to low interest rates and they are gonna keep raising until we see inflation back to 2%.

>> H.R.: Hey, Neil, is the student in this macroeconomics class here? And I`ll just try to get my class participation grade up a little bit.

Could I ask you what`s the relationship between all of this and unemployment? I did see something that seemed to be encouraging in terms of a reversal of the great resignation and a return of a number of people to the workforce. And unemployment numbers are quite low, I`d just like to hear your thoughts.

Thoughts on is that as positive indicators? It seems to someone who's not educated in this field.

>> Niall: I'm so glad you asked that, because there are two big issues we need to cover before we can move on from our macro seminar. One is the labor market, which is definitely not behaving in ways that are familiar to students of recent economic history.

The other is housing. We're gonna come back to that. But John, one of the most striking features of the economy right now is the strength of the labor market. It's continuing to add jobs, maybe not quite as fast as before, but this is still a pretty hot labor market with a very low unemployment rate.

And thats part of, I think, the reason why people dont sort of see or feel the recession. What they see is real wages going up. They see job opportunities. In fact, there are just way too many openings relative to the people who seem able to fill them. So help us understand why the labour market is like this.

 

>> John: Well, it is to, HR's question, it is a great and good thing. We want employment, especially inclusive employment, whatever the current buzzword is for it. This is really helping people with lower opportunities. But there's this great puzzle in economics. Just how does the Fed raising interest rates do anything about inflation?

I got to warn you, it's a feature, not a bug. Now, I think it's largely wrong, but here's the Fed's mental model. We raise interest rates, that tightens financial conditions or something or other that makes business less and that raises unemployment, that lowers employment. And that, through some phillips curve magic, is how inflation goes down.

This is a feature, not a bug, in the Fed's causal understanding of the world. And it's kinda weird. Why is the Fed so focused on labor markets? We saw the price of chickens go up and Krugman's talking about supply chains. The Fed is the labor market, labor market, labor market.

Well, that's their causal view of the world is that inflation comes through the labor market. So they're deliberately trying to slow down labor markets on their way to inflation. Now if inflation goes away without causing that recession in labor markets, that'll be a great and wonderful thing because we want people to have jobs.

 

>> Niall: There are all kinds of theories about why this labor market's a bit different. Obviously immigration, certainly legal immigration's down. There are some demographic dynamics at work, too. There are people who left the labour force during the pandemic who have been at least reluctant to return. I mean, is this partly a structural story?

Is this just not your father's labor market or are these just slow moving changes as we emerge from the pandemic period? How should we think about this? Is it a permanently different labor market, or is all this just gradually a kind of transition out of a crisis?

>> John: Yeah, well, there are, of course, always permanent differences going on.

I think we're not in a recession. The economy's still kind of humming along. So unemployment, people looking for jobs as low, there are long-term problems. So employment is really the most important thing. And the fraction of people who are working or looking for jobs is still low. It's only like 62% I think.

Even prime age men, there's something like ten to 15% who aren't working and aren't looking for work. So we would like to see more people working overall, but that's long-term demographics, social program incentives, problems like that. And we should. The big economic question is long-term growth. It's not really business cycles coming and going.

That's a whole other set of questions. But I always have to put in a plug for that. Get the long run growth rate back up is the most important thing we should be thinking about.

>> Niall: So, housing, one way in which higher rates are supposed to act on the economy is that the costs of borrowing go up.

And the way that that impacts the population most is because mortgage rates go up and mortgage rates sure enough have gone up. And they've gone up by quite a lot relative to where they've been over the past 20 years or so. And yet it doesn't feel like housing is rolling over.

In fact, even the most recent monthly data suggests there's been a slight pop in house prices. So is this another weird, unfamiliar landscape, the housing market? Is it just not behaving like it should?

>> John: It's different. And yes, in fact, most of the previous recessions have been largely about housing.

Interest rates go up, housing construction collapses, people who build houses are out of work, and that's one of the most important things, and that's just not happening. There's been a little ease off, but housing is going a little bit of a puzzle right now. Again, a 6% mortgage isn't so bad if you think inflation is gonna stick in at four to 5%.

So the real interest rates really have not gone up that much. That's part of it. Part of it is a lot of people who are buying houses are so expensive, only people who could pay cash or buying them, and a lot of people are doing great because they got mortgages.

Part of why the economy's doing well. If you had a 1%, 2% mortgage, 30 year fixed. You're in great shape right now with interest rates this high so that people staying in houses that are easily affordable. Around the world is different, the US is very weird with this 30 year fixed rate mortgage.

And I was at a central banker conference a couple of weeks ago where a lot of countries, they're gonna see much different dynamics because all their mortgages are adjustable rate. And when interest rates go up, people's house payments go up immediately next month. So that's a very different dynamic between the US and the rest of the world.

 

>> Niall: So a quick show of hands, who's got a mortgage amongst the GoodFellows?

>> Niall: And another show of hands, who has to refinance?

>> John: I'm a Scott, we don't borrow money.

>> Niall: Very prudent John. Who has to refinance the mortgage within, let's say two years?

>> H.R.: Not me.

 

>> Niall: So it looks like I'm the one who misjudged this the most disastrously.

>> H.R.: It's probably the only decent financial decision I've made in my life, Neil, and it was completely by chance.

>> Niall: Well, hats off to you, HR. This is a good time not to have to go back to the bank and ask for a new rate.

You won't like what you hear. I think that probably is my cue to shut up about economics, which I obviously don't really understand that well. I have a segue that's gonna get us from economics to geopolitics. And it's the debt, John's favorite subject, the great driver of inflation.

And there's no question that there's been an enormous increase in the US federal debt. I think over ten years it has gone from $16 trillion to over $30 trillion. And although, John, you said that some of that fiscal overshoot of very recent years has been inflated away, I would say not all of it.

And if you look at the Congressional Budget Office projections, the debt ratio to gross domestic product is gonna just keep going up and the deficit is above 5% as far as the eye can see. So this is definitely nothing, a fiscal problem that's gone away. But HR, I keep asking myself, if the cost of that debt service is going up the way my mortgage is gonna go up next year.

Then presumably that's gonna squeeze the stuff that we call discretionary expenditure and the federal budget, and that includes defense. How concerned are you about a potential squeeze on the resources available to the Department of Defense at a time when, as you just said, there are more geopolitical problems out there than just the Russian invasion of Ukraine.

Is this gonna become a real constraint on us foreign policy in the coming years, do you think?

>> H.R.: I think so, Neil. Unless there is an effort. For it to either increase revenue or to take on non discretionary spending and to reform that in some way. And as interest payments go up on the debt, it does squeeze discretionary spending and a significant portion of that is the defense budget.

And what makes it particularly dangerous is that as the threats are growing, as we've been discussing on Goodfellas across the last couple of years, but also we're in a situation where we have a huge bow wave of deferred modernization. And that modernization is critical because our principal adversary, other adversaries, have developed capabilities to take apart what they saw as our differential advantages.

And these are kind of asymmetric capabilities like counter satellite and offensive cyber capabilities, electromagnetic warfare, long range precision missiles and tiered and layered air defense and drone and swarm drone capabilities. And we have developed technological countermeasures, right? There's always a countermeasure, right? You have the submarine, the sonar, the bomber, the radar, the machine gun, the tank, the anti tank missile.

But we have not yet really fielded those countermeasures to those countermeasures in sufficient capacity. And also we've drawn our military down to a very small, all volunteer professional force under the theory that we could have a bigger and bigger impact militarily over wider and wider areas with more exquisite platforms and fewer, more exquisite platforms that were typically more expensive.

And that model has shifted, as our friend Christian Brose and others have argued. We now really need more capacity and we need to deliver more military capability at a lower price per platform. So anyway, it's just a bad time to see this kind of constraint because of the threats and because a lot of the assumptions on which our defense budget has been based for many, many years have turned out to be flawed.

 

>> John: I don't think it's that a big issue because defense is cheap. HR and his buddies are costing us 3% of GDP per year. This is, we're at a historic low in defense as a share of GDP. It's just, it's a lot of money. But the US has a lot of money.

Our deficit problems are, you mentioned that unfunded social programs, the immense amounts of subsidies we're pouring down various rat holes. I think we've got the money if we want to spend it on HR and his friends. The problems are, yes, supply chains. How is it that we don't know how to produce artillery shells, that sort of problem?

 

>> Niall: Well, that's the problem, isn't it? It's not so much that defence is cheap, it's that the defence budget is gradually getting squeezed, and that has consequences. Let me give you a little fact to illustrate the point. I'm sorry, HR, this is a navy fact, not an army fact.

There you go, so under the 2018 National Defence Authorization Act, Congress required the navy to increase the number of its combat ships to 355 from fewer than 300 now as soon as practicable. But the DOD's building plans don't make that feasible for decades, perhaps until the 2050s. Meanwhile, under China's more autocratic less bureaucratic system, the PLA Navy, past the US Navy in fleet size around 2020, now has around 340 warships and is expected to grow to 400 ships by 2025.

Now, that's just one of dozens of examples one can give where the US is meaningfully falling behind China. And I think this could become a real issue, particularly if, as we've discussed on previous shows, there's a showdown over Taiwan, HR.

>> H.R.: It's even worse than that Neil, than the statistics because China tends to employ those platforms exclusively across the Pacific region, of course, to some degree as well in the Indian Ocean and the Bob Elm and Deb.

But the US has more global responsibilities, as you can see, with the need to provide deterrent capabilities along with other NATO fleets in Europe and in the Black Sea and so forth. So I think that it is really a capacity issue. As with the number of naval platforms as well as aircraft capacity and land forces as well, we have continued to drive down capacity based on the assumption that exquisite capabilities would provide us with overmatch.

Well, we've allowed our technology to be transferred quite easily to China, not only through intellectual property theft and espionage, but also willing transfer for many US companies who have given China the ability to match some of our technological capabilities and apply them to the people's liberation army. So capacity, size, quantity has a quality of its own.

China's building a significantly large force, but also incorporating into that force much more exquisite technologies and capable technologies that have eroded our differential advantages.

>> Niall: So, I wanna just turn to the war that's happening right now. Just a couple of weeks ago, we were talking with some enthusiasm about the situation in Russia following the abortive mutiny by Mister Prigozhin and his Wagner group.

And I think some of us were hoping that this was a sign that Russian resistance to Ukraine's great counteroffensive might crumble. It doesnt look as if thats happening. HR, what's your assessment of the situation in the war? Is there any sign that this Ukrainian offensive could achieve a major breakthrough?

Or are we looking as if we're stuck in a battle, a war of attrition?

>> H.R.: Neil, I don't know, but I'm still hopeful, and I believe that there's cause to believe that there could be a major breakthrough, and that's because defenses like Russia has established look strong until they collapse.

And I think that those Russian forces are under significant physical as well as psychological duress. I'm trying to imagine what it looks like from the vantage point of a Russian soldier when you see your leadership fragmented the way it's been, but then also the effect of the loss of so many junior leaders.

I mean, there's a new estimate out now on the numbers of Russians who have been killed in action since the reinvasion, and it's 50,000 killed in action. And typically a rule of thumb is that there are three times that many who are wounded. I think it's probably more like two times because of how poor Russian medical support is to their military.

But that's 150,000 casualties, and the initial invasion force was something like 120,000. And if you think about the conscripts, the Russian army, we should say, is bigger than it was when the reinvasion started based on the conscription. But these are poorly trained replacements, and you can't pull somebody off the street and make them a platoon leader and a company commander and expect them to lead competently.

So I think that combined with, I think, what is a smart approach by the Ukrainian armed forces, to not throw everything into an offensive until they've prepared the battlefield with these probing attacks, trying to get the Russians to reveal some of their high payoff targets from the Ukrainian perspective.

For example, like their artillery forces and long range rocket artillery, as well as their command posts, some of their logistics formations. So I think that once the Ukrainians can breach these obstacles and restore mobility to the battlefield, this is kind of world war one situation almost, and then force the Russians out of the prepared positions.

That's where I think the Ukrainians will have a significant advantage and to isolate the Crimean Peninsula. And that's when I think you have a fundamental change in the military situation that could then bridge into some sort of a vision toward the end of the conflict.

>> Niall: It's World War I with drones, though, isn't it?

I mean, we've got this familiar pattern of lines of defense trenches, all very much out of 100 plus years ago, but what's novel is the use of drones. And the Ukrainians have been very innovative in this area. I heard a fascinating presentation by Eric Schmidt on this. You may have read his piece in the Wall Street Journal last week that how far do you assess that as a major change in the nature of war?

HR, you're somebody you've been in combat, you know what war is like, you've written eloquently on it. But this looks like a new kind of war in which, if nothing else, the reconnaissance capabilities have become much more accurate. How big change is this?

>> H.R.: Well, I think it's the first significant change in the character of warfare, I don't think it changes the nature of war.

I think what you've seen is the ubiquity of this drone capability really creating a condition in which all forces on the battlefield have to act as if they're in visual range of the enemy, right? And that requires you to take particular countermeasures, dispersion, concealment, intermingling with civilian populations, but also deception, as well as developing technological countermeasures to drones.

And there are a number of those that are being developed and fielded now by certain traditional defense companies, but some of the newer defense companies. And this involves electromagnetic warfare capabilities, where you can interrupt the signals, for example, between drones and the stations to which they have to disseminate their data.

But also there's some new directed energy systems that are quite capable. I mean, these drones are very lightly constructed oftentimes, and a laser can take them down quite easily. And there are some quick fixes. A lot of our radars, the software for those radars were not really designed to detect low, slow, and small airborne platforms, and now they've been modified to do that.

I think you're in a situation now where you're seeing the predominance of a new weapon, the machine gun. And there's gonna be a development of a new set of defensive capabilities and offensive capabilities that are analogous to the tank, maybe, for example. So I see this as more of a continuity in war and the development of a new capability that'll be followed by countermeasures.

But of course, if drones are not the only aspect of what is sort of lifting the veil or parting the curtain in war and allowing forces to see the other quite clearly. You have low earth satellites, for example, and other means. I mean, even soldiers use of social media or now Russians operating in and among the Ukrainian population and how susceptible they are to the app that the Ukrainians had developed to report on Russian positions.

So I think we are in an era of increasing transparency of the battlefield, and we have to keep that in mind as we design future forces and their capabilities.

>> Niall: One thing that strikes me about this war is the greater accuracy of weaponry when there is this much higher quality of reconnaissance and intelligence.

And if you had to characterize the war in one way, it would be technology is making the weapons more accurate and therefore the casualties of the fighting force is higher. This was a point you already made, HR. I would estimate that pretty much all of that initial invasion force of February 2022 is now either dead or wounded and no longer capable of fighting.

That's an amazing thought, considering that we saw much lower casualty rates in the wars in Iraq and Afghanistan. This is a really bloody war, and you have to feel a lot of empathy with those Ukrainian soldiers who are mounting this offensive with insufficient airpower on their side and tremendous exposure to Russian countermeasures.

This is a truly heroic offensive, and I hope you're right about the breakthrough. It would be good timing if it were to happen right now, because right now there is a negotiation going on about Ukraine's future relationship with NATO. And I just wanted to get your thoughts, also yours, John's, because this is a real kinda tough question.

Should Ukraine join NATO? There are those who say that that very question kinda was the start of the war itself. I don't agree with that, but the argument's been made, interestingly, Prigozhin didn't agree with it either but we'll leave that to one side. Of all people, Henry Kissinger has changed his position on this.

He was very much against Ukraine joining NATO back in the day, but he's now been arguing for some months that Ukraine has earned NATO membership with its extraordinary heroic defense of its own territory. Where are you on this question that's currently being debated at Vilnius? It doesn't look like Ukraine is gonna get NATO membership anytime soon, but I'd really welcome your thoughts, HR, and also yours, John.

 

>> H.R.: Well, I think it was important and it was a bit of a disappointment not to establish a timeline and a really clear path to membership in NATO. I think it's quite clear that Ukraine now has developed a quite capable armed force and is fighting in the interest not only of Ukraine but other countries that have been under the threat of revanchist Russia for quite some time.

Including the Baltic states and those in eastern Europe who have been the greatest champions, obviously of Ukraine's effort to defend itself. But of course NATO is an organization that requires 100% unanimity. We saw that with the long delayed accession of Sweden into NATO. So this is something that's gonna take time.

I would like to see the US lead more. It was disappointing for me to hear President Biden saying, well, there is a consensus, okay, well, we're the United States, darn it let's help forge that consensus. And I do think it is in the us interest to have that clear path.

Of course it's impractical now to admit Ukraine immediately, but I do think it would just to bolster the morale of the Ukrainians. It would be important, I think at this stage to provide a clearer path than that which was provided at the latest NATO summit.

>> Niall: John, it's kind of remarkable that the US is the dominant member of NATO, that the US has contributed far more to Ukraine's defense of its territory than any other NATO member.

I think I worked out that the US commitments to Ukraine are seven times more than the next largest nation state. And even if you add together all the EU countries and the EU institutions, the US's commitments are still 15% more. So surely the US is in a position to say we're doing this.

Do you think the US should be exerting its muscle power a bit more to get Ukraine into NATO, or was this compromise the rational one for Joe Biden to make?

>> John: The US has not been, I mean, we've been supporting Ukraine but sort of still enough to not have them lose but not enough to let them win.

So it doesn't look like we're really pushing on that. There's a good joke, Ukraine will now be the only country required to defeat Russia on its own before it's allowed to join NATO, which is a little sad on where we are. Zelenskyy also told a great joke about how two people are talking on Odessa and say 200,000 Russians are done.

Where's in the fight with NATO? Where's NATO? NATO hasn't showed up yet. I think this is important because we are slowly realizing this is NATO's war, this is our war. This is not just Ukraine's little border fight with the Soviet Union. So it's clear what's got to happen.

No, they can't come in right now because there is an article five and NATO isn't ready to realize it's our war yet and start fighting. But it would be nicer to say, here's the process. We will help you more with this war. When this war is won, you're part of us, which is clearly where it needs to go.

 

>> Niall: So you did one of those things that we all do periodically. You called the Russian Federation the Soviet Union.

>> John: I'm sorry.

>> Niall: But that's good because it allows me to take a step back, and before we wrap up this segment of the show, to think about how cold war two is going.

Because I've been arguing, I think, for five years now that we're kinda in Cold War 2, and this time it's China rather than the Soviet Union that's on the other side. And we should probably think about the war in Ukraine as being a bit like the Korean war at the beginning of Cold War 1.

And it seems to have reached a similar kind of stage. It's gone from the dynamic war of movement to a war of attrition. But if you step back and ask how Cold War 2 is going, I'm gonna cut some slack to the Biden administration. I think they've had a few wins recently that aren't trivial.

And we should acknowledge, for example, you just mentioned at HR, the Turks were persuaded to put aside their veto and let Sweden join NATO. Finland already joined. The enlargement of NATO was definitely not one of Vladimir Putin's war aims. I'm also struck by the extent to which the Pragian mutiny dealt a real blow to Putin's credibility as a leader, even if it seems as if Praguian is negotiating with Putin.

This week they seem to have had a meeting in Moscow or somewhere in Russia, which is certainly not a sign of Putin's dominance at this point. So there have been wins. The big question is, how is it going with China? So Janet Yellen just made a trip. I guess you saw that John, a treasury secretary, was in Beijing doing quite a bit of bowing, I thought, in at least one of our meetings.

But in a way, this is the substance of the US China relationship right now. Because the US is kinda doing what we might call economic warfare in China by restricting Chinese access to semiconductors. And the Chinese respond by saying, right, well, we're gonna restrict our exports of critical minerals.

If it's an economic war that's going on, gentlemen, who's winning it at this point, the US or China? HR, do you wanna go first?

>> H.R.: Well, I think the US is winning it in terms of at least coming to the recognition that giving the authoritarian regime in China course of power over economy is a bad idea.

And so I'm in favor of the measures that have been taken to make our supply chains more resilient, less reliant on China. China's taking advantage of, really, our poor policies of the past, not recognizing the dangers associated with this. And this is not unprecedented in terms of Chinese export restrictions on upstream components and minerals critical to microelectronics for example.

Remember, Japan really fell prey to CCP coercion in, I think, 2012 or so at a time when they were over 90% reliant on certain minerals from China. Now they've reduced that reliance to, I think, around 50% or so. And that's about the same time as the US reopened a mine here in the United States for rare earths.

And so we have to, I think, continue to recognize how important it is for us to make those supply chains more resilient. So we compete more effectively, and then also to recognize it's actually China's plan to decouple under Xi Jinping. He wants to create, and he's gonna fail, I think.

But he's trying to create this dual circulation economy in which he creates a really coercive power over the United States and others because of reliance on China for manufacturing. But as well as for critical upstream components, for example, the energy transition, while he insulates China from any kind of economic or financial consequences for Chinese aggression.

So I think this should be a wake up call in terms of the Chinese export controls. I don't think anybody's winning or losing yet, but I think we've won in terms of finally recognizing that it was a grave mistake to give the CCP course of power over our economy.

 

>> Niall: We're almost out of time and we need to go to the lightning round. And I know you're just basically against these economic war type things, but let me ask you a specific question. Jake Sullivan has recently introduced de risking into his vocabulary. And that's the alternative to decoupling, which is clearly a less drastic change in the relationship between the US and China.

Do you buy the idea that we can de risk without decoupling?

>> John: Fancy words, look, you win an economic war when the other side changes its policy in response to your pressure. They're not doing that. An economic war is like that. Those scenes in the fight movies where the guy says, this is going to hurt me more than it hurts you, kabunk or something of this.

Well, that's the way it is. Yes, they are doing some good things, but we still have Trump tariffs on steel. There's no economic, what is the economic that hurts us more than it hurts them? And we're still doing that kind of stuff. So I disagree that we are winning the economic war in that sense, although we are taking some important, the small, targeted, national security oriented things fine.

But winning an economic war is about shooting yourself in the foot, and he shoots himself in the foot. At least you try to get them to change. And it is very seldom that countries change policy because of economic pressure.

>> H.R.: If I could just make a quick prediction, though, Anil, I think what's next is restrictions on cloud computing access.

Because what we've done has been able to try to, we've been trying to restrict the PLA's access, the Chinese defense community's access to the highest end computing power. But they're still accessing that kind of computing power through the Cloud. So I think those will be the next actions you'll see from a regulatory perspective in the US.

 

>> John: There's a theme to all of this that I want to tie together, and that theme is reputation. Why is it important to win in Ukraine? Well, I think pulling out of Afghanistan was a lot of the reason why Putin invaded Ukraine. And what we do in Ukraine will determine a lot.

That will determine a lot how aggressive the PRC is towards Taiwan. Why is the Fed gonna keep raising interest rates? Because they know these lessons of foreign policy. They know that their reputation is at stake for keeping inflation low, and they don't wanna lose their reputation, reputations matter.

And that's the most important deterrence.

>> Niall: So HR has given us a slogan for a future episode. Hey, you, get off of my cloud could be the theme tune of the next round of US economic measures against China. That's my cue to switch to the lightning round.

>> Niall: And it's a summer special, lightning round.

We are gonna talk about what we do in the holidays, and we're gonna start with one of the great American dilemmas. Beach or mountains? You might have guessed. If you know my backgrounds as a regular viewer, that I am in the mountains as we speak. I have retreated to Montana, where there's beautiful cool breeze blowing to mitigate the heat of summer.

I'm guessing at least two of my colleagues are closer to the ocean in California. Okay, HR, are you a staunch beach man? I know you like the beach, but do you ever kinda sneak off to the mountains to cool down?

>> H.R.: Well, hey, I was just in Ketchum, Idaho, beautiful place, but I do prefer the beach.

And I'm a paddle boarding enthusiast. And actually, I prefer the beach because I get to bump into Neil there. Actually, my daughter bumped into there in Newport beach recently, and. You can't see Neil Ferguson in a speedo in the mountains. You know what I mean? So I'm a beach guy.

 

>> Niall: Well, I have to say I swim in the mountains, too.

>> Niall: Even though the water in some of these ponds and lakes in Montana is still quite chilly. John, beach or mountains?

>> John: When I was a kid, I was a beach guy, but now I'm a mountain guy.

All of my favorite outdoor activities are mountains. And I love the clarity of the air, the beauty of the view, the refreshing calm that comes from the wonderful scenery, as well as all of my great outdoor exploits.

>> Niall: Okay, next question, America v the rest of the world, where should you spend the summer?

I'll go first on this one, I think the American summer is the best summer. And of course, being British, where it rains half the time, it's not surprising, I think, that. But I've tried summer elsewhere, in France, in Italy, in Greece, the American summer is the best summer.

Anyone want to disagree?

>> H.R.: No, I won't disagree, especially California. Okay, we're always bagging on California, right, because it's so poorly governed. But, hey, you can't beat the weather. I'm an east coast guy, we would go down the shore from Philadelphia, as the vernacular, but there's quite a bit of humidity still on the east coast.

I mean, California beaches, I mean, you can't be a California mountains, for that matter, so anyway, I love summer in California.

>> John: I go California mountains, Colorado mountains are wonderful, beaches, surfing, Cape Cod's lovely. And the places I love to go in the world, I love to go to Europe.

But it's such a horde of tourists in the summer, and all the Europeans are gone, that if you wanna go there, go there at some other time of the year.

>> Niall: Yeah, let me just also enter a mention for the east coast, late summer. The time to go to New England to the shore is actually late in the summer.

And if you can stick around past Labor Day, that's actually the best time there. Okay, music now, the ultimate summer song. What are you listening to, gentlemen? HR is legendary for his music recommendations, often seen as retro by the younger generations. What's playing in your earbuds these days HR?

 

>> H.R.: Okay, I'm gonna go retro retro to Gershwin's summertime. Okay, I mean, great aria that he composed for Porgy and Bess. It's performed, I think, 25,000 different versions of it, beginning with Abby Mitchell in the beginning, but Billy Holiday in the 30s, and then Ella Fitzgerald and Louis Armstrong performing together.

Janis Joplin in the 60s. BB Seton did a reggae version of it. But I think the version, a really beautiful version, is on YouTube, you can find it by Nadine Benjamin, who's a trained opera singer. And it's a great American tune, summertime and the living is easy. But, of course, it's about black Americans at a time when living was not easy.

But it gets to kind of the stoicism and determination to overcome obstacles. But, hey, as a Philadelphian, and as General Funkenstein, I have to also recommend a more recent summertime. And that, of course, I'm talking about Will Smith's version that he did with DJ Jazzy Jeff called Summertime.

Which I also recommend YouTube video because it's set in the center of the universe, Philadelphia, Pennsylvania. And instead of summertime and the living is easy, it's summertime, summertime, summertime, time to set back and unwind. But I just thought I'd bookend these two summertimes.

>> Niall: So hard to follow that, John, got anything?

 

>> John: Impossible to follow that, my tastes are nowhere near as well refined as HRs. When you go to summer vacation, you want nostalgia. When you go to the beach in LA, you got to put on the Beach Boys. You go hiking in Colorado, you got to put on that old John Denver, we're showing how old we are.

And my favorite of all, I'm a big James Taylor fan, summer's here, I'm for that. And imagine yourself on Cape Cod with your cold beer and your inner hat.

>> Niall: Fergusons have a completely different approach. Summer is when I let the kids choose the music. And I've been educated so well by my kids over the years.

I can remember driving around, in New England, or was it Long island, listening to Biz Markey, thanks to my daughter Freya. This year, the youngsters, Thomas and Campbell have created a playlist, which is really blowing my mind because they've discovered rock and roll. And Green Day is our current favorite.

We're listening to the Jesus of suburbia, which is a wild and amazing piece of rock music. So, yeah, my tip to everyone listening, who's a boomer like us old guys, is let the kids choose the music in the summer, you might actually learn something. We are fast approaching the end of the show, and I think that rules out the summer reading recommendations that we were thinking of giving you will save that for the next time.

I think that's about it for this episode of Goodfellas, we'll be back soon with a new conversation. If you're worried about missing out on any of our content, especially in the summer when we kind of don't keep to an entirely regular schedule, then you should subscribe to the show.

And you should also take advantage of the opportunity to leave comments as we actually read them. And very often your comments and questions inspire content on the show. Don't forget to give John and HR as many stars as is possible. They too, have Twitter accounts, if a Twitter is still a thing in your life and you haven't gone over to threads or some other rival establishment.

And don't forget to sign up for the Hoover Daily report, which keeps you abreast of all that's going on at our fine institution. And there's a lot, even in summertime. That's it, on behalf of John Cochrane, HR McMaster and all of us here at the Hoover Institution as well as in Montana, we hope you enjoyed today's conversation.

Take care, enjoy the summertime, we'll see you soon.

>> Narrator: If you enjoyed this show and are interested in watching more content featuring HR McMaster, watch battlegrounds. Also available at hoover.org.