The $3.5 Trillion ‘Catch 22’ of Re-Globalization
Author’s Note: I miss you, Z. I would give anything to have another conversation with you. I’m finally starting to figure this all out.
I’m a big believer that the recent VC investment surge and interest in Defense Tech is here to stay.
Not out of hype, but geopolitical necessity.
However, given the capital-intensive nature of deep tech technologies, is venture capital as an asset class best suited to take advantage of the present moment?
It’s hard to say.
However, I’ve noticed a convergence of government, academia, and industry focusing on deep technology investment and development.
In academia, MIT’s launch of The Engine reflects the need for universities to help its graduate students and postdocs nurture their research into standalone commercial ventures.
In the venture capital (VC) industry, Katherine Boyle leads the charge for VCs to invest more in hardware in addition to software through her thought leadership on American Dynamism.
And most recently (and importantly) in government, we have Jake Sullivan’s recent elaborations about a “New Washington Consensus” in the face of recent geopolitical conflicts.
General Catalyst Managing Director Hemant Taneja and CNN’s Fareed Zaharia capture these shifts in their Harvard Business Review article “Geopolitics Are Changing. Venture Capital Must, Too.” The co-authors immediately declared, “The era of American hegemony is ending.”
How can that be?
The USD is still the world’s global reserve currency (GRC). The Bank of International Settlements estimates that “half of global trade and three-fourths of Asia-Pacific trade are denominated in US dollars.”
The U.S. and the rest of the West still dominate global media.
The U.S. military still dominates the globe, despite current events.
Recent geopolitical conflicts such as the Russia-Ukraine War, the Israel-Hamas conflict, the Yemen Red Sea blockade, and the simmering China-Taiwan dispute are distinct challenges that test American foreign policy and its leadership around the globe.
The Eastern European war has put immense strain on U.S. and NATO allies supply chains and armament stocks to support Ukraine in its fight against Russia.
The Israel and Hamas conflict tests America’s resolve to support the former against the latter while preventing a broader military conflict from emerging in the Middle East.
The U.S. was not too far from the above happening when 10 Yemeni soldiers died in a recent skirmish amid the latter’s country blockade on any ships traveling to Israel. The American public is wary of being drawn into yet another conflict in the Middle East.
Most importantly, the U.S. continues to contest China’s development as the latter attempts to complete the “reunification” (in their words) of themselves with Taiwan.
Taneja and Zaharia see the winds blowing in the direction away from globalization and towards re-globalization. The two define re-globalization as countries seeking “to balance the benefits of globalization with the desire to build greater independence and resiliency in their most complex and systemically important industries: healthcare, defense, energy, manufacturing, and financial services.”
Sounds familiar to Sullivan’s conception of a “foreign policy for the middle class,”:
“A modern American industrial strategy identifies specific sectors that are foundational to economic growth, strategic from a national security perspective, and where private industry on its own isn’t poised to make the investments needed to secure our national ambitions.”
These conflicts require a strong defense industrial base for the U.S. to prevail.
These overseas conflicts are testing our supply chains concerning scale and cost.
How can defense tech investment thrive in an era of high interest rates and major geopolitical conflicts?
As Tenaja and Zakaria note, “This will require a new model of venture capital, one that espouses larger capital commitments, longer investment horizons, greater levels of collaboration, and more significant degrees and depth of governance.”
According to Sullivan, he’s “estimated that the total public capital and private investment from President Biden’s agenda will amount to some $3.5 trillion over the next decade.”
There’s a lot of money at stake here for VCs to be involved in investing in a post-globalization era.
A fundamental contradiction must be addressed as America tries to rebuild its defense industrial base with help from private sector (e.g., VC) investment.
The biggest challenge to the U.S. entering this new era of re-globalization is the USD maintaining its status as the global reserve currency (GRC).
How?
I won’t claim to be the first to identify or notice this contradiction. Luke Gromen, an independent global research analyst, is one of the few who have identified this issue before others. (Check the date of the below tweet!)
We can explain this paradox by employing the macroeconomics of currency exchange. With the USD being the GRC, foreign countries must hold on to USDs to conduct trade for dollar-denominated assets, such as US Treasury (UST) bonds.
Countries have to pay for USTs using dollars only. This requirement generates built-in demand for USD.
Increased demand for USD increases the value of a dollar relative to other currencies.
A strong USD is favorable because one can purchase more foreign goods with fewer dollars. Thus, the U.S. imports more goods cheaper than buying them domestically.
However, a strong USD is unfavorable for domestic producers. Domestic firms cannot stay competitive with their foreign counterparts, leading to reduced sales, layoffs, business closures, and consolidation of remaining smaller firms by larger incumbents.
This is what happened to manufacturing over the past half-century. A strong USD made domestic U.S. manufacturing uncompetitive with their foreign counterparts. Managers of these corporations outsourced their manufacturing to lower labor countries, such as China, over time, steadily reducing overall employment of the U.S.’s manufacturing sector and decreasing the industry’s share of U.S. GDP.
Outsourcing or eliminating manufacturing jobs has had a direct, negative impact on the country’s defense industrial base. Some of our most critical supply chains depend on China-based vendors, which the U.S. identifies as a national security risk.
The DoD summarized these issues below in their September 2018 report, “Assessing and Strengthening the Manufacturing and Defense Industrial Base and Supply Chain Resiliency of the United States.”
Our defense industrial base does not have the skilled workforce, production capacity, and cost-effectiveness to produce the necessary resources at scale. Consolidation of the industrial base after slashed military spending at the end of the Cold War reduces competition in the sector, exacerbating the ongoing symptoms.
A diminished industrial base reduces the Department of Defense’s effectiveness in ensuring the safety of global trade across the oceans.
Any potential inability of the DoD to safeguard global trade across our oceans undermines the USD’s GRC status.
Therein lies America’s ‘Catch-22': a strong USD undermines the defense industrial base, undermining the DoD’s overall strength and capabilities. Yet, America needs the DoD at full strength and capacity, as the USD remaining the GRC is a positive byproduct of the DoD’s vitality.
The lay public commonly intuits that the strength of the U.S. armed forces backs the dollar as the GRC.
However, it’s important to show this relationship between the DoD and the USD in a more rigorous, causal manner.
On the economic side of the relationship, “around three-quarters of foreign government holdings of safe U.S. assets are by countries with some military tie to the U.S,” according to Colin Wright, an economist at the Federal Reserve Board of Governors.
Our economic relationship with our allies depends on our “military tie” to them.
The “military tie” Wright refers to results from a combination of hard and softer power that comprises U.S. foreign policy. The hard power exists in the form of the U.S. Armed Forces, which the DoD oversees.
Thus, the DoD’s capabilities impact the USD’s GRC status.
Gromen defines two choices:
Suppose America opts to maintain a strong USD. In that case, the defense industrial base will continue to atrophy unabated, leaving the U.S. unable to adequately respond to conflicts against peer or near-peer competitors in both scale and cost-efficiency.
Suppose America chooses to prioritize her defense industrial base. In that case, the USD will weaken to allow domestic manufacturing to become competitive again but puts the USD at risk of losing its GRC status.
(One of the main benefits of the USD being the GRC is that America can print money as needed with few immediate consequences. The power to print money allowed for Quantitative Easing as the main economic response to the 2008 Great Financial Crisis. This, combined with the Fed’s zero-interest rate policy, led to the recent “golden age” of venture capital, where excess money flowed into the asset class to turbocharge investing in startups over the past decade.)
This tension must be resolved before any other foreign and domestic issues can be addressed.
There are no easy decisions to make, and there’s no guarantee that America can reindustrialize with the prevailing global macroeconomic and geopolitical conditions. The U.S. venture capital industry has a role to play but will face major challenges as it is accustomed to investing in software, which has lower capital requirements, higher margins, and quicker returns.
The latest statistics show that VC hardware-software investing has gotten even worse in favor of software. Gilman Louie, CEO of the Frontier Fund, testified to Congress on May 25th, 2022, stating, “In 2021, U.S. venture capital investment in hardware startups was just $9 billion. By comparison nearly 14 times the investment went to software, or $124 billion.”
Will venture capital become patient capital?
Can the venture capital industry successfully collaborate with the U.S. government, particularly the DoD (via the Office of Strategic Capital and other initiatives), to get America’s defense industrial base back up to speed?
Will VCs develop the governance skills required to support hardware startups in the defense tech sector?
Time will tell.
There are two additional long-term questions that VCs consider amid this transition into a new era of investing:
Will U.S. consumers tolerate less access to cheap goods from countries America is not friendly in this re-globalization era?
Harvard economist Larry Summers had a thorough critique of Sullivan’s address, best depicted in the Tweet below:
Remember — a weak USD means that imports become more expensive while exporting becomes more profitable. But during this transition, will domestic producers be able to provide cheap, accessible goods as currency exchanges begin to disfavor their foreign competitors? Summers gives a great example below of this not always being the case:
Finally, will American finance tolerate a resurgent manufacturing sector in the U.S.? Remember, in the 70s, corporations chose to offshore manufacturing because labor was becoming too powerful relative to capital. Finance defeated manufacturing half a century ago, and we live in the aftermath of the former’s victory.
A simpler way of stating this question is: Can our nation’s government find a compromise between Capital and Labor in this potential era of re-globalization?
Time will tell.
The path of re-globalization is difficult and uncertain. Still, it may be possible today, as there’s one clear-cut, recent example of successful U.S. industry policy.
Who?
SpaceX.
Soda
