Archive for June, 2009

OECD Economic Outlook: Should we trust the economists?

June 24, 2009

May of OECD Members.   Source: Google Images

Why should we trust them?  Economists in think tanks the world over got it wrong before this crisis.  Now, many of them point to the “Black Swan” event, the large-impact, hard-to-predict rare event, to explain away their flawed work and keep their jobs.  Yet the data were there – reversion of U.S. households to negative savings, prolonged run-up in real estate prices, irresponsible monetary policy based on outmoded, ideological ideas (yes, that means you, Sir Alan). 

The OECD semi-annual economic outlook was released today, and they revised up their projections for the first time in two years.  The OECD is forecasting a bottoming of the global economy this year, but a weak and fragile recovery.  The report is useful in explaining the past, forecasting the near-future (i.e. 2009), and in detailing the challenges ahead.  However, as in the past, these economists base their forecasts on a continuation of current trends, instead of using intuitive thinking to discover future drivers of economic growth.

I’m reminded of a discussion I had with an economist at a rating agency in January 2008, when I suggested his forecasts for U.S. growth be revised way down due to the unknown impact of the painful adjustment of the abysmal household savings rate.  Equipped with his fancy charts and always a prisoner of his numbers (which economists usually are), he affirmed that there was no evidence in the figures to suggest things would be worse than he forecast.  They turned out to be much worse and exactly for the reason that should have been clear – the painful adjustment from the run-up in household debt we saw this decade.  What’s more, institutions with economists on staff, including the OECD but especially for-profit firms with money to lose, cannot be seen as putting a drag on market confidence with pessimistic forecasts.  It is only the odd gadfly analyst at a no-name institution that is willing to take such a risk (I’m reminded of a small analytical firm called CreditSights).    

Don’t get me wrong.  We can’t base our forecasts on fancy.  We have to look to the numbers.  But, the really good analysts, as opposed to the legions of well-educated ones whose salaries waste too much of our GDP, make intuitive leaps and see the problems and opportunities ahead. 

The OECD report forecasts growth in OECD countries of negative 4.1% this year, with inflation of 0.6%.  Growth in 2010 is forecast to be a sluggish 0.7% with inflation still under 1%.  These inflation rates suggest that the bond market today, with U.S. long rates at 3.7%, is wrong.  The real long rate (after subtracting inflation) thus stands at about 3%, while real short rates are zero or negative.  The bond market is worried about all the borrowing governments are doing and that fiscal deficits will not be trimmed in the medium term.  This pushes up long rates.

Unemployment will remain high through next year, according to the OECD, at above 10% in most major economies.  Disturbingly, world trade should contract this year by 16%, still below the nearly one-third contraction in the thirties, which was in part caused by protectionism.  The OECD rightly warns against the latter.  I hope Democrats in Congress are listening. 

The U.S. current account deficit, an indicator of U.S. borrowing from the rest of the world, will be more than halved in 2009, a positive development.  But it is still negative, and as such, does not reduce the enormous stock of debt U.S. residents (government and the private sector) have to non-residents.  At over 250% of broad exports, America’s net debt to foreigners is astronomical, only exceeded among sizable economies by Spain’s.  This suggests that the economic adjustment in the U.S. could be prolonged.  Economists underestimated this drag on the U.S. economy, with such guiding lights as Ben Bernanke arguing current account deficits were due to a global savings glut and superior U.S. investment returns, not to profligacy at home.

The OECD warns against governments failing to balance the fiscal books in the medium term, but also against consolidating too soon, which could derail the recovery.  The OECD advocates ensuring that spending plans put in place by the stimulus package are implemented in order to support recovery.  The flawed reasoning here is as follows:  the most powerful impulse to the economy provided by fiscal and monetary stimulus is the jolt to market confidence it provides.  The government cannot hold up a sagging economy on its own forever, without becoming insolvent.  If they tried to, they’d be the Soviet Union.  The best a government can do is to announce programs to stimulate the economy and clean up the banks, and hope confidence within the private sector is thus restored.  This confidence boost causes firms and consumers to spend, and that is the only sustainable way to grow.  By spending an additional 10% of GDP in one year, the government can add a couple of points to one year’s GDP growth rate.  But in so doing, the government’s debt-to-GDP ratio rises  — in the U.S. to a worrisome 85% of GDP this year.  The ideal situation is: the government announces a plan; consumers and businesses become so happy as a result that they spend and invest, driving the economy higher; this way the government avoids much of its announced stimulus outlays during later years (or even months), safeguarding its creditworthiness.  Remember, S&P recently put the U.K.’s AAA rating on a Negative Outlook (see previous post).

Agreed — the fiscal stimulus should not be withdrawn too soon.  Further, an announcement soon of a medium-term deficit reduction strategy would calm markets – thereby allowing long rates to fall.  However, the OECD in its report does not sound the alarm bells loud enough about the lack of indications that governments will consolidate over the medium term.  With Democrats tucking all their pet ideological projects, such as health care reform, into the current legislative calendar and not yet announcing a medium-term strategy, long bond rates remain high, making it difficult for private borrowers to raise and invest funds.

The OECD may underestimate the prospects for a double-dip recession as well.  The degree of balance sheet repair needed at banks may be more extensive than markets and analysts expect right now.  And, once the fiscal stimulus wears off, if private agents don’t step in, we’re back where we were in late 2008, except with a staggering government debt. 

If this latter scenario obtains, then the OECD’s dismissal of deflation as a risk could prove wrong.  Deflation is a worse enemy than inflation.  With price deflation, borrowers default en masse.  So, lenders refuse to lend and the economy spins downward.  Fixing the banks, whose balance sheet impairment hinders the transmission of monetary stimulus, is paramount here.  The Fed and other central banks should withdraw liquidity at some point, but not soon.  Better to withdraw the fiscal stimulus earlier, in order to prevent a deterioration in sovereign creditworthiness, allowing long rates to fall, which in turn reinforces the monetary stimulus.

In terms of reforming the regulatory framework, the OECD applauds; however, the Obama administration has not seized the opportunity to cut the U.S.’s overlapping and inefficient regulatory system, in which competing agencies – the Fed, the OCC, the FDIC, state regulators, etc. – compete for scarce resources, pass the buck, defend turf, and inadequately supervise.  Sure, the Fed should be strengthened.  True, it’s worthwhile to have some bureaucratic competition to keep the Fed honest.  But streamlining is needed, and they have decided not to press for any.    It seems the kid gloves Obama wears when handling Iran, he uses as well with the financial bureaucracy, members of Congress, and the financial industry.

Interestingly, the OECD forecasts Euro area economies to contract more this year (4.8%) than the U.S. economy and not to grow at all next year.  Unemployment is expected to be higher (around 12%) than in the U.S.  This looks to be in part due to the reluctance of governments in the region to stimulate their economies as much as was done in the U.S., China, and the U.K.  It is also due to their dependence on trade, which has contracted so much, and perhaps to structural rigidities in the labor and product markets.

In any event, the OECD report is useful in highlighting current trends and in pointing out risks and challenges.  Take its 2010 forecasts with a huge grain of salt.  Use it to make your own intuitive leaps about whether or not the global economy is bottoming out.  And, consider that what is needed across the planet includes:  medium-term fiscal consolidation plans drawn up and announced right away; scrapping ideological spending initiatives such as health care reform; continued emphasis on cleaning up bank balance sheets; and resisting any calls from the left or the right for trade protectionism.  Happy reading…

Obama on Iran: Good analysis, Poor judgment?

June 19, 2009


In a small segment of a 17 minute interview President Obama had with John Harwood of the NYTimes that dealt mostly with financial regulation and health care (watch it on the link below), the president analyzed US-Iran relations in light of the election stand-off.  His comment that dealing with Moussavi would not be much different than dealing with Ahmadinejad has been widely criticized for undermining the reformers in Iran.  This is the trouble that highly analytical politicians can get into.  Remember John Kerry?

Obama made a point that some Iran observers, generally on the right, have made, and that I made in an earlier post, that no matter who becomes Iran’s next president, it will be hard to dissuade that nation from building the bomb.  This is an important insight.  The probability of success in talks on nuclear proliferation with the moderates in Iran would still be low, albeit a bit higher than with the conservatives. 

In spite of this analysis holding water, Obama is being faulted for saying this and for not coming out heavily in favor of the protestors.  I applaud his hands-off approach, really quite unique for an American president, ensuring that conservatives in Iran have the least possible evidence of American interference in Iran’s affairs as possible.  Yet the president should be careful in holding forth on foreign policy analytics, as he is not some snarky blogger seeking to impress readers, but rather the President of the United States…

Obama interview with John Harwood of the New York Times. June 16, 2009

Karim Sadjadpour on Iran…

June 17, 2009

Karim Sadjadpour of the Carnegie Endowment on CNN this morning.

Karim Sadjadpour of the Carnegie Endowment was on CNN this morning analyzing the situation in Iran of late (see below).  Which way the Iranian Revolutionary Guard Corps and the paramilitary Basij will turn in this standoff will be critical, as will the staying power of the protestors in the coming days.  Note Sadjadpour’s article that I embedded in an earlier post on Iran as well.  Very good reading on the man with difficult decisions to make, Supreme Leader Khamenei…

From CNN’s American Morning with John Roberts:

John Roberts: Where do you see this ending?

Karim Sadjadpour: It’s difficult to say, John. A lot of it depends on what the opposition leaders decide they want to do. Certainly there’s a tremendous sense of outrage in Tehran. Not only in Tehran, throughout the country there’s a tremendous sense of injustice that these young people have. At the same time, it’s a country which endured an eight-year war with Iraq. People are allergic to the prospect of further carnage and bloodshed and violence. But at the moment, I think there’s truly a sense of outrage and I see these protests continuing.

Roberts: The Iranian Revolutionary Guard Corps (IRGC) and the government have told people to stay inside. The IRGC is saying if you put up certain materials on blog sites you could face legal charges. How big of a role is the Revolutionary Guard Corps and this paramilitary organization, the Basij, playing in trying to tamp down these protests?

Sadjadpour: They’re playing a definitive role. But what’s been amazing is they haven’t dissuaded people from going in to the streets. Historically, when the regime has announced that the Basij and the Revolutionary Guard are authorized to use force to shoot people, that will quell the protests. But so far, we haven’t seen the protests really quelled. The other day there were several hundred thousand people in Tehran. And it just gives you an idea of how outraged people feel that they’re willing to go out in to the streets and risk their lives.

Roberts: And this ruling Guardian Council, which has said it will recount certain parts of the election. Of course, Moussavi and his supporters are calling for a new election. How far do you think they will go in that? Are they playing for time here, hoping all of the protests will die down and eventually people will get tired of going out in the streets and accept the results of the election? Or might this actually lead to a new election? Can they resist the will of the people?

Sadjadpour: The Guardian Council is not like our Supreme Court. It’s not an objective entity. It’s essentially under the hegemony of Ayatollah Khamenei, the supreme leader. And I think Khamenei deferred to the Guardian Council simply as a tactical move to buy time. But Khamenei may be faced with a dilemma and it may be one day soon, whether to sacrifice President Ahmadinejad or sacrifice himself. Because it’s really gotten to the point where people are calling for the head of Khamenei. And this is unprecedented in the last 20 years.

Roberts: Khamenei has been supreme leader since 1989. This is, as you suggest, all about his survival as well. Right now he’s hitched his wagon to Ahmadinejad who’s got the loyalty of the Revolutionary Guard Corps and the Basij. Can you foresee any circumstances under which he might, for his own survival, throw Ahmadinejad overboard?

Sadjadpour: I think it’s certainly within the realm of possibilities. And I would argue, John, Ahmadinejad doesn’t necessarily have the loyalty of the Revolutionary Guards and the Basij. I was based in Iran for a couple of years and I spoke to many of these young people within the IRGC and Basij who recognize that this “death to America” culture of 1979 is obsolete today and Iran will never achieve its full potential unless there’s reform made in the political, economic, social realm. So I think we shouldn’t take for granted the fact that all of the regime’s shock troops are necessarily going to side with President Ahmadinejad.

Roberts: What will it take to initiate that huge fracture? As we see now, the Guard Corps and the Basij are on the side of the government.

Sadjadpour: We have to get inside the head of Ayatollah Khamenei…his world view is very clear. When you’re under siege, never compromise. Because if you compromise it’s going to project weakness. If he orders a mayor clampdown, I think we may start to see fissures within the regime’s shock troops.

Netanyahu’s Speech: Coarse, but airs Israel’s point of view

June 15, 2009

Benjamin Netanyahu, Israeli Prime Minister   Source:

Well, actually, Israel has several points of view.  The one expressed by Netanyahu is just one of them.  Nevertheless, in the “dialogue of civilizations” launched by expert bridge-builder Barack Obama in Cairo earlier this month, when he raised the Arab-Israeli conflict as an obstacle to dialogue, one voice was not heard.  Israel’s.  It’s like negotiating an end to the global financial crisis without inviting China.

Benjamin Netanyahu is no Barack Obama.  He is no Shimon Peres.  He lacks their diplomatic skill.  I have had extensive meetings with him on a number of occasions, and found him to be a man enthused with his own self-importance.  Just like Barack Obama and Shimon Peres, but a lot less charming.  What a discovery?  Political leaders are vain.  Yet Netanyahu proved an effective leader as Israel’s finance minister, freeing up the economy to realize its potential.  Can he be an effective and visionary prime minister his second time around?  This speech falls short of the mark.

What Netanyahu did in his speech yesterday (see text) was to say, Wait a minute!  Listen to our point of view! 

Obama made efforts to recognize the Arab narrative in his speech in Cairo.  He recognized the Jewish narrative in part by discussing the Holocaust.  Netanyahu gave voice to another part of the Jewish narrative – the claim to the land in Israel.

But the Arab reaction has been sour.  Mubarak is angry, saying that the requirement that Palestinians acknowledge Israel as a Jewish state, a cornerstone of Netanyahu’s speech, “scuttles the chances for peace,” and that no one in Cairo will answer the phone when Netanyahu calls.

It’s not a very radical idea.  Given the Arab insistence on the “right of return” of Palestinian refugees to Israel, an act that would destroy Israel as a Jewish state, it’s not asking a lot.  The Arab Peace Initiative of 2002, which Obama and some Israeli leaders have applauded, called for a just solution to the refugee problem, according to U.N. General Assembly Resolution 194, which many insist calls for a right of return (“Resolves that the refugees wishing to return to their homes and live at peace with their neighbours should be permitted to do so at the earliest practicable date…”)

Arguably, Obama’s conciliatory speech in Cairo opened the door for this sharp Arab reaction to Netanyahu’s speech.  Bush pushed the Arabs to accept Israel’s narrative; Obama is pushing Israel to accept the Arab narrative.  Obama may have inadvertently created huge expectations on the Arab street for Israeli concessions.

There is a deal to be had in the Arab-Israeli conflict.  But both sides have to make concessions.  The deal is:  the dismantling of most West Bank settlements in exchange for Jerusalem.  Israel gets sovereignty over Jerusalem – because no cities, including Berlin, remain divided over the long term – with substantive measures to ensure that Muslim/Palestinian interests in Jerusalem, especially around the holy sites, are overseen by Muslims and Palestinians, much as the Ottomans allowed the French and Russians to oversee their holy sites in centuries past.  In exchange, Israel dismantles most West Bank settlements, forcing tens of thousands, perhaps over a hundred thousand Jewish people to relocate inside Israel behind agreed borders.  As George Bush agreed to, some Israeli settlement blocks, major cities in place for over forty years, generally in and around Jerusalem and very close to the Green Line, perhaps representing some eighty thousand people, will remain as part of Israel.  The Palestinians get a viable, contiguous state in the West Bank with transportation links to Gaza.

That is a deal in which both sides make concessions.  The Arab Peace Initiative demands one-sided concessions from Israel in exchange for the Arabs agreeing not to make war.  It’s like Vito Corleone making you an offer you can’t refuse.

The only problem with the Jerusalem-for-Settlements idea is that Palestinians, Arabs and Muslims will never go for it.  It’s become too emotional a part of their narrative.  Jerusalem is the third holiest city of Islam.

Putting aside such discussions of what is fair, the key question in all of this is, Whose side is time on?  Given demographic realities, it seems that time is on the Arab/Muslim side.  Peres and others on Israel’s left acknowledge this, which has underpinned their efforts to move quickly to a negotiated settlement.  The right in Israel emphasizes their neighbors’ weaknesses – economic and political — and argue that time is on Israel’s side, a potentially risky misconception. 

Netanyahu, spokesman of the right, basically said in his speech, Here is our position; now come to us.  He has adopted the Arab strategy:  stake out a hard line and let others begin concessions.  Netanyahu has stood up to Barack Obama, maybe not the last foreign leader to do so.  Read Jeffrey Goldberg for insight into how Mr. Netanyahu thinks.

Politics in Israel is dysfunctional, leaving that nation bereft of visionary leadership.  It takes so much effort to make and hold coalitions together there, that politicians have little time for policy making.  Political reform is needed, included raising the minimum for parties to be seated in parliament.  The religious parties must be folded into larger groupings.  If things remain as they are, Israeli leaders will miss opportunities, and for tiny Israel with so few friends in the world, this could be an existential threat.

Photo:  Benjamin Netanyahu, Israel’s Prime Minister.   Source:

Does the election in Iran matter?

June 14, 2009

Ayatollah Ali Khamenei, Iran's Supreme Leader   Source:


Iran remains divided between reformists and conservatives.  President Ahmadinejad “won” the election Friday, and hundreds of opposition leaders have been detained.  Emotions among Iran-watchers worldwide have been on a roller coaster ride, as hopes of a new era have been dashed.

Certainly, elections in Iran matter – the importance of nascent democratic institutions, even in a theocracy, should not be underestimated.  Still, all rivers of power in Iran converge and flow directly into the office of the Supreme Leader, Ayatollah Khamenei.  In making sense of the elections in Iran, the task is twofold:  one, understanding Khamenei and how the election fits into where he is taking Iran; and two, what is the outlook for Iran in a post-Khamenei era.  For these tasks, I recommend reading an article by Karim Sadjadpour, of the Carnegie Endowment for International Peace.

Iran is ruled by a small group of clerics, desperate to stay in power.  They have opened enough avenues of expression to channel social pressures, while retaining ultimate power.  They garner support from a segment of the populace (arguably a declining one) by appealing to the ideals of the Islamic Revolution and warning of foreign enemies, especially the United States.  And, they position loyal “clerical commissars” throughout the bureaucracy, maintaining informal control of formal institutions.  This give-and-take between the clerical oligarchy and the people they rule can become a game of chicken that the authoritarians in the end ultimately lose.

The Constitution of 1979, as amended in 1989, confers extensive powers to the Supreme Leader.  Sadjadpour says:

“ As Supreme Leader, Khamenei’s constitutional authority is unparalleled. He controls the main levers of state—the courts, military, and media—by appointing the heads of the judiciary, state radio and television, the regular armed forces, and the elite Revolutionary Guards. He also has effective control over Iran’s second most powerful institution, the Guardian Council, a twelve-member body (all of whom are directly or indirectly appointed by Khamenei) that has the authority to vet electoral candidates and veto parliamentary decisions.”

It is true that the Supreme Leader is chosen by and answers to the elected Assembly of Experts, headed by one-time ally and rival, former President Rafsanjani.  The Assembly is a body of 86 largely septuagenarian clerics, required to meet twice annually.  Assembly members are elected by the people to eight year terms; however, candidates come from a list prepared by the government.  So, in theory, Khamenei controls the body that can, in the end, dismiss him.  He likewise has a finger, if not a full hand, in many of Iran’s complicated and overlapping political institutions.

In addition to his formal powers, as the Constitutionally-sanctioned final interpreter of Islamic issues, the Supreme Leader has the potential for nearly absolute power.  As a consequence, the Iranian president has much less power than the Supreme Leader, executing policy and managing the bureaucracy.  Yet in practice, the president is the country’s front man, as we have seen so unpleasantly with Ahmadinejad, both because of Khamenei’s reclusive nature and the regime’s strategy of fostering a theological mystique about the man and the office.

Khamenei, a close disciple of Ayatollah Ruhollah Khomeini, remains true to the ideals of the Revolution.  He does so probably out of belief and as a strategy for survival.  The Iranian mullahs’ claim to legitimacy rests on their role in expelling foreign influence and cleaning up the corruption of the Shah.  They accomplished this through a return to Islamic piety.  Naturally, they keep sounding these themes to remind the impoverished Iranian public of the clerics’ rightful claim to power.  We shall see if this claim remains credible as time puts greater distance between the Iranian public and the Revolution.  (Regarding Iran’s mistreatment over the years at the hands of the great powers, especially the British, see Ken Pollack’s book, The Persian Puzzle.)

Khamenei is said to lack both the charisma and clerical legitimacy of his predecessor.  He was only made an ayatollah shortly before Khomeini designated him as his successor.  There is a dissident group of clerics in Iran that does not recognize his legitimacy.  Even though he has been in power twice as long as Khomeini, his shortcomings relative to the father of the Iranian Revolution can explain his behavior.  For example, even if he wanted to (and it is likely he does not), he could not become an Iranian Gorbachev or F.W. DeKlerk.  He must placate right-wing clerics by continuing to condemn the United States and Israel, and by maintaining strict Islamic piety, including the mandatory veil (hejab) for women.

Khamenei’s insecurity as leader has also necessitated a balancing of clashing interests in Iran.  First, by supporting Presidents Rafsanjani and Khatami from 1989-2005, Khamenei countenanced an opening of Iran to the world — while never compromising on the regime’s hostility to the United States and Israel, and a modest loosening of restrictions on social practices.  Later, as a result of the popularity of the reformers, he swung back to the conservative “principalists,” epitomized by the pious, young engineer and mayor of Tehran, Ahmadinejad, who ensured a re-emphasis of the ideals of the Revolution.  This way he kept his rivals off balance, facilitated modest pragmatism both domestically and internationally (which by the way, ensured progress on the nuclear weapons program), reminded Iranians not to abandon key tenets of the Revolution, and allowed a release of pent-up social tension.  His swing back to orthodoxy was largely domestically driven, however, the advent of Bush on the international stage likewise facilitated this swing.

As for potential successors to Khamenei, the outlook is unclear.  Ahmadinejad, as a layman, is precluded from becoming Supreme Leader.  However, lest we forget that Khomeini had to amend the constitution to allow Khamenei to succeed him, the Assembly could amend the Constitution again.  Rafsanjani is five years older than Khamenei.  There are both conservative and reformist ayatollahs in the wings.  Sadjadpour’s article discusses some scenarios. 

What is clear is that authoritarian regimes can ignore popular pressure for participation only by delivering the economic goods. This is what we have seen in China over the last three decades, and in Russia more recently.  However, political monopoly can coexist with economic diversity only so long, especially once economic growth and the distribution of wealth falter.  Iran’s economy is state-dominated and creaking, with billions of petro-dollars going to food and energy subsidies, buying off the populace, especially the poor.  As in Russia, Venezuela and other populous oil exporters, as long as oil prices are high, the authoritarian regime has time.  But, commodity markets rise and fall, as do governments.

What about Iran’s so-called democracy?  We should not dismiss the importance of formal institutions, such as Iran’s legislature, presidency and other elected bodies.  These institutions, though emasculated of real power, can ease a transition to a broader democracy, the way the Soviet Duma did with the fall of Communism.  Countries with arguably less-developed institutions, such as Saudi Arabia, where some 5,000 princes rule and its consultative assembly (majles) is very limited, should have a more difficult time transitioning to representative democracy.

Finally, what does the election mean for relations with the West?  First, the bad news.  Whether reformists or conservatives rule Iran, the nation’s determination to acquire a nuclear weapon will likely remain firm.  Self-reliance and freedom from foreign influence remain key pillars of the Revolution and of the Iranian narrative.  A nuclear weapon symbolizes a broad-based commitment of the Iranian nation to rising to great power status.

Sure, engagement would be easier with moderates.  Further, the probability of an acceptable agreement over the bomb, however low, is higher with the moderates.  And, the bomb is only one aspect of the West’s relationship with Iran, though arguably the most important.  Nevertheless, if the West really wants to stop Iranian acquisition of a nuclear weapon, nothing short of a boycott of oil exports would do the trick.

Sadjadpour says this about a policy of engagement with Iran:

“Any successful approach to engaging Iran must be tailored to take into account Khamenei’s central role in Iran’s decision-making process and his deeply held suspicions:

• Khamenei must be convinced that the United States is prepared to recognize and respect the legitimacy of the Islamic Republic and must be disabused of his conviction that U.S. policy is to bring about regime change, not negotiate behavior change.

• Khamenei will never agree to any arrangement in which Iran is expected to publicly retreat or admit defeat, nor can he be forced to compromise through pressure alone. Besides the issue of saving face, he believes deeply that compromising in the face of pressure is counterproductive, as it projects weakness and only encourages greater pressure.

• Successful engagement will require a direct channel of communication with the Supreme Leader’s office, preferably with Khamenei himself. He is wary of domestic rivals and will not take any foreign policy decision that may benefit Iran but risk hurting his own political interests. The Clinton administration’s unsuccessful attempts to downplay and bypass Khamenei and engage Khatami and the reformists in 2000 are a case in point.”

So, engagement is possible.  President Obama may have the magic to do it.  Nevertheless, engagement is unlikely to yield extensive results, especially regarding nuclear weapons.  And, the good news?  In spite of Moussavi’s loss this Friday (real or fraudulent), reformism is alive and well in the Islamic Republic.

 Photo:  Ayatollah Ali Khamenei, Iran’s Supreme Leader.  Source:

Are Status-quo Powers’ AAA ratings vulnerable?

June 11, 2009

Standard & Poor's Logo    Source: Bloomberg

S&P thinks so.  Moody’s and Fitch do not.

Actually, it is more nuanced than that.  A number of what we might call Status-quo or even declining, though still formidable, great powers — including the U.S., U.K., Germany and France – have sustained dramatic negative consequences from the global recession, including rapidly rising government debt levels.  It is a time of testing our assumptions about what makes a great power, what makes a strong economy, and what makes a wealthy society.  And, however painful, we must revise our assessments of relative power and sovereign creditworthiness as needed.   

No doubt such rising powers as China, India and Brazil are poorer – especially in terms of per capita income, but among advanced countries, the economic growth outlook over the medium term looks dismal, as government seeps into more corners of the economy, controlling banking systems and industrial companies, which if not reversed, could eventually stifle private initiative.  In addition, if gaping government deficits are reversed over the medium term via higher taxes, rather than through spending cuts, the government’s stranglehold on the economy will persist.  No matter what, things should get a lot worse before they get better.  Whether or not they get better is in the hands of policy makers.

The U.S. and its allies in Europe are undergoing exactly what Paul Kennedy warned against over twenty years ago in his book, The Rise and Fall of the Great Powers.  Sovereign financial solvency is the foundation on which military and political power can be projected, and this foundation crumbles when governments ignore deteriorating finances.  Governments today must act quickly to cut deficits, once signs of a durable recovery are clear.

The rating agencies remain relatively sanguine.  With the exception of S&P, they don’t expect the major countries to lose their coveted AAA status, as Japan did over a decade ago.  Moody’s even points out that if all AAA’s deteriorate together, they can all remain AAA because ratings are comparative.  However, what is required right now is to compare these AAA’s to lower-rated credits, for example, to such emerging markets as China and Singapore, Hong Kong, Korea and Saudi Arabia.  In spite of what a revision of the relative assessment of, say, the U.K. versus Kuwait might say for how wrong sovereign analysts were in the past, this reassessment must be done.

As for the U.S. and the U.K., the two economies experiencing the textbook example of the current crisis — with declining real estate values, indebted consumers, and failing banks — Fitch Ratings says they:

“possess strong capacity for adjustment, thanks partly to supply-side flexibility, a track record of fiscal consolidation, as well as exceptionally strong balance sheet and financing flexibility.”


 “Benchmark borrower and reserve currency status are two key features of this financing flexibility.”

 About the U.K. and the U.S., Moody’s says, they:

 “are being tested because of a shock to their growth model and large contingent liabilities. However, in our opinion, these countries display an adequate reaction capacity to rise to the challenge.”

Yet S&P a couple of weeks ago revised the Outlook on the U.K.’s AAA rating to Negative, saying that:  

“in light of the challenges to strengthen the tax base and contain public expenditures, the U.K. government debt burden could approach 100% of GDP by 2013 and remain near that level thereafter. The rating could be lowered if we conclude that, following the forthcoming general election, the next government’s fiscal consolidation plans are unlikely to put the U.K. debt burden on a secure downward trajectory over the medium term.”

S&P, in its report of June 4, forecasts the U.K.’s government debt burden to rise above most other AAA’s, including the U.S., by 2011.  Although the U.K.’s exposure to the current crisis is similar to America’s, its boom in credit to the private sector surpassed that which occurred in the US, with domestic credit to the private sector (and public corporations) representing approximately 200% of GDP in the U.K. versus approximately 150% in the U.S. and a AAA median closer to 130%.   The run-up in U.K. government debt is expected to be even more dramatic than in the U.S.   

Likewise, the U.K.’s GDP growth outlook looks worse in the coming years than its AAA peers’.

Paul Kennedy warned us that “The relative strengths of the leading nations in world affairs never remain constant, principally because of the uneven rate of growth among different societies and of the technological and organizational breakthroughs which bring a greater advantage to one society than to another.”  And, that history shows, “a very significant correlation over the longer term between productive and revenue-raising capacities on the one hand and military strength on the other.”

Kennedy argued that:  1) competition and commercial advances in western Europe in the centuries up to the 16th allowed this region to eclipse other power centers – Ming China, the Ottoman Empire, Mogul India, Muscovy, and Tokugawa Japan – which suffered from excessive centralization of authority; 2) the Habsburgs over-extended themselves militarily relative to their weakening economic base in the 150 years up to the mid 17th century; 3) Great Britain emerged as an economic superpower and a military power that could balance rivalries in Europe, by virtue of innovation in banking, shipping and manufacturing; 4) rapid shifts in economic power up through the turn of the 20th century made for unstable relationships among the rising and status-quo powers; and 5) the the U.S. economy has been in relative decline since the middle of the 20th century with the emergence of the rising powers. 

 The more rapid the shifts in relative power, the more unstable the international system can be – risking war – as the distribution of authority and responsibility rushes to catch up with power realities.  The relative decline of such powers as the U.S. and Europe over the long term cannot be avoided, as poorer nations such as China gain technological know-how to rapidly increase per capita income.  However, the speed and size of the relative decline and its management (i.e. through diplomacy) will determine how shocking this change will be (i.e. through war or through peace). 

Which is all to say that AAA sovereigns, such as the U.K. and U.S., would be well-advised to seek substantive fiscal consolidation (read: cut deficits, especially through spending cuts), once there is confidence the worst of the financial crisis is over.

See:  Standard & Poor’s report on the United Kingdom of June 4, 2009, Moody’s report “How Far Can Aaa Governments Stretch Their Balance Sheets” of February 2009, and Fitch’s report “High-Grade Sovereigns and the Global Financial Crisis” of March 17, 2009.

From BRIC to BIC…or even IC?

June 8, 2009

BRIC leaders meeting last year.  Source:

The Economist published an article this week suggesting that Russia’s slide into recession this year – due to lower oil prices, capital flight, weak banks and greater state involvement in the economy — could mean the fabled BRICs will become BICs. Of the four BRICs that made it into Goldman’s arbitrary moniker for major emerging market economies, Fitch Ratings forecasts only China and India will grow this year. Does that mean the BRICs should actually be the ICs? Does Brazil’s shrinking economy also knock Latin America’s largest country out of this select group? Somehow IC doesn’t sound as good as BRIC. Before the global financial crisis, some had said that Brazil had hit a BRIC wall, due to its much worse economic growth performance. I guess that would have been RIC, right?

Fitch Ratings forecasts Earth’s economy will contract 2.7% this year, driven by a nearly-unprecedented shrinkage of the major advanced economies by 3.8%, much worse than the zero growth of the 1975 and 1982 global recessions. Russia is likely to contract by about 3%, Brazil by a little over 1%, while China and India expand by 5-6% each (slow for these countries). Russia’s contraction is driven by its dependence on energy exports, the price of which has fallen markedly since highs last year. However, should the recent push upward in the price of a barrel of oil to nearly $70 persist, Russia’s contraction this year could be more muted.

As noted, Russia is also buffeted by weak banks, capital flight and the heavy unmet external financing needs of the private sector. In addition, as The Economist points out in an article likening Putin’s Russia to the Ottoman Empire, the greater intrusion of the state in the economy and the corporatist corruption of Putin and his men have stymied, though not uprooted, private entrepreneurship in Russia.

The comparison between Russia and Brazil is interesting. Fitch rates Russia’s sovereign debt “BBB” with a Negative Outlook, and Brazil a notch below at “BBB-” with a Stable Outlook (the Outlook reflects the likely direction of the rating within two years). India is also rated “BBB-” with a Stable Outlook. And China, in a class by itself with its $1.8 trillion in reserves – perhaps Goldman’s next appellation should simply be C – is rated “A+” with a Stable Outlook.

But as I said in a previous note about Moody’s, ratings are notoriously sticky. Brazil is looking better than Russia these days. Its economy is more market-oriented and better structured. Its exports are much more diversified. Its domestic market is stronger, as are its banks. Its only negatives vis-à-vis Russia are: its higher government debt, though its deficits are lower than Russia’s because the latter relies on volatile oil to balance its books; and, Russia’s stronger external balance sheet, i.e. excess of foreign exchange reserves over money it owes foreigners. However, Brazil’s balance between external assets and liabilities is near zero — pretty darn good — so I’m not sure Russia is so far ahead on this front. India likewise has a heavy government debt burden and fiscal deficits (both larger than Brazil’s).

India’s and Brazil’s fiscal woes emanate out of their tradition of coalition politics, a dynamic described in an earlier post. India now has the potential to improve its fiscal performance, given the strength of the Congress Party after last month’s elections. Congress should require less pork to distribute to keep its coalition together. India likewise has external assets in excess of liabilities, but not to as great an extent as Russia. Both Brazil and India benefit from a relatively closed economy (at least during a global meltdown) and a strong domestic market. (China’s openness to trade has become a major vulnerability in this crisis.) So perhaps the ratings of both Brazil and India should equalize with or even best Russia’s. Let’s wait and see.

Fitch regularly publishes an interesting report on banking sector risks across the countries it rates. The last one came out May 11, 2009. They assign a letter grade and a number rank based on the health of a country’s banks and vulnerability to shocks. The letter grade (A-E) is an average of the credit quality of the nation’s banks. The number (1-3, 3 being the worst) reflects the vulnerability of the country’s banks to financial shocks from asset prices (including real estate), excessive growth in bank lending, and exchange rate movements. The risk indicators for the famed BRICs are as follows:

Brazil C-3

Russia D-3

India C-2

China D-1

By this measure, India may be the least vulnerable to a banking crisis. China’s score of 1 for financial shocks is good, but may change given the breakneck growth in bank lending of late. China’s banks are fairly weak, given heavy policy lending to state-owned enterprises. Russia’s banks are also weak and prone to shocks. Fitch’s banking sector indicators were always much better in the advanced industrialized countries than in emerging markets in the past. In late 2006, the US and UK were both B-2, and now they’re both C-3, same as Brazil. Some powers rise and some powers fall.  My email is

Obama’s Speech to the Muslim World

June 4, 2009

President Obama with Egypt's Hosni Mubarak  Source:  Huffington Post

President Obama’s speech to the Muslim world today, titled “A New Beginning,” was at its best when it explained the grievances of both sides of the Muslim/non-Muslim divide, but much less effective when it dealt with substantive issues, such as Iran’s acquisition of a nuclear weapon. 

Like he did so powerfully for Americans in his famous speech on race of March 2008, President Obama in this speech exhorted the citizens of Planet Earth to bridge our differences, understand each other better, and solve our common problems peacefully.  I applaud his effort at launching a new beginning between what he calls Muslim-majority nations and the rest of the world, especially the United States, in order to build a peaceful “alliance of civilizations.” Barack Obama, in his now-famous speech on race (“A More Perfect Union”), drew tens of millions of Americans to his movement, even though arguably he failed to adequately explain his association with his pastor, whose comments had offended Americans and precipitated the speech.  Nevertheless, this kind of speech, which the president is so good at, can work well.  It helped get him elected; and, he believes the power of his personality can solve Huntington’s clash of civilizations.

In spite of the hubris underlying Movement Obama’s appeal to our better angels (his predecessors were incapable of the moral transformation this singular man and his team believe they can accomplish), we all hope it works.  It is foolish to cynically dismiss such important, yet elusive, building blocks of civilization as legitimacy that can win over hearts and minds to good causes.  Charismatic moral leadership can help us pitiful humans stop the slaughter and evolve.   Yet it is likewise naive, though emotionally satisfying, to discount the risks of disillusionment that underlie a phenomenon such as Barack Obama.

The president outlined seven key issues that Muslims and the West must address: the violence of extremists, the Arab-Israeli conflict, nuclear weapons, democracy, religious freedom, women’s rights, and economic development.  He definitely covered the major issues, though some of them, while not unimportant, appear more the product of a Democratic focus group, or more accurately, an effort to please a number of constituencies, than issues really critical to a new beginning of peace and cooperation between the West and the Muslim world.  I’ll let the reader decide which ones should be high on the priority list.

Here is a transcript of the speech, but it is worthwhile to have a look at what he said specifically about nuclear weapons and Iran.  Of note is how short this section was, especially when compared to issue number two, the Arab-Israeli conflict.

“The third source of tension is our shared interest in the rights and responsibilities of nations on nuclear weapons.

This issue has been a source of tension between the United States and the Islamic Republic of Iran. For many years, Iran has defined itself in part by its opposition to my country, and there is indeed a tumultuous history between us. In the middle of the Cold War, the United States played a role in the overthrow of a democratically-elected Iranian government. Since the Islamic Revolution, Iran has played a role in acts of hostage-taking and violence against U.S. troops and civilians. This history is well known. Rather than remain trapped in the past, I have made it clear to Iran’s leaders and people that my country is prepared to move forward. The question, now, is not what Iran is against, but rather what future it wants to build.

It will be hard to overcome decades of mistrust, but we will proceed with courage, rectitude and resolve. There will be many issues to discuss between our two countries, and we are willing to move forward without preconditions on the basis of mutual respect. But it is clear to all concerned that when it comes to nuclear weapons, we have reached a decisive point. This is not simply about America’s interests. It is about preventing a nuclear arms race in the Middle East that could lead this region and the world down a hugely dangerous path.

I understand those who protest that some countries have weapons that others do not. No single nation should pick and choose which nations hold nuclear weapons. That is why I strongly reaffirmed America’s commitment to seek a world in which no nations hold nuclear weapons. And any nation – including Iran – should have the right to access peaceful nuclear power if it complies with its responsibilities under the nuclear Non-Proliferation Treaty. That commitment is at the core of the Treaty, and it must be kept for all who fully abide by it. And I am hopeful that all countries in the region can share in this goal.”

He alludes to the differing perceptions underlying the mistrust between Iran and the West.  He points out  the danger of a nuclear arms race in the region.  And, as he does throughout the speech, he portrays himself as someone who, unlike his predecessors, understands the other side’s point of view.  He understands Muslim frustration over the fact that some countries are allowed to have nuclear weapons, while others are not. 

What is missing in this speech is anything Churchillian.  What is missing is realism…for example, a statement that the U.S. is determined to prevent the acquisition of nuclear weapons by unstable or radical regimes, be they Muslim or not.  The risk of the Obama phenomenon is that his extended hand and emotional understanding will not be backed up by a steely determination to oppose dangerous regimes.  True, he takes a stab at this in his remarks about Al Qaeda and extremism.  However, just as it was nearly impossible for Bush to establish moral authority, it will be challenging for Obama to convey strength and determination, and to inspire respect and, yes, fear among America’s adversaries.  I understand he was addressing Muslims, but still there were no unequivocal statements against the Iranian acquisition of the bomb.  

He acquiesced to the Arab narrative in many ways.  The most salient example was his putting the Arab-Israeli conflict, or as he termed it, “the situation between Israelis, Palestinians and the Arab world,” as one of his seven key issues causing tension in the region.  It sure is, but why not the India-Pakistan conflict over Kashmir?  The Shia-Sunni divide was noted, but not as a key cause of tension.  Genocide in Darfur was not mentioned.  Saudi Wahhabism and other sources of extremism in Muslim education were not mentioned. 

The Arab narrative suggests that everything nasty that happens in that part of the world is linked to, if not caused by, Israeli actions vis-à-vis the Palestinians.  Never mind how the rest of the Arab World has treated the Palestinians, refusing to settle these refugees in neighboring countries, the way India and Pakistan settled Hindu and Muslim refugees after their 1948 conflict.  What’s more, the language about Israeli settlements was harsher in this speech than in the past.  The United States does not accept the legitimacy of settlements, and the settlements must stop.  This is quite different from Bush’s statement that after forty years of conflict, forty years of woeful Palestinian (and in most cases, Arab) leadership, some of Israel’s settlements have become a reality on the ground and the subject of negotiation.  Of course, Obama may turn around and tell the Israelis he was only talking about the “growth” of settlements, not the full dismantling of all settlements.  The Obama administration has asked the Israeli government for clarification of its views on settlements, when “clarify” is exactly what Team Obama needs to do on this issue.   

Nevertheless, all in all, it was a valiant effort on the part of President Obama.  I hope he can engender understanding and cooperation through the power of his personality.  His administration has orchestrated this overture to the Muslim world quite well.  The president argued as much in his speech.  He has stuck it to Israel on settlements.  He is pulling out of Iraq. He has called for all nations in the region, and in the world, to give up nuclear weapons.  He is giving humanitarian aid to Pakistan and Afghanistan.  He is launching educational and economic initiatives in the region.  This is the change he offers from Bush’s bluster.  And, he says, the Arab world must do its part.  I hope it works.

China Update…

June 2, 2009

Source: AP

Update from our China post  yesterday — U.S. Treasury Secretary Geithner appears to have had a nice meeting with Chinese leaders today.  Smoothing over any ruffled feathers of the recent past.  Stressing cooperation.  Setting it up nicely for a little Obama administration “good cop, bad cop” routine, starting with a meeting in late July, with Secretary of State Clinton playing the role of the baton-wielding heavy.

At the same time, the Chinese government today arrested a former protestor from the Tiananmen Square movement twenty years ago.  The Chinese government is nervous about the anniversary of the democracy protests coming up on Thursday.  Read a previous post on the contradiction of political monopoly and economic pluralism

A NYTimes article today suggests that Obama’s China strategy is “kinder and gentler” than Bush’s was, which I, and some other China observers, do not agree with.  In any case, it is early.  Read Elizabeth Economy on the subject in Foreign Affairs. 

Finally, worries about China’s banking system over the medium term are increasing due to strong, though slowing, credit growth, especially lending to unprofitable state-owned enterprises.  See an Economist article, as well as a Fitch report (email me at, on the matter.

Geithner in China

June 1, 2009
Geithner's tougher audience:  U.S. Congress   Source: AP
Geithner facing a tougher audience than China: the U.S. Congress Source: AP

A long-time China hand, Mandarin speaker, East Asia major at SAIS, son of an East Asia expert who opened the Ford Foundation’s office in Beijing, U.S. Treasury Secretary Tim Geithner is in China to jumpstart the Obama administration’s “strategic and economic dialogue.”  This effort puts a stamp of change on Bush’s “strategic economic dialogue,” the so-called G-2, or regular meetings between U.S. and Chinese leaders, initially headed up ably by the much-maligned former Treasury Secretary Hank Paulson, Geithner’s erstwhile partner in saving the planet last fall when the global financial system was in collapse.  The main “change we can believe in” the Obama administration will impose will be the insertion of Secretary of State Clinton into the dialogue.  The State Department, our country’s chief diplomatic agency, should well be involved in diplomacy with America’s most important partner/adversary.  But one wonders if the insertion of Mrs. Clinton is due to the belief that Geithner needs a tough-minded chaperone or because the Democrat-controlled government wants to hammer away at human rights and greenhouse gasses at every opportunity.  Under Bush, a division of labor was implemented, with Paulson taking the lead on China and Condy Rice on the Middle East.

Geithner made the rounds in Beijing today, ahead of his meeting tomorrow with China’s President Hu Jintao and Prime Minister Wen Jiabao.  Read his speech at Peking University, a nice, though not earth-shattering, lecture where he hit all the right political points.  He graciously applauded Chinese efforts to help the world exit the current crisis by stimulating their economy, a measure the Europeans have been reluctant to do.  Yet he still preached to the Chinese about consuming more, following an industrial policy less centered on heavy industry and manufacturing, and building a social safety net so the Chinese will spend more.  He committed to nervous Chinese watching their holdings of U.S. treasuries lose value of late that Obama would bring the fiscal deficit down to 3% of GDP, from a high above 10% this year, at the same time as he reiterated his administration’s firm commitment to expensive reforms of health care, education, infrastructure, and energy.  And, he hit the climate change gong for Al Gore (and for all inhabitants of the blue planet), though as the nation’s chief economic officer, he left any harangues about human rights to the much more cantankerous Mrs. Clinton.

Watch a video snippet of Geithner appearing before Chinese lawmakers, a much more accepting crowd than the U.S. Congress.  He felt compelled last January to cowtow to the protectionists and China-bashers in Congress (especially in his party, such as Senator Schumer), when he called China a “currency manipulator,” for which he later had to apologize.

Some China observers today, including this one, emphasize the rockier relationship likely for the G-2 under the Obama administration, compared to the fine bedfellows Bush and Co. and China made, due to likely U.S. moralizing on human rights and pressure on greenhouse gases.  Read a nice NYTimes piece on Geithner’s first day in China this June.