John Mauldin's Outside the Box : China

Eclectica November Fund Commentary

John Mauldin — Mon, 16 Nov 2009 20:55:00 GMT

Today's Outside the Box comes to us from England. My European partner Niels Jensen from time to time sends me some of the best letters he reads from the hedge fund world. He is an excellent filter for me, and this week's Outside the Box offering is no exception. Below is the November commentary from Eclectica fund manager Hugh Hendry. He challenges the current preoccupation with the falling dollar and China, and posits what would happen if that thinking is wrong? It offers some very thought-provoking ideas. You can contact them for more information at info@eclectica-am.com or visit their website: http://www.eclectica-am.com

Your wondering if we are all turning Japanese analyst,

John Mauldin, Editor
Outside the Box

Eclectica November Fund Commentary

by Hugh Hendry
Eclectica Fund Manager

"The power to become habituated to his surroundings is a marked characteristic of mankind."

John Maynard Keynes
The Economic Consequences of the Peace, 1921

This month I will attempt to answer the entrance examination for the Chinese civil service. That is to say, I will attempt to tell you everything that I know. In doing so, I will argue that this year's rally in inflationary assets, from emerging stock markets to industrial commodities to the fall in the US dollar, could be a FAKE. Let me explain why.

But first, I am indebted to Scott Sumner, professor of economics at the University of Bentley, and his essay on the economic lessons that can be drawn from timelessness in art (see http://blogsandwikis.bentley.edu/themoneyillusion/?p=2542). It is a theme that I will constantly revisit in my arguments below.

Sumner is able to take us from the Flemish forger, Van Meegeren, and his horrendous reproductions of the Dutch painter, Vermeer, to the notion that every recession seems unique and special to its protagonists. So just how did Van Meegeren fool the Nazis with paintings that today look so awful, so un-Vermeer? Jonathan Lopez, the noted art historian, argues that a FAKE succeeds owing to its power to sway the contemporary mind. Or in other words, the best forgeries tend to pay homage to the tastes and prejudices of their time. The present is so seductive.

However, forget the art world. Controlling the psyche of this generation of investor is the indelible mark of the falling dollar and the associated fear of inflation. Monetary inflation has been the distinguishing feature of the last ten years, and it is now firmly embedded in the contemporary mind. I am sure I need not remind you that gold, along with just about every other commodity, has at least quadrupled in price since 1999. You already know my explanation for why this has happened.

The spectacular rise in the Chinese trade surplus, predominantly with America, to $320bn per annum at its peak in 2007, and the mercantilist desire to prevent currency appreciation drove the Asians and the sheiks to buy Treasuries and print their own currencies. The ability of fractional reserve banking to leverage this liquidity many times over provided the monetary mo-jo to instigate ever higher commodity prices. In other words, quantitative easing, masquerading as a cheap but fixed currency regime, has succeeded where Japan's orthodox version has failed. The QE succeeded because, amongst other features, it raised the velocity of monetary circulation.

However, it was not always like this. As an example, ten years ago it was unthinkable that the dollar would prove so fragile. Recall that back then, when the euro was first launched in 1999, it promptly lost 31% of its value against the greenback. The subsequent reconstruction of modern China, though, intervened. In order to finance the emergence of a new economic superpower, an abundance of dollars was needed. Have no doubt that had we not had the dollar as a reserve currency, the rise of China would not have been as swift nor as decisive.

The Yellow Brick Road

Consider another economy needing to be rebuilt: that of the United States in 1865, the post Civil War era. The rebirth of the American economy was funded from the monetary rectitude of the gold standard, not from the generosity of a foreign and infinitely expandable paper currency. However, all of this occurred before the discovery of cyanide for heap-leaching and the opening up of the huge South African gold fields. In other words, hard money was in tight supply and the recovery was neither swift nor decisive. Indeed, 30 years later, during the presidential election campaign of 1896, Williams Jennings Bryan was still hotly contesting its merits. He railed against the persistent price deflation and argued that the economy was burdened by a "cross of gold" (see The Eclectica Fund Report, December 2005).

Perhaps I Should Stick to the Twenty-First Century?

My previous investment letter attempted to explain the subtleties of the Triffen dilemma and the dollar's pre-eminent role in regenerating modern day economies. Let me repeat once more: lots of dollars were required, and duly delivered, to build modern China. They did not have to wait on the vagaries of a gold discovery to promote and sustain their economic engine. Instead, they required the willingness of their trade partners to run trade deficits. The US delivered and, partly as a consequence, the Fed's broader trade weighted dollar index has now fallen 20% since its peak in 2002 (the narrower DXY index compiled by the Intercontinental Exchange has fallen more, but excludes the renminbi and overstates the role of the euro). In return, the world has a new $4trn trading partner: China.

Heady stuff, but not without precedent: recall the Marshall Plan, a watershed American aid program that assisted the reconstruction of the Western European economy during the 1950s and 60s. This was further augmented by America's willingness to run trade deficits, the modern day equivalent to a gold discovery, which became necessary to sustain the emergence of the new economic trading bloc. This resulted in the dollar's huge devaluation versus gold in the 1970s. However, back then, the broad trade weighted index kept rising. This time it has fallen sharply.

What an Ungrateful Lot We Are?

The dollar's role as the world's sole reserve currency has both assisted and accelerated the development of world trade. America's trading partners have come to rely upon the bounty of dollars necessary to recycle their trade surpluses and thus finance their growing prosperity. This was done even at the expense of domestic American job losses. Replace the dollar with IMF special drawing rights; I hear your retort. Sure, but have you ever bought a cup of coffee with an accounting identity? And, fundamentally that argument still suffers from the dearth of any other major economy showing any willingness to sacrifice its short term economic standing for the longer-term mutual benefit of having enriched trading partners.

Do not forget that the Chinese could replicate equivalent currency baskets to SDRs at any moment. Instead, they continue to recycle almost three quarters of their trade surplus back into dollars. This is not coercion but simple commercial pragmatism. They know full well that neither Europe nor Japan nor Britain nor Switzerland nor the rest of Asia are willing to sacrifice the implicit loss of manufacturing jobs. They understand that it is only the US that is willing to embrace the benefits of comparative advantage that arise from international trade. Have you ever asked yourself why car prices in America are so low compared with those in Europe? This is my point.

I keep hearing that a dollar devaluation would help matters. I agree; it has. Let me say it again; we have already had the devaluation. That is what the last five years were all about. Now with China rebuilt, and the trade deficit in full retreat (note the -47% contribution from net exports to China's GDP growth in the first 9 months of this year), there are less dollar bills being exported overseas to ungrateful recipients. Is it not time we drop our fascination with the present and consider the future? Is it really inconceivable that the dollar could now strengthen?

Women in Love, Investors in Love. What's the Difference?

Of course this is a minority view. Investors have reacted to last year's deflationary traumas by insisting that it is business as usual. They behave like D.H. Lawrence's coal miner Gerald from the novel Women in Love, who, just days after his father's funeral, steals into his former lover's bedroom and, "...into her he poured all his pent-up darkness and corrosive heat, and he was whole again." Or was he? The trouble is that we are so anchored to the recent past. Investors are fearful of what now seems so familiar and recognisable; at what they perceive as the reckless behaviour of our monetary authorities. "Inflation is a monetary phenomenon" is their Friedmanite dogma. Their salvation can only be found in the safe sanctuary of gold and the embrace of risky assets, but are they truly safe?

This is my home. Don't be so sure about anything, Big Horace. Not about anything in this world.

The Orphan's Home Cycle
Horton Foote

And so, just as the Church of England commissioners became convinced by the cult of equity way back in the whimsical days of 1999 and went 100% long the stock market, investors today recant a new mantra of, "anything but the dollar (A-B-D)". Inflation bets are all the rage. Some would insist that it is their fiduciary duty to protect their clients' capital; I say tell that to the Church of England pension fund, whose assets today are just £461m against liabilities of £813m. Austerity beckons for the clergymen; heaven will have to pay their stipend.

But the spell cast by a contemporary cult is hard to resist. Take another august body, the Harvard Endowment Fund. Not typically renowned as a hotbed of reactionary fervour, the fund is nevertheless radical in its construction and has come to typify the A-B-D stance.

Harvard's position could well be construed as a one-way bet. Almost half of the fund is invested in emerging market equities, commodities, real-estate, private equity and junk bonds. It is as though the rap artist 50 Cent has taken over the advisory board. The fund is going to, "get rich or die tryin'".

We, on the other hand, approach risk by considering the worst possible outcome. For a current pension scheme the greatest torment would be a repeat of last year's final quarter when 30 year Treasuries yielded just 2.5%. This would require a CAGR of 20% or more from the fund's riskier assets at precisely the time that their future returns would seem most questionable; insolvency would beckon. And yet, they blithely run the risk of ruination.

Of course, they are not alone. Another popular argument is that the emerging economies have to urgently diversify their immense dollar reserves. And so the Chinese are colonising the African continent in the pursuit of commodities and the Indian government has just agreed to buy 200 tons of the IMF's gold hoard.

Is this not a reincarnation of the 1980 trade of the brothers Hunt? It is hardly an exaggeration to suggest that China, for all intents and purposes, is already the commodity market. For despite providing less than 8% of global GDP, China accounts for more than half of the world's steel production and more than half of global seaborne iron ore freight. Indeed, this peculiarity is circular in nature. Consider that a modern aluminium plant requires 25% of the project's cost to be spent on buying aluminium in the first place. And remember that investments in fixed capital formation (think new aluminium plants et al.) have made up 95% of Chinese GDP growth this year. China Inc. is Commodities Inc.

Accordingly, China shares the same risk as the world's largest pension schemes. An over- leveraged American consumer does not return to his/her manic buying of old. As William White, former chief economist of the BIS, has argued:

Many countries that relied heavily on exports as a growth strategy are now geared up to provide goods and services to heavily indebted countries that no longer have the will or the means to buy them.

Surely, the Chinese stash of Treasuries is a prudent elimination of the fat tail risk that private sector deleveraging in the west ends up killing the golden goose of the trade surplus. But instead, in exercising good ol' Texan tradition, they have opted, like the Hunt brothers did, to double up. It is the old dice game, Mort Subite, played by the employees of the National Bank of Belgium in the busy lunch time cafes of Brussels in 1910. If the players didn't have time to complete their business, they played a final round with a sudden ending where the loser would be pronounced dead.

Much is made of the comparison between today's balance sheet recession and Japan's demise back in 1989. Despite their bubble never coming close to matching China's prominence in industrial commodities, the loss of Japanese economic growth in the 1990s was nevertheless a major factor in the waterfall crash in commodities. This plunge ultimately saw oil trade for as little as $10 per barrel in the next decade. Just consider how much more devastating the experience would have been had they gone very long the commodity market in 1989 rather than golf courses and Rockefeller Centre. At least the Harvard endowment scheme did not share their enthusiasm for golf. But, this time around, I fear a Mort Subite beckons for the losers in Asia and the pension market.

Last Orders: Inflation or Deflation?

If a poet knows more about a horse than he does about heaven,
he might better stick to the horse... the horse might carry him to heaven.

Charles Ives

I am now going to return to the torturous and binary debate concerning inflation. As you know, I am in the deflation camp for now, and we own a modest amount of government bonds and a series of asymmetric bets which would receive a boost from a return to some form of risk aversion. You could say that I am sticking to my horse.

My intellectual foes, on the other hand, are adamant that long duration government bonds are a short. I even hear that some Wall Street legends are so convinced of the argument made by the likes of Niall Ferguson that they personally own Treasury put options and are actively counselling others to do the same. The argument can be condensed into just two fears.

First, they will suggest that 4.5% is not an adequate return for lending your money to the profligate United States for 30 years. I agree wholeheartedly. Again, I fear it is my accent, but let me stress once more that I do not propose that anyone adopt a buy-and-hold policy for the next thirty years in bonds. However, a nominal rate of 4.5% might prove very profitable over the coming year should breakeven inflation expectations head south again.

Second, the bears contend, a lower Chinese trade surplus will eliminate a very large source of Treasury buyers at a time of burgeoning supply. Again, we find ourselves agreeing vigorously. However, it is our contention that US savings are heading north over the months and years to come. And an America that saves is an America that does not run a current account deficit. It is an American that can finance its own spending domestically. The US produced a small surplus back in the 1990-91 recession, so why not again?

As a consequence the Chinese surplus is set to fall further and, with fewer dollars needing to be recycled to maintain the currency peg, their demand for Treasuries will continue to shrink. Now this is potentially a huge headache owing to the massive projected American budget deficits for this year and next, and the Treasury's desire to extend the maturity of the existing stock of government bonds which is becoming perilously short dated. Some estimate new issuance of around $2.5trn for the upcoming year. Perhaps, it is better that we buy those Treasury put options after all?

American Gothic

Or is it? I have quoted Don Coxe's definition of a bull market before and I intend to do so again. "The most exciting returns are to be had from an asset class where those who know it best, love it least." On this point, America has fallen out of love with its own currency and bond market. Foreigners own over half of the outstanding Treasury stock. But, like I said, I think events could reignite some of the natives' old amour.

It is almost like declaring an enthusiasm for Say's Law. Think of it this way, a greater supply of Treasuries would be a very obvious by-product of weaker than anticipated economic growth. And in this environment risk aversion stimulates the investment desire for risk free assets. So, in a round about way, there are circumstances when supply and demand can match in the bond market. But weaker economic growth? Surely the governments' interventions this year have remedied the economy?

The surprise might concern the role that rising leverage has played in boosting GDP and in anchoring investors' expectations to an unrealistic level of nominal GDP. Over the last decade, each marginal dollar of debt has generated less and less marginal income. We knew that there would be a "zero-hour" for the economy when the creation of new debt would not contribute to GDP growth. The government's reaction to last year's demand shock has been to increase its own leverage. But, with the economy operating at its zero-hour, we believe this incremental leverage will actually have a negative impact. That is to say, the public sector will fail in its attempt to bring the economy back to its previous level of nominal GDP. In this scenario, the outcome will disappoint the market's expectations, which are rampantly bullish as evidenced by this year's dramatic re-pricing of risk assets.

This zero-hour for America has perhaps arrived sooner than many had anticipated. It was heralded by the Japanese experience. Japan is the bogeyman that confronts all academic thinkers, regardless of creed, from Krugman to Ferguson, as well as all who would choose to intervene in the workings of the economy. In a debate I had with Mr. Ferguson in London last month, he claimed that Japan was an extreme outlier and could be ignored. Really?

No sex, no drugs, no wine, no woman, no fun, no sin, no wonder it's dark
Everyone around me is a total stranger.
Everyone avoids me like a psyched loan-ranger
That's why I'm turning Japanese,
I think I'm turning Japanese,
I really think so

The Vapors, 1980

Japan has championed both Friedman and Keynes. They have built bridges to nowhere and dropped Yen notes from helicopters for twenty years and still they have nothing to show for it. Clearly the additional return from Yen debt in Japan is close to zero and it exposes the nightmare of interventionists everywhere: it may just be that there are no policy remedies for a debt deflation. So to elaborate further, our chances of financial success are greatest under conditions where investors believe government spending will succeed but in reality it fails.

However, where will the demand for all of this additional government debt come from? Let us review the Fed's Z1 numbers. The US has household wealth of some $67trn. Of that, $20trn is accounted for by real estate and is perhaps out of bounds for our purposes. But $8trn is held in the form of private pensions and insurance funds. And yet, remarkably, these institutions presently allocate just $630bn to Treasuries et al. Households have a further $22trn in time deposits and other financial assets. But again they own just $500bn of Treasuries, and commercial banks own a tiny $130bn or, 1% of their total asset base of $12trn.

Consider that in 1952, at the very end of the supernova bond bull market formed from the ashes of the Great Depression and the Liberty Bonds that financed the Second World War, US banks held 40% of their gross assets in Treasuries. That is a potential $5trn of demand from this one source alone, albeit spread out over a number of years. And again, the Japan experience lends support. Japanese financial institutions have quadrupled the percentage of their assets held in JGBs. Furthermore, their households have lifted their government bond weightings five-fold over the last ten years. Should the same pattern repeat itself stateside, American households would need to buy another $2.5trn, but again, over ten years.

And let us not forget that a trend of rising prices allied to the most basic human emotion of avarice encouraged commercial banks and other financial institutions to buy $3.2trn of questionable mortgage backed securities in 2004, $1.9trn in 2005, $2.2trn in 2006 and $2.1trn in 2007. So it is not inconceivable, at least in my mind, that financial institutions, and notable amongst them the nation's pension and endowment schemes, could be motivated by another basic human emotion, namely fear for their own survival, to snap up all these new government bonds. Perhaps in the end supply will create its own demand.

Again, it all really comes down to your take on the ratio of total debt-to-GDP. If you believe, like I do, that it peaked in 2007 then the repercussions are enormous. The leverage does not necessarily have to come down (after peaking in 1932 at 300% it troughed 20 years later at 150%). Rather, it may well be that low interest rates allow the mountain of debt to continue to be serviced. This has been the Japanese experience to date. However, everything in our economic life exists at the margin, and the consequences of just maintaining the leverage constant would be a very low delta in nominal GDP growth. Consider that the Japanese, under these very circumstances, have managed to grow nominal GDP at just 1% compound since 1990.

In Bernie We Trust?

This is why China's mad dash for commodities and its investment splurge this year is so worrying. In my marketing presentations I show a picture of Madoff superimposed on a dollar bill and ask, "...in Bernie we trust?" My point is that if the hedge fund fraudster had been given the responsibility for US GDP accounting, he would surely have overstated the figure. And in a similar way, the rise in leverage has probably misrepresented the truly recurring nature of nominal GDP. Now, if we repeat the Japanese experience then it is possible that nominal US GDP will rise from $14trn today to perhaps just $16trn in ten years time. Along similar lines, the German government does not anticipate its economy exceeding its previous GDP high until 2014. And yet it is as though the other surplus countries are behaving like Bernie's former investors who, believing in the stated NAV and its promise of more of the same (i.e., predictable and attractive compound growth rates), were happy to spend lavishly. The Chinese are building capacity to meet a world where US nominal GDP is $25trn in ten years time. I fear they could be in for a nasty shock.

What Do I Mean?

Consider the steel market. The homogeneous nature of steel, as well as other factors such as its price-to-density, allows for the export of the finished good across trade boundaries. Now with China having been on such an expansionary tear, it may not surprise you to hear that finished Chinese steel prices today trade below their production cost. Furthermore, import license applications to sell steel in the US, the world's largest export market, rose 24% last month. Now, mostly this comes from Mexican and Korean producers, but clearly there is the implicit threat that their Chinese competitors might also be tempted.

But the Economy is Growing?

Clearly it would be inappropriate to annualise the production of the US steel industry in the fourth quarter of last year when capacity utilisation plummeted to just 32%. So consider, instead, the annual run rate this year from January to August. This was a period of stabilisation in tandem with the cash-for-clunkers program, which boosted the industry's largest customer, the car sector. It is quite chilling to note that steel production in America is on a par with output back in 1938, when GDP was a mere 7% of its current size. The industry's run rate dropped to a paltry 13% during the Great Depression. However, output only troughed at its 1908 level; a twenty year retracement that is a far cry from our 70 year retracement. So the physical developments in the western steel markets should raise some concern. However, with an active steel futures market in China turning over $15bn a day (consult the Bloomberg page <RBTA CMDY CT>), speculative fears concerning the dollar have overcome the paucity of industrial demand in the west.

Of course, it is not just steel. Consider the aluminium market. We recently had a very bearish meeting with the Norwegian company Norsk Hydro. Admittedly, their strong petro-currency does not help and you have to discount the solace I seek in finding people even more miserable than myself. Even so, the aluminium situation mimics that of steel, but with an even mightier inventory overhang. Four and a half million tons reside at the London Metal Exchange, perhaps 20% of world ex-China annual capacity. It is probable that 75% of this surplus stock is accounted for by financial players exploiting a contango.

Does Life Imitate Art?

The advocates of Prechter's socio-economics would not be surprised to hear that the Romanian writer Herta Mueller has been awarded this year's Nobel Prize for literature for her work depicting "the landscape of the dispossessed". In a Los Angeles Times review of her book, The Appointment, they noted,

"...it is sometimes difficult to tell whether we are reading about people driven mad by a mad regime or people who may not have had all their marbles in the first place."

My partner, Mr. Lee, reflected on this as he sat in the chilly offices of Norsk Hydro last week watching the snow fall outside. The Norwegians continued with their tale of woe: a couple of million tonnes of inventory remains unaccounted for on the world stage and are believed to be hidden in cheaper warehouses in Russia. The rationale behind this is the same as the rationale used by LME speculators. Furthermore, the big Russian players like Rusal are under intense pressure from Putin not to cut capacity (check out 'Putin bitch slaps Deripaska' on http://www.youtube.com/watch?v=PprlM5R3Hbg), and are rumoured to be surviving only by not paying their electricity bills.

To make matters even worse, the Chinese have stopped importing and are eager to ramp up domestic aluminium production. They havethe capacity to produce another 13mt annually, which is equivalent to 52% of global production. Lastly, there is the fact that Rio Tinto bought Alcan right at the very top of the cycle, though they dare not admit it is a terrible business.

Poor Old Norsk Hydro?

Who would want to share a stage with so many mad villains? The Norwegians noted that construction demand had just taken another leg down as buildings started pre-crisis are now finished whilst no further pipeline exists outside of China. Even Ryanair are talking about suspending their aggressive growth plans and may delay the purchase of more planes.

The Norwegians suffer the most pain at present, but if the dollar were to strengthen Alcoa could conceivably go bust. Their dollar cost is the company's only competitive advantage. Let us not forget Alcoa has the most exposure to aircraft construction and still has $10bn of gross debt lording over an almost equivalent market cap. Imagine that we have not even considered their pension liabilities. Yet the Alcoa CDS trades at 200 basis points, down from its high of 1200 earlier this year. Why?!

"May sorrow break these chains of my sufferings, for pity's sake"

Lascia ch'io pianga
Handel

Now remember I have been describing a positive macro scenario: a world in which low interest rates make the debt load manageable and that we muddle through with lower growth rates in nominal GDP. But clearly the consequences for corporate profitability are very poor. The alarming thing is that my opponents (see Ferguson et al.) believe that government bond yields are going much higher. Effectively, the world's bond vigilantes are going to punish the Fed and tighten monetary policy. It is almost as if the world's greatest speculators are agitating for their own demise. It is my contention that the leverage of the economy is only tenable if interest rates stay low and yet, whilst I believe some of them agree, they still fervently expect a rise.

Je consens, ou plutôt j'aspire à ma ruine.

Pierre Corneille
Polyeucte, 1642

Do not forget that the US does not share the distinction of the British or Australian housing markets. According to FSA data, 55% of UK mortgages are fixed rate and 45% are floating. The latter have, of course, collapsed and have proven a boon for disposable income. We must remember, however, that British fixed rates are determined by two and three year swap rates; so effectively the entire stock of UK mortgages are determined by the central bank and could be thought of as floating. In the US, however, things are very different. Total single-family mortgages outstanding are $11trn but $9trn is fixed to the prevailing 30 year Treasury yield. Banks just do not offer variable rate or teaser mortgages anymore. You might say that the American housing market hangs by the tender threads of the bond market's generosity. Lose it, and let us say that the markets demand 6% yields on 30 year durations and mortgage rates would then shoot back up to 7%. And, I would argue, the economy would come to a crashing halt. Do speculators really want this to happen?

Perhaps I am describing a pressure cooker. The private sector's debt may be sustained by maintaining low nominal interest rates.But the pressure from so much issuance at a time of great reluctance from financial institutions to purchase bonds could break the stalemate. And with it the ominous precedent of 1931, outlined in our February report, when a back up in ten year Treasury yields from 3.1% to 4.4% undoubtedly accelerated the rate of deflation in the US economy.

The China Files (Special Project): Real Estate

John Mauldin — Thu, 15 Oct 2009 15:46:00 GMT

Today I offer you an insightful look at China's real estate market - a "burgeoning bubble" that deserves a close eye as the possibility for breaking increases. Remember the chaos in Japan after their own housing dreamscape got violently yanked back to earth? As investors, we have to recognize opportunities - and know what to avoid. With a global economic crisis - and now surging housing prices in China - investors in any global market need to keep watch on political and economic developments around the world.

Today's analysis comes courtesy my friends at STRATFOR, a global intelligence company. They provide unique and on-the-money analysis and forecasts on all things global, essential for any alternative investment strategy. They've got a free newsletter as well, for which I encourage you to sign up by clicking here - so you're not limited to my caprice.

John Mauldin
Editor, Outside the Box

The China Files (Special Project): Real Estate

October 13, 2009 | 1149 GMT

Summary

The real estate market in China, particularly the residential side, is a burgeoning bubble that is growing bigger and more breakable by the day. Land and housing prices were already rising steadily when Beijing's stimulus package hit the sector in early 2009. Now prices are surging, with developers, bureaucrats and investors cashing in while urban Chinese - once encouraged to invest in home ownership by the central government - become less and less able to buy.

Editor's Note: This analysis is part of a series that explores China's industry, finance and statistics.

Analysis

Origins of the Bubble

Since 1978, China's pace of urbanization has increased dramatically, with the number of middle-size and large cities (those having nonagricultural populations of more than 200,000) growing rapidly. Beginning in 1985, economic reforms implemented in urban areas to make China's planned economy more market-oriented added even more momentum to the real estate boom, with real estate investment increasing by 71 percent by 1987. The government's macroeconomic policy of monetary belt-tightening helped cool this overheated market, which was further tempered by the government's continuing to provide housing for state employees (fu li fen fang, or "welfare housing").

However, when the state significantly cut back on its welfare housing program in 1998, the Chinese perception of personal property changed, and this would have an important impact on the real estate sector. The government began this privatization process by making a private dwelling a "commodity" and granting the purchaser the right to own a newly built house for 70 years. (Likewise, the developer who buys the property on which residential or commercial buildings are to be constructed may own that property for 70 years.) Home ownership in China could now be a sound financial investment.

Thus, the residential real estate market would boom in almost every urban area in China - and particularly in the "first-tier" and "second-tier" cities (only Beijing, Shenzhen, Guangzhou and Shanghai are in the first tier, with more than 20 cities, and mostly provincial capitals or coastal ports are in the second tier). But rising land prices would eventually put housing prices out of reach for the general public. In Dongguan, a coastal second-tier city in Guangdong province, land prices averaged 4,957 yuan ($726.42) per square meter in 2007, a more than 500 percent increase from 2003, while personal disposable income increased 24 percent during the same period (from 20,526 yuan [$3,008] to 27,025 yuan [$3,960] per year).

A 2006 survey conducted by the National Development and Reform Commission showed that the average ratio between housing prices and income was approaching 12:1 in many large and middle-size cities in China (in Beijing it had reached 27:1). Twelve to one is significantly higher than the World Bank's suggested affordability ratio of 5:1 and the United Nations' 3:1. The problem was compounded by the fact that, of the more than 80 percent of Chinese who owned their own homes in urban areas (generally considered cities with populations of more than 20,000), 54.1 percent were making monthly mortgage payments that constituted 20 percent to 50 percent of their monthly incomes.

The Recovery Bubble

Following a temporary drop toward the end of 2007, land prices rose steadily, then began surging again with Beijing's stimulus package and a flood of easy credit in 2009. With much of this money flowing into the real estate sector, major beneficiaries included large state-owned enterprises (SOEs) involved in speculative real estate and housing investment, contributing to the inflating bubble. Among the 10 highest-priced land purchases in major cities in the first half of 2009, 60 percent went to SOEs.

Paradoxically, as the global financial crisis continues, China sees little choice but to loosen its monetary policy even further, fearing the opposite would curtail economic growth and result in massive unemployment, which could lead to social instability. Beijing knows that one of the country's underlying economic problems continues to be an overheated real estate market, but it also knows that the real long-term solution - limiting the flow of cash and credit - could have dire socio-economic ramifications. Meanwhile, real estate developers, government officials and investors continue to speculate on real estate, raising land and housing prices.

As housing prices continue to rise, a parallel trend is manifesting itself - rising vacancy rates in urban areas. A 2009 report by the Shanghai Yiju Real Estate Research Institute revealed that, by the end of 2008, the average vacancy rate for "commodity housing" (as opposed to welfare housing) in Beijing was 16.64 percent, and vacancies reached as high as 30 percent in some districts. Most of these vacant houses, however, are not unsold ones. They have been purchased by investors as speculative investments. While there are fewer and fewer ordinary people who can afford to buy houses, there is still excessive demand for investment housing - pressure that continues to drive up the prices.

This closed loop in the Chinese real estate market is facilitated by the country's political and bureaucratic system. In China, all land is initially owned by the state, and local governments have the sole authority to sell it. And income from property taxes and land sales are a primary source of revenue for local jurisdictions. According to estimates by the State Council's Development and Research Center, tax revenue from the land in some jurisdictions accounts for 40 percent of the local budget. Moreover, net income from land sales accounts for more than 60 percent of the local governments' extra-budgetary revenue. The soft budget and lack of accountability to the people reinforces the local governments' incentive to expand their real estate investments without much concern for cost or impact on public services.

Economic performance also is the prime prerequisite for bureaucratic advancement, which gives local officials the incentive to generate as much revenue as possible through land auctions. And this generally involves a level of collusion - and corruption - among government officials, real estate developers and investors.

One typical strategy is for a developer to buy a big chunk of urban land from the local government but leave the land undeveloped, or build on only a small portion of it, thereby keeping the housing supply limited. Despite various state policies to lower land prices in order to make homes more affordable, local government officials and real estate developers control the land auctions. When a lower sale price is dictated from above, it is easy enough for the local sponsors to officially deem the auction a failure. Even when the developer does build houses on the property, a speculative investor, working hand in hand with the developer and government officials, can bribe both parties to ensure that he can buy all the houses at a low volume price and keep them off the market, thereby maintaining a limited supply and high prices.

Another factor that enters the equation is a cultural one. The Chinese people generally prefer to buy new houses, as opposed to renting homes or buying secondary houses in which people have already lived. Indeed, in urban areas, marriage proposals often include a promise to buy a new commodity house. As a result, the secondary housing market remains very small in comparison (due also to fewer available bank loans for lived-in houses and the complicated process involved in transferring ownership).

All of these factors contribute to the burgeoning real estate bubble - and make it difficult to predict when that bubble will burst. With 70 percent of real estate investment in China coming from bank loans, a dramatic drop in land values could send shock waves throughout the economy. There are already signs of decline. In Shenzhen, one of China's first-tier cities, real estate prices have been dropping for the past two years (30 percent for housing), and many developers and speculators have suffered great losses. The threat looms in other large cities such as Beijing and Shanghai and may be emerging in many second-tier cities as well.

Given the current global economy and the economic balancing act it must maintain domestically, Beijing has few good choices. It must keep enough cash flowing to maintain economic growth and social stability in the short term while tightening credit to avoid a tsunami of bad loans and a market collapse over the long term. Certainly, Beijing does not want to face the kind of collapse in the housing market that Japan experienced in the 1990s, which triggered a financial crisis and more than a decade of economic malaise.

But in China's real estate, as in most sectors of this vast and complex land, implementing and enforcing prudent regulation has never been an easy task

A Country for Old Men and a Bit of Samba

John Mauldin — Mon, 05 Oct 2009 20:05:00 GMT

We all know that a large wave of Baby Boomers in the US are approaching retirement. But what about the rest of the world? And what happens when those retirees need to spend out of savings? There is more than just a credit crisis and a government deficit crisis in our future. A rising level of retirrees to workers is happening even as I write. And the US is not, for once, the center of the problem. As this week's writer of your Outside the Box Niels Jensen explains, we cannot all export our way out of the problem. There is a global adjustment that must happen and when it does, it will have serious consequences for all. This week's letter is guaranteed to make you think. Set aside a few minutes to do so.

Niels Jensen is the Senior Partner of Absolute Return Partners based in London. I have worked closely with Niels for years and have found him to be one of the more savvy observers of the markets I know. You can see more of his work at www.arpllp.com and contact them at info@arpllp.com.

John Mauldin, Editor
Outside the Box

A Country for Old Men and a Bit of Samba

The Absolute Return Letter October 2009

The Man Card

"Excuse me Sir, can I see your Man Card?" The stone-faced look of the security guard at Dallas Fort Worth Airport gave nothing away and, after two days of celebrating John Mauldin's 60th, my brain was probably operating somewhat below full capacity. "I need to see your Man Card Sir". Couldn't he just go away, I thought to myself, not really sure how to deal with the situation. Suddenly his face cracked wide open and in the broadest possible Texas drawl he said: "With those pink socks on Sir, I need to make sure you are a man". Welcome to Dallas!

The highlight of the weekend was a two hour roundtable discussion on Saturday afternoon where John had asked 15 of his friends and business associates to share with the group what their fears and hopes were for the next 15-20 years. I duly noted that the issues on the minds of our American friends are not at all dissimilar to what we worry about in Europe – our children's welfare, unemployment, immigration, racism, the impact of technology and the aging of our society to mention but a few.

This month's letter is about demographics and is the second in our series about major trends defining the future of the world we live in. Last month I wrote about the energy outlook, and I had an unusually high number of emails commenting on the letter. Many of them made the point that the world is in better shape than I seem to think, even if oil supplies are dwindling, as natural gas reserves are ample. We just need to switch source. Whilst I don't disagree that natural gas seems the way forward, one should not underestimate the task ahead of us. About 2/3 of all oil is used for transportation purposes and it is an enormous task to reduce our oil dependency. It will take many, many years and cost gigantic sums of money.

It is the banks, Stupid!

Back to this month's topic - in the financial press, there has been no shortage of attempts to apportion blame for the credit crisis. Disregarding the more obvious finger-pointing (it is the banks, stupid!), there seems to be a growing acknowledgement that large imbalances in the global economy are to blame for the current mess.

Put differently, a large number of countries - mainly Anglo-Saxon in origin but also the majority of our Eastern European friends - became credit junkies and spent beyond their means, year-in year-out. Conversely countries with large current account surpluses (e.g. China, Japan and Germany) were only too happy to deliver the drug to the intoxicated.

It is therefore too simplistic to suggest that only the deficit countries are to blame. The suppliers of credit must accept that they carry no small part of the responsibility, just like the drug dealers do when supplying junkies. In the past, I have been critical of Ms. Merkel of Germany when she stated publicly that Germany should continue to do what Germany does best, and that is to export goods of high quality. The obvious point here is that if Germany pursues such a strategy, the world will be no more balanced ten years from now than it is today, and a crisis similar to the one we have just been through could happen again.

It should therefore be obvious that not only should the deficit nations become more disciplined (i.e. save more and spend less), but the large surplus nations should actually put measures in place to ensure that their citizens save less and spend more. In practice, however, that is easier said than done. Demographic forces have a much bigger say on spending and savings patterns than generally acknowledged.

The Life Cycle Hypothesis

My story begins with Franco Modigliani. In 1985 he was awarded the Nobel Memorial Prize in Economic Sciences for his life cycle hypothesis which (somewhat simplified) states that spending and savings patterns are predictable and largely a function of demographics. When you are in your 20s and 30s, savings are low as much of your income is spent on establishing a family, buying and furnishing your home, putting the children through education, etc. Then comes a phase, from your early to mid 40s until just before you reach retirement age, where your savings grow significantly. The outgoings are smaller during this phase of your life as the kids have left home, and you focus on accumulating wealth to pay for your retirement. Eventually, when you retire, your savings rate turns negative as you begin to live on your life savings¹.

Empirical evidence has since shown that this is generally true both for the individual and for society at large. Obviously, you don't win the Nobel Prize for pointing out something that can hardly be classified as original thinking, but Modigliani's claim to fame was to demonstrate the effect this pattern has on the general economy as the population ages. Let me introduce you to a chart constructed by fellow Dane Claus Vistesen who is an economist and active blogger. He has made a solid attempt to graphically illustrate the consequences of Modigliani's work (chart 1).

The blue line represents the current account – it is in surplus when above the red line and in deficit when below. As you can see, when a country's population is relatively young, the country should (all other things being equal) run a current account deficit. As the population grows older, and the savings rate rises for the reasons described above, the deficit turns into a surplus until such time that the elderly begin to dominate the young at which point the surplus turns into a deficit yet again.

Our export dependency

Why is all this important? Well, take another look at chart 1, but focus on the purple line instead, which represents the country's export dependency. Translated into plain English, Modigliani's work implies that a country with an ageing population must grow its exports aggressively in order not to build up an unsustainably large current account deficit. Unfortunately, as you can see from the shape of the curve, it is not a linear function. The problem gets progressively worse as the population ages.

Now, with most OECD countries fast approaching the danger zone where an uncomfortably large part of the population consists of old-age pensioners, how do we get out of this pickle? We can't all export our way out of the problem. Somebody needs to buy our products. I will get back to answering this question later, but let's take a quick look at the so-called dependency ratio first. If the ratio is, say, 30, it means that there are 30 people at the age of 65 or older for every 100 people between the age of 15 and 64 (which defines the working population).

Obviously, the higher the dependency ratio, the fewer working people there are to pay for the elderly. At some point the cost of supporting the elderly will reach a level which spells economic disaster, and some of the more exposed countries may quite simply be forced to abandon their welfare standards to cope. More about this later -let's get some data points on the table. In chart 2 below, I have tried to keep things relatively simple. I have assumed, for example, that the fertility rate will remain unchanged going forward. This may or may not be a reasonable assumption. Only time can tell.

A walk in the park

The first thing that struck me when I produced this chart was how relatively benign the US outlook is. I read an awful lot of US centric macro economic research (my wife thinks too much!) and, more often than not, there is a reference to the bleak future for America given the fact that baby boomers in large numbers will be retiring over the next two decades. However, when you compare the US numbers (a dependency ratio of 19 today growing to 34 by 2050) to most other developed nations, the US demographic challenge suddenly looks like a walk in the park.

No other country is aging as quickly as Japan. Saddled with a large number of old age pensioners already (the dependency ratio is currently 35), the ratio will grow to an astonishing 76 over the next four decades. The Japanese economy has struggled to drag itself out of a slow growth environment for the past twenty years (give or take). The problems in Japan are well publicised and are often blamed on failed policy measures. I just wonder how big a role demographics have actually played in all of this and whether the Japanese mire is a sign of things to come for the rest of us?

Europe is toasted

The outlook for Europe doesn't make for pretty reading either. In fact, you can argue that we are worse off than Japan given our lower savings, and it raises some serious questions about the sustainability of our entire welfare model. The IMF has calculated that the cost of age-related spending in the average advanced G20 country will cause public debt-to-GDP to grow to over 400%, with Spain and Greece reaching over 600% unless the existing welfare model is cut back. For comparison, Japan has the highest public debt-to-GDP ratio today at about 225%.

As our business partner, John Mauldin, always reminds us, what cannot happen, will not. We may have to prohibit the use of condoms (not advisable for other reasons), import more labour from countries with higher birth rates (immensely unpopular) or simply reduce old-age benefits. The latter carries its own set of challenges as the political influence of the elderly is on the rise, and it won't exactly become any easier over the next 20 years to pass draconian legislation to reduce old-age benefits. Frankly, I have no idea how we will find a way out of this pickle. But find a way we will.

BRICs versus PIGS

As far as emerging economies are concerned, the outlook is considerably brighter (note the big difference between the BRICs and the PIGS in chart 2) but perhaps not as straightforward as you may think. Most investors seem to buy into the idea that, over the next few decades, emerging markets will offer better investment opportunities than more mature markets, as their economies are likely to grow much faster, and you don't yet pay for the faster growth through higher P/E ratios. Whilst we wrestle with depressing issues such as how to pay for the credit crisis and how not to bankrupt ourselves as we age, emerging economies should benefit from a growing labour force. In fact, as you can see from chart 3, in the next few years less developed countries, which tend to have very young populations, will actually outgrow more developed countries in terms of the size of the working population relative to the total population (which is good for economic growth).

The growing number of workers should, according to Modigliani, be followed by stronger economic growth and rising savings. If these savings can be invested into new productivity enhancing investments, emerging economies should enjoy much higher living standards in the years to come. You may raise a hand here and say "STOP – didn't you just argue that countries with young populations should run current account deficits and hence low savings rates?" It is indeed correct that 'young' countries should, according to Modigliani's hypothesis, not be able to generate savings rates at the magnitude we have seen coming out of South East Asia in recent years.

Cheating is omnipresent

But Modigliani didn't take cheating into account. Virtually every country in Asia has artificially depressed its currency in recent years in order to export itself to prosperity. This cannot, and will not, go on forever. As living standards rise in these countries, and domestic demand fuels economic growth, expect their currencies to appreciate against the old world currencies.

At the same time, one should not ignore the fact that not all emerging economies have young populations. I have included the four BRIC countries in chart 2 in order to make this point clear. As you can see, by the middle of the century, China and Russia will actually both have a higher dependency ratio than the United Kingdom, whereas Brazil and in particular India should continue to benefit from relatively young populations.

In a recent research paper², BCA Research analysed a number of emerging economies and found that, broadly speaking, they can be divided into 3 categories – those where the working population is peaking just about now, those that will peak in the next 7-10 years and finally those where the peak is still 15-20 years away (chart 4).

It is clear from BCA Research's work that some countries are in much better shape demographically than others. Most interestingly, China, which everybody (well, almost everybody) raves and rants about, does not look particularly attractive. Obviously you cannot judge the investment appeal based only on demographics, but if you add to that China's fragile banking system and a construction boom which has left most new buildings half empty and led the Chinese authorities to block local access to hedge fund manager Hugh Hendry's website, because he had the audacity to point out the insanity of many of the construction projects in China, then the Chinese investment story loses some of its glamour.

Too much of a good thing

A great growth story like China will always attract plenty of capital but, in the case of China, you can actually argue that too much capital has been attracted. As I was taught at university, economic growth loses its momentum if capital spending outgrows labour because of the diminishing return on capital. BCA has illustrated this graphically (chart 5), and it is obvious that China is attracting too much capital for its own good. You want to invest where capital is scarce, not plentiful.

You are therefore likely to earn a higher return on investment by investing elsewhere in the universe of emerging economies. One such country is Brazil which does not attract nearly the amount of capital that China does. I have been keeping an eye on Brazil for some time now as I am intrigued about their fledgling oil industry, and the more I learn about this country, the more excited I get. The story has not gotten any worse in recent days after the International Olympic Committee's decision to award the 2016 summer games to Rio de Janeiro. But that is an entirely different story which I may write more about another day.

Going back to the question I raised earlier, how do we get out of this pickle? As already stated, we cannot all become exporters as we grow older and domestic demand begins to fade. The only way out, if we want to maintain economic growth, is for the younger and more dynamic emerging economies to become net importers. This will require a sea change in policy, and attitude, in those countries. Most importantly, it will require the exchange rate cheating to stop once and for all. There is no alternative, unless you are prepared to accept negative GDP growth year-in year-out. And that is no fun.

Niels C. Jensen

Footnotes:
1 See http://www.princeton.edu/~deaton/downloads/romelecture.pdf for more information on Modigliani's work.
2 'Demographics, Investments and Growth: Where are the opportunities?', BCA Research, August 2009.

Iran Sanctions (Special Series), Part 3

John Mauldin — Thu, 01 Oct 2009 19:36:00 GMT

Recently I had a discussion with a colleague about university athletes. I was previously unaware that NCAA colleges set up guidance programs that develop the well-roundedness of student athletes. 'Life coaches' ensure that these individuals balance their rigorous athletic commitments with personal and academic accomplishments. I'm not judging your ability to run a mile or catch a football, but well-roundedness is an element to being successful - whatever your area may be.

To be a solid investor, it's important to consider a variety of markets, and you must be well-informed in a myriad of sectors. This is where having the best information comes in, and one of the better places for intelligence is STRATFOR. They offer a straightforward recipe of news about global affairs - causes, outcomes and what to expect next based on a rational, time-tested methodology.

I'm including a STRATFOR report that discusses the possibility of gasoline import sanctions against Iran. It's an absolute must-read for anyone interested in energy, foreign relations, Russia, the Middle East, etc. I'd encourage you to sign up for their free weekly reports here, so you aren't limited to what I send you on occasion. Begin (or continue) your journey to well-roundedness... Now, get to the line and practice your free throws.

John Mauldin
Editor, Outside the Box

Iran Sanctions (Special Series), Part 3: Preparing for the Worst

September 25, 2009

Summary

Iran has long been preparing itself for U.S.-led sanctions against gasoline imports and is confident in its ability to circumvent them. But even if the sanctions did get Iran's attention, they would not necessarily bring it to the negotiating table. Iran takes resistance very seriously, and while extolling the virtues of self-sacrifice it could close the Strait of Hormuz, which would wreak havoc on the global economy.

Editor's Note: This is part three of a three-part series on what sanctions against Iran could mean for Iran, U.S.-Russian relations, Israel and the global economy.

As the Iranian regime continued apace with its nuclear program, it understood that it was only a matter of time before the West would aim for its gasoline imports, a potential Achilles' heel for Iran. Although Iran may be one of the world's top-five crude-oil producers and exporters, its rogue reputation isn't exactly good for business. The Iranian energy industry has been sagging under the weight of sanctions for decades as the foreign energy majors with the technical skill Iran so badly needs wait for the geopolitical storm clouds to clear before tapping the country's vast energy reserves.

To contain domestic political dissent, the Iranian regime has heavily subsidized the population's energy needs. The drawback to such a policy is that ridiculously cheap gasoline prices (gasoline in Iran costs around 9 cents per liter) tend to fuel rapid consumption and rampant smuggling. As Iran's population continued to grow, so did its appetite for gasoline, and the regime has now reached a point where it simply cannot keep up with domestic demand without importing at least one-third of its fuel.

So, while Iran's Arab rivals, such as energy heavyweight Saudi Arabia, profited immensely from record-high crude prices in 2008, the Iranian regime was still struggling to balance its accounts. Then came the global economic collapse, which sliced the country's oil revenues in half. And given the sponsorship by the Islamic Revolutionary Guard Corps (IRGC) of militant and political proxies in Iraq and Lebanon, Iranian President Mahmoud Ahmadinejad's repeated raids on the country's rainy-day oil funds for his political campaigning, and funding for the Iranian nuclear program, Tehran does not have much cash to spare.

Unreliable Allies

Iran is not oblivious to its gasoline vulnerabilities, but it also isn't left without options should Washington become more aggressive with its sanctions campaign. As discussed in detail in part two of this series, Russia — for its own strategic reasons — has developed a contingency plan, most likely involving Russia's former Soviet surrogate, Turkmenistan, to cover the gasoline gap should Iran start experiencing shortfalls. The Russians are certainly not planning to do this out of the goodness of their hearts and sincere loyalty to their allies in Tehran. On the contrary, sabotaging Washington's sanctions regime against Tehran is yet another way Moscow can turn the screws on the United States if the Obama administration refuses to take seriously the Kremlin's demand that the West respect its influence in the former Soviet sphere. Since the Obama administration backed down recently from its Ballistic Missile Defense (BMD) plans in Central Europe, there could be more room for Russia and the United States to engage in serious negotiations. That said, there is no guarantee that Washington would be willing to pay the price of Russian hegemony in Eurasia in return for Russia's cooperation on Iran, and Moscow will drive a hard bargain before it even thinks about sacrificing its leverage with Iran.

Iran could certainly use Russia's help in maintaining its gasoline supply, but Tehran is also quite wary of becoming that much more dependent on Moscow's good graces for its energy security. Russia and Iran have quite a tumultuous history (the Soviets briefly occupied Iran during World War II), and the Iranian leadership is fearful of being abandoned by Russia should Moscow reach some sort of compromise with Washington.

Iran's other energy-producing ally hostile to the United States is Venezuela, which recently announced it would come to Iran's aid in the event of sanctions and supply its Persian friends with 20,000 barrels per day (bpd) of gasoline starting in October for an $800 million annual fee. Beneath the revolutionary rhetoric of oppressed regimes sticking it to their imperialist foes, this Venezuelan-Iranian energy deal is filled with holes. For starters, Venezuela — much like Iran — is facing serious refining problems due to mismanagement and a severe drop in foreign investment. Also like Iran, Venezuela's populist regime heavily subsidizes its constituents (gasoline in Venezuela is even cheaper than in Iran at 4 cents per liter), sending consumption soaring over the past four years. While Venezuela is currently refining around 420,000 bpd, it still needs to import gasoline to help meet domestic demand.

Caracas could always go through a third party to supply gasoline to Iran from a source closer to the Persian Gulf, but finding a willing supplier could prove difficult and costly when insurance premiums and political risks are taken into account. Moreover, should push come to shove, Washington has substantial leverage over the Venezuelan regime given the abundance of assets that Citgo, the refining unit of Venezuelan state oil company Petroleos de Venezuela, has spread throughout the United States. The United States also is the largest recipient of Venezuela's crude exports and one of the few markets in the world with the technological capabilities to process Venezuela's heavy crude, leaving Venezuela without much of a viable alternative market.

Iran has already turned to China to help backfill its gasoline supply. Latest estimates show that starting in September, China began to directly supply up to one-third of Iran's total gasoline imports. Until now, Chinese involvement in the gasoline trade had mostly been limited to shipping companies. In the run-up to the Oct. 1 talks, China now has the extra incentive to poke the United States and profit from these gasoline shipments to Iran. After having boosted its refining capacity this year, China has surplus gasoline to sell on the international market. In August alone China exported 140,000 barrels of gasoline per day. Like Malaysia's Petronas, which began supplying Iran with gasoline in August, China sees an opportunity to profit off of Iran's gasoline trade at a time when political tensions are rising and major energy firms, such as BP, Reliance and Total, have already stopped or are cutting back their shipments to Iran. But Iran may not be able to rely on Chinese aid over the long term.

China currently is in a heated trade spat with Washington over a recent U.S. tariff on Chinese tire imports and could push back against Washington even further by flouting the threatened sanctions regime. However, this is a decision with major strings attached. Washington still has a great deal of leverage over Beijing in the form of Section 421, a U.S. law that was incorporated into China's accession agreement with the World Trade Organization in 2001 and allows the United States to legally impose tariffs on nearly any Chinese export until 2013. Now that Obama has put Section 421 to use in restricting tire imports, the Chinese have to think twice before making any moves that could compel Washington to go even further in slapping trade restrictions on China. Additionally, China is a massive energy importer itself, so shipping any sort of energy product to the Middle East, where its supply lines are unprotected, is something that works directly against most of China's energy security strategies.

The United States has not yet formalized the gasoline sanctions against Iran in the form of legislation or a U.N. Security Council resolution, and this may be providing Beijing a limited opportunity to hit back at the United States during the trade spat and demonstrate the limits of Beijing's cooperation. However, Beijing will be far more cautious than Russia when it comes to blocking sanctions against Iran and will keep a close eye on Russia's intentions in deciding its next steps. China has long been noncommittal when it comes to sanctions against Iran and will align itself with Russia in forums like the U.N. Security Council to demonstrate its opposition to punitive U.S. economic measures. Of course, if Russia folds and reaches some sort of compromise with Washington, China will comply with the sanctions and avoid being left in the spotlight as the sole sanctions-buster allied with Iran.

In short, Iran has friends that it can turn to if necessary, but the reliability of those friends is by no means guaranteed.

Fending for Itself

In the spirit of self-sufficiency, Iran has long been preparing itself for a U.S.-led offensive against Iranian gasoline imports. Over the past two years, as talk of gasoline sanctions intensified, Iran sought out willing suppliers to help stockpile its gasoline reserves. Iranian gasoline consumption currently stands at around 300,000 to 400,000 bpd, but over the past several months, Iran has been importing well in excess of that amount from mostly Swiss suppliers and now newcomers like Malaysia's state-owned Petronas, which are looking to replace the energy majors that are dropping out of the Iranian gasoline trade while political tensions are high. Iranian and U.S. intelligence sources claim that Iran currently has at least three months worth of gasoline needs (estimates average around 30 million barrels) stockpiled. The director of the National Iranian Oil Refining and Distribution Company claims Iran's gasoline storage capacity is about 15.7 million barrels, which gives Iran about four months of in-storage capacity. Some of the surplus gasoline is sitting on tankers off Kharg Island, but the bulk of the supply is stored on land, where it is less vulnerable to airstrikes.

The Iranian government continues to make bold claims about its ability to massively ramp up its refining capacity and become self-sufficient in gasoline production within four years, but this is mostly hot air. Iran simply doesn't have the capability to meet its gasoline production goals on its own without the necessary foreign investment. And even if Iran had willing partners in places like Central Asia, it would still need to overcome its extreme reluctance to actually foot the bill for such projects.

It may strike some as odd that Iran has acquired a capability to develop nuclear technology but still struggles to build and operate refineries on its own. There are a number of reasons for this, but the simple answer is that the technology for a nuclear program dates back to the 1930s and 1940s and has not changed much since, while refining technology is continually updated and Iran has been out of the global oil-and-gas mainstream for 30 years now. A nuclear weapons program requires a couple dozen or so highly trained scientists and engineers to operate it, and these personnel can be trained in any number of institutions around the world. On the other hand, a permanent staff for a refinery producing around 300,000 bpd would require some 1,200 highly trained technicians and petroleum engineers, and most of Iran's intelligentsia — particularly the group with strong technical skills — left the country following the Iranian Revolution. Iran's stated energy goals are full of delusion as well as ambition.

Confronting the Subsidy Problem

Iran thus has little choice but to figure out a way to reduce gasoline consumption at home. The Iranians started on this initiative in June 2007 when the regime implemented a rationing system. Though the move was extremely unpopular and instigated a spate of riots in Tehran, the backlash was swiftly contained and, according to energy industry sources, Iranian gasoline imports dropped from 40 percent of total domestic consumption to about 25 to 30 percent.

The next step is for the regime to start cutting untenable subsidy rates by raising the price of gasoline. This is a plan that has long been in the works but has been put off time and time again due to the regime's deep-rooted fear of sparking major social unrest. This especially became a concern following the June presidential election debacle, which gave scores of Iranian citizens the courage to pour into the streets to voice their dissent against Ahmadinejad. Though the protests have dramatically dwindled in size, they continue sporadically and are a persistent irritant to the regime. Iranian sources claim that the coming gasoline price hike will not be that dramatic in the beginning. The government would likely continue to subsidize domestically produced gasoline while allowing the cost of imported gasoline to rise so it can pass along a portion of the costs to the consumer and further dampen demand.

Besides the potential political fallout, there is another significant issue with this gasoline price-hike plan. Since gasoline prices are heavily subsidized in Iran and are, therefore, much cheaper than the gasoline sold in neighboring countries, Iran has a major problem with gasoline smuggling to these countries. Iranian sources claim that more than 750,000 barrels are smuggled every month from Iran to Turkey, Afghanistan and Iraq, and this puts a considerable drain on Iran's energy revenues. The smuggling rings are run by a variety of actors, from Iranian organized crime entities linked to the IRGC to Balochi tribesmen to Kurdish smugglers, and they are extremely difficult for the regime to dismantle. Moreover, Iranian officials tend to turn a blind eye to these smuggling practices in order to buy political patronage from non-Persian minorities (Kurds, Balochis and Azeris) in the borderlands who could otherwise cause serious trouble for the regime. With the political situation at home particularly dicey right now, the Iranian government will have to proceed cautiously with any future price hikes, which are sure to be applied unevenly across the country.

Natural Gas Relief?

Iran also has an alternative-fuel plan under way that capitalizes on the country's natural gas resources and reduces its reliance on refined crude, but the results have so far been limited. The plan involves encouraging the use of compressed natural gas (CNG) for Iranian motorists. Cars that can run on CNG, which are prevalent in South Asia and Latin America, can be more economical and environmentally friendly. In fact, the price of CNG retails at around 4 cents per cubic meter (roughly equivalent to one liter of gasoline). Moreover, the technology used to compress natural gas is far less complex than that needed to refine crude. Considering that Iran is the world's fourth-largest producer of natural gas, the switch to CNG makes sense, but there is one big drawback. Vehicles must be modified to run on CNG, and CNG stations would have to be built across the country. None of this would be quick or cheap for Iran.

Nevertheless, Iran has made notable progress since kicking off its CNG plan in 2007, when Iran Khodro Industrial Group — Iran's leading automaker — invested $50 million in low-consumption, flexible-fuel engine production lines. Former Iranian Oil Minister Gholam Hossein Nozari said in July that there are currently 880 CNG stations in Iran, with plans to build an additional 400 within the next several months. Since Iran Khodro started ramping up production of CNG-capable vehicles, Iran has become the world's fourth-largest CNG-vehicle producer following Argentina, Pakistan and Brazil, according to the International Association for Natural Gas Vehicles. As of May 2009, Iranian government officials claim the official count of CNG-capable vehicles on the road totaled 1.4 million. The total number of cars in Iran was estimated to be 11.7 million in 2008, according to the Global Market Information Database. All in all, estimated fuel replacement by CNG is currently around 7 percent of Iran's total automobile fuel consumption, up from zero five years ago. While Iran seems to be making steady progress in the CNG arena, it still has a way to go before the switch to CNG would make a significant dent in the country's gasoline imports.

Responding to Pressure

When STRATFOR speaks to Iranian sources, we get the sense that the regime is feeling fairly confident in its ability to slip the sanctions noose while continuing to work on its nuclear program, using the same rhetoric it has used for the past seven years to drag negotiations into a stalemate. This continued confidence may be due to the fact that the Iranians have yet to feel the pinch of Washington's quiet campaign against Iran's gasoline suppliers. Though the energy majors appear to be dropping out of the Iranian gasoline trade, the numbers we have seen indicate that Tehran is importing surplus amounts of gasoline in preparation for tougher days to come. However, should Iran fail to outmaneuver the P-5+1 come Oct. 1, those tougher days could arrive sooner than it thinks.

In the weeks and months ahead, Israel will likely determine whether Iran and the United States are headed for a collision course in the Persian Gulf. The Israelis were promised "crippling" sanctions against Iran by the Obama administration. If that promise goes unfulfilled, and the Iranians (as they are expected to do) refuse to freeze their enrichment activities, the Israelis are likely to turn to the military option and demand Washington's cooperation. Israel understands Russia's leverage over Iran — particularly its ability to arm the Iranians with critical defense systems and sabotage a gasoline sanctions regime — and would rather deal decisively with the Iranian nuclear issue while the program is still several steps away from a critical phase.

Israel, unlike the United States, never had much faith in the sanctions to begin with. The U.S. administration appears to be operating under the assumption that severe sanctions against Iran will create a dire economic situation in the country, galvanize the masses against the clerical elite and thus coerce the regime into making significant concessions on its nuclear program. More imaginative policymakers believe that such economic sanctions could build on the dissent that followed the election and produce a third front to challenge and topple the regime. But Tehran's actual actions are unlikely to mesh nicely with Washington's preferred perception of the regime's mindset. Iran — at least for now — has no intention of meeting the West's demands to curb its nuclear program and takes the idea of resistance very seriously.

A Doomsday Scenario

Israel is willing to see how the sanctions regime plays out, but it also knows that it has a limited menu of options. If the sanctions are blown apart with Russia's help, the Iranians will obviously feel little pressure to negotiate seriously and the Israelis will have to turn to alternative options. If the sanctions prove effective because of Russian cooperation, a U.S. willingness to risk trade spats to enforce the sanctions or a combination of the two, the Iranians will be left feeling extremely vulnerable. However, that vulnerability would not necessarily bring Iran to the negotiating table. On the contrary, the Iranians are more likely to turn increasingly insular and aggressive with their nuclear ambitions. While extolling the virtues of self-sacrifice for national solidarity, the Iranian regime would begin to seriously threaten to use its "real" nuclear option — closing the Strait of Hormuz with mines and its arsenal of anti-ship missiles.

This is an option of last resort for the Iranians, but if Tehran feels sufficiently threatened, either by sanctions or potential military strikes, it could wreak havoc on the global economy within a matter of hours.

Setting ablaze the Strait of Hormuz would undoubtedly inflict intense pain on the Iranian economy, but this may be a pain that the regime is willing to bear while it watches energy prices soar and the world's industrial powers plunge deeper into recession. At such a level of brinksmanship, the United States would have to seriously consider a military campaign to preempt an Iranian move to close the strait, providing Israel with an opportunity to strike at Iran's nuclear facilities. If the United States failed to act in time and Iran succeeded in mining this critical energy chokepoint, then the U.S. military would have to clear the strait. Either way, the Persian Gulf would become a war zone and the global ramifications would be immense.

This may be a doomsday scenario, but it is one of increasing credibility given that the main players — Iran, the United States, Russia and Israel — continue to raise the stakes in pursuing their respective national imperatives. A number of questions remain: Will the United States put its trade relations on the line and aggressively enforce sanctions? Will Russia go the extra mile for Tehran and bust the sanctions regime? Can the United States and Russia reach a strategic compromise that will leave Iran out in the cold? Has Israel's patience regarding Iranian diplomatic maneuvers run out? Will Iran resort to its real nuclear option and threaten the Strait of Hormuz?

STRATFOR does not know the answers, and neither do the main stakeholders in this saga. However, come Oct. 1 these stakeholders must begin making some critical decisions that could dramatically alter the geopolitical landscape.

History lesson for economists in thrall to Keynes

John Mauldin — Tue, 09 Jun 2009 02:36:45 GMT

There is a debate in academic circles on the lessons of the current economic crisis. While most ivory tower debates are of little concern to our daily affairs, this debate should concern you, as it will inform those who hold central bank and political power. Remember, there is no playbook of rules for what to do in deflationary, deleveraging recessions. They are making it up as they go along.

Today we have a short essay by Niall Ferguson published last week in the Financial Times. It speaks for itself, and you should take a few minutes to read it.

John Mauldin, Editor
Outside the Box

History lesson for economists in thrall to Keynes

By Niall Ferguson

On Wednesday last week, yields on 10-year US Treasuries -- generally seen as the benchmark for long-term interest rates -- rose above 3.73 per cent. Once upon a time that would have been considered rather low. But the financial crisis has changed all that: at the end of last year, the yield on the 10-year fell to 2.06 per cent. In other words, long-term rates have risen by 167 basis points in the space of five months. In relative terms, that represents an 81 per cent jump.

Most commentators were unnerved by this development, coinciding as it did with warnings about the fiscal health of the US. For me, however, it was good news. For it settled a rather public argument between me and the Princeton economist Paul Krugman.

It is a brave or foolhardy man who picks a fight with Mr Krugman, the most recent recipient of the Nobel Prize for Economics. Yet a cat may look at a king, and sometimes a historian can challenge an economist.

A month ago Mr Krugman and I sat on a panel convened in New York to discuss the financial crisis. I made the point that "the running of massive fiscal deficits in excess of 12 per cent of gross domestic product this year, and the issuance therefore of vast quantities of freshly-minted bonds" was likely to push long-term interest rates up, at a time when the Federal Reserve aims at keeping them down. I predicted a "painful tug-of-war between our monetary policy and our fiscal policy, as the markets realise just what a vast quantity of bonds are going to have to be absorbed by the financial system this year".

De haut en bas came the patronising response: I belonged to a "Dark Age" of economics. It was "really sad" that my knowledge of the dismal science had not even got up to 1937 (the year after Keynes's General Theory was published), much less its zenith in 2005 (the year Mr Krugman's macro-economics textbook appeared). Did I not grasp that the key to the crisis was "a vast excess of desired savings over willing investment"? "We have a global savings glut," explained Mr Krugman, "which is why there is, in fact, no upward pressure on interest rates."

Now, I do not need lessons about the General Theory. But I think perhaps Mr Krugman would benefit from a refresher course about that work's historical context. Having reissued his book The Return of Depression Economics, he clearly has an interest in representing the current crisis as a repeat of the 1930s. But it is not. US real GDP is forecast by the International Monetary Fund to fall by 2.8 per cent this year and to stagnate next year. This is a far cry from the early 1930s, when real output collapsed by 30 per cent. So far this is a big recession, comparable in scale with 1973-1975. Nor has globalisation collapsed the way it did in the 1930s.

Credit for averting a second Great Depression should principally go to Fed chairman Ben Bernanke, whose knowledge of the early 1930s banking crisis is second to none, and whose double dose of near-zero short-term rates and quantitative easing -- a doubling of the Fed's balance sheet since September -- has averted a pandemic of bank failures. No doubt, too, the $787bn stimulus package is also boosting US GDP this quarter.

But the stimulus package only accounts for a part of the massive deficit the US federal government is projected to run this year. Borrowing is forecast to be $1,840bn -- equivalent to around half of all federal outlays and 13 per cent of GDP. A deficit this size has not been seen in the US since the second world war. A further $10,000bn will need to be borrowed in the decade ahead, according to the Congressional Budget Office. Even if the White House's over-optimistic growth forecasts are correct, that will still take the gross federal debt above 100 per cent of GDP by 2017. And this ignores the vast off-balance-sheet liabilities of the Medicare and Social Security systems.

It is hardly surprising, then, that the bond market is quailing. For only on Planet Econ-101 (the standard macroeconomics course drummed into every US undergraduate) could such a tidal wave of debt issuance exert "no upward pressure on interest rates".

Of course, Mr Krugman knew what I meant. "The only thing that might drive up interest rates," he acknowledged during our debate, "is that people may grow dubious about the financial solvency of governments." Might? May? The fact is that people -- not least the Chinese government -- are already distinctly dubious. They understand that US fiscal policy implies big purchases of government bonds by the Fed this year, since neither foreign nor private domestic purchases will suffice to fund the deficit. This policy is known as printing money and it is what many governments tried in the 1970s, with inflationary consequences you do not need to be a historian to recall.

No doubt there are powerful deflationary headwinds blowing in the other direction today. There is surplus capacity in world manufacturing. But the price of key commodities has surged since February. Monetary expansion in the US, where M2 is growing at an annual rate of 9 per cent, well above its post-1960 average, seems likely to lead to inflation if not this year, then next. In the words of the Chinese central bank's latest quarterly report: "A policy mistake ... may bring inflation risks to the whole world."

The policy mistake has already been made -- to adopt the fiscal policy of a world war to fight a recession. In the absence of credible commitments to end the chronic US structural deficit, there will be further upward pressure on interest rates, despite the glut of global savings. It was Keynes who noted that "even the most practical man of affairs is usually in the thrall of the ideas of some long-dead economist". Today the long-dead economist is Keynes, and it is professors of economics, not practical men, who are in thrall to his ideas.

The writer is Laurence A. Tisch professor of history at Harvard University and author of The Ascent of Money (Penguin)

The Geography of Recession

John Mauldin — Thu, 04 Jun 2009 21:16:46 GMT

Dear Friends:

One of the first things you learn about analyzing a company is how to dissect a balance sheet. What assets and liabilities can be deployed by a company to create equity over time? I've enclosed a fascinating variant on this process. Take a look at how STRATFOR has analyzed the "geographic balance sheets" of the US, Russia, China, and Europe to understand why different countries' economies have suffered to varying degrees from the current economic crisis.

As investors, it's precisely this type of outside-the-box thinking that can provide us profitable opportunities, and it's precisely this type of outside-the-box thinking that makes STRATFOR such an important part of my investment decision making. The key to investment profits is thinking differently and thinking earlier than the next guy. STRATFOR's work exemplifies both these traits.

I've arranged for a special deal on a STRATFOR Membership for my readers, which you can click here to take advantage of. Many of you are invested in alternative strategies, but I want to make sure that you also employ alternative thinking strategies. So take a look at these different "country balance sheets" as you formulate your plans.

Your Mapping It Out Analyst,

John Mauldin

The Geography of Recession

By Peter Zeihan

The United States and the Free Market

The most important aspect of the United States is not simply its sheer size, but the size of its usable land. Russia and China may both be similar-sized in absolute terms, but the vast majority of Russian and Chinese land is useless for agriculture, habitation or development. In contrast, courtesy of the Midwest, the United States boasts the world's largest contiguous mass of arable land — and that mass does not include the hardly inconsequential chunks of usable territory on both the West and East coasts.

Second is the American maritime transport system. The Mississippi River, linked as it is to the Red, Missouri, Ohio and Tennessee rivers, comprises the largest interconnected network of navigable rivers in the world. In the San Francisco Bay, Chesapeake Bay and Long Island Sound/New York Bay, the United States has three of the world's largest and best natural harbors. The series of barrier islands a few miles off the shores of Texas and the East Coast form a water-based highway — an Intercoastal Waterway — that shields American coastal shipping from all but the worst that the elements can throw at ships and ports.

The real beauty is that the two overlap with near perfect symmetry. The Intercoastal Waterway and most of the bays link up with agricultural regions and their own local river systems (such as the series of rivers that descend from the Appalachians to the East Coast), while the Greater Mississippi river network is the circulatory system of the Midwest. Even without the addition of canals, it is possible for ships to reach nearly any part of the Midwest from nearly any part of the Gulf or East coasts. The result is not just a massive ability to grow a massive amount of crops — and not just the ability to easily and cheaply move the crops to local, regional and global markets — but also the ability to use that same transport network for any other economic purpose without having to worry about food supplies.

The implications of such a confluence are deep and sustained. Where most countries need to scrape together capital to build roads and rail to establish the very foundation of an economy, transport capability, geography granted the United States a near-perfect system at no cost. That frees up U.S. capital for other pursuits and almost condemns the United States to be capital-rich. Any additional infrastructure the United States constructs is icing on the cake. (The cake itself is free — and, incidentally, the United States had so much free capital that it was able to go on to build one of the best road-and-rail networks anyway, resulting in even greater economic advantages over competitors.)

Third, geography has also ensured that the United States has very little local competition. To the north, Canada is both much colder and much more mountainous than the United States. Canada's only navigable maritime network — the Great Lakes-St. Lawrence Seaway —is shared with the United States, and most of its usable land is hard by the American border. Often this makes it more economically advantageous for Canadian provinces to integrate with their neighbor to the south than with their co-nationals to the east and west.

Similarly, Mexico has only small chunks of land, separated by deserts and mountains, that are useful for much more than subsistence agriculture; most of Mexican territory is either too dry, too tropical or too mountainous. And Mexico completely lacks any meaningful river system for maritime transport. Add in a largely desert border, and Mexico as a country is not a meaningful threat to American security (which hardly means that there are not serious and ongoing concerns in the American-Mexican relationship).

With geography empowering the United States and hindering Canada and Mexico, the United States does not need to maintain a large standing military force to counter either. The Canadian border is almost completely unguarded, and the Mexican border is no more than a fence in most locations — a far cry from the sort of military standoffs that have marked more adversarial borders in human history. Not only are Canada and Mexico not major threats, but the U.S. transport network allows the United States the luxury of being able to quickly move a smaller force to deal with occasional problems rather than requiring it to station large static forces on its borders.

Like the transport network, this also helps the U.S. focus its resources on other things.

Taken together, the integrated transport network, large tracts of usable land and lack of a need for a standing military have one critical implication: The U.S. government tends to take a hands-off approach to economic management, because geography has not cursed the United States with any endemic problems. This may mean that the United States — and especially its government — comes across as disorganized, but it shifts massive amounts of labor and capital to the private sector, which for the most part allows resources to flow to wherever they will achieve the most efficient and productive results.

Laissez-faire capitalism has its flaws. Inequality and social stress are just two of many less-than-desirable side effects. The side effects most relevant to the current situation are, of course, the speculative bubbles that cause recessions when they pop. But in terms of long-term economic efficiency and growth, a free capital system is unrivaled. For the United States, the end result has proved clear: The United States has exited each decade since post-Civil War Reconstruction more powerful than it was when it entered it. While there are many forces in the modern world that threaten various aspects of U.S. economic standing, there is not one that actually threatens the U.S. base geographic advantages.

Is the United States in recession? Of course. Will it be forever? Of course not. So long as U.S. geographic advantages remain intact, it takes no small amount of paranoia and pessimism to envision anything but long-term economic expansion for such a chunk of territory. In fact, there are a number of factors hinting that the United States may even be on the cusp of recovery.

Russia and the State

If in economic terms the United States has everything going for it geographically, then Russia is just the opposite. The Russian steppe lies deep in the interior of the Eurasian landmass, and as such is subject to climatic conditions much more hostile to human habitation and agriculture than is the American Midwest. Even in those blessed good years when crops are abundant in Russia, it has no river network to allow for easy transport of products.

Russia has no good warm-water ports to facilitate international trade (and has spent much of its history seeking access to one). Russia does have long rivers, but they are not interconnected as the Mississippi is with its tributaries, instead flowing north to the Arctic Ocean, which can support no more than a token population. The one exception is the Volga, which is critical to Western Russian commerce but flows to the Caspian, a storm-wracked and landlocked sea whose delta freezes in the winter (along with the entire Volga itself). Developing such unforgiving lands requires a massive outlay of funds simply to build the road and rail networks necessary to achieve the most basic of economic development. The cost is so extreme that Russia's first ever intercontinental road was not completed until the 21st century, and it is little more than a two-lane path for much of its length. Between the lack of ports and the relatively low population densities, little of Russia's transport system beyond the St. Petersburg/Moscow corridor approaches anything that hints of economic rationality.

Russia also has no meaningful external borders. It sits on the eastern end of the North European Plain, which stretches all the way to Normandy, France, and Russia's connections to the Asian steppe flow deep into China. Because Russia lacks a decent internal transport network that can rapidly move armies from place to place, geography forces Russia to defend itself following two strategies. First, it requires massive standing armies on all of its borders. Second, it dictates that Russia continually push its boundaries outward to buffer its core against external threats.

Both strategies compromise Russian economic development even further. The large standing armies are a continual drain on state coffers and the country's labor pool; their cost was a critical economic factor in the Soviet fall. The expansionist strategy not only absorbs large populations that do not wish to be part of the Russian state and so must constantly be policed — the core rationale for Russia's robust security services — but also inflates Russia's infrastructure development costs by increasing the amount of relatively useless territory Moscow is responsible for.

Russia's labor and capital resources are woefully inadequate to overcome the state's needs and vulnerabilities, which are legion. These endemic problems force Russia toward central planning; the full harnessing of all economic resources available is required if Russia is to achieve even a modicum of security and stability. One of the many results of this is severe economic inefficiency and a general dearth of an internal consumer market. Because capital and other resources can be flung forcefully at problems, however, active management can achieve specific national goals more readily than a hands-off, American-style model. This often gives the impression of significant progress in areas the Kremlin chooses to highlight.

But such achievements are largely limited to wherever the state happens to be directing its attention. In all other sectors, the lack of attention results in atrophy or criminalization. This is particularly true in modern Russia, where the ruling elite comprises just a handful of people, starkly limiting the amount of planning and oversight possible. And unless management is perfect in perception and execution, any mistakes are quickly magnified into national catastrophes. It is therefore no surprise to STRATFOR that the Russian economy has now fallen the furthest of any major economy during the current recession.

China and Separatism

China also faces significant hurdles, albeit none as daunting as Russia's challenges. China's core is the farmland of the Yellow River basin in the north of the country, a river that is not readily navigable and is remarkably flood prone. Simply avoiding periodic starvation requires a high level of state planning and coordination. (Wrestling a large river is not the easiest thing one can do.) Additionally, the southern half of the country has a subtropical climate, riddling it with diseases that the southerners are resistant to but the northerners are not. This compromises the north's political control of the south.

Central control is also threatened by China's maritime geography. China boasts two other rivers, but they do not link to each other or the Yellow naturally. And China's best ports are at the mouths of these two rivers: Shanghai at the mouth of the Yangtze and Hong Kong/Macau/Guangzhou at the mouth of the Pearl. The Yellow boasts no significant ocean port. The end result is that other regional centers can and do develop economic means independent of Beijing.

With geography complicating northern rule and supporting southern economic independence, Beijing's age-old problem has been trying to keep China in one piece. Beijing has to underwrite massive (and expensive) development programs to stitch the country together with a common infrastructure, the most visible of which is the Grand Canal that links the Yellow and Yangtze rivers. The cost of such linkages instantly guarantees that while China may have a shot at being unified, it will always be capital-poor.

Beijing also has to provide its autonomy-minded regions with an economic incentive to remain part of Greater China, and "simple" infrastructure will not cut it. Modern China has turned to a state-centered finance model for this. Under the model, all of the scarce capital that is available is funneled to the state, which divvies it out via a handful of large state banks. These state banks then grant loans to various firms and local governments at below the cost of raising the capital. This provides a powerful economic stimulus that achieves maximum employment and growth — think of what you could do with a near-endless supply of loans at below 0 percent interest — but comes at the cost of encouraging projects that are loss-making, as no one is ever called to account for failures. (They can just get a new loan.) The resultant growth is rapid, but it is also unsustainable. It is no wonder, then, that the central government has chosen to keep its $2 trillion of currency reserves in dollar-based assets; the rate of return is greater, the value holds over a long period, and Beijing doesn't have to worry about the United States seceding.

Because the domestic market is considerably limited by the poor-capital nature of the country, most producers choose to tap export markets to generate income. In times of plenty this works fairly well, but when Chinese goods are not needed, the entire Chinese system can seize up. Lack of exports reduces capital availability, which constrains loan availability. This in turn not only damages the ability of firms to employ China's legions of citizens, but it also removes the primary reason the disparate Chinese regions pay homage to Beijing. China's geography hardwires in a series of economic challenges that weaken the coherence of the state and make China dependent upon uninterrupted access to foreign markets to maintain state unity. As a result, China has not been a unified entity for the vast majority of its history, but instead a cauldron of competing regions that cleave along many different fault lines: coastal versus interior, Han versus minority, north versus south.

China's survival technique for the current recession is simple. Because exports, which account for roughly half of China's economic activity, have sunk by half, Beijing is throwing the equivalent of the financial kitchen sink at the problem. China has force-fed more loans through the banks in the first four months of 2009 than it did in the entirety of 2008. The long-term result could well bury China beneath a mountain of bad loans — a similar strategy resulted in Japan's 1991 crash, from which Tokyo has yet to recover. But for now it is holding the country together. The bottom line remains, however: China's recovery is completely dependent upon external demand for its production, and the most it can do on its own is tread water.

Discordant Europe

Europe faces an imbroglio somewhat similar to China's.

Europe has a number of rivers that are easily navigable, providing a wealth of trade and development opportunities. But none of them interlinks with the others, retarding political unification. Europe has even more good harbors than the United States, but they are not evenly spread throughout the Continent, making some states capital-rich and others capital-poor. Europe boasts one huge piece of arable land on the North European Plain, but it is long and thin, and so occupied by no fewer than seven distinct ethnic groups.

These groups have constantly struggled — as have the various groups up and down Europe's seemingly endless list of river valleys — but none has been able to emerge dominant, due to the webwork of mountains and peninsulas that make it nigh impossible to fully root out any particular group. And Europe's wealth of islands close to the Continent, with Great Britain being only the most obvious, guarantee constant intervention to ensure that mainland Europe never unifies under a single power.

Every part of Europe has a radically different geography than the other parts, and thus the economic models the Europeans have adopted have little in common. The United Kingdom, with few immediate security threats and decent rivers and ports, has an almost American-style laissez-faire system. France, with three unconnected rivers lying wholly in its own territory, is a somewhat self-contained world, making economic nationalism its credo. Not only do the rivers in Germany not connect, but Berlin has to share them with other states. The Jutland Peninsula interrupts the coastline of Germany, which finds its sea access limited by the Danes, the Swedes and the British. Germany must plan in great detail to maximize its resource use to build an infrastructure that can compensate for its geographic deficiencies and link together its good — but disparate — geographic blessings. The result is a state that somewhat favors free enterprise, but within the limits framed by national needs.

And the list of differences goes on: Spain has long coasts and is arid; Austria is landlocked and quite wet; most of Greece is almost too mountainous to build on; it doesn't get flatter than the Netherlands; tiny Estonia faces frozen seas in the winter; mammoth Italy has never even seen an icebreaker. Even if there were a supranational authority in Europe that could tax or regulate the banking sector or plan transnational responses, the propriety of any singular policy would be questionable at best.

Such stark regional differences give rise to such variant policies that many European states have a severe (and understandable) trust deficit when it comes to any hint of anything supranational. We are not simply taking about the European Union here, but rather a general distrust of anything cross-border in nature. One of the many outcomes of this is a preference for using local banks rather than stock exchanges for raising capital. After all, local banks tend to use local capital and are subject to local regulations, while stock exchanges tend to be internationalized in all respects. Spain, Italy, Sweden, Greece and Austria get more than 90 percent of their financing from banks, the United Kingdom 84 percent and Germany 76 percent — while for the United States it is only 40 percent.

And this has proved unfortunate in the extreme for today's Europe. The current recession has its roots in a financial crisis that has most dramatically impacted banks, and European banks have proved far from immune. Until Europe's banks recover, Europe will remain mired in recession. And since there cannot be a Pan-European solution, Europe's recession could well prove to be the worst of all this time around.

Long-Term Outlook: Slow Growth And Deflation

John Mauldin — Mon, 16 Mar 2009 22:07:22 GMT

This week I am really delighted to be able to give you a condensed version of Gary Shilling's latest INSIGHT newsletter for your Outside the Box. Each month I really look forward to getting Gary's latest thoughts on the economy and investing. Last year in his forecast issue he suggested 13 investment ideas, all of which were profitable by the end of the year. It is not unusual for Gary to give us over 75 charts and tables in his monthly letters along with his commentary, which makes his thinking unusually clear and accessible. Gary was among the first to point out the problems with the subprime market and predict the housing and credit crises. You can learn more about his letter at http://www.agaryshilling.com. If you want to subscribe (for $275), you can call 888-346-7444. Tell them that you read about it in Outside the Box and you will get not only his recent 2009 forecast issue with the year's investment themes, but an extra issue with his 2010 forecast (of course, that one will not come out for a year. Gary is good but not that good!) I trust you are enjoying your week. And enjoy this week's Outside the Box....

And if you have cable and get Fox Business News, I will be on Happy Hour tomorrow Tuesday the 17th at 5 pm Eastern. Have a great week.

John Mauldin, Editor
Outside the Box

Long-Term Outlook: Slow Growth And Deflation

(excerpted from the March 2009 edition of A. Gary Shilling's INSIGHT)

From 1982 until 2000, the U.S. economy enjoyed rapid growth with real GDP rising at a 3.6% average annual rate. Furthermore, this 18-year expansion, which cumulated to an 89% rise in inflation-adjusted economic activity, was interrupted by only one recession, the relatively mild 1990-1991 downturn, which depressed real GDP by only 1.3% from peak to trough.

Extended Expansion

From a fundamental standpoint, the growth spurt ended in 2000 as shown by basic measures of the economy's health. The stock market, that most fundamental measure of business fitness and sentiment, essentially reached its peak with the dot com blow-off in 2000 and has been trending down ever since (Chart 1). The same is true of employment, goods production and household net worth in relation to disposable (after-tax) income.

Nevertheless, the gigantic policy ease in Washington in response to the stock market collapse and 9/11 gave the illusion that all was well and that the growth trend had resumed. The Fed rapidly cut its target rate from 6.5% to 1% and held it there for 12 months to provide more-than ample monetary stimulus. Meanwhile, federal tax rebates and repeated tax cuts generated oceans of fiscal stimulus.

As a result, the speculative investment climate spawned by the dot com nonsense survived. It simply shifted from stocks to housing (Chart 2), commodities, foreign currencies, emerging market equities and debt, hedge funds and private equity. Investors still believed they deserved double-digit returns each and every year, and if stocks no longer did the job, other investment vehicles would. Thus persisted what we earlier dubbed the Great Disconnect between the real world of goods and services and the speculative world of financial assets.

Not Sustainable

Even before these final speculative binges, the forces driving the economy in its long expansion were unsustainable, as we've been stressing for years in Insight. These forces included the decline in the consumer saving rate and jump in consumer debt, the vast leveraging of the financial sector, increasingly freer trade and loose financial regulation, all of which are now being reversed.

In the 1980s and 1990s, American consumers were more than willing to cut their saving rate because they believed stock portfolios would continue to grow rapidly and take care of all their financial needs. Then, when stocks collapsed in 2000-2002, house appreciation (Chart 3) seamlessly took over to continue the push down the household saving rate from 12% in the early 1980s to zero. Americans saw their houses as continually-filling piggybanks because, they believed, home price appreciation would continue indefinitely. They tapped that equity freely with home equity loans and cash-out refinancing.

The flip side of saving less is borrowing more, as evidenced by the leap in all consumer debt and debt service, both in relation to disposable (after-tax) income and relative to assets. In relation to GDP, the cumulative outside financing of the household as well as the financial sector leaped for three decades, measuring the immense leveraging in these two areas. Not surprising, amidst this consumer borrowing and spending binge, consumer spending's share of GDP leaped from 62% in the early 1980s to 71% at its peak in the second quarter of 2008 (Chart 4).

The Tide Turns

Now, however, consumers have run out of borrowing power. As of the third quarter 2008, homeowners with mortgages had on average 25% equity in their abodes after all mortgage debt was removed and that number will probably drop to the 10%-15% range with the further decline in house prices we are forecasting (Chart 3). At that bottom, after a 37% peak-to-trough collapse, almost 25 million homeowners, or nearly half the 51 million with mortgages, will be under water, with their mortgages bigger than their house values. In total, the gap will be about $1 trillion.

The nosedive in stocks has also discouraged consumer spending as have mounting layoffs (Chart 5), maxed out credit cards and tighter lending standards and weak consumer confidence. Rising medical costs are also a drag on consumers as their co-pays and deductibles mount. For decades, credit card issuers and other lenders encouraged consumers to indulge in instant gratification. Buy now, pay later. But now, habits are changing. Debit cards are becoming popular since they deduct charges directly from the user's checking account and, therefore, don't increase indebtedness. Layaway plans are back in style after nearly disappearing.

Financially Unprepared

Between low saving levels in recent years and weak stock prices, few Americans are prepared financially for retirement. About 54% of 401(k) assets are invested in stocks, which fell 39% last year as measured by the S&P 500 index. And except for Treasurys, almost all other investments suffered huge losses in 2008. Around 50 million Americans have 401(k) plans, with $2.5 trillion in assets, and in the 12 months after the stock market peak in October 2007, over $1 trillion in stock value was wiped out in 401(k)s and other defined contribution plans. Another $1 trillion in IRAs was lost.

After 401(k)s were initiated in 1978, those containing stock assets appreciated in the long 1982-2000 bull market, which convinced many that they didn't need to save, as mentioned earlier. In 1983, 33% of working-age households were financially unprepared for retirement, but the number rose to 40% in 1998 as a result of lower saving and more borrowing, and to 44% in 2006 as the 2000-2002 bear market also depressed retirement funds. Obviously, with the subsequent collapse in house and stock prices, many more -- over 50% -- are unprepared. In 2007, in defined contribution accounts administered by Vanguard, the median account balance for 55-64 year-olds was just $60,740 and only 10% of participants contributed the maximum amount.

Economic Effects

As households increase their saving rate, their spending growth will slow, a distinct contrast from the decline of the saving rate from 12% in the early 1980s to zero recently. That decline, which averaged about a half-percentage point per year, meant that consumer spending grew an average of around a half-percentage point faster than disposable income annually. For the next decade, we're forecasting a one percentage point rise in the saving rate annually. That still would not return it to the early 1980s level of 12% even though the demographics for saving have gone from the worst to the best in the interim. Applying a 1.5 multiplier to account for the total destimulating effects as those dollars are saved, not spent, this means a reduction of about one percentage point in real GDP growth, from 3.6% per annum in the 1982-2000 years to 2.6%.

Although the stock bulls may salivate over the prospect that increased saving will mean more equity purchases, we believe that most of the money will go to debt repayment--the flip side of a saving spree. Note that if the saving rate rises one percentage point per year for 10 years, the cumulative increase in saving will total about $5.5 trillion. That will go a long way in offsetting federal deficits and debt.

So will the deflation that we'll explore later. Incomes may grow on average in real or inflation-adjusted terms, but shrink in current dollars. But debts are denominated in current dollars and therefore will grow in relation to incomes and the ability to service them. This will be the reverse of inflation, which reduced the value of debts in real terms and makes it easier to service them as incomes rise with inflation.

Foreign Effects

The effects, then, of a consumer switch from a 25-year borrowing-and-spending binge to a saving spree will be profound for the U.S. economy. Even more so for the foreign economies that have depended for growth on American consumers to buy the excess goods and services for which they have no other ready markets.

In 2007, U.S. consumers accounted for 18.2% of global GDP, and that share has jumped from 14.9% in 1980 and 16.8% in 1990. Furthermore, the shares of American consumer spending on durable and nondurable goods accounted for by imports from Central and South America and from the Pacific Rim have leaped since the early 1990s.

A clear result of the upward trend in consumers' share of GDP (Chart 4) and declining saving rate for a quarter-century has been the downtrend in the foreign trade and current account balances. We can't overemphasize the importance of the profligate U.S. consumer in fueling economic growth in the rest of the world, as we've discussed in many past Insights. We have also published our analysis of Asian exports. The intra-Asian trade was much bigger than the direct exports to the U.S., but when we accounted for the components produced in, say, Taiwan that were sent for subassembly to Thailand, then to Malaysia for final assembly with the finished product destined for the U.S., over half of Asian exports ended up in America.

Export-Dependent China

In late 2007, most forecasters disagreed with us and said China's economy would continue to grow at double-digit rates, and even support the U.S. economy if it softened. However, in "The Chinese Middle Class: 110 Million Is Not Enough" (Nov. 2007 Insight), we explained that China was not yet far enough along the road to industrialization to have a big enough middle class of free spenders to sustain economic growth if exports fell with U.S. consumer spending, as we were predicting.

As we noted in that report, in China, it takes $5,000 or more in per capita income to have meaningful discretionary spending. The 110 million who fit that category are a lot of people, but only 8% of China's population. In India, the middle and upper income classes are even smaller, 5%. In contrast, in the U.S. it takes $26,000 or more to have middle-class spending power, and 80% of Americans qualify. So we wrote in that report that all the cell phones and PCs being bought by Chinese was not the result of domestic economic strength, but merely the recycling of export revenues and direct foreign investment funds. And we went on to forecast that U.S. consumers would retrench, resulting in a nosedive in Chinese exports and a deep recessionary slump in China's growth.

Well, as they say, the rest is history. It now seems likely that China's earlier double-digit growth rates will slip to the 5%-6% range that would probably constitute a major recession, and probably lower. About 8% growth is needed to accommodate the vast numbers who continually flood from the countryside to the cities in search of work and better lives. Of those who went back to their villages to celebrate the recent lunar new year, 20 million didn't return because their factory jobs had vanished along with Chinese exports. Worker unrest us mounting and just as civil disturbances have ended many past Chinese dynasties, the Mao Dynasty's days may be numbered, as we've discussed in past Insights.

No Winners

With subdued U.S. consumer spending in the years ahead and the resulting weakness in American imports, economic growth abroad will be even weaker than in the U.S. Note that in previous U.S. recessions, the current account and trade balances tend to rise as imports weaken with economic activity, but exports fall less as economic growth abroad persists. That's been true of late, even though most would prefer strengthening balances from strong U.S. exports, not weaker imports. In any event, falling economies overseas are already weakening U.S. exports (Chart 6) and subdued global growth in the years ahead will probably limit the improvement in the U.S. current account and trade balances. Notice the close link between world industrial production and merchandise exports (Chart 7).

First And Last Resort

Now, with American consumers embarking on a saving spree, the U.S. will no longer be the buyer of first and last resort for the globe's excess goods and services. Furthermore, with slower global growth for years ahead, virtually every country will promote exports to spur domestic activity. Already, China has stopped allowing her yuan to rise in order to gain a bigger share of a declining pool of global exports.

Financial Deleveraging

There's no question that the financial sector is deleveraging, and its embarrassed leaders, pressured by regulators and everyone else, will no doubt continue this process for years to come. Securitization, off-balance sheet financing, derivatives and other financial vehicles that both stimulated and distorted economic activity are disappearing.

Big banks are reducing exposure to volatile proprietary trading and emphasizing safer asset management. Hence, Morgan Stanley's interest in buying Smith Barney, the brokerage unit of cash-hungry Citigroup. Furthermore, banks are cutting their financing of hedge funds by concentrating on the likely survivors in the ongoing shake-out and cutting off the rest. This will hasten the demise of many less-successful as well as smaller shops that are also at risk of investor withdrawals.

Banks are retrenching from lending to the point that corporate borrowers are turning to the bond market instead for funding. Despite government bailouts, writedowns continue to erode bank capital. Many still hold some of the leveraged loans they made to fund private equity leveraged buyouts back in the boom days. Lenders normally recover 80% on those loans when borrowers default since they rank high in the recovery pecking order. But recent bankruptcies indicate 25% recovery rates. Earlier, Japanese banks were flush with cash, but sharply lower earnings outlooks suggest they no longer will be able to provide capital to international markets.

As banks retreat to their core competencies, they're selling non-essential units. Faced with lasting fear spawned by huge losses and pressed by regulators, these institutions are retreating to basic banking 101. That's spread lending in which deposits are lent with a market-determined interest rate spread that covers costs plus a modest profit. Banks are also consolidating in response to gigantic losses and bleak outlooks. France's BNP Paribas bought the Belgium and Luxembourg assets of Fortis. Spain's Santander is acquiring full control of Sovereign Bancorp based in Wyomissing, Pa. Large consolidated financial institutions don't tend to be big risk-takers, and often lack the entrepreneurial spirit that promotes productivity and economic growth. Also, with fewer institutions, there are fewer counterparts to share risks, and that also dampens activity.

Eastern Europe

Overseas, Western banks largely financed the rapid economic growth in the former Iron Curtain countries in Europe after the Soviet Union collapsed in 1991. In addition, many companies in those lands financed their domestic businesses by borrowing Swiss francs, euros and other hard currencies at lower rates than in their own inflation-prone countries. Individuals entered the same carry trade to fund their home mortgages.

Now, however, lenders are retreating as they delever. Exports to Western Europe, another important source of growth, are falling. Eastern European borrowers need to repay $400 billion owed to Western banks this year, much of it denominated in foreign currencies. Eurozone banks have outstanding loans to Central and Eastern Europe totaling $1.3 trillion. EU leaders, led by German Chancellor Merkel, recently rejected a $240 billion bailout of Eastern Europe proposed by Hungary.

Like Asia 1997-1998

The dependence of Central and Eastern Europe on foreign financing is painfully similar to that is Asia in the 1990s that led to the 1997-1998 financial and economic collapse--except it probably will be worse this time since banks are delevering this time and weren't back then. Also, these European countries were more leveraged in 2008 than their Asian counterparts a decade ago. This can be seen in their foreign debts in relation to GDP (Chart 8) and in their current account deficit/GDP (Chart 9) as well as in their currency declines.

Asian lands reacted to the 1997-1998 crisis by cutting foreign borrowing and building foreign currency reserves. Ironically, however, they still didn't escape the current global recession and financial crisis. They're no longer as dependent on inflows of foreign capital, but this time are highly dependent on exports, which are plummeting as U.S. consumers retrench.

Commodity Crisis

The collapse of the commodity bubble will also subdue global economic growth in future years. Sure, commodity consumers benefit from lower prices as producers lose. But the share of total spending on commodity imports by consumers, especially developed lands, is tiny while they account for the bulk of exports for producers, notably developing countries.

Budget Signals

The new Obama federal budget points clearly to more government regulation and involvement in the economy. Going well beyond dealing with the deepening recession and financial crisis, the President wants $630 billion to move toward national health insurance. Businesses that emit carbon dioxide and other greenhouse gases would have to purchase permits. Another $20 billion would go for clean energy technology. The government would essentially take over student loans while eliminating private lenders, and make them entitlements with no annual limits on loan totals.

Obama also plans to increase taxes in higher-income households and capital gains and estate while redistributing money to lower-income people, even those who don't pay taxes. This reflects his populist views on the campaign trail, but with considerably more edge. The President's budget document states, "Prudent investments in education, clean energy, health care and infrastructure were sacrificed for huge tax cuts for the wealthy and well-connected. In the face of these trade-offs, Washington has ignored the squeeze on middle-class families that is making it harder for them to get ahead. There's nothing wrong with making money, but there is something wrong when we allow the playing field to be tilted so far in the favor of so few." The President's budget message also attacks "a legacy of misplaced priorities...and irresponsible policy choice in Washington."

Corporations, the energy industry, hedge funds and large farmers would also pay higher taxes while families with annual incomes under $200,000 and especially the working poor would get government checks.

The budget calls for more enforcement money for the FDA to step up drug safety rules, more for the EPA to crack down on industrial polluters, additional funds to protect endangered species and land and water conservation and to protect wildlife from climate change. More money is also requested to enforce fair housing laws and better disclosure of mortgage terms and to reverse "years of erosion in funding for labor law enforcement agencies." Employers that don't offer retirement plans will be forced to open IRAs for employees. There's also additional funds requested for enforcing workplace safety rules.

Stress Tests

Major banks are being stress-tested to determine their volatility under adverse conditions. To date, Fannie and Freddie are in conservatorship and controlled by the government. The remaining major investment banks, Goldman Sachs and Morgan Stanley are bank holding companies with Federal Reserve regulation. Is it a big surprise that Litton Loan Servicing, owned by Goldman, recently changed its strategy on mortgage modification to reduce borrowers' monthly payments to 31% of income from 38%, the industry standard?

Citigroup and BofA are, for all intents and purposes, wards of the state while the media and Washington spar over whether they will be formally owned by the government. Those two banks recently agreed to suspend mortgage foreclosures until the Treasury sets up its rescue program.

AIG is 85% owned by the Fed, which probably wishes it owned nothing of that bottomless money pit that has already absorbed $150 billion in government money. Recently, the government initiated its fourth plan to rescue AIG,which just reported a $62 billion loss in the fourth quarter. The firm is so troubled that Washington has completely backed away from its role as a stern lender that forced AIG to pay high interest rates on what it assumed would be short-term loans. Now the government is relaxing loan terms by wiping out interest in hopes of preserving some value for AIG. And it will be more involved as it splits AIG into two pieces and gets preferred shares in each entity.

Auto Bailout Payback

Beyond the financial sector, the ongoing bailout of U.S. auto producers is leading to more government intervention in that industry. As usual, he who pays the piper calls the tune. The government has already pumped $17.4 billion into GM and Chrysler, and they say they may need $21.6 billion more. GM also proposes a $4.5 billion credit insurance program for the auto parts makers. Furthermore, GMAC may need more than the $5 billion sunk into it by the Treasury last December.

Bonuses

Of all the signs of opulence carried over from the bubble years, corporate jets and big executive bonuses seem to bother Washington the most. BofA is selling three of its seven jets, a helicopter that was owned by Merrill Lynch and one of two of its New York corporate apartments. Obama wants firms that accept "extraordinary assistance" from the government to cap annual pay at $500,000, disclose pay to shareholders for a non-binding vote, claw back bonuses of corporate officials who provide misleading information, eliminate golden parachutes for those terminated and adopt board policies for luxuries such as entertainment and jets.

This reaction to big bonuses in firms that are taking huge writeoffs, losing big money and requiring massive government bailouts was predictable. From 2002 to 2008, the five largest Wall Street firms paid $190 billion in bonuses while earning $76 billion in profits. Last year, they had a combined net loss of $25 billion but paid bonuses of $26 billion.

The Trouble With More Regulation

Increased regulation may be the natural reaction to financial and economic woes, but it is fraught with problems. It's a reaction to crises and, therefore, comes too late to prevent them. And it often amounts to fighting the last war since the next set of problems will be outside the purview of these new regulations. That's almost guaranteed to be the case since fixed rules only invite all those well-paid bright guys and gals on Wall Street and elsewhere to figure ways around them.

Furthermore, government regulators have never, as far as we know, stopped big bubbles or caught big crooks. Consider the dot com and then the housing blowoffs, both of which occurred while the SEC, the Fed, other regulators, Congress, etc. sat on their hands. Think about Enron, WorldCom and Bernie Madoff, all of whom went on their merry ways until their self-induced collapses, completely free of regulatory interference.

Most importantly, government regulation and involvement in the economy is almost certain to prove inefficient. Risk-taking has been excessive, but government bureaucrats are likely to eliminate much of it, to the detriment of entrepreneurial activity, financial innovation and economic growth. Fannie, Freddie and government-controlled banks are now being directed by the government to modify mortgages to accommodate distressed homeowners. That may implement government policy, but leads to bad business decisions.

Confusion

Furthermore, if financial regulation changes massively, it probably will create confusion and uncertainty to the detriment of adequate financing, spending and investment. Some academics believe that the Great Depression was prolonged because the New Deal measures were so disruptive that banks and other financial firms as well as individual investors, consumers and businessmen were too scared to do anything. Recently, Tadao Noda, a Bank of Japan policy board member, said, "We are in a position where the central bank needs to interfere in financial markets, but if we do too much, the market functioning in turn may be hurt." In any event, major problems inexorably lead to greater government involvement. The Bush Administration was staunchly deregulatory in philosophy but forced to intervene in the financial crisis. The 20th century saw tremendous growth in government involvement in all aspects of the economy and financial markets as a result of three tremendous traumas--World Wars I and II and the Great Depression.

Protectionism

Recessions spawn economic nationalism, protectionism, and the deeper the slump, the stronger are those tendencies. It's ever so easy to blame foreigners for domestic woes and take actions to protect the home turf while repelling the invaders. The beneficial effects of free trade are considerable but diffuse while the loss of one's job to imports is very specific. And politicians find protectionism to be a convenient vote-getter since foreigners don't vote in domestic elections.

U.S. Leadership

Sadly, the U.S. appears to be among the leaders for protection of goods and services against foreign competition. The auto loan program last year under the Bush Administration largely excluded foreign transplants. Obama advocates a super-competitive economy, which requires highly productive workers. Yet the recent fiscal stimulus law restricted H-1B visas, granted to foreigners with advanced education and skills, for employees of firms that receive TARP (bank bailout) money.

Some in Congress worried that tax credits for renewable energy should be confined to American-produced equipment. And recall that during the presidential campaign, Obama called for renegotiating the North American Free Trade Agreement. Furthermore, the President's emphasis on health care, education and renewable energy turns attention inward, toward self-sufficiency and away from a global focus.

Outside the U.S., protectionism is being promoted by labor unrest. In England, workers at a French-owned oil refinery struck because Total awarded a construction contract to an Italian firm that planned to use its own staff from abroad rather than local workers. Rioters on the French Caribbean island of Guadeloupe protested high prices for food and other necessities for a month recently. High unemployment rates, especially among younger workers, have precipitated riots in Latvia, Lithuania, Greece, Russia and Bulgaria as well as France.

Competitive Devaluations

Good old-fashioned competitive devaluations to spur exports and retard imports, a mainstay of the 1930s, are making a comeback. Kazakhstan recently devalued, in part because of devaluations of her trading partners. As noted earlier, China stopped allowing her yuan to appreciate, in part because her labor costs are being undercut by countries like Vietnam and Bangladesh.

With the understanding that protectionism helped make the Great Depression "Great," country leaders still publicly espouse free trade and reject protectionism. And they express confidence that global organizations like the WTO, IMF and World Bank will forestall protectionism and economic nationalism, and they engage in endless meetings to promote free trade as well as global standards and cooperation for handling the deepening financial crisis. But almost nothing happens, as shown by the recent EU refusal to bail out Eastern Europe.

Stealth Protectionism

In any event, protectionism is returning by stealth. U.S. steelmakers plan to file anti-dumping suits against foreign producers, a strategy they have employed successfully for decades, and India recently proposed increased steel tariffs. In the first half of 2008, WTO antidumping investigations were up 30% from a year earlier. Bank bailouts have been aimed at protecting local institutions, as discussed earlier, and the Japanese government is buying stocks of Japan-based corporations to help company balance sheets, but also giving them a competitive advantage over the subsidiaries of foreign outfits.

Like America, France is aiding its own auto producers, not transplants, and has created a sovereign wealth fund to keep "national champions" out of foreign ownership. Since last November, Russia has introduced 28 import duty and export subsidies affecting steel, oil and other products as well as imposed special road tolls on trucks from the EU, Switzerland and Turkmenistan. Russia's tariff on imported cars recently rose 5 to 10 percentage points, curtailing shipments of used cars from Japan to the Russian Far East.

Meanwhile, Argentina has imposed new obstacles to imported shoes and auto parts. The EU again is giving export refunds to dairy farmers, to the detriment of New Zealand, slapped anti-dumping charges on Chinese nuts and bolts, and threatens duties on U.S. biodiesel imports in retaliation for America's export subsidies. Not to be outdone, the U.S. plans retaliatory tariffs on Italian water and French cheese in reaction to EU restrictions on U.S. chicken and beef imports in the hormones war.

Ecuador lifted tariffs across the board recently, with the levy on imported meat rising to 85.5% from 25%. Indonesia is using special import licenses to limit the inflow of clothing, shoes and electronics and also is curtailing toy imports by allowing them to enter through only a few of its ports. And there's the old standby, health and safety standards that Japan relies on consistently to keep out unwanted products.

Deflation

Long-time Insight readers know that we have been forecasting chronic deflation to start with the next major global recession. Well, that recession is here. As discussed in our Nov. 2008 Insight, deflation results when the overall supply of goods and services exceeds demand, and can result from supply leaping or from demand dropping. We've been forecasting chronic good deflation of excess supply because of today's convergence of many significant productivity-soaked technologies such as semiconductors, computers, the Internet, telecom and biotech that should hype output. Ditto for the globalization of production and the other deflationary forces we've been discussing since we wrote two books on deflation in the late 1990s, Deflation: Why it's coming, whether it's good or bad, and how it will affect your investments, business and personal affairs (1998) and Deflation: How to survive and thrive in the coming wave of deflation (1999). As a result of rapid productivity growth, fewer and fewer man-hours are needed to produce goods and services. Estimates are that 65% of jobs lost in manufacturing between 2000 and 2006 were due to productivity growth with only 35% due to outsourcing overseas.

Similar conditions held in the late 1800s when the American Industrial Revolution came into full flower after the Civil War. Value added in manufacturing leaped, and at the same time, real GNP grew 4.32% per year from 1869 to 1898, an unrivaled rate for a period that long, and consumption per consumer jumped 2.33% per year. Yet wholesale prices dropped 50% between 1870 and 1896, a 2.6% annual rate of decline. Good deflation also existed in the Roaring '20s when the driving new technologies were electrification of factories and homes and mass-produced automobiles.

The 1930s

In contrast, bad deflation reigned in the 1930s as the Great Depression pushed demand well below supply. As in the 1839-1843 depression, the money supply, prices, banks and real goods and services all nosedived. Employment dropped along with prices in the Great Depression and the unemployment rate rose to 25%. That depression was truly global.

We've consistently predicted the good deflation of excess supply, but in our two Deflation books and subsequent reports, we said clearly that the bad deflation of deficient demand could occur--due to severe and widespread financial crises or due to global protectionism. Both are clear threats, as explained earlier in this report.

Furthermore, with slower global economic growth in the years ahead due to the U.S. consumer saving spree, worldwide financial deleveragings, low commodity prices, increased government regulation and protectionism, excess global capacity will probably be a chronic problem. So deflation in the years ahead is likely to be a combination of good and bad.

Supply will be ample due to new tech, globalization and other factors we've explored over the years such as no big global wars (we hope), continual inflation worries by central bankers, continuing restructuring, and cost-cutting mass retailing. But demand will be weak, as discussed earlier. The chronic 1% to 2% deflation from excess supply that we forecast earlier still seems likely, but now we're adding 1% due to weak demand for a total of 2% to 3% annual declines in aggregate price indices for years to come.

2009 Seems Easy

For four reasons, the deflation that started several months ago (Chart 10) is quite likely to persist along with the recession, or at least until early 2010. First, the collapse in commodity prices continues and past declines are still working their way through the system. Crude oil prices have collapsed from $147 per barrel to around $40. Steel semi-finished billet prices were $1,200 a metric ton last summer but now is $350. Iron ore costs per metric ton dropped from $200 early last year to $80. It takes time for steel prices to work through to final consumer goods prices such as for washing machines.

Second, producers, importers, wholesalers and retailers were caught flat-footed by the sudden nosedive in consumer spending late last year and continue to unload surplus goods by slashing prices. All the giveaway bargains at Christmas still didn't entice enough consumers to open their wallets. Spring apparel, ordered before consumer retrenchment, is clearly in excess and being marked down before it's put on the racks. Retailers from Saks on down continue to chop prices. Branded food product manufacturers are willing to promote their wares alongside the private-label goods that supermarkets shoppers increasingly favor.

Wage Cuts

Third, wages are actually being cut for the first time since the 1930s. Previously, labor costs were controlled by layoffs, which still dominate. Benefits have also been trimmed in recent years by switching from defined contribution pensions to 401(k)s and increasing employee contributions to health care costs. Most workers are less sensitive to benefits than to salaries and wages, but the deepening recession and mounting layoffs (Chart 5) are making them more amenable to wage cuts.

So is the growing use of this approach. In a recent poll, 13% of companies plan layoffs in the next 12 months, but 4% expect to reduce salaries and 8% will cut workweeks.

So it just isn't the CEO who is taking the symbolic pay cut to deal with tough times. We argued in our Deflation books that cutting pay rather than staff is more humane, better for morale and better for keeping the organization together and ready for a business rebound. Now increasing numbers of employers agree with us.

A final reason to expect deflation in coming quarters in the U.S. is the surplus of aggregate supply over demand. Notice that the supply-demand gap is an excellent forerunner of inflation six months later. And deflation this year is spreading globally. Japan is once again flirting with falling prices, Thailand's CPI in January fell year over year for the first time in a decade. In Europe, inflation rates are rapidly approaching zero.

Prices In Recovery

The real test of deflation will come when the economy recovers--in early 2010 or later, we believe. Inflation rates normally fall in recessions, but then revive when the economy resumes growth. This time, inflation rates started low, so declines into negative territory are normal, especially given the severity of the recession and the collapse in energy and other commodity prices. If we're right, however, aggregate price indices like the CPI and PPI will continue to drop in economic recovery and verify the arrival of chronic deflation.

Few agree with us. They've never seen anything but inflation in their business careers or lifetimes, so they think that's the way God made the world. Few can remember much about the 1930s, the last time deflation reigned. Furthermore, we all tend to have inflation biases. When we pay higher prices, it's because of the inflation devil, but lower prices are a result of our smart shopping and bargaining skills. Furthermore, we don't calculate the quality-adjusted price declines that result from technological improvements. This is especially true since many of those items, like TVs, are bought so infrequently that we have no idea what we paid for the last one. But we sure remember the cost of gasoline on the last fill-up a week ago.

Too Much Money?

The main reason most expect inflation to resume, however, is because of all the money that's being pumped out by the Fed and other central banks as well as the Treasury to finance the mushrooming federal deficit. When the economy revives, they fear, all this liquidity will turn into inflationary excess demand.

At present, the Fed's generosity isn't getting outside the banks into loans that create money.

When cyclical economic recovery finally does arrive in 2010 or later, it will probably be sluggish and lenders will still likely be cautious, as discussed earlier. Furthermore, any meaningful increase in loans will probably continue to be more than offset by the continual destruction of liquidity as writedowns, chargeoffs, elimination of derivatives, etc. persists for years. Derivatives represent liquidity. You can't use them at the grocery store, but at least until recently, they were interchangeable from money in many uses.

In Sum

The deepening recession and spreading financial crisis is the beginning of the unwinding of about three decades of financial leverage and spending excesses. The process will probably take many years to complete as U.S. consumers mount a decade-long saving spree, the world's financial institutions delever, commodity prices remain weak, government regulation intensifies and protectionism threatens, if not dominates. Sluggish economic growth and deflation are the likely results.

A. Gary Shilling's INSIGHT - March 2009
Telephone: 973-467-0070

China: Exports Drop

John Mauldin — Thu, 12 Mar 2009 18:50:19 GMT

Dear Friends:

When I read the headline, "China: Exports Drop," plastic toys, cheap sneakers and milk scandals come to mind. But the impact of China's financial health is more far-reaching than simply affecting the Wal-Mart consumer; China matters on a global investing stage. So that's why I don't just read headlines; I read STRATFOR. My friend George Friedman's team of analysts will take the numbers and explain to me what they mean and how they impact the country, without bias or partisanship. They don't make value judgments, they outline the full financial picture so I can make my own.

Understanding China is critical to anyone with investments. In the following piece, STRATFOR graphically presents the decline in exports in a historical context, and outlines other critical measurements in the Chinese economy -- giving me the frame of reference I need. I highly recommend that you start reading STRATFOR for this kind of focused analysis. George has kindly arranged a special offer just for my readers: a full year of Membership for just $199. Click here to take advantage of this offer today.

I read STRATFOR because I only want to know what's important and why.

Yours,
John Mauldin

China: Exports Drop

March 11,2009 | 1651 GMT

China's exports in February fell by 25.7 percent from a year earlier, dashing expectations that the country's crucial export sector would hold up better after January's 17.5 percent slowdown in export value, according to China's customs bureau on March 11. The sudden and sharp drop reveals that China's most critical source of business and government revenues are far from recovery and are running dry due to depressed global demand.

In the past few weeks, the Chinese government and state press have drawn attention to signs that the domestic economy is improving. Bank lending increased substantially in January and February in support of struggling businesses and consumers, as well as government-prompted development projects. The purchasing managers index (PMI), a rough measure of overall manufacturing activity, climbed for the last 3 months to a reading of 49 in February, and the government is predicting positive growth of 54 percent in March. (A reading above 50 indicates growth, while one below 50 indicates contraction.) Even in the February export news released March 11, the losses are allegedly offset by a 26.5 percent increase in January's and February's fixed asset investment, slightly over the 2008 growth rate of 26.1 percent, possibly indicating that fiscal stimulus policies are having an effect.

Nevertheless, exports are vital for the Chinese economy, comprising about 40 percent of gross domestic product (GDP). By means of robust trade surpluses, China manages its day-to-day expenditures and puts away foreign currency reserves in case things get worse. February's trade surplus, however, fell to a mere $4.84 billion, down from $39.1 billion in January. China still retains its nearly $2 trillion in reserves to resist the economic downturn, but it is reluctant to tap this last resort and prefers to rely on trade surpluses — which are now dwindling.

February's export numbers do not bode well for China's recovery — the similarly drastic 24.1 percent drop in imports also indicates how badly domestic demand has been struck, especially given the vast amount of effort Beijing has devoted to trying to increase that demand. China's latest trade data, while not complete, reveal the increasingly high toll that the global recession is taking on the Chinese economy. Ultimately, the pain in China's export sector will contribute to social problems that are already bubbling up from unemployment. This in turn will increase the heat on the Communist Party as it steps up security efforts and tries to maintain order.

Where Will the Growth Come From?

John Mauldin — Mon, 09 Feb 2009 19:51:28 GMT

One of my most significant learning experiences came from a basic forecasting mistake. Back in 1998, I looked at 40 years of documented evidence that 50% of all large programming projects ended up coming in late. That set of data was consistent over all industries and over decades. I checked it out with industry experts. I really did my homework. And thus I said that the Y2K bug would be a problem, as a sufficient number of corporations around the world would have bugs that would create supply and management problems, which would slow the economy down. I did not suggest that we would see blackouts or major problems, just enough to slow things down and, when coupled with other macro issues (like the tech bubble), could trigger a recession. We had the recession, so my investment advice actually turned out to be right (lucky?), but it was not caused by Y2K.

Almost 100% of the Y2K fixes came in on time. From a metric that said 50% was the norm, we went straight to 100%. What caused the change? I had a debate with (my good friend) the late Harry Browne, who many of you will remember as a very wise investment counselor, multi-book best-selling author, two-time presidential nominee of the Libertarian Party, gold bug, and from the school of Austrian economics. He said that Y2K would be a non-event. When presented with my marshaled facts, he said, "John, each company will figure out what it has to do to survive. That is the way markets work." And sure enough, faced with extinction if they failed, it seems that CEOs found ways to get the programmers to meet a very clear deadline. Besides knowing they fudged deadlines in the past, we now know if you hold a gun to their heads and give them resources, they can in fact perform.

Why this comment to open today's Outside the Box? Today we read a piece sent to me by my friend Louis Gave of GaveKal (and who will be at my conference in April). It is entitled "Where Will the Growth Come From?" It reminds us of the lessons that Harry gave me. Each person and company is responsible for their own part of the recovery. You can't rely on mass statistics, or you miss the important lesson in individual responsibility.

I don't think anyone can accuse me of being bullish the past few years. Interestingly, I get a lot of emails from people telling me the end of the world is coming, and deriding my longer-term optimism. They are convinced we are going into some deep national morass worse than the Great Depression (and such deflationary times will somehow make their gold go to $3,000!?!?). Yet they are working to make sure their own personal worlds are covered. I get no letters from people who are simply giving up. What company will keep a CEO who does not work hard to figure out how to keep the company alive? If you lose your job, do you not try and get another one or figure out how to make ends meet? Do you not put in extra hours to try and make your personal life or business or job better? Even if it is terribly difficult, the very large majority of people don't throw in the towel. Each of us, in our own way, gets up every morning to fight the good fight, even when the swamp is full of more alligators than we ever counted on. We just pick up a baseball bat, wade into the swamp, kill as many alligators as we can in one day, and then go home to get ready to fight the next day.

The lesson from Harry is the same as it was in 1998: It is the individual working to get his or her own house in order that will help us all collectively get our national house in order. This is not to diminish the Herculean tasks we have in front of us, collectively. We have dug ourselves into a very deep hole of credit and leverage. It is going to take lots of time. The way back is not entirely clear at this point. This is not an ordinary business-cycle recession. But each of us will do what we can to make our small corner of the world better. And in the fullness of time, we will collectively get back to trend growth and a rational market.

Of course, we will then find we have other problems to face. There is no nirvana. There will always be more problems. But that's what a free-market collection of motivated individuals does: We face problems and solve them to the best of our ability. And as a group, the clear path for centuries is one of growth and progress. Cautious optimism is the proper long-term stance.

So, today Louis speculates about what sectors might come back first, and offers a good lesson in economics along the way. I think you will enjoy this Outside the Box, unless you just want to believe in the end of the world.

John Mauldin, Editor
Outside the Box

Where Will the Growth Come From?

In a book written in 2005 and entitled Our Brave New World (now out of print but available for free download from our website), we argued that the defining feature of the global economy was overcapacity. Back then, it was hard to fully appreciate the overcapacity that existed in the world, and in the subsequent years, we can not remember how many debates we had with clients trying to dispel the notion that the world was going through simultaneous "peak oil", "peak copper", "peak wheat", etc. One of the pillars of our case was that what was masquerading as consumption was really investment; global growth dynamics were running full steam, and OECD manufacturing capacity was very quickly being replaced by ASEAN capacity. Fast forward to today, and with production now collapsing at unprecedented rates around the world, the overcapacity to produce everything is now blindingly obvious. In the race to the bottom:

The International Labor Office recently warned in its annual report that 51 million jobs are likely to disappear by the end of 2009 as a result of the economic slowdown, pushing the global unemployment rate to 6.5% by the end of the year.
The IMF warned that global growth would slow to 0.5% this year, well below the 2.5% typically used to define a global recession.

We could go on but our readers know the dismal stats by heart. Everywhere one cares to turn to, one finds recession, and a grim economic outlook and nowhere more so than in the US where overcapacity is manifest in falling capacity utilization and declining employment. We combine these variables in what we call Economic Utilization (which is just capacity utilization minus unemployment) and compare that to the OECD's output gap measure for the US. As the chart below makes clear, given the continued rise in the unemployment rate and drop in and capacity utilization, predicting a much deeper drop in the output gap is not really heroic:

Most investors have a natural tendency to project their most recent experiences far out in the future. Thus, we probably should not be surprised that the question on everyone's lips today is "where will the growth come from". And undeniably, answers to that question are hard to find - which means that we should probably go "back to basics" in a bid to identify the winners of the next cycle.

1- A Quick Theoretical Primer on Different Growth Models

In his Law of Eponymy, statistician Stephen Stigler wrote that "no scientific discovery is named for its original discoverer". As far as we can tell, this is definitely true of economics!

Take the notion of "comparative advantages" as an example. It was first introduced by Robert Torrens in 1815 in Essays on the External Corn Trade but it was David Ricardo who formalized the idea in On the Principles of Political Economy and Taxation in 1817. And the idea, like all good economics idea, was simple enough: Ricardo showed conclusively that a country can gain from trade even if it is technologically inferior in producing every good. Instead, a country is said to have a comparative advantage in the production of a certain good if it can produce that good at a lower opportunity cost than any other country. And by introducing this notion of relative opportunity cost, Ricardo identified the first potential source of growth for an economy: the rational reorganization of production that results when an economy moves form a state of autarky to one where trade becomes the norm, whether through better infrastructure, lower barriers, less regulations etc... In our research we have called such impetus the "Ricardian growth".

Or take the notion of "creative destruction" which we all associate with Joseph Schumpeter's explanations that it is the entrepreneur's job to break out of the steady-state circular flow of the economy and develop new methods, techniques, and products and which, as highlighted in Our Brave New World (calling it Schumpeterian growth), is the second pillar on which economic growth rests. That notion was actually first developed by Johann Heinrich von Thunen who transformed the incomplete marginalism of classical Ricardian theory into comprehensive neoclassical marginal productivity. Indeed, Ricardo assumed that there was only a single factor of production—labor. But this does not account for improvements in capital, nor for a deepening of the capital base. Thunen was the first to treat labor and capital symmetrically, showing that each is subject to diminishing returns and that labor's marginal productivity is an increasing function of the quantity of capital per worker. Thunen's work on capital deepening and the resulting productivity addressed the chief shortcoming of the mistaken Malthusian and Ricardian prophecies of doom.

In his book Isolated State, Thunen also wrote the first algebraic production function—a set of recipes or techniques for combining inputs to produce output. His original algebraic production function, it turns out, is basically the same as the well known Cobb-Douglas production function, created in 1927 by University of Chicago economist Paul Douglas and Amherst mathematics professor Charles Cobb. And further confirming Stigler's rule, Robert Solow also built on the work of the Cobb-Douglas duo, creating the Solow Growth Model, for which he won the Nobel prize in 1990. The Solow Growth Model is the most modern and simple algebraic production function one can use to illustrate the different foundations for growth. The equation is simply:

q = Ak.5, where:
q = output per worker
A = multifactor productivity
k = capital per worker

This equation gives us a simple tool to illustrate economic growth based on capital accumulation, productivity, or some combination of the both. In other words, it helps us understand the constraints on growth offered by Ricardo and the opportunities for growth offered by Schumpeter.

2– The Concrete Use of Multi-Factor Productivity

Consider, in our first example, a country like China that has recently moved out a state of autarky and is saving, and accumulating capital, furiously. For illustration sake, let us say that China is not yet generating multi-factor productivity (MFP) as it is still figuring out how to organize its enterprises and is still learning how to use its capital efficiently. Still, despite the lack of MFP, China's output is still growing at a very rapid pace due to the low starting point and a rapid accumulation of capital financed by a very high savings rates (25% in our example). But, in due course, rapid growth rates slow and, within twelve periods, output per worker grinds to a halt, resulting in the stationary state that Ricardo predicted. From that point onwards, growth becomes solely a function of workforce growth, i.e.: demographics.

Now, let us consider a second example of a country like the United States with a lower rate of capital accumulation, say 15%, but MFP of 1%. In such a case, output very quickly falls, but it never falls to zero. For as long as the US maintains a MFP rate of 1%, output per worker—or labor productivity—remains at 2%. Combined with a small incremental growth of the workforce of say 1%, the US can thus maintain 3% GDP ad infinitum.

From the above two examples it is easy to understand:

Why the growth dynamics of countries like China (or other emerging markets) are so different from those of mature economies like the US or Europe.
Why productivity growth is so important for a country to achieve as it opens the door to endless growth and wealth creation.
Why emerging economies need to have high savings rates, while developed economies need to have sustained productivity.

While the Solow growth model is designed to take a macro-economic perspective looking at countries, it is easy to translate the ideas into micro-economic terms looking at companies. Companies generating sustainable productivity growth have, in theory, limitless growth as the continuous achievement of multifactor productivity allows for infinite capital accumulation, output and wealth creation. And this brings us back to the pet theory that ran through Our Brave New World, namely the fact that a new business model has emerged (in our book, we called it the "platform-company" business model) whereby companies increasingly focus on the processes in which they have the most value-added and outsource the rest.

3– The Emergence of Platform Companies

Our work on platform companies has led us to some simple conclusions that we will briefly reiterate:

Platform-companies have fractionalized their production process, keeping knowledge intensive activities like design and distribution in-house, while outsourcing low-value added physical production. For those companies that still have significant manufacturing assets, they are devoted to complex processes or products, where knowledge is embedded in the fixed capital.
Platform-companies have worked furiously to develop new products, new markets, and new products for new markets. The US in particular has been very aggressive about investing in foreign countries. Foreign direct investment accounts for some 10% of total nonfinancial corporate assets and generates some $4.7 trillion a year in sales and some $700 billion a year in earnings.

Platform-companies have piled up huge cash hoards as they optimize supply chains and monetize productivity. Due to the backward tax laws, US multinationals have hundreds of billions of dollars stored up in overseas bank accounts. It is estimated that the nine largest US pharmaceutical companies alone have $113 billion stashed abroad. US companies have so much money squirreled away that Allen Sinai of Decision Economics concluded that, if the US lowered tax rates temporarily on repatriated earnings, companies would repatriate US$545 billion. There is a precedent for this: we saw US companies bring home $360 billion in 2004 as a result of the temporary 5% tax rate contained in the American Jobs Creation Act.

The net result of all this is that platform companies are productivity passthrough vehicles that monetize the continuous evolution of the global production possibility frontier. In other words, platform companies are the beneficiaries of both Ricardian and Schumpeterian growth.

4– Platform Companies & the Financial Crisis

As everyone knows, one feature of the current financial crisis has been a complete evaporation in trade finance. Letters of credit to secure shipping have become hard to come by and local producers have suddenly found it challenging to secure financing from local banks. And while this is undeniably a consequence of the global credit crunch, it is also a side-effect of the overcapacity discussed above. In the current environment, no one wants to take the risk of a ship full of rapidly depreciating widgets making their way from Shenzhen to Long Beach. As a result of these new trends, the Institute for International Finance, a Washington association of international financial firms, estimates that private capital flows to emerging markets will tumble over 60% in 2009 to $165 billion, further exacerbating the global squeeze.

Undeniably this new landscape presents both challenges and opportunities for astute platform companies and the question now has to be how platform companies navigate, and thrive, in this tricky environment? As we see it, there is tremendous opportunity for platform companies to take advantage of the dislocations now prevalent in the global economy. These companies can further their aspirations through any of Peter Drucker's three conditions for success:

Businesses Can Improve. A good example here would be IBM, who, faced with the current highly challenging environment, has chosen to make its current offerings more efficient rather than embark on the more costly endeavor of developing something entirely new. In recent months, IBM has found a number of new uses for old software that was originally designed to help casinos apprehend card counters; now, with minor modifications, the same software is used to monitor immigration in both the US and UK. Another system, developed to mitigate traffic congestion in Stockholm, has been adapted to function in London and Singapore. In a similar fashion (pardon the pun), American Eagle has taken steps to trim 4-8% from its pergarment manufacturing costs by moving its production from Chinese factories to cheaper labor markets in Southeast Asia. And with the collapse in transportation costs, some embroidering and bead work will further move to India to help cut costs.
Businesses Can Expand. The decision to expand into new markets also presents significant prospects for companies like Wal-Mart, Coca-Cola, Inditex, H&M, Fast Retailing and many others. Wal-Mart (not to mention other retailers) is on a rather aggressive expansion schedule in international markets, with plans to add more square footage abroad in the next year than in the U.S. With a new, internationally-focused CEO, Wal-Mart plans to add 80-90 new stores in Brazil as well as continue expansion in second-tier Chinese cities (the company already has 217 retail units in China) in an effort to boost its international sales, which currently account for about 24% of its total sales. Coca-Cola is yet another example of a business that is surviving in spite of the downturn. In Russia, for example, the company's impressive distribution system stocks some 480,000 stores—a critical asset in a time where many distributors are unable to secure credit in order to deliver goods. And, to take advantage of falling advertising rates across the country, Coke has opted to maintain its ad budget in the hopes of increasing its market share. Then there is Inditex, Fast Retailing and H&M—all apparel retailers planning to continue growing, each opening hundreds of new stores from Cairo to Beijing to Singapore in order to take advantage of the current, rather favorable, leasing terms.
Businesses Can Innovate. Finally, platform companies can choose to innovate their way to achievement. Both Cisco and SAP appear ready to delve into the world of cloud-computing and software as a service. Cisco's potential foray into the computer market have spurred discussion of the commoditization of computers and networking. In its response to the economic slump, SAP has plans to allow users to pay for and use specific pieces of the product, rather than an entire system. As large, maturing tech companies, Cisco and SAP are seeking other avenues of growth; this volumemonetizer, platform company-esque strategy highlights the increasing importance of cloud computing. In a similar vein, Siemens plans to offer lowcost products—simpler versions of goods, based on the same technology as their high-tech counterparts—in the hopes of capitalizing on faster growing markets such as China and India. Capitalizing on Clayton Christensen's concept of low-end disruptive innovation, it can't hurt to sell those same lower-cost products in newly budget-conscious developed markets, too; when the production costs are kept low by manufacturing them in countries where labor is relatively cheap, margins can look the same as those of more sophisticated designs.

In a combination of each of these three attributes, we are hearing rumblings that a large, U.S. multinational household retailer, started last week to offer guarantees and financing to its Chinese manufacturers, in exchange for heavy discounts on current finished inventories and future production. Additionally, this company is actively buying inventories from bankrupt firms at deep discounts. Far from being deterred by today's extraordinary circumstances, the company is seizing the opportunity to improve its procurement efficiency, strengthen its supply chain, advance its open innovation, and possibly gain a better foothold in the local market.

5- Conclusion

The platform model came to the fore a little over a decade ago as: 1) information and communications prices plummeted, 2) global trade soared and 3) global capital flows surged. This convergence of factors enabled emerging economies to specialize, accumulate capital, and establish new comparative advantages, leading to a dramatic increase in the efficiency of global production. This process also triggered an accelerating pace of creative destruction among the world's developed countries, raising the stakes on the achievement of multi-factor productivity.

The current financial crisis is the first real test of the twin Ricardian and Schumpeterian growth dynamics that gave rise to the platform business model and the growth trends that we have witnessed in recent years. And today, most of our clients seem to believe that the crisis actually marks the death-knell of the model; the coming years are bound to be marked by growing protectionism, collapsing productivity and consequent economic misery.

We disagree and instead believe that recent evidence suggests that, far from being the beginning of the end for the platform-company model, we are simply going through the end of the beginning. With every day that goes by bringing another spate of earnings disappointments, bankruptcies, and examples of mismanagement, it would seem intuitive to expect corporate behavior to reflect these grim times, with companies retreating, retrenching, and regressing. But, in recent weeks, we have started to pick up on examples of the exact opposite, as the well-capitalized platform companies have used this period of turbulence to position themselves for the next phase of growth.

Our bet is thus that the platform model itself will emerge stronger from the current crisis, and play a larger role in future global economic development than most investors currently believe. Globalization is far from dead and the companies that are positioning themselves today to reap its rewards will be the winners of tomorrow.

Geithner, China, and the Specter of Technical Insolvency

John Mauldin — Mon, 26 Jan 2009 22:28:30 GMT

This week I bring you two different articles as an offering for Outside the Box. As a way to introduce the first, let me give you the quote from Merrill Lynch economist David Rosenberg about the rising threat of global trade protectionism:

"The Financial Times weighs in on the rising threat of global trade protectionism in today's Lex Column on page 14 ("Economic Patriotism"). The FT points out that the stimulus packages of many countries include "buy local" provisions. At home, there is a proposed inclusion of a 'Buy American' provision in the economic recovery package and this could set off trade retaliation from importers of US goods. Here is what the FT had to say, 'It was trade protectionism that made the 1930s Depression "Great". Congress would do well to understand that it is in everyone's interest to keep trade open today.'"

I have long written that the one thing that could derail my Muddle Through (at least eventually) view point is a return to trade protectionism. Nothing could be more devastating to the hopes of a recovery. Nothing could more surely turn a recession into a depression, and a global one at that.

David Kotok of Cumberland Advisors notes the very real problem with Tim Geithner's written testimony, threatening China and calling the manipulators, clearly making the point that this is Obama's policy. I did not have time to touch last Friday on the dangerous policy if it is that and not just rhetoric, but David says everything I would want to say and does it shortly and eloquently.

Second, several people requested a chance to look at the actual paper I cited in last week's Thoughts from the Frontline by Nouriel Roubini and Elisa Parisi-Capone of RGE Monitor (www.rgemonitor.com) on how they come up with an estimated potential loss of $3.6 trillion dollars in the US financial system. It makes for rather grim reading, but they go sector by sector to show where the losses are coming from.

Tomorrow I will hold my first "conversation" with Ed Easterling and Dr. Lacy Hunt. To find out more about how to listen in and still get the half price discount for the rest of this week at https://www.johnmauldin.com/newsletters2.html. Just enter the code JM44 when asked. Have a great week.

John Mauldin, Editor
Outside the Box

Geithner, Obama and China

By David Kotok

Following Treasury Secretary designee Tim Geithner's public confirmation hearing, an extensive Q & A occurred in writing. We have posted a copy of the US Senate Finance Committee's 100-page text on our website. See: http://www.cumber.com/special/geithnerquestions2009.pdf. This is must reading for any serious investor, economist, strategist, analyst, or observer. In this text you will find what is on the minds of the Senators, and you will gain insight into the policies that will be forthcoming from the Obama administration.

One telling example is found in the following quote that has already created international consternation. Geithner twice answered questions about currency and China. In so doing he has placed the Obama administration squarely in the middle of the tension between the United States and the largest international buyer and holder of US debt: China. This happened as the same Obama administration is unveiling a package that will add to the TARP financing needs and the cyclical deficit financing needs and cause the United States to borrow about $2 trillion this year. Two trillion dollars of newly issued Treasury debt -- and this is how the question was answered. Not once but twice.

Geithner (on page 81 and again on page 95) answered: "President Obama -- backed by the conclusions of a broad range of economists -- believes that China is manipulating its currency. President Obama has pledged as President to use aggressively all the diplomatic avenues open to him to seek change in China's currency practices."

"Manipulation?" "Aggressively?" This is strong language. Geithner did not do this on his own authority. These are prepared answers. He is citing the new President, not once but twice.

China's response was fast and direct. China's commerce ministry said in Beijing that China "has never used so-called currency manipulation to gain benefits in its international trade. Directing unsubstantiated criticism at China on the exchange-rate issue will only help US protectionism and will not help towards a real solution to the issue."

Are we seeing the world's largest and third largest economies calling each other names in the middle of a global economic and financial meltdown?

The world is in recession. The economic growth rates in the major and mature economies are now negative numbers. In China the growth rate is at least 4 and maybe as much as 8 points below last year. All the governments of the world that are running deficits are enlarging them in order to finance stimulus packages. Their central banks are bringing the policy interest rates toward zero. Trillions will need to be borrowed by those governments. Either they will be financed by the outright massive printing of money through the central bank mechanism, or they will be financed by those in the world who have savings. China is the largest single holder of financial savings in the world. Japan is next.

Why are we picking a fight with China? The implied question is why are we alluding to one with Japan, whose currency is currently the strongest of the G4 majors? In a world where global finance is mostly in US dollars, British pounds, euros, and yen, this is engaging in a dangerous sport.

The pound has lost one third of its value against the dollar since the crisis began. It is destined to weaken more. The euro struggles because of the structural issue of having to conduct monetary policy in the sovereign debt of the various euro zone member countries. The gap between those sovereign interest rates has reached nearly 3% between the weakest and strongest. This is an extremely difficult task for the European Central Bank to manage.

And Japan is getting killed by the flight to the strong yen. Japan will intervene soon to weaken the yen; they have as much as said so. The yen is strengthening against the Chinese Yuan; that is Japan's largest trading partner. The yen is 1.5 standard deviations above the JPY/USD exchange rate. It is nearly 3 standard deviations above the JPY/EUR cross rate that has been established during the ten years the euro existed. And it is over 3 standard deviations above the JPY/GBP cross rate.

So that leaves the dollar likely to get stronger. Right now it is the default choice of the world. We have currency strength not because we are so desirable but because we are currently better than the others. All bad; we're not as bad as they are. Or all bad and the others are even worse.

So what do we do within 72 hours of launching the Obama administration that says it is seeking "change?" We fire the first public salvo in what could easily become a trade war or a threat to global financial integration.

What makes us so credible? Is it our proven record of regulatory oversight of our financial markets, as demonstrated by the Madoff scandal and the SEC? Is it the way our rating agencies work so diligently to place a coveted "AAA" on paper that was peddled to the rest of the world and was found out to be highly toxic? Is it the way we honor the promises of federal agencies by having tier-one-eligible Fannie and Freddie preferred held in the US and abroad by institutions, and then essentially cause a structural default on that preferred (actually, dividend suspension)? Or is it the way the actions of Treasury and the Federal Reserve allowed a primary dealer (Lehman) to fail, thus triggering a global contagion?

C'mon? Where is the plan to restore confidence and credibility and transparency and consistent policy for the United States? And how does the Obama administration believe that launching a fight with China is beneficial?

In the 1930s the severe recession of 1929-1931 was turned into the depression of 1931-1933 because of protectionism. Every historian knows that. Every economist learns it in school. This is well-known by Geithner and even better-known by Larry Summers and Paul Volcker. They are the three members of the Obama economic troika.

The statement Geithner repeated twice was certainly known to them in advance. Why did they not temper it? What is the plan? Do they want to threaten and see if China backs down? This, too, is dangerous. Do they intend to pursue the Schumer tariff scheme? There are more questions than answers.

Lastly, Larry Summers was going to attend the World Economic Forum in Davos, Switzerland. He has cancelled. Why? Was it because he did not want to have to face the private conversations that would follow such statements as have been made by Geithner in the name of the President?

Watch Davos closely. And remember that the absence of statements is as revealing, if not more so, than the presence of them. Not one mention of trade openness appears in our reading of the 100 pages of answers to the Senate. Maybe someone else can find an affirmation of free and open trade. I cannot.

We fear protectionism. It starts with rhetoric. We now have that threat. If it is pursued, it ends badly for everyone. No one wins.

Geithner's answers are sobering. We are now in the realm of fiscal policy and national policy. This is not in the realm of the central bank; the Federal Reserve is not the player here. The Fed is doing all it can to unfreeze the financial system and restore it to functionality. If permitted to complete its task, that policy will work. If stymied or corrupted by conflicting policy in trade or federal finance, the recession will worsen and the pain will become more severe.

Specter of Technical Insolvency for the Banking System Calls for Comprehensive Solution

By Nouriel Roubini and Elisa Parisi-Capone

Back in February 2008, we at RGE Monitor warned that that the credit losses of this financial crisis would amount to at least $1 trillion and most likely closer to $2 trillion.

At that time such estimates were derided as being exaggerated as the market consensus at that time was around $200-300 billion of subprime mortgage related losses. But we pointed out that losses were not limited to subprime mortgages and would rapidly mount -- following a severe US and global recession -- to near prime and prime mortgages, commercial real estate loans, credit card loans, auto loans, student loans, leveraged loans, muni bonds, industrial and commercial loans, loans to real estate developers and contractors, corporate bonds, CDS and the securities (MBS, CDOs, CMOs, CPDOs, and the entire alphabet soup of derivative instruments) that -- via securitization -- represented claims on these underlying loans.

Soon enough, market estimates of loan and securities losses mounted: by April 2008 the IMF estimated them to be $945 billion; then Goldman Sachs came with an estimate of $1.1 trillion; the hedge fund manager John Paulson estimated them at $1.3 trillion; then in the fall of 2008 the IMF increased its estimate to $1.4 trillion; Bridgewater Associates came with an estimate of $1.6 trillion; and most recently, in December 2008, Goldman Sachs cites some estimates close to $2 trillion (and argues that loan losses alone may be as high as $1.6 trillion and expects a further $1.1 trillion of loan losses ahead).

In mid-November 2008, the threshold of $1 trillion in global financial writedowns was finally reached. Thus, as we argued throughout 2008, our $1 trillion estimate was only a floor - not a ceiling - for eventual losses and our upper range of $2 trillion would become more likely.

We have now revised our estimates and we now expect that total loan losses for loans originated by U.S. financial institutions will peak at up to $1.6 trillion out of $12.37 trillion loans . Our estimates assume that national house prices will fall another 20% before they bottom out some time in 2010 and that the unemployment rate will peak at 9%. If we include then around $2 trillion mark-to-market losses of securitized assets based on market prices as of December 2008 (out of $10.84 trillion in securities), total losses on the loans and securities originated by the U.S. financial system amount to a figure close to $3.6 trillion.

U.S. banks and broker dealers are estimated to incur about half of these losses, or $1.8 trillion ($1 -1.1 trillion loan losses and $600-700bn in securities writedowns) as 40% of securitizations are assumed to be held abroad. The $1.8 trillion figure compares to banks and broker dealers capital of $1.4 trillion as of Q3 of 2008, leaving the banking system borderline insolvent even if writedowns on securitizations are excluded.

Arguably, mark-to-market losses on private sector securitizations have so far been largely compensated for by increased activity in the government-sponsored sectors, but mark-to-market writedowns may become a more important factor going forward for bank capitalizations and credit provision to the private sector (see discussion in Hatzius (2008))

Moreover, even assuming that securitized assets may have fallen in value excessively because of a liquidity premium -- rather than credit risk alone -- we still get very large losses. Assume -- generously -- that securities are now underpriced because of illiquidity and that market losses will be eventually 20% lower than we currently estimate because of such temporary factors. Then writedowns on market securities would be $1.6 trillion rather than $2 trillion and total credit losses would be $3.2 trillion rather than $3.6 trillion.

In this paper we argue that, in order to restore safe credit growth, the U.S. banking system thus needs an additional $1 -- 1.4 trillion in private and/or public capital. These magnitudes call for a comprehensive solution along the lines of a 'bad bank', or preferably a restructuring of the financial system through an RTC or our through our HOME proposal.

Loss Estimates

Our data on outstanding loan and securities amounts are as in IMF Global Financial Stability Report, Table 1.1, as well as the weights in assigning loss shares to banks and non-bank (see data in Appendix 1).Different from the IMF which focuses on charge-offs only, we look at both charge-off and delinquency rates as we assume a high proportion of delinquent loans will turn bad in this cycle, especially as financial institutions have thin capital bases inadequate to deal with unexpected losses.

Compared to the IMF we estimate for loan losses based not on current default/ delinquencies rates but rather what those losses will be when such default and delinquencies will reach their peak some time in 2010. Our calculations are assume a further 20% fall in house prices (Case/Shiller) and unemployment peaking at 9% during this cycle as discussed in the RGE 2009 Global Economic Outlook.

With respect to credit losses on unsecuritized loans, recent research by the Federal Reserve Board (Sherlund (2008)) using comparable house price assumptions (but assuming high oil prices) concludes that over half of 2006-2007 subprime mortgage originations are set to default (i.e. $150bn out of $300bn in our data). The loss trajectories for Alt-A loans are similar, resulting in a 25% default rate ($150bn out of $600bn). Even prime mortgage delinquencies display a very high correlation with subprime loan delinquencies (Doms/Furlong/Krainer (2008), implying an approximate 7% default rate when the potential for 'jingle mail' is taken into account ($266bn out of $3,800bn). Our dollar losses for the subprime and Alt-A categories (incl. RMBS) are broadly in line with similar estimates in the literature.

The cycle has also turned in the commercial real estate (CRE) area with the traditional lag of around 2 years. Current serious delinquency plus default rates of 5.9% of CRE loans (Fed data) are projected to increase to up to 17% by industry experts cited in a Fitch study referring to CMBS data and assuming a 25% fall in prices ($408bn out of $2.4 trillion.) This compares with a 1991 peak charge-off plus delinquency rate of 14.5%.

In the consumer loan area, we estimate credit card charge-off rates could increase to 13% in the worst case scenario. Adding a typical 4% delinquency rate during recessions, the total loan losses on unsecuritized consumer loans are projected to increase to $238bn out of $1.4 trillion.

The IMF warned that commercial and industrial loans (C&I) losses are likely to climb to historical peaks and potentially beyond in this cycle. Compared to past C&I loan loss rates, we project charge-off and delinquencies to reach 10% or $370bn out of $3.7 trillion of unsecuritized C&I loans. With regard to leveraged loans, the latest research by Boston Consulting/IESE Business School based on the 100 largest PE firms engaged in LBOs calculates an expected book loss from default of about 30%. This translates into $51bn in losses out of $170bn unsecuritized leverage loans.

Based on these calculations, RGE now expects total loan losses to the financial system to reach about $1.6 trillion out of $12.37 trillion of unsecuritized loans alone,

implying an aggregate default rate of over 13%. Applying IMF weights, the U.S. banking system (commercial banks and broker dealers) carries about 60-70% of unsecuritized loan losses, or around $1.1 trillion.

Total mark-to-market (mtm) writedowns on a further $10.8 trillion of U.S. originated securities outstanding reached about $2 trillion by the end 2008 based on cash bond and derivatives prices. In particular, applying Markit ABX prices to $1.1 trillion of outstanding subprime RMBS results in a mtm loss rate of 50%, or $550bn. Markit TABX prices also show that $400 billion ABS CDOs consisting of mostly junior subprime RMBS tranches are all but worthless by now and expected to remain that way (95% or 380bn month-to-month loss.)

Writedowns in the prime MBS universe are primarily driven by jumbo mortgages which we assume to trade at 97% based on the record 3% spread between the 30-year jumbo mortgage and the 10-year Treasury yield with comparable average maturity. Mtm losses on prime MBS are therefore assumed to be $114bn out of $3.8 trillion outstanding. CMBX spreads spiked up implying a month-to-month write down of about $282bn out of $940bn outstanding.

The aggregate consumer debt ABS price index across all ratings trades at 80% thus implying $130bn in month-to-month writedowns out of $650bn outstanding. The high-yield corporate debt index traded at 75% (month-to-month $150bn out of $600bn), whereas high-grade corporate debt traded at 95% before moving back to 100%: we assume a writedown of $190bn out of $3.8 trillion. Derivatives indices for securitized leveraged loans implied a month-to-month loss of 123bn by the end of 2008 out of $350bn in CLOs outstanding. Flow of funds data show that 40% of U.S. originated securitizations are held abroad, leaving U.S. institutions with 60% of m-t-m writedowns, and U.S. banks in particular with a share of 50-60% thereof, i.e. $600 --700bn, when applying IMF weights.

Expected U.S. banks loan losses of about $1.1 trillion out of a total $1.6 trillion, plus bank month-to-month writedowns of $600 - $700bn on securities based on December 2008 prices amount to about $1.8 trillion. Compared with a total bank capitalization of $1.4 trillion (incl. FDIC insured plus investment banks as of Q3), the estimated capital shortfall amounts to around $400bn in the worst case scenario before recapitalization.

(Our colleague Christopher Whalen of Institutional Risk Analytics -- one of the leading experts of U.S. banking - has long predicted that peak charge-offs for the US banking industry will reach 2x 1990 levels during 2009, which would mean 4% charge-offs against total loans and leases for all FDIC insured banks or some $800 billion in realized losses. In reviewing a draft of our paper, Chris noted that the Q4 2008 results from Citi, JPMorgan, Bank of America show that charge-offs were running at a rate roughly double 2007 levels and that he expects charge-offs for these larger banks to double again by Q2 2009 and to continue rising through the second half of 2009. He thinks that our "$1.1t loss estimate is very reasonable for the financials in terms of charge-offs". The total accumulated loss for all FDIC insured banks will depend upon how long the industry remains at this peak level of loss experience; thus, our loss estimates for U.S. banks losses could be conservative and losses may end up being much larger than we predict.

Even including the TARP 1 injection of capital of $230 billion into the banking system and the further $200 billion of capital injected by private investors and sovereign wealth funds since the start of the crisis, the overall banking system would still be borderline insolvent.

Moreover, in order to restore the capital of the banking system to the previous level of $1.4 trillion (a level close to the 8% capital requirement of Basel II) an additional $1.4 trillion of private and public/government capital would have to be injected in the banking system to restore safe credit growth. If a reform of the regime of regulation of banking institutions were to argue that banks and broker dealers need more than the Basel II 8% criteria to operate safely even more than $1.4 trillion of new capital will have to be injected in the banking system.

Thus, even the release of TARP 2 (another $350 billion) and its use to recapitalize banks only would not be sufficient to restore the capital of banks and broker dealers to internationally accepted capital ratios. A TARP 3 and 4 of up to $1.05 trillion (assuming generously that all of TARP 2 goes to banks and broker dealers) may be needed to restore capital ratios to adequate levels.

Even assuming that private and foreign capital would contribute to 50% of this additional required recapitalization an additional TARP 3-4 of $560 billion may be needed in the form of public capital injections in banks and broker dealers alone. This would leave out the insurance companies, finance companies and other financial institutions (the GMAC, GE Capital, etc.) which may also need further public capital. Our estimates may turn out to be too pessimistic as the current illiquidity premium in prices of securities may disappear over time and a faster than expected growth recovery may reduce the expected losses on loans. But even in that case the current shortfall of capital in the banking system would be close to a staggering $1 trillion rather than an even bigger $1.4 trillion.

Conversely, credit losses may turn out to be even larger than we estimate: if instead of a U-shaped recession that is over by the end of 2009, the US recession were to last well into 2010 and turn out to be a Japanese style L-shaped recession, total loan and especially securities losses would end up being much larger than our benchmark of $3.6 trillion, potentially as high as $5 trillion.

Thus, the release of TARP 2 is welcome news for the banking sector but the prospect of further month-to-month losses and feedback loops that are not yet priced in calls for a more comprehensive solution for toxic assets along the lines of the proposed 'aggregator bank' or preferably an outright restructuring of the banking system a la RTC. Moreover, in order to address the root causes of the financial crisis in the mortgage and the household sectors, we proposed recently the "HOME (Home Owners' Mortgage Enterprise): A 10 Step Plan to Resolve the Financial Crisis" that includes an RTC to deal with toxic assets, a HOLC to reduce homeowner mortgage debt, and an RFC to refinance viable banking institutions.

The US banking system is borderline insolvent in the aggregate and it will take a huge amount of public financial resources and complex and time-consuming work-out of insolvent institutions to restore its financial health and allow it to lend again in ways that support sustained economic growth.

On G-20 and GM: Economics, Politics and Social Stability

John Mauldin — Thu, 20 Nov 2008 16:32:36 GMT

The Big Three have a new customer, and it isn't you. As Detroit's former heavyweights fight for a slice of a $25 billion bailout package, more than humble pie is being eaten. If the automakers fail and take their companies into bankruptcy, Michigan as we know it ceases to exist economically. The trickle-down impact could rapidly become a waterfall: the seat supplier in Georgia loses three major customers. The factory worker who makes seats is out of a job. The bank who holds his mortgage takes another hickey. Commercial lending at that bank dries up. Ad nauseum. In the best of economic times, this would be a troublesome scenario. In today's economy, it's easy to see how policymakers are as worried about social stability as they are economics.

No astute person thinks that the Big Three will be able to return to the business practices of last year. And no intelligent investor should be trying to evaluate portfolio decisions the same way this year either. We have moved from the realm of finance to political economy, and for that you need a different set of tools and a different mindset.

I've enclosed an article by my friend George Friedman, the founder of global intelligence firm Stratfor. This is a fascinating, must-read piece that examines US policy options by looking at the Chinese as an example. The parallels are illuminating. I've stressed before the importance of reading Stratfor's intelligence in order to gain a clear understanding of the political and economic landscape you're investing in, but you need it now more than ever.

George has arranged a special offer just for my readers. And I'm excited to tell you that in addition to a Stratfor Membership, you'll also get a copy of his new book, The Next 100 Years.

Click here to take advantage of this special offer. You'll find George's new book as fascinating and insightful as Stratfor's daily work.

Yours,
John Mauldin

On G-20 and GM: Economics, Politics and Social Stability

November 17, 2008 | 1840 GMT

By George Friedman

From Financial Crisis to Cyclical Recession

The financial crisis has been mitigated, if not solved. The problem now is that we are in a cyclical recession, and that every country is trying to figure out how to cope with the recession. Unlike the past two recessions, this one is more global than local. But unlike the 1970s, when recession was global, this one is not accompanied by soaring inflation and interest rates.

All recessions have different dynamics, but all have one thing in common: They impose punishment and discipline on economies run wild. This is happening around the world.

China, for example, faces a serious problem. China is an export-oriented economy whose primary market is the United States. As the United States goes into recession, demand for Chinese goods declines. Chinese businesses have always operated on very tight - sometimes invisible - profit margins designed to emphasize cash flow and to pay off debts to banks. As U.S. demand contracts, many Chinese firms find themselves in untenable positions, without room to decrease prices, lacking operating reserves and insufficiently capitalized. Recessions are designed to cull the weak from the herd, and a huge swath of the Chinese economy is ripe for the culling.

If the world were all about economics, culling is what the Chinese would do. But the world is more complex than that. A culling would lead to massive unemployment. Many Chinese employees live on Third World wages; indeed, the vast majority of Chinese have incomes of less than $1,000 a year. To them, unemployment doesn't mean problems with their 401k. It means malnutrition and desperation - neither of which is unknown in 20th century Chinese history, including the Communist period. The Chinese government is rightly worried about the social and political consequences of rational economic policies: They might work in the long run, but only if you live that long.

Economic Restructuring vs. Stability

The Chinese have therefore prepared a massive stimulus package that is more of a development program to make up for declining U.S. demand. It aims to keep businesses from failing and spilling millions of angry and hungry workers into the street. For the Chinese, the economic problem creates a much larger and more serious issue. It is also an issue that must be solved quickly, and the amount of time needed outstrips the amount of time available.

This is not only a Chinese problem. Wherever there is an economic downturn, politicians must decide whether society - and their own political futures - can withstand the rigors recessions impose. Recessions occur when, as is inevitable, inefficiencies and irrationalities build up in the financial and economic system. The resulting economic downturn imposes a harsh discipline that destroys the inefficient, encourages everyone to become more efficient, and opens the doors to new businesses using new technologies and business models. The year 2001 smashed the technology sector in the United States, opening the door for Google Inc.

The business cycle works well, but the human costs can be daunting. The collapse of inefficient businesses leaves workers without jobs, investors without money and society less stable than before. The pain needed to rectify China's economy would be enormous, with devastating consequences for hundreds of millions of Chinese, and probably would lead to social chaos. Beijing is prepared to accept a high degree of economic inefficiency to avoid, or at least postpone, the reckoning. The reckoning always comes, but for most of us, later is better than sooner. Economic rationality takes a back seat to social necessity and political common sense.

Every country in the world is looking inward at the impact of the recession on its economy and measuring its resources. Countries are deciding whether they have the ability to prop up business that should fail, what the social consequences of business failure would be, and whether they should try to use their resources to avoid the immediate pain of recession. This is why the G-20 ended in meaningless platitudes.

Each country is also trying to answer the question of how much pain it - and its regime - can endure. The more pain imposed, the healthier countries will emerge economically - unless of course the pain kills them. Ultimately, the rationality of economics and the reality of society frequently diverge.

Recession and the U.S. Auto Industry

For the United States, this choice has been posed in stark terms with regard to the dilemma of whether the U.S. government should use its resources to rescue the American auto industry. The American auto industry was once the centerpiece of the U.S. economy. That hasn't been true for a generation, as other industries and services have supplanted it and other countries' auto industries have surpassed it. Nevertheless, the U.S. auto industry remains important. It might drain the U.S. economy by losing vast amounts of money and destroying the equity held by its investors, but it employs large numbers of people. Perhaps more important, it purchases supplies from literally thousands of U.S. companies.

There can be endless discussions of why the U.S. auto industry is in such trouble. The answer lies not in one place but in many, from the decisions and makeup of management to the unions that control much of the workforce, and from the cost structure inherent in producing cars in the American economy to a simple systemic inability to produce outstanding vehicles. There might be varying degrees of truth to all or some of this, but the fact remains that each of the U.S. carmakers is on the verge of financial collapse.

This is what recessions are supposed to do. As in China and everywhere else, recessions reveal weak businesses and destroy them, freeing up resources for new enterprises. This recession has hit the auto industry hard, and it is unlikely that it is going to survive. The ultimate reason is the same one that destroyed the U.S. steel industry a generation ago: Given U.S. cost structures, producing commodity products is best left to countries with lower wage rates, while more expensive U.S. labor is deployed in more specialized products requiring greater expertise. Thus, there is still steel production in the United States, but it is specialty steel production, not commodity steel. Similarly, there will be specialty auto production in the United States, but commodity auto production will come from other countries.

That sounds easy, but the transition actually will be a bloodletting. Current employees of both the automakers and suppliers will be devastated. Institutions that have lent money to the automakers will suffer massive or total losses. Pensioners might lose pensions and health care benefits, and an entire region of the United States - the industrial Midwest - will be devastated. Something stronger will grow eventually, but not in time for many of the current employees, shareholders and creditors.

Here the economic answer, cull, meets the social answer, stabilize. Policymakers have a decision to make. If the automakers fail now, their drain on the economy will end; the pain will be shorter, if more intense; and new industries would emerge more quickly. But though their drain on the economy would end, the impact of the automakers' failure on the economy would be seismic. Unemployment would surge, as would bankruptcies of many auto suppliers. Defaults on loans would hit the credit markets. In the Midwest, home prices would plummet and foreclosures would skyrocket. And heaven only knows what the impact on equity markets would be.

In the U.S. case, the healthful purgative of a recession could potentially put the patient in a coma. Few if any believe the U.S. auto industry can survive in its current form. But there is an emerging consensus in Washington that the auto industry must not be allowed to fail now. The argument for spending money on the auto industry is not to save it, but to postpone its failure until a less devastating and inconvenient time. In other words, fearing the social and political consequences of a recession working itself through to its logical conclusion, Washington - like Beijing - wants to spend money it probably won't recover to postpone the failure. Indeed, governments around the world are considering what failures to tolerate, what failures to postpone, and how much to spend on the latter. General Motors is merely the American case in point.

The Recession in Context

The people arguing for postponement aren't foolish. The financial system is still working its way through a massive crisis that had little to do with the auto industry. Some traction appears to be occurring; certainly there was no crisis atmosphere at the G-20 meeting. The economy is in recession, but in spite of the inevitable claims that we have never seen anything like this one before, we have. There is always some variable that swings to an extreme - this time, it is consumer spending - but we are still well within the framework of recent recessions.

Consider the equity markets, which we regard as a long-term measure of the market's evaluation of the state of the economy. In March 2000, the S&P 500 peaked at 1530. This was the top of the market. In October 2002, 18 months later, the S&P bottomed out at 777. Over the next five years it rose to 1562 in October 2007, the height for this cycle. It fell from this point until Nov. 12, 2008, when it closed at 852.30. This past Friday, it was at 873.29.

We do not know what the market will do in the future. There are people much smarter than we are who claim to know that. What we do know is what it has done. And what it has done this time - so far - is almost exactly what it did last time, except that in 2000-2002 it took 18 months to do it, while this time it was done in about 16 and a half months (assuming it bottomed out Nov. 12). But even if the market didn't bottom out then, and it falls to 775, for example, it will have lost 50 percent of its value from the peak. This would be more than in 2000-2002, but not unprecedented.

The point we are making here is that if we regard the equity markets as a long-term seismograph of the economy, then so far, despite all the storm and stress, the markets - and therefore the economy - remain within the general pattern of the 2000-2002 market at the 2001 recession. That recession certainly was unpleasant, what with the devastation of the tech sector, but the economy survived. At the same time, however, it is clear that things are balanced on a knife's edge. Another hundred points' fall on the S&P, and the markets will be telling us that the world is in a very different place indeed.

A massive bankruptcy in the automotive sector could certainly set the stage for an economic renaissance in the next generation. But at this particular moment in time (it's no coincidence that the crisis in the U.S. automotive industry comes as we enter a recession), a wave of bankruptcies would dramatically deepen the recession. This probably would be reflected by the destruction of trillions more in net worth in the equity markets.

There is a powerful counterargument to bailing out the U.S. auto industry. This argument holds that the auto industry is a drain on the U.S. economy, that it will never be globally competitive, and that if it is dragged back from the edge, no one will then say it is time to push it to the edge and over. The next time it will be on the brink will be during the next recession, and the same argument to save it will be used. In due course, the United States, like China, will be so terrified of the social and political consequences of business failure that it will maintain Chinese-like state owned enterprises, full of employees and generation-old plants and business models. Clearly, short-run solutions can easily become long-term albatrosses.

The only possible solution would be a bailout followed by a Washington-administered restructuring of the auto industry. This causes us to imagine a collaboration between the auto industry's current management and Washington administrators that would finally put Detroit on a path to where it can compete with Toyota. Frankly, the mind boggles at this. But boggle though we might, hitting the economy with another massive financial default, a wave of bankruptcies, massive unemployment surges and another blow to housing prices boggles our mind even more.

The geopolitical problem confronting the world at the moment is that it has been forced to offer massive support to the global financial system with sovereign wealth - e.g., via taxes and currency printing presses. The world might just have squeaked through that crisis. Now, the world is in an inevitable recession and businesses are on the brink of failure. A wave of massive business failures on top of the financial crisis might well move the global system to a very different place. Therefore, each nation, by itself and indifferent to others, is in the process of figuring out how to postpone these failures to a more opportune time - or to never. This will build in long-term inefficiencies to the global economy, but right now everyone will be quite content with that.

Thus the financial crisis became a recession, and the recession triggered bankruptcies. And because no one wants bankruptcies right now, everyone who can is using taxpayer dollars to protect the taxpayer from the consequences of mismanagement. And the last thing any one cared about was the G-20 concept for the future of the economic system.

The New President and the Global Landscape

John Mauldin — Wed, 01 Oct 2008 21:26:38 GMT

In times of crisis, those with psychological fortitude discover opportunities that most people miss. A friend of mine in Houston tells me of unending piles of tree limbs broken down by the hurricane. The homeowner laments his disaster; the tree trimmer and the roofer order a new Mercedes. Most of the world sees a Wall St. meltdown. Buffett takes the opening to deploy billions from his cash hoard. They're all seeing the same thing, but they're reacting differently based on different visions of the future.

I've included a piece today from my friend George Friedman over at Stratfor about the landscape the next US President will face. This article is a perfect example of why I rely on Stratfor for my geopolitical intelligence. The newspapers and other media do better or lesser jobs of telling me about what's happening right now. But that's not what an investor needs. What I need - and I recommend for you - is an analysis of what we're going to be facing. That's where George and his team absolutely excel.

For at least the next month, the public conversation is going to be completely dominated by the November election and the political maneuvering to address the financial crisis. There will be tremendous drama. There will be dizzying swings back and forth in emotions, expectations, and more than likely the markets. And if you focus on it, you'll miss the real opportunities to position yourself for the emergence. George has made a special offer on a Stratfor Membership available to my readers, and I strongly encourage you to click here to take advantage of this opportunity. Now is the time to get positioned for future opportunities, while everybody else is wallowing in the here and now.

John Mauldin, Editor
Outside the Box

The New President and the Global Landscape

By George Friedman

It has often been said that presidential elections are all about the economy. That just isn't true. Harry Truman's election was all about Korea. John Kennedy's election focused on missiles, Cuba and Berlin. Lyndon Johnson's and Richard Nixon's elections were heavily about Vietnam. Ronald Reagan's first election pivoted on Iran. George W. Bush's second election was about Iraq. We won't argue that presidential elections are all about foreign policy, but they are not all about the economy. The 2008 election will certainly contain a massive component of foreign policy.

We have no wish to advise you how to vote. That's your decision. What we want to do is try to describe what the world will look like to the new president and consider how each candidate is likely to respond to the world. In trying to consider whether to vote for John McCain or Barack Obama, it is obviously necessary to consider their stands on foreign policy issues. But we have to be cautious about campaign assertions. Kennedy claimed that the Soviets had achieved superiority in missiles over the United States, knowing full well that there was no missile gap. Johnson attacked Barry Goldwater for wanting to escalate the war in Vietnam at the same time he was planning an escalation. Nixon won the 1968 presidential election by claiming that he had a secret plan to end the war in Vietnam. What a candidate says is not always an indicator of what the candidate is thinking.

It gets even trickier when you consider that many of the most important foreign policy issues are not even imagined during the election campaign. Truman did not expect that his second term would be dominated by a war in Korea. Kennedy did not expect to be remembered for the Cuban missile crisis. Jimmy Carter never imagined in 1976 that his presidency would be wrecked by the fall of the Shah of Iran and the hostage crisis. George H. W. Bush didn't expect to be presiding over the collapse of communism or a war over Kuwait. George W. Bush (regardless of conspiracy theories) never expected his entire presidency to be defined by 9/11. If you read all of these presidents' position papers in detail, you would never get a hint as to what the really important foreign policy issues would be in their presidencies.

Between the unreliability of campaign promises and the unexpected in foreign affairs, predicting what presidents will do is a complex business. The decisions a president must make once in office are neither scripted nor conveniently timed. They frequently present themselves to the president and require decisions in hours that can permanently define his (or her) administration. Ultimately, voters must judge, by whatever means they might choose, whether the candidate has the virtue needed to make those decisions well.

Virtue, as we are using it here, is a term that comes from Machiavelli. It means the opposite of its conventional usage. A virtuous leader is one who is clever, cunning, decisive, ruthless and, above all, effective. Virtue is the ability to face the unexpected and make the right decision, without position papers, time to reflect or even enough information. The virtuous leader can do that. Others cannot. It is a gut call for a voter, and a tough one.

This does not mean that all we can do is guess about a candidate's nature. There are three things we can draw on. First, there is the political tradition the candidate comes from. There are more things connecting Republican and Democratic foreign policy than some would like to think, but there are also clear differences. Since each candidate comes from a different political tradition -- as do his advisers -- these traditions can point to how each candidate might react to events in the world. Second, there are indications in the positions the candidates take on ongoing events that everyone knows about, such as Iraq. Having pointed out times in which candidates have been deceptive, we still believe there is value in looking at their positions and seeing whether they are coherent and relevant. Finally, we can look at the future and try to predict what the world will look like over the next four years. In other words, we can try to limit the surprises as much as possible.

In order to try to draw this presidential campaign into some degree of focus on foreign policy, we will proceed in three steps. First, we will try to outline the foreign policy issues that we think will confront the new president, with the understanding that history might well throw in a surprise. Second, we will sketch the traditions and positions of both Obama and McCain to try to predict how they would respond to these events. Finally, after the foreign policy debate is over, we will try to analyze what they actually said within the framework we created.

Let me emphasize that this is not a partisan exercise. The best guarantee of objectivity is that there are members of our staff who are passionately (we might even say irrationally) committed to each of the candidates. They will be standing by to crush any perceived unfairness. It is Stratfor's core belief that it is possible to write about foreign policy, and even an election, without becoming partisan or polemical. It is a difficult task and we doubt we can satisfy everyone, but it is our goal and commitment.

The Post 9/11 World

Ever since 9/11 U.S. foreign policy has focused on the Islamic world. Starting in late 2002, the focus narrowed to Iraq. When the 2008 campaign for president began a year ago, it appeared Iraq would define the election almost to the exclusion of all other matters. Clearly, this is no longer the case, pointing to the dynamism of foreign affairs and opening the door to a range of other issues.

Iraq remains an issue, but it interacts with a range of other issues. Among these are the future of U.S.-Iranian relations; U.S. military strategy in Afghanistan and the availability of troops in Iraq for that mission; the future of U.S.-Pakistani relations and their impact on Afghanistan; the future of U.S.-Russian relations and the extent to which they will interfere in the region; resources available to contain Russian expansion; the future of the U.S. relationship with the Europeans and with NATO in the context of growing Russian power and the war in Afghanistan; Israel's role, caught as it is between Russia and Iran; and a host of only marginally related issues. Iraq may be subsiding, but that simply complicates the world facing the new president.

The list of problems facing the new president will be substantially larger than the problems facing George W. Bush, in breadth if not in intensity. The resources he will have to work with, military, political and economic, will not be larger for the first year at least. In terms of military capacity, much will hang on the degree to which Iraq continues to bog down more than a dozen U.S. brigade combat teams. Even thereafter, the core problem facing the next president will be the allocation of limited resources to an expanding number of challenges. The days when it was all about Iraq is over. It is now all about how to make the rubber band stretch without breaking.

Iraq remains the place to begin, however, since the shifts there help define the world the new president will face. To understand the international landscape the new president will face, it is essential to begin by understanding what happened in Iraq, and why Iraq is no longer the defining issue of this campaign.

A Stabilized Iraq and the U.S. Troop Dilemma

In 2006, it appeared that the situation in Iraq was both out of control and hopeless. Sunni insurgents were waging war against the United States, Shiite militias were taking shots at the Americans as well, and Sunnis and Shia were waging a war against each other. There seemed to be no way to bring the war to anything resembling a satisfactory solution.

When the Democrats took control of Congress in the 2006 elections, it appeared inevitable that the United States would begin withdrawing forces from Iraq. U.S expectations aside, this was the expectation by all parties in Iraq. Given that the United States was not expected to remain a decisive force in Iraq, all Iraqi parties discounted the Americans and maneuvered for position in anticipation of a post-American Iraq. The Iranians in particular saw an opportunity to limit a Sunni return to Iraq's security forces, thus reshaping the geopolitics of the region. U.S. fighting with Iraqi Sunnis intensified in preparation for the anticipated American withdrawal.

Bush's decision to increase forces rather than withdraw them dramatically changed the psychology of Iraq. It was assumed he had lost control of the situation. Bush's decision to surge forces in Iraq, regardless by how many troops, established two things. First, Bush remained in control of U.S. policy. Second, the assumption that the Americans were leaving was untrue. And suddenly, no one was certain that there would be a vacuum to be filled.

The deployment of forces proved helpful, as did the change in how the troops were used; recent leaks indicate that new weapon systems also played a key role. The most important factor, however, was the realization that the Americans were not leaving on Bush's watch. Since no one was sure who the next U.S. president would be, or what his policies might be, it was thus uncertain that the Americans would leave at all.

Everyone in Iraq suddenly recalculated. If the Americans weren't leaving, one option would be to make a deal with Bush, seen as weak and looking for historical validation. Alternatively, they could wait for Bush's successor. Iran remembers -- without fondness -- its decision not to seal a deal with Carter, instead preferring to wait for Reagan. Similarly, seeing foreign jihadists encroaching in Sunni regions and the Shia shaping the government in Baghdad, the Sunni insurgents began a fundamental reconsideration of their strategy.

Apart from reversing Iraq's expectations about the United States, part of Washington's general strategy was supplementing military operations with previously unthinkable political negotiations. First, the United States began talking to Iraq's Sunni nationalist insurgents, and found common ground with them. Neither the Sunni nationalists nor the United States liked the jihadists, and both wanted the Shia to form a coalition government. Second, back-channel U.S.-Iranian talks clearly took place. The Iranians realized that the possibility of a pro-Iranian government in Baghdad was evaporating. Iran's greatest fear was a Sunni Iraqi government armed and backed by the United States, recreating a version of the Hussein regime that had waged war with Iran for almost a decade. The Iranians decided that a neutral, coalition government was the best they could achieve, so they reined in the Shiite militia.

The net result of this was that the jihadists were marginalized and broken, and an uneasy coalition government was created in Baghdad, balanced between Iran and the United States. The Americans failed to create a pro-American government in Baghdad, but had blocked the emergence of a pro-Iranian government. Iraqi society remained fragmented and fragile, but a degree of peace unthinkable in 2006 had been created.

The first problem facing the next U.S. president will be deciding when and how many U.S. troops will be withdrawn from Iraq. Unlike 2006, this issue will not be framed by Iraq alone. First, there will be the urgency of increasing the number of U.S. troops in Afghanistan. Second, there will be the need to create a substantial strategic reserve to deal with potential requirements in Pakistan, and just as important, responding to events in the former Soviet Union like the recent conflict in Georgia.

At the same time, too precipitous a U.S. withdrawal not only could destabilize the situation internally in Iraq, it could convince Iran that its dream of a pro-Iranian Iraq is not out of the question. In short, too rapid a withdrawal could lead to resumption of war in Iraq. But too slow a withdrawal could make the situation in Afghanistan untenable and open the door for other crises.

The foreign policy test for the next U.S. president will be calibrating three urgent requirements with a military force that is exhausted by five years of warfare in Iraq and seven in Afghanistan. This force was not significantly expanded since Sept. 11, making this the first global war the United States has ever fought without a substantial military expansion. Nothing the new president does will change this reality for several years, so he will be forced immediately into juggling insufficient forces without the option of precipitous withdrawal from Iraq unless he is prepared to accept the consequences, particularly of a more powerful Iran.

The Nuclear Chip and a Stable U.S.-Iranian Understanding

The nuclear issue has divided the United States and Iran for several years. The issue seems to come and go depending on events elsewhere. Thus, what was enormously urgent just prior to the Russo-Georgian war became much less pressing during and after it. This is not unreasonable in our point of view, because we regard Iran as much farther from nuclear weapons than others might, and we suspect that the Bush administration agrees given its recent indifference to the question.

Certainly, Iran is enriching uranium, and with that uranium, it could possibly explode a nuclear device. But the gap between a nuclear device and weapon is substantial, and all the enriched uranium in the world will not give the Iranians a weapon. To have a weapon, it must be ruggedized and miniaturized to fit on a rocket or to be carried on an attack aircraft. The technologies needed for that range from material science to advanced electronics to quality assurance. Creating a weapon is a huge project. In our view, Iran does not have the depth of integrated technical skills needed to achieve that goal.

As for North Korea, for Iran a very public nuclear program is a bargaining chip designed to extract concessions, particularly from the Americans. The Iranians have continued the program very publicly in spite of threats of Israeli and American attacks because it made the United States less likely to dismiss Iranian wishes in Tehran's true area of strategic interest, Iraq.

The United States must draw down its forces in Iraq to fight in Afghanistan. The Iranians have no liking for the Taliban, having nearly gone to war with them in 1998, and having aided the United States in Afghanistan in 2001. The United States needs Iran's commitment to a neutral Iraq to withdraw U.S. forces since Iran could destabilize Iraq overnight, though Tehran's ability to spin up Shiite proxies in Iraq has declined over the past year.

Therefore, the next president very quickly will face the question of how to deal with Iran. The Bush administration solution -- relying on quiet understandings alongside public hostility -- is one model. It is not necessarily a bad one, so long as forces remain in Iraq to control the situation. If the first decision the new U.S. president will have to make is how to transfer forces in Iraq elsewhere, the second decision will be how to achieve a more stable understanding with Iran.

This is particularly pressing in the context of a more assertive Russia that might reach out to Iran. The United States will need Iran more than Iran needs the United States under these circumstances. Washington will need Iran to abstain from action in Iraq but to act in Afghanistan. More significantly, the United States will need Iran not to enter into an understanding with Russia. The next president will have to figure out how to achieve all these things without giving away more than he needs to, and without losing his domestic political base in the process.

Afghanistan, Pakistan and the Taliban

The U.S. president also will have to come up with an Afghan policy, which really doesn't exist at this moment. The United States and its NATO allies have deployed about 50,000 troops in Afghanistan. To benchmark this, the Russians deployed around 120,000 by the mid-1980s, and were unable to pacify the country. Therefore the possibility of 60,000 troops -- or even a few additional brigades on top of that -- pacifying Afghanistan is minimal. The primary task of troops in Afghanistan now is to defend the Kabul regime and other major cities, and to try to keep the major roads open. More troops will make this easier, but by itself, it will not end the war.

The problem in Afghanistan is twofold. First, the Taliban defeated their rivals in Afghanistan during the civil war of the 1990s because they were the most cohesive force in the country, were politically adept and enjoyed Pakistani support. The Taliban's victory was not accidental; and all other things being equal, without the U.S. presence, they could win again. The United States never defeated the Taliban. Instead, the Taliban refused to engage in massed warfare against American airpower, retreated, dispersed and regrouped. In most senses, it is the same force that won the Afghan civil war.

The United States can probably block the Taliban from taking the cities, but to do more it must do three things. First, it must deny the Taliban sanctuary and lines of supply running from Pakistan. These two elements allowed the mujahideen to outlast the Soviets. They helped bring the Taliban to power. And they are fueling the Taliban today. Second, the United States must form effective coalitions with tribal groups hostile to the Taliban. To do this it needs the help of Iran, and more important, Washington must convince the tribes that it will remain in Afghanistan indefinitely -- not an easy task. And third -- the hardest task for the new president -- the United States will have to engage the Taliban themselves, or at least important factions in the Taliban movement, in a political process. When we recall that the United States negotiated with the Sunni insurgents in Iraq, this is not as far-fetched as it appears.

The most challenging aspect to deal with in all this is Pakistan. The United States has two issues in the South Asian country. The first is the presence of al Qaeda in northern Pakistan. Al Qaeda has not carried out a successful operation in the United States since 2001, nor in Europe since 2005. Groups who use the al Qaeda label continue to operate in Iraq, Afghanistan and Pakistan, but they use the name to legitimize or celebrate their activities -- they are not the same people who carried out 9/11. Most of al Qaeda prime's operatives are dead or scattered, and its main leaders, Osama bin Laden and Ayman al-Zawahiri, are not functional. The United States would love to capture bin Laden so as to close the books on al Qaeda, but the level of effort needed -- assuming he is even alive -- might outstrip U.S. capabilities.

The most difficult step politically for the new U.S. president will be to close the book on al Qaeda. This does not mean that a new group of operatives won't grow from the same soil, and it doesn't mean that Islamist terrorism is dead by any means. But it does mean that the particular entity the United States has been pursuing has effectively been destroyed, and the parts regenerating under its name are not as dangerous. Asserting victory will be extremely difficult for the new U.S. president. But without that step, a massive friction point between the United States and Pakistan will persist -- one that isn't justified geopolitically and undermines a much more pressing goal.

The United States needs the Pakistani army to attack the Taliban in Pakistan, or failing that, permit the United States to attack them without hindrance from the Pakistani military. Either of these are nightmarishly difficult things for a Pakistani government to agree to, and harder still to carry out. Nevertheless, without cutting the line of supply to Pakistan, like Vietnam and the Ho Chi Minh Trail, Afghanistan cannot be pacified. Therefore, the new president will face the daunting task of persuading or coercing the Pakistanis to carry out an action that will massively destabilize their country without allowing the United States to get bogged down in a Pakistan it cannot hope to stabilize.

At the same time, the United States must begin the political process of creating some sort of coalition in Afghanistan that it can live with. The fact of the matter is that the United States has no long-term interest in Afghanistan except in ensuring that radical jihadists with global operational reach are not given sanctuary there. Getting an agreement to that effect will be hard. Guaranteeing compliance will be virtually impossible. Nevertheless, that is the task the next president must undertake.

There are too many moving parts in Afghanistan to be sanguine about the outcome. It is a much more complex situation than Iraq, if for no other reason than because the Taliban are a far more effective fighting force than anything the United States encountered in Iraq, the terrain far more unfavorable for the U.S. military, and the political actors much more cynical about American capabilities.

The next U.S. president will have to make a painful decision. He must either order a long-term holding action designed to protect the Karzai government, launch a major offensive that includes Pakistan but has insufficient forces, or withdraw. Geopolitically, withdrawal makes a great deal of sense. Psychologically, it could unhinge the region and regenerate al Qaeda-like forces. Politically, it would not be something a new president could do. But as he ponders Iraq, the future president will have to address Afghanistan. And as he ponders Afghanistan, he will have to think about the Russians.

The Russian Resurgence

When the United States invaded Afghanistan in 2001, the Russians were allied with the United States. They facilitated the U.S. relationship with the Northern Alliance, and arranged for air bases in Central Asia. The American view of Russia was formed in the 1990s. It was seen as disintegrating, weak and ultimately insignificant to the global balance. The United States expanded NATO into the former Soviet Union in the Baltic states and said it wanted to expand it into Ukraine and Georgia. The Russians made it clear that they regarded this as a direct threat to their national security, resulting in the 2008 Georgian conflict.

The question now is where U.S.-Russian relations are going. Russian Prime Minister Vladimir Putin called the collapse of the Soviet Union a geopolitical catastrophe. After Ukraine and Georgia, it is clear he does not trust the United States and that he intends to reassert his sphere of influence in the former Soviet Union. Georgia was lesson one. The current political crisis in Ukraine is the second lesson unfolding.

The re-emergence of a Russian empire in some form or another represents a far greater threat to the United States than the Islamic world. The Islamic world is divided and in chaos. It cannot coalesce into the caliphate that al Qaeda wanted to create by triggering a wave of revolutions in the Islamic world. Islamic terrorism remains a threat, but the geopolitical threat of a unifying Islamic power is not going to happen.

Russia is a different matter. The Soviet Union and the Russian empire both posed strategic threats because they could threaten Europe, the Middle East and China simultaneously. While this overstates the threat, it does provide some context. A united Eurasia is always powerful, and threatens to dominate the Eastern Hemisphere. Therefore, preventing Russia from reasserting its power in the former Soviet Union should take precedence over all other considerations.

The problem is that the United States and NATO together presently do not have the force needed to stop the Russians. The Russian army is not particularly powerful or effective, but it is facing forces that are far less powerful and effective. The United States has its forces tied down in Iraq and Afghanistan so that when the war in Georgia broke out, sending ground forces was simply not an option. The Russians are extremely aware of this window of opportunity, and are clearly taking advantage of it.

The Russians have two main advantages in this aside from American resource deficits. First, the Europeans are heavily dependent on Russian natural gas; German energy dependence on Moscow is particularly acute. The Europeans are in no military or economic position to take any steps against the Russians, as the resulting disruption would be disastrous. Second, as the United States maneuvers with Iran, the Russians can provide support to Iran, politically and in terms of military technology, that not only would challenge the United States, it might embolden the Iranians to try for a better deal in Iraq by destabilizing Iraq again. Finally, the Russians can pose lesser challenges in the Caribbean with Venezuela, Nicaragua and Cuba, as well as potentially supporting Middle Eastern terrorist groups and left-wing Latin American groups.

At this moment, the Russians have far more options than the Americans have. Therefore, the new U.S. president will have to design a policy for dealing with the Russians with few options at hand. This is where his decisions on Iraq, Iran, Afghanistan and Pakistan will intersect and compete with his decisions on Russia. Ideally, the United States would put forces in the Baltics -- which are part of NATO -- as well as in Ukraine and Georgia. But that is not an option and won't be for more than a year under the best of circumstances.

The United States therefore must attempt a diplomatic solution with Russia with very few sticks. The new president will need to try to devise a package of carrots -- e.g., economic incentives -- plus the long-term threat of a confrontation with the United States to persuade Moscow not to use its window of opportunity to reassert Russian regional hegemony. Since regional hegemony allows Russia to control its own destiny, the carrots will have to be very tempting, while the threat has to be particularly daunting. The president's task will be crafting the package and then convincing the Russians it has value.

European Disunity and Military Weakness

One of the problems the United States will face in these negotiations will be the Europeans. There is no such thing as a European foreign policy; there are only the foreign policies of the separate countries. The Germans, for example, do not want a confrontation with Russia under any circumstances. The United Kingdom, by contrast, is more willing to take a confrontational approach to Moscow. And the European military capability, massed and focused, is meager. The Europeans have badly neglected their military over the past 15 years. What deployable, expeditionary forces they have are committed to the campaign in Afghanistan. That means that in dealing with Russia, the Americans do not have united European support and certainly no meaningful military weight. This will make any diplomacy with the Russians extremely difficult.

One of the issues the new president eventually will have to face is the value of NATO and the Europeans as a whole. This was an academic matter while the Russians were prostrate. With the Russians becoming active, it will become an urgent issue. NATO expansion -- and NATO itself -- has lived in a world in which it faced no military threats. Therefore, it did not have to look at itself militarily. After Georgia, NATO's military power becomes very important, and without European commitment, NATO's military power independent of the United States -- and the ability to deploy it -- becomes minimal. If Germany opts out of confrontation, then NATO will be paralyzed legally, since it requires consensus, and geographically. For the United States alone cannot protect the Baltics without German participation.

The president really will have one choice affecting Europe: Accept the resurgence of Russia, or resist. If the president resists, he will have to limit his commitment to the Islamic world severely, rebalance the size and shape of the U.S. military and revitalize and galvanize NATO. If he cannot do all of those things, he will face some stark choices in Europe.

Israel, Turkey, China, and Latin America

Russian pressure is already reshaping aspects of the global system. The Israelis have approached Georgia very differently from the United States. They halted weapon sales to Georgia the week before the war, and have made it clear to Moscow that Israel does not intend to challenge Russia. The Russians met with Syrian President Bashar al Assad immediately after the war. This signaled the Israelis that Moscow was prepared to support Syria with weapons and with Russian naval ships in the port of Tartus if Israel supports Georgia, and other countries in the former Soviet Union, we assume. The Israelis appear to have let the Russians know that they would not do so, separating themselves from the U.S. position. The next president will have to re-examine the U.S. relationship with Israel if this breach continues to widen.

In the same way, the United States will have to address its relationship with Turkey. A long-term ally, Turkey has participated logistically in the Iraq occupation, but has not been enthusiastic. Turkey's economy is booming, its military is substantial and Turkish regional influence is growing. Turkey is extremely wary of being caught in a new Cold War between Russia and the United States, but this will be difficult to avoid. Turkey's interests are very threatened by a Russian resurgence, and Turkey is the U.S. ally with the most tools for countering Russia. Both sides will pressure Ankara mercilessly. More than Israel, Turkey will be critical both in the Islamic world and with the Russians. The new president will have to address U.S.-Turkish relations both in context and independent of Russia fairly quickly.

In some ways, China is the great beneficiary of all of this. In the early days of the Bush administration, there were some confrontations with China. As the war in Iraq calmed down, Washington seemed to be increasing its criticisms of China, perhaps even tacitly supporting Tibetan independence. With the re-emergence of Russia, the United States is now completely distracted. Contrary to perceptions, China is not a global military power. Its army is primarily locked in by geography and its navy is in no way an effective blue-water force. For its part, the United States is in no position to land troops on mainland China. Therefore, there is no U.S. geopolitical competition with China. The next president will have to deal with economic issues with China, but in the end, China will sell goods to the United States, and the United States will buy them.

Latin America has been a region of minimal interest to the United States in the last decade or longer. So long as no global power was using its territory, the United States did not care what presidents Hugo Chavez in Venezuela, Evo Morales in Bolivia and Daniel Ortega in Nicaragua -- or even the Castros in Cuba -- were doing. But with the Russians back in the Caribbean, at least symbolically, all of these countries suddenly become more important. At the moment, the United States has no Latin American policy worth noting; the new president will have to develop one.

Quite apart from the Russians, the future U.S. president will need to address Mexico. The security situation in Mexico is deteriorating substantially, and the U.S.-Mexican border remains porous. The cartels stretch from Mexico to the streets of American cities where their customers live. What happens in Mexico, apart from immigration issues, is obviously of interest to the United States. If the current trajectory continues, at some point in his administration, the new U.S. president will have to address Mexico -- potentially in terms never before considered.

The U.S. Defense Budget

The single issue touching on all of these is the U.S. defense budget. The focus of defense spending over the past eight years has been the Army and Marine Corps -- albeit with great reluctance. Former Defense Secretary Donald Rumsfeld was not an advocate of a heavy Army, favoring light forces and air power, but reality forced his successors to reallocate resources. In spite of this, the size of the Army remained the same -- and insufficient for the broader challenges emerging.

The focus of defense spending was Fourth Generation warfare, essentially counterinsurgency. It became dogma in the military that we would not see peer-to-peer warfare for a long time. The re-emergence of Russia, however, obviously raises the specter of peer-to-peer warfare, which in turn means money for the Air Force as well as naval rearmament. All of these programs will take a decade or more to implement, so if Russia is to be a full-blown challenge by 2020, spending must begin now.

If we assume that the United States will not simply pull out of Iraq and Afghanistan, but will also commit troops to allies on Russia's periphery while retaining a strategic reserve -- able to, for example, protect the U.S.-Mexican border -- then we are assuming substantially increased spending on ground forces. But that will not be enough. The budgets for the Air Force and Navy will also have to begin rising.

U.S. national strategy is expressed in the defense budget. Every strategic decision the president makes has to be expressed in budget dollars with congressional approval. Without that, all of this is theoretical. The next president will have to start drafting his first defense budget shortly after taking office. If he chooses to engage all of the challenges, he must be prepared to increase defense spending. If he is not prepared to do that, he must concede that some areas of the world are beyond management. And he will have to decide which areas these are. In light of the foregoing, as we head toward the debate, 10 questions should be asked of the candidates:

If the United States removes its forces from Iraq slowly as both of you advocate, where will the troops come from to deal with Afghanistan and protect allies in the former Soviet Union?
The Russians sent 120,000 troops to Afghanistan and failed to pacify the country. How many troops do you think are necessary?
Do you believe al Qaeda prime is still active and worth pursuing?
Do you believe the Iranians are capable of producing a deliverable nuclear weapon during your term in office?
How do you plan to persuade the Pakistani government to go after the Taliban, and what support can you provide them if they do?
Do you believe the United States should station troops in the Baltic states, in Ukraine and Georgia as well as in other friendly countries to protect them from Russia?
Do you feel that NATO remains a viable alliance, and are the Europeans carrying enough of the burden?
Do you believe that Mexico represents a national security issue for the United States?
Do you believe that China represents a strategic challenge to the United States?
Do you feel that there has been tension between the United States and Israel over the Georgia issue?

A Value Investor Looks At China

John Mauldin — Tue, 12 Aug 2008 14:44:19 GMT

China is all the rage for the next few weeks as the Olympics are going on. Many are calling this China's time to showcase itself to the world. I have a lot of friends and analysts who are big China bulls, believing that the next few years will see continued high growth in China, although less than the above 10% of the past few years.

In Outside the Box, we like to look at some contrarian analysis from time to time. Value Investor Vitaliy Katsenelson gives us some reasons why the outlook for China might not be so bright. This has implications for lots of markets that are driven by Asian demand.

Vitaliy N. Katsenelson, CFA, is a Director of Research at Investment Management Associates in Denver and teaches a graduate investment class at the University of Colorado at Denver. He is also the author of Active Value Investing: Making Money in Range-Bound Markets (Wiley 2007). Enjoy the essay.

John Mauldin, Editor
Outside the Box

A Value Investor Looks At China

By Vitaliy Katsenelson

What do Starbucks and China have in common? A lot! Both got us hooked on consumption: one of fancy, expensive caffeinated liquids; the other on cheap foreign made goods. Both have defied the conventional wisdom - they grew faster and longer than common sense told us was possible. They also share another striking commonality: both are suffering from late stage growth obesity (LSGO).

The Starbucks story

With the beautiful benefit of hindsight we know what happened to Starbucks - it grew too fast, opened too many stores, and sacrificed its own standards to meet unrealistic targets. The company first claimed that it only had a few hundred stores that it needed to close, and then the few hundred spilled into six hundred. Weak consumer spending will likely push Starbucks to re-examine its store count again, doubling or tripling the store closures.

Starbucks percentage of new stores growth in 2007 was only slightly lower than it was in 1999. But in 1999 it had 2,000 stores; in 2007 it was pushing a 10,000 company owned stores mark. Let's put this in perspective: in 1999 Starbucks opened 447 stores - 1.8 stores per working day; in 2007 that number more than tripled to 1,403 stores a year - 5.5 stores per working day. At this level of growth physical limitations come in: there is only so much real estate that fits a company's criteria at a certain point in time. Management started sacrificing on the quality of their decisions, compromises were made that were unthinkable several years before. Stores were opened too close to each other or on the wrong side of the street, expensive leases were signed, they even hired baristas that would have fit in better at McDonalds - you get the idea.

Unfortunately the present and the future will pay for the decisions of the past: stores will need to be closed, long-term leases terminated, charges taken, corporate costs created in hopes of high growth eliminated, and corporate culture of partnership strained by barista layoffs.

Starbucks needs to go on a permanent growth diet (at least in the US), and realize that it has the metabolism of a 37 year old and can digest fewer new stores. By tightening its standards for opening new stores the company will be on the way to recovery, though at slower growth. Starbucks is blessed with financial strength, capable management and unbelievable brand. If management admits to themselves that the heydays of growth are behind, recovery should be fairly painless. Starbucks generates tremendous operating cash flows, which in the past were completely consumed by opening new stores. If the company were to go on the LSGO diet, its capital expenditures would decline and free cash flows balloon - the value unlocked.

But this discussion is not about Starbucks, it is about what is taking place in China.

The Great China story

The benefit of hindsight that provides clarity in analysis of Starbucks today is not there for China, at least not yet. But if you were to open your mind and look past today's cheery newspaper headlines you'd see that China is suffering from a severe case of LSGO.

Ten for ten. Since 1998 its GDP has grown at about a 10% annual real growth rate, and its economy more than tripled in size (in real terms). There were no recessions, just expansion - the Chinese miracle growth? The origins of China's tremendous growth are well known: large population migrating from low (farming) to higher productivity (manufacturing) activity, cheap labor, a capitalism-friendlier communist government, and insatiable demand from the US and the rest of the developed world for cheap goods.

Unlike Starbucks - a private enterprise that has free market principles deeply inbred in its DNA - China is a communist country. Though it is moving towards free market capitalism, it is not there yet. The rule of law is weak, the country infested with corruption, and due to central planning and tight government control of the banking system capital is often allocated based on cronyism (or political relationships) not merit.

Prolonged high growth in this environment results in inefficiencies that are compounded year after year. In other words, though the growth is high, the quality of growth is low, thus asset allocation decisions are likely to be poor. The ten year super-high growth marathon put China at high risk, actually more likely of a certainty, of a severe case of LSGO.

From today's perch we can only guess of the consequences of LSGO, but we'll gain that clarity after the fact - a luxury we don't have. Newspapers that are praising the Chinese growth miracle today will write exposes on what went and is going wrong in China.

I have absolutely no facts to back up what I am about to say, but it is not hard to imagine future stories about poverty stricken farmers that moved to big cities for a better life and found despair; or that inland migration (from farming to factories) only brings a onetime productivity jump as poorly educated farmers-turned-factory-workers add little to productivity improvements afterwards; or how weak and debt ridden the financial system is; or the devastating impact that pollution has on health and productivity; or how the biggest shopping mall in the world, that happens to be in China, is almost completely empty.

Oh wait, the story about the shopping mall is not a figment of my imagination (I am not that good) but has already taken place. In 2005 NY Times ran an article titled China, New Land of Shoppers, Builds Malls on Gigantic Scale, it talked about the biggest shopping mall in the world that happened to be in Dongguan, China. The article said:

"Not long ago, shopping in China consisted mostly of lining up to entreat surly clerks to accept cash in exchange for ugly merchandise that did not fit. But now, Chinese have started to embrace America's modern "shop till you drop" ethos and are in the midst of a buy-at-the-mall frenzy.... by 2010, China is expected to be home to at least 7 of the world's 10 largest malls... Already, four shopping malls in China are larger than the Mall of America. Two, including the South China Mall, are bigger than the West Edmonton Mall in Alberta, which just surrendered its status as the world's largest to an enormous retail center in Beijing." (emphasis added)

Fast forward three years and you find a very different story: the biggest mall in the world - the South China mall, with space for fifteen hundred stores, only has a dozen stores open for business - it is empty. Shoppers never materialized. Billions of dollars have been wasted.

Analyzing the Chinese economy while it is growing at superfast rates is like analyzing a credit card company or a mortgage originator during an economic expansion - all you see is reward - the growth. But the defaults - the risk - are masked by a healthy economy and constantly increasing new business that is profitable at first. The true colors of that growth only appear after the economy slows down and new accounts mature. (In fact, the banks or credit card companies in the U.S. that showed the lowest loan growth during last expansionary cycle have a lot fewer credit problems than those that did - U.S. Bank Co comes to mind here.)

The consequences of LSGO are likely to be very painful for China. As of today we don't know how much of the recent growth came from wasteful, unproductive growth. Only after a slowdown will the true problems surface.

The Speed. What makes things even worse is that China cannot afford a slow down. I discussed this in the past but it is worth repeating. The Chinese economy is like the bus from the movie "Speed". In the movie the bus is wired by a villain (played by Dennis Hopper) with explosives, and will explode if its speed drops below 50 miles per hour. The Chinese economy has 1.3 billion unsuspecting people on board. It could blow if economic growth drops below its historical pace.

A combination of high financial and operation leverage sprinkled with past high growth rates will send this economy into a severe recession if growth rates slow down. Let me explain:

High operational leverage. China has become a de facto manufacturer for the world. With the exception of food products, it is difficult finding a product that was not, at least in part, manufactured in China. Industrial production accounts for 49% of GDP, double the rate of most developed nations (i.e. industrial production for the United States is 20.5 % of GDP, UK 18.2% , and Japan 26.5%).

Chinese miracle growth is largely driven by the manufacturing sector; historically its industrial production grew at a faster rate than GDP. The manufacturing industry is very capital intensive. Building factories requires a large upfront investment. High commodity prices and rapid wage inflation has driven those costs up. Once a factory is built the costs of running it are to a large degree independent of the utilization level - they are fixed - a classical definition of operational leverage. On top of these factors, laying-off workers is a politically sensitive process in China, which creates another layer of fixed costs.

High financial leverage. Debt is the instrument of choice in China. Due to a lack of equity-fund- raising alternatives (their stock market is very young), bank debt and underground finance companies that charge very high interest rates are the predominate sources of capital in China - this generates a great degree of financial leverage. (Though according to my friend Bill Mann, The Motley Fool's advisor of Global Gains newsletter, a frequent visitor to China, state owned enterprises are much more leveraged than private enterprises.)

Total operational leverage. Large piles of debt (financial leverage) combined with high fixed costs (operational leverage) create a very high total operational leverage.

Total operational leverage in China is elevated further as factories are built to accommodate future demand - this is a classical byproduct of LGSO. It is a human tendency to draw straight lines and thus making linear projections from the past into the future. During the fast growth period the angle of the straight lines is tilted upward, causing an over investment in fixed assets, as inability to keep up with demand may cause manufacturers to lose valuable customers. (Fear of over investment is overrun by fear of losing customers.)

This type of thinking results in tremendous overcapacity when demand cools. Here is an example: let's say a company saw demand for its widgets rise 10% year after year. It builds a new factory to accommodate future demand, let's say five years. It will likely model a 10% annual increase in demand as well. But what if demand comes in at 6% a year over the next five years? This will translate into overcapacity - not 4% but 20% (4% per year times five years). Suddenly you don't need to build factories or add capacity for awhile.

This greatly leveraged growth is terrific as long as the economy continues to grow at a fast pace: sales rise, costs rise at a slower rate (in large they are fixed) - margins expand - the beauty of leverage. However, leverage is not so sweet and soft when sales decline. Overcapacity is a death sentence in the manufacturing (fixed costs) world. As companies face overcapacity or slowdown in demand, they try to stimulate sales by cutting prices, which in part lead to price wars (similar to what we observed in the U.S. between Sprint, MCI and AT&T in the long distance business during the mid 90s) and to a fatal deflation. Sales decline, costs remain the same - margins collapse.

The weakness in the US and European economies will temper demand for Chinese made goods. China is already showing first signs of slow down - inflation is increasing and rate of real growth is decreasing.

It gets worse: high commodity prices

Chinese demand for stuff (oil, metals, machinery etc...) has a tremendous impact on commodities, driving their prices many fold. High (and rising) commodity prices are negative for developed world economies but they are catastrophic to developing economies - they bring comparatively higher inflation and often stagflation. Here is why:

Inflation is sourced from two broad categories: commodities (stuff) and wages. Emerging markets are twice as cursed when it comes to inflation:

Commodity prices (less shipping costs and government controls - the Chinese government limits price increases on certain commodities, but we know that doesn't work in the long-term) are the same around the world. Thus the U.S. and China will see a similar increase in commodity prices (at least in dollar terms). But the commodity component represents a larger portion of the total product cost in China than in the U.S., as wages in China are a less significant component of a total cost. For instance, bread baked in the U.S. and China will require the same amount of wheat and wheat will cost as much. But baker wages will be significantly larger in the U.S. than in China and will result in a much higher cost of the finished product. Therefore, a spike in wheat prices will have a larger impact on the loaf of bread in China than in the US.
Wage inflation: the US and Europe have little wage inflation, as rising unemployment has diminished the already weak bargaining power of the labor force, keeping wages in check. Economic expansion has put significant upward pressure on wages inflation in China (and India as well).

In combination, these two factors were responsible for inflation in high single digits in China, double the rate of inflation in the U.S.

China is not the cheapest place in the world to manufacture, not anymore. To its benefit, cheaper countries (Singapore, Vietnam etc...) are not big enough to steal a significant amount of capacity and the US in many cases doesn't have the needed infrastructure to bring manufacturing back. Appreciation in the renminbi and high oil prices (which are driving shipping rates up, placing a significant premium on the distance factor) are making Chinese produced goods even less attractive. Something has to give: either the U.S. will consume less or China will keep prices low to stimulate the demand, swallowing the loss, or a combination of both.

It gets even worse...

I constantly catch myself wanting to say "the story only gets worse", but unfortunately it does. The US and Europe can cope with energy and food inflation a lot better than China and other developing nations, as we spend a lot less on food and energy as a percent of our income and have a lot more discretionary income. (Just take a look at magazine section in the book store. There is probably a fishing magazine for the left handed fishermen.)

Though the Chinese consume a lot less gasoline than Americans. They don't have as many cars and don't drive as much, but they do have stomachs - they eat. High energy prices have translated in food inflation that in China runs in the high teens. The average American family spends only 15% of their household budget on food, whereas the Chinese spend 37% . Maybe this is one of the reasons their shopping malls are empty. People that pay high gasoline prices but are full don't riot, but hungry people do. The current situation raises political risk in China and also the chances that government (social) intervention will rise. This also puts in doubt the significant development of a Chinese middle class, at least in the near future.

When I wrote an article for Financial Times in May discussing risks in stuff stocks (commodities, energy and industrials) I called today's environment "a global commodity bubble". I was imprecise, after a conversation with the brilliant Ed Easterling of Crestmont Research (by the way, Ed wrote "Unexpected Returns" - a must read) and reading a wonderful interview with James Montier by Kate Welling, I'd like use James' more precise definition of today's environment: a "global growth expectations" bubble. After all, it is the supply demand (to a large degree) that was responsible for this unprecedented growth in "stuff", shifting the mentality of the market into "this time is different" gear. It is not.

In the past "stuff" stocks were cyclical, their margins played a very predictable foxtrot of bouncing together with the whims of the US economy. Today they are behaving if as Google is their middle name - their sales are climbing in double digits, margins keep expanding and now they are called "growth" stocks. They are not. It is just Chinese late stage growth obesity, which has disproportionately impacted the demand for stuff, creating an expectation that the "growth story" will continue forever. Nothing is forever. Starbucks discovered that and so will China. China is likely to have a bright future, but it doesn't consist of straight to the sky growth trajectories.

Implications. Demand for commodities will decline, while more supply from past investments (there is a significant lag) will be coming to the market - they'll come crushing down to earth. Companies that make stuff will suffer, their margins are at multi-multi-multi-year highs, margins pendulum will swing the other way, to the other extreme. Suddenly they won't appear to be as cheap. (Take a look at my January Barron's article in which I discuss the risk in corporate margins and May Financial Times article which explores China and stuff stocks.)

Intelligence Guidance

John Mauldin — Fri, 27 Jun 2008 03:26:52 GMT

This week I want to share with you one of the more important tools in my arsenal for keeping up with what is going on in the world. As I've told you before, George Friedman and his team at Stratfor are my go-to guys for geopolitical intelligence. Their insights into this facet of the world are simply without peer. Now I want you to see their Intelligence Guidance which they publish each Friday for the upcoming week; last week's edition is below.

The Intelligence Guidance is an internal document that guides their intelligence team for the upcoming week. It's not a forecast of what's going to happen (more on that in a minute) but a list of potential inflection points that bear close scrutiny. On a short term basis, these are the critical items that can move policy in one direction or another. I put this side-by-side with my calendar of Fed meetings, statistics releases, and earnings announcements to get a holistic picture of what's going to be driving markets and plan tactics. I highly encourage you to click here for a Stratfor Membership, at special prices available to my readers, and add Stratfor's Intelligence Guidance to your weekly thinking.

Now about that forecast. Stratfor is just about to issue their third quarter forecast, and you definitely want to incorporate this thinking in your strategic planning. Stratfor's past calls on everything from the Asian currency meltdown to China's internal problems have proven to be eerily prescient. And I should point out that they also provide a scorecard that makes it very clear where their calls have been off, too. The Quarterly Forecast is included free as part of your Stratfor Membership, so click this link for the special deals available to my readers and make sure that you don't miss out on this important look ahead.

John Mauldin, Editor
Outside the Box

Intelligence Guidance Summary:

The following are internal Stratfor documents produced to provide high-level guidance to our analysts. These documents are not forecasts, but rather a series of guidelines for understanding and evaluating events, as well as suggestions on areas for focus.

Analysis

All guidance from last week remains in place (see those below). Supplemental guidance:

1. The situation in Iraq: Let's spend next week focusing on something that is not happening: the war in Iraq. The bombing in a Baghdad market really drove home how few there are. So did indications that Iraq is going to open the oil fields to investment. We need to review the status of the war carefully. Our perception has been that the war is winding down and the general outlines of the resolution are in place. Time to do a net assessment re-evaluating our position.

2. China and oil prices: China has lifted the caps on oil prices, the Saudis are promising to raise output and consumption appears to be dropping. That would indicate that oil prices will fall, but that is not our business. Our business remains figuring out what higher energy prices do to the international system. The China watch remains essential. That is the center of gravity of the problem. They are still trying to ride it out with subsidies. Questions like "What is the status of their cash reserves?" and "What is happening to export profit margins?" become very interesting. They are spending real money to keep these caps on to keep those margins up. We do not know where prices will go but we know where they are. Let's drill into the reserve and margin question.

3. Venezuela and Cuba: Venezuelan President Hugo Chavez tried to create a police state then backed off. Next thing we hear are stories the he is giving sanctuary to Hezbollah, which we assume is psychological pressure from Washington. Then he turns up in Havana for talks with Fidel and Raul Castro. In the meantime the European Union drops whatever sanctions are left on Cuba. Cuba needs Venezuelan help on oil. But it also seems to want to get out of its isolation. It's not all that interesting what Chavez said to the Castros, but it would really be interesting to find out what Raul said to Chavez. Fidel cranked him up. Is Raul following the old line with Chavez, or telling him to calm down?

4. Israeli domestic politics: What is holding Israeli Prime Minister Ehud Olmert up? In any other country the allegations alone would have bought him down, not to mention Ehud Barak, a coalition partner, calling for his resignation. With the Syrian talks clearly proceeding and Hamas agreeing to a truce with Israel, things are at a crucial point. Since this is the Middle East, that's usually when disaster strikes. Olmert's fall would seem to derail everything, but he does not fall. Let's dissect the Israeli situation and see what we can learn.

5. Zimbabwe and South Africa: Zimbabwe is not important in itself. South Africa is, or more precisely, the degree to which South Africa plans to exercise power in Africa. With commodity prices high, Africa becomes important, and as the Chinese increase their presence, the South Africans could use their longstanding close ties to move in as well. It would make geopolitical and business sense to do that. Zimbabwe is the test for South Africa. If either South African President Thabo Mbeki or African National Congress President Jacob Zuma can help pull Zimbabwean President Robert Mugabe out of office, his authority in the continent will be solid. Mbeki and Zuma have the power, but it isn't clear they have the will. If they do not have the will in Zimbabwe, they will not have it to create a sphere of influence elsewhere. The Zimbabwe crisis is in a quiet phase but that won't hold indefinitely. We need to watch South Africa to see if it will act.

Ongoing items:

1. Oil and food markets: Oil and food prices remain at the top of the list. We need to be watching carefully what the Arabian Peninsula is doing with its money and what the Russians are planning to do. In the immediate, we need to be following global crop forecasts. Unseasonable rain in the U.S. Midwest has threatened to bring the corn harvest down by about 10 percent this year. Flooding is hitting China's harvests right now as well, and corn crops in Mexico have been threatened by unseasonably dry weather. As other crops see seasonal disruptions worldwide, we could see increased fluctuations in the prices of these goods. Particularly vulnerable to increases in the price of corn are Japan, South Korea, Mexico and Egypt. Mexico and Egypt are particularly prone to food-related civic unrest, a development that must be monitored carefully. Along those lines, all food crops around the globe must be carefully monitored as prices continue to climb. This is much more immediately significant than oil prices right now. If there are crop failures larger than the U.S. corn crop looming, prices are really going to soar. That is not going to result in a one or two point drop in gross domestic product; it can result in chaos in large parts of the world. We don't know if this is going to happen, but we need to be on top of this whole process hour by hour.

2. China's economy: China is getting hit both ways. As one source put it, bad margins are disappearing. As they disappear, we can expect massive problems. The government has plenty of resources in the short run, and we can expect things to hold together until after the Olympics, but we need to watch carefully to make sure that they do. By then, all of these pressures might recede. But that is dubious. September -- and the rest of 2008 -- should be interesting for China.

3. The European Union: The Irish referendum on the European Union's Lisbon Treaty is in one sense no surprise. The EU is based on unanimity, and there was no way this was going to pass without someone blackballing it. There are two choices here. Either the EU accepts that it is an economic bloc and not a proto-nation, or the EU changes the rules on how constitutions are ratified. Both are hard for the union to do, and as a unit the EU does not do hard things. We need to watch the Germans and French and see what they have up their sleeves. The burden especially falls on France to patch things up because it is taking over the bloc's presidency soon. Never forget that the French solution to violating the Stability Pact by higher than acceptable deficits was to ignore it. There are ways out of this. Let's figure out if there is any consensus among the major players as to what these solutions will be.

4. Turmoil within Iran: Iran is giving off more and more signals of political turmoil. Iranian President Mahmoud Ahmadinejad certainly is not backing off on his public statements, and his opponents -- some pretty powerful -- have said things it is hard to back off from, too. Meanwhile, from what we can tell, the clerical establishment is not looking to oust Ahmadinejad, preferring to see him exit the system next June when he is up for re-election. The clerics fear an intra-conservative rift could cost the conservatives next year's presidential election -- hence the naming of Ahmadinejad's political foil, Ali Larijani, as parliament speaker to contain the president's moves, especially on the foreign policy matters that are preventing Iran from prospering in a time of high energy prices. Meanwhile, the European Union's foreign policy adviser is in Tehran to offer new incentives in the nuclear controversy. In the midst of the rhetoric of defiance, there the Iranians have faintly signaled that they might be ready to reach a compromise of sorts. So let's not take our eyes of this.

5. U.S.-Iranian talks: The controversy over a future U.S. military presence in Iraq, a key part of U.S.-Iraqi strategic talks, continues to escalate. Opposition to any deal that could cut into Baghdad's sovereignty has brought together not just warring Shiite factions but also elements from both major sectarian groups. The Iranians are obviously making this an issue because it not only undercuts their influence in the U.S.-Iraqi dynamic but could create a security threat for them. The Iranians have done more than issue statements; they are threatening to unleash a Shiite uprising -- something that has not happened throughout U.S. forces' involvement in Iraq. Obviously U.S.-Iraqi talks should be watched, but more importantly, we should keep an eye on any signs of renewed U.S.-Iranian contacts because both Washington and Tehran are posturing and do not seek a confrontation.

6. U.S.-Pakistani relations: A U.S. military strike in Pakistan's northwest tribal belt struck a Pakistani military border post and killed 11 soldiers, including an officer. The two sides have agreed to jointly investigate the matter, but Washington's position has been that it struck at hostile forces and the strike was in line with standard operating procedures. This incident clearly shows that Washington's attitude towards Islamabad has entered a new phase where U.S. forces will engage in routine overt military actions -- something Stratfor had forecast for some time. The thing to watch is the reaction from not just the Pakistani street but the state, especially the army.

7. Chavez's difficulties: Chavez reversed himself on three policies: his stance on the Revolutionary Armed Forces of Colombia, a new tax and a new intelligence law that would have required citizens to spy on one another. In the past he has been enormously surefooted. Last week he seemed to be behaving like a man under a great deal of pressure from all sides who had engaged in some pretty careless politics, got burned and retreated. He seems to be weakening. Venezuelan state-owned energy company Petroleos de Venezuela's inability to pay its contractors bodes ill for the company's ability to keep funding Chavez's social programs. Without that support, Chavez is in trouble. We need to keep watching for cracks in Chavez's party as the November local elections approach. Ongoing dissatisfaction with Chavez could give the opposition the fuel it needs to pursue change.

8. Asian economies: Vietnam is having economic problems. Not important in itself, unless like the Thai bhat in 1997, it signals deeper problems. We see issues in Korea and elsewhere. Asia's economies have always appeared to be shakier than others to us. Let's evaluate our position based on these rapid developments.

Your Guided-by-Intelligence-Voices-Analyst,

John Mauldin

The Geopolitics Of China

John Mauldin — Thu, 12 Jun 2008 18:56:31 GMT

No matter where in the world I am, in South Africa, in Europe, in La Jolla, there's one question I get asked over and over, "What about China?" And small wonder. The increasing impact of China in the last generation is just staggering and seemingly accelerating every day. If you're in the market for oil, minerals, arable land, equities or debt, you're bidding against Chinese government-sponsored entities with a $1 trillion warchest. And the list of markets where China is a key player grows every day. Bottom line: whether you're filling up your gas tank or trading credit default swaps, China's decisions impact your pocket book.

The only thing that's crystal clear about China is the need to look long term, at the underlying forces that don't change day by day. Nobody does this better than my friend George Friedman and his team at Stratfor. Their geopolitical focus filters out the noise in the popular press and concentrates on the real drivers behind national policy. This is especially critical for a market like China, where traditional financial statement analysis is impossible and profit motives just don't apply.

On Monday, George and his team are releasing the second in their series of Geopolitical Monographs, called The Geopolitics of China. I've received an advance copy of the report below, and it is today's Special Edition of Outside the Box. Click this link to take advantage of a special pre-release offer on a Stratfor Membership that George is offering just to my readers. Did you know that China is functionally an island? Want to understand China's strategy behind their sovereign wealth funds? Policy in Tibet and Darfur? Join Stratfor now. You'll get a whole year of Stratfor's insights, plus you'll get The Geopolitics of China and their other Geopolitical Monographs included free. You really don't want to miss out on this opportunity.

Look at the map below that shows how China is functionally an island. Fascinating. It's just one of the maps George uses to illustrate what makes China, China. I hope you find this report intriguing, and do take George up on his offer for a free copy of the entire series included with your Stratfor Membership.

John Mauldin, Editor
Outside the Box

THE GEOPOLITICS OF CHINA: A Great Power Enclosed

Contemporary China is an island. Although it is not surrounded by water (which borders only its eastern flank), China is bordered by terrain that is difficult to traverse in virtually any direction. There are some areas that can be traversed, but to understand China we must begin by visualizing the mountains, jungles and wastelands that enclose it. This outer shell both contains and protects China.

Internally, China must be divided into two parts: The Chinese heartland and the non-Chinese buffer regions surrounding it. There is a line in China called the 15-inch isohyet. On the east side of this line more than 15 inches of rain fall each year. On the west side annual rainfall is less than that. The bulk of the Chinese population lives east and south of this line. This is Han China, the Chinese heartland. It is where the vast majority of Chinese live and the home of the ethnic Han, what the world regards as the Chinese. It is important to understand that over a billion people live in an area about half the size of the United States.

The Chinese heartland is divided into two parts, northern and southern, which in turn is represented by two main dialects, Mandarin in the north and Cantonese in the south. These dialects share a writing system but are almost mutually incomprehensible when spoken. The Chinese heartland is defined by two major rivers -- the Yellow River in the north and the Yangtze in the South, along with a third lesser river in the south, the Pearl. The heartland is China's agricultural region. However -- and this is the single most important fact about China -- it has about one-third the arable land per person as the rest of the world. This pressure has defined modern Chinese history -- both in terms of living with it and trying to move beyond it.

A ring of non-Han regions surround this heartland -- Tibet, Xinjiang province (home of the Muslim Uighurs), Inner Mongolia and Manchuria. These are the buffer regions that historically have been under Chinese rule when China was strong and have broken away when China was weak. Today, there is a great deal of Han settlement in these regions, a cause of friction, but today Han China is strong.

These are also the regions where the historical threat to China originated. Han China is a region full of rivers and rain. It is therefore a land of farmers and merchants. The surrounding areas are the land of nomads and horsemen. In the 13^th century, the Mongols under Ghenghis Khan invaded and occupied parts of Han China until the 15^th century, when the Han reasserted their authority. Following this period, Chinese strategy remained constant: the slow and systematic assertion of control over these outer regions in order to protect the Han from incursions by nomadic cavalry. This imperative drove Chinese foreign policy. In spite of the imbalance of population, or perhaps because of it, China saw itself as extremely vulnerable to military forces moving from the north and west. Defending a massed population of farmers against these forces was difficult. The easiest solution, the one the Chinese chose, was to reverse the order and impose themselves on their potential conquerors.

There was another reason. Aside from providing buffers, these possessions provided defensible borders. With borderlands under their control, China was strongly anchored. Let's consider the nature of China's border sequentially, starting in the east along the southern border with Vietnam and Myanmar. The border with Vietnam is the only border readily traversable by large armies or mass commerce. In fact, as recently as 1975, China and Vietnam fought a short border war, and there have been points in history when China has dominated Vietnam. However, the rest of the southern border where Yunnan province meets Laos and Myanmar is hilly jungle, difficult to traverse, with almost no major roads. Significant movement across this border is almost impossible. During World War II, the United States struggled to build the Burma Road to reach Yunnan and supply Chiang Kai-shek's forces. The effort was so difficult it became legendary. China is secure in this region.

Hkakabo Razi, almost 19,000 feet high, marks the border between China, Myanmar and India. At this point, China's southwestern frontier begins, anchored in the Himalayas. More precisely, it is where Tibet, controlled by China, borders India and the two Himalayan states, Nepal and Bhutan. This border runs in a long ark past Pakistan, Tajikistan and Kirgizstan, ending at Pik Pobedy, a 25,000-foot mountain marking the border with China, Kirgyzstan and Kazakhstan. It is possible to pass through this border region with difficulty; historically, parts of it have been accessible as a merchant route. On the whole, however, the Himalayas are a barrier to substantial trade and certainly to military forces. India and China -- and China and much of Central Asia -- are sealed off from each other.

The one exception is the next section of the border, with Kazakhstan. This area is passable but has relatively little transport. As the transport expands, this will be the main route between China and the rest of Eurasia. It is the one land bridge from the Chinese island that can be used. The problem is distance. The border with Kazakhstan is almost a thousand miles from the first tier of Han Chinese provinces, and the route passes through sparsely populated Muslim territory, a region that has posed significant challenges to China. Importantly, the Silk Road from China ran through Xinjiang and Kazakhstan on its way west. It was the only way to go.

There is, finally, the long northern border first with Mongolia and then with Russia, running to the Pacific. This border is certainly passable. Indeed, the only successful invasion of China took place when Mongol horseman attacked from Mongolia, occupying a good deal of Han China. China's buffers -- Inner Mongolia and Manchuria -- have protected Han China from other attacks. The Chinese have not attacked northward for two reasons. First, there has historically not been much there worth taking. Second, north-south access is difficult. Russia has two rail lines running from the west to the Pacific -- the famous Trans-Siberian Railroad (TSR) and the Baikal-Amur Mainline (BAM), which connects those two cities and ties into the TSR. Aside from that, there is no east-west ground transportation linking Russia. There is also no north-south transportation. What appears accessible really is not.

The area in Russia that is most accessible from China is the region bordering the Pacific, the area from Russia's Vladivostok to Blagoveschensk. This region has reasonable transport, population and advantages for both sides. If there were ever a conflict between China and Russia, this is the area that would be at the center of it. It is also the area, as you move southward and away from the Pacific, that borders on the Korean Peninsula, the area of China's last major military conflict.

Then there is the Pacific coast, which has numerous harbors and has historically had substantial coastal trade. It is interesting to note that, apart from the attempt by the Mongols to invade Japan, and a single major maritime thrust by China into the Indian Ocean -- primarily for trade and abandoned fairly quickly -- China has never been a maritime power. Prior to the 19^th century, it had not faced enemies capable of posing a naval threat and, as a result, it had little interest in spending large sums of money on building a navy.

China, when it controls Tibet, Xinjiang, Inner Mongolia and Manchuria, is an insulated state. Han China has only one point of potential friction, in the southeast with Vietnam. Other than that it is surrounded by non-Han buffer regions that it has politically integrated into China. There is a second friction point in eastern Manchuria, touching on Siberia and Korea. There is, finally, a single opening into the rest of Eurasia on the Xinjiang-Kazakh border.

China's most vulnerable point, since the arrival of Europeans in the western Pacific in the mid-19^th century, has been its coast. Apart from European encroachments in which commercial interests were backed up by limited force, China suffered its most significant military encounter -- and long and miserable war -- after the Japanese invaded and occupied large parts of eastern China along with Manchuria in the 1930s. Despite the mismatch in military power and more than a dozen years of war, Japan still could not force the Chinese government to capitulate. The simple fact was that Han China, given its size and population density, could not be subdued. No matter how many victories the Japanese won, they could not decisively defeat the Chinese.

China is hard to invade; given its size and population, it is even harder to occupy. This also makes it hard for the Chinese to invade others -- not utterly impossible, but quite difficult. Containing a fifth of the world's population, China can wall itself off from the world, as it did prior to the United Kingdom's forced entry in the 19^th century and as it did under Mao Zedong. All of this means China is a great power, but one that has to behave very differently than other great powers.

China's Geopolitical Imperatives

China has three overriding geopolitical imperatives:

Maintain internal unity in the Han Chinese regions.
Maintain control of the buffer regions.
Protect the coast from foreign encroachment.

Maintaining Internal Unity
China is more enclosed than any other great power. The size of its population coupled with its secure frontiers and relative abundance of resources, allows it to develop with minimal intercourse with the rest of the world, if it chooses. During the Maoist period, for example, China became an insular nation, driven primarily by internal interests and considerations, indifferent or hostile to the rest of the world. It was secure and, except for its involvement in the Korean War and its efforts to pacify restless buffer regions, was relatively peaceful. Internally, however, China underwent periodic, self-generated chaos.

The weakness of insularity for China is poverty. Given the ratio of arable land to population, a self-enclosed China is a poor China. Its population is so poor that economic development driven by domestic demand, no matter how limited it might be, is impossible. However, an isolated China is easier to manage by a central government. The great danger in China is a rupture within the Han Chinese nation. If that happens, if the central government weakens, the peripheral regions will spin off, and China will then be vulnerable to foreigners taking advantage of Chinese weakness.

For China to prosper, it has to engage in trade, exporting silk, silver and industrial products. Historically, land trade has not posed a problem for China. The Silk Road allowed foreign influences to come into China and the resulting wealth created a degree of instability. On the whole, however, it could be managed.

The dynamic of industrialism changed both the geography of Chinese trade and its consequences. In the mid-19^th century, when Europe -- led by the British --compelled the Chinese government to give trading concessions to the British, it opened a new chapter in Chinese history. For the first time, the Pacific coast was the interface with the world, not Central Asia. This in turn, massively destabilized China.

As trade between China and the world intensified, the Chinese who were engaged in trading increased their wealth dramatically. Those in the coastal provinces of China, the region most deeply involved in trading, became relatively wealthy while the Chinese in the interior (not the buffer regions, which were always poor, but the non-coastal provinces of Han China) remained poor, subsistence farmers.

The central government was balanced between the divergent interests of coastal China and the interior. The coastal region, particularly its newly enriched leadership, had an interest in maintaining and intensifying relations with European powers and with the United States and Japan. The more intense the trade, the wealthier the coastal leadership and the greater the disparity between the regions. In due course, foreigners allied with Chinese coastal merchants and politicians became more powerful in the coastal regions than the central government. The worst geopolitical nightmare of China came true. China fragmented, breaking into regions, some increasingly under the control of foreigners, particularly foreign commercial interests. Beijing lost control over the country. It should be noted that this was the context in which Japan invaded China, which made Japan's failure to defeat China all the more extraordinary.

Mao's goal was three-fold, Marxism aside. First, he wanted to recentralize China -- re-establishing Beijing as China's capital and political center. Second, he wanted to end the massive inequality between the coastal region and the rest of China. Third, he wanted to expel the foreigners from China. In short, he wanted to recreate a united Han China.

Mao first attempted to trigger an uprising in the cities in 1927 but failed because the coalition of Chinese interests and foreign powers was impossible to break. Instead he took the long march to the interior of China, where he raised a massive peasant army that was both nationalist and egalitarian and, in 1948, returned to the coastal region and expelled the foreigners. Mao re-enclosed China, recentralized it, and accepted the inevitable result. China became equal but extraordinarily poor.

China's primary geopolitical issue is this: For it to develop it must engage in international trade. If it does that, it must use its coastal cities as an interface with the world. When that happens, the coastal cities and the surrounding region become increasingly wealthy. The influence of foreigners over this region increases and the interests of foreigners and the coastal Chinese converge and begin competing with the interests of the central government. China is constantly challenged by the problem of how to avoid this outcome while engaging in international trade.

Controlling the Buffer Regions
Prior to Mao's rise, with the central government weakened and Han China engaged simultaneously in war with Japan, civil war and regionalism, the center was not holding. While Manchuria was under Chinese control, Outer Mongolia was under Soviet control and extending its influence (Soviet power more than Marxist ideology) into Inner Mongolia, and Tibet and Xinjiang were drifting away.

At the same time that Mao was fighting the civil war, he was also laying the groundwork for taking control of the buffer regions. Interestingly, his first moves were designed to block Soviet interests in these regions. Mao moved to consolidate Chinese communist control over Manchuria and Inner Mongolia, effectively leveraging the Soviets out. Xinjiang had been under the control of a regional war lord, Yang Zengxin. Shortly after the end of the civil war, Mao moved to force him out and take over Xinjiang. Finally, in 1950 Mao moved against Tibet, which he secured in 1951.

The rapid-fire consolidation of the buffer regions gave Mao what all Chinese emperors sought, a China secure from invasion. Controlling Tibet meant that India could not move across the Himalayas and establish a secure base of operations on the Tibetan Plateau. There could be skirmishes in the Himalayas, but no one could push a multi-divisional force across those mountains and keep it supplied. So long as Tibet was in Chinese hands, the Indians could live on the other side of the moon. Xinjiang, Inner Mongolia and Manchuria buffered China from the Soviet Union. Mao was more of a geopolitician than an ideologue. He did not trust the Soviets. With the buffer states in hand, they would not invade China. The distances, the poor transportation and the lack of resources meant that any Soviet invasion would run into massive logistical problems well before it reached Han China's populated regions, and become bogged down -- just as the Japanese had.

China had geopolitical issues with Vietnam, Pakistan and Afghanistan, neighboring states with which it shared a border, but the real problem for China would come in Manchuria or, more precisely, Korea. The Soviets, more than the Chinese, had encouraged a North Korean invasion of South Korea. It is difficult to speculate on Joseph Stalin's thinking, but it worked out superbly for him. The United States intervened, defeated the North Korean Army and drove to the Yalu, the river border with China. The Chinese, seeing the well-armed and well-trained American force surge to its borders, decided that it had to block its advance and attacked south. What resulted was three years of brutal warfare in which the Chinese lost about a million men. From the Soviet point of view, fighting between China and the United States was the best thing imaginable. But from Stratfor's point of view, what it demonstrated was the sensitivity of the Chinese to any encroachment on their borderlands, their buffers, which represent the foundation of their national security.

Protecting the Coast
With the buffer regions under control, the coast is China's most vulnerable point, but its vulnerability is not to invasion. Given the Japanese example, no one has the interest or forces to try to invade mainland China, supply an army there and hope to win. Invasion is not a meaningful threat.

The coastal threat to China is economic, and most would not call it a threat. As we saw, the British intrusion into China culminated in the destabilization of the country, the virtual collapse of the central government and civil war. It was all caused by prosperity. Mao had solved the problem by sealing the coast of China off to any real development and liquidating the class that had collaborated with foreign business. For Mao, xenophobia was integral to natural policy. He saw foreign presence as undermining the stability of China. He preferred impoverished unity to chaos. He also understood that, given China's population and geography, it could defend itself against potential attackers without an advanced military-industrial complex.

His successor, Deng Xiaoping, was heir to a powerful state in control of China and the buffer regions. He also felt under tremendous pressure politically to improve living standards, and he undoubtedly understood that technological gaps would eventually threaten Chinese national security. He took a historic gamble. He knew that China's economy could not develop on its own. China's internal demand for goods was too weak because the Chinese were too poor.

Deng gambled that he could open China to foreign investment and reorient the Chinese economy away from agriculture and heavy industry and toward export-oriented industries. By doing so he would increase living standards, import technology and train China's workforce. He was betting that the effort this time would not destabilize China, create massive tensions between the prosperous coastal provinces and the interior, foster regionalism or put the coastal regions under foreign control. Deng believed he could avoid all that by maintaining a strong central government, based on a loyal army and communist party apparatus. His successors have struggled to maintain that loyalty to the state and not to foreign investors, who can make individuals wealthy. That is the bet that is currently being played out.

China's Geopolitics and its Current Position

From a political and military standpoint, China has achieved its strategic goals. The buffer regions are intact and China faces no threat in Eurasia. It sees a Western attempt to force China out of Tibet as an attempt to undermine Chinese national security. For China, however, Tibet is a minor irritant; China has no possible intention of leaving Tibet, the Tibetans cannot rise up and win, and no one is about to invade the region. Similarly, the Uighur Muslims represent an irritant in Xinjiang and not a direct threat. The Russians have no interest in or capability of invading China, and the Korean peninsula does not represent a direct threat to the Chinese, certainly not one they could not handle.

The greatest military threat to China comes from the United States Navy. The Chinese have become highly dependent on seaborne trade and the United States Navy is in a position to blockade China's ports if it wished. Should the United States do that, it would cripple China. Therefore, China's primary military interest is to make such a blockade impossible.

It would take several generations for China to build a surface navy able to compete with the United States Navy. Simply training naval aviators to conduct carrier-based operations effectively would take decades -- at least until these trainees became admirals and captains. And this does not take into account the time it would take to build an aircraft carrier and carrier-capable aircraft and master the intricacies of carrier operations.

For China, the primary mission is to raise the price of a blockade so high that the Americans would not attempt it. The means for that would be land- and submarine-based-anti-ship missiles. The strategic solution is for China to construct a missile force sufficiently dispersed that it cannot be suppressed by the United States and with sufficient range to engage the United States at substantial distance, as far as the central Pacific.

In order for this missile force to be effective, it would have to be able to identify and track potential targets. Therefore, if the Chinese are to pursue this strategy, they must also develop a space-based maritime reconnaissance system. These are the technologies that the Chinese are focusing on. Anti-ship missiles and space-based systems, including anti-satellite systems designed to blind the Americans, represent China's military counter to its only significant military threat.

China could also use those missiles to blockade Taiwan by interdicting ships going to and from the island. But the Chinese do not have the naval ability to land a sufficient amphibious force and sustain it in ground combat. Nor do they have the ability to establish air superiority over the Taiwan Strait. China might be able to harass Taiwan but it will not invade it. Missiles, satellites and submarines constitute China's naval strategy.

For China, the primary problem posed by Taiwan is naval. Taiwan is positioned in such a way that it can readily serve as an air and naval base that could isolate maritime movement between the South China Sea and the East China Sea, effectively leaving the northern Chinese coast and Shanghai isolated. When you consider the Ryukyu Islands that stretch from Taiwan to Japan and add them to this mix, a non-naval power could blockade the northern Chinese coast if it held Taiwan.

Taiwan would not be important to China unless it became actively hostile or allied with or occupied by a hostile power such as the United States. If that happened, its geographical position would pose an extremely serious problem for China. Taiwan is also an important symbolic issue to China and a way to rally nationalism. Although Taiwan presents no immediate threat, it does pose potential dangers that China cannot ignore.

There is one area in which China is being modestly expansionist -- Central Asia and particularly Kazakhstan. Traditionally a route for trading silk, Kazakhstan is now an area that can produce energy, badly needed by China's industry. The Chinese have been active in developing commercial relations with Kazakhstan and in developing roads into Kazakhstan. These roads are opening a trading route that allows oil to flow in one direction and industrial goods in another.

In doing this, the Chinese are challenging Russia's sphere of influence in the former Soviet Union. The Russians have been prepared to tolerate increased Chinese economic activity in the region while being wary of China's turning into a political power. Kazakhstan has been European Russia's historical buffer state against Chinese expansion and it has been under Russian domination. This region must be watched carefully. If Russia begins to feel that China is becoming too assertive in this region, it could respond militarily to Chinese economic power.

Chinese-Russian relations have historically been complex. Before World War II, the Soviets attempt to manipulate Chinese politics. After World War II, relations between the Soviet Union and China were never as good as some thought, and sometimes these relations became directly hostile, as in 1968, when Russian and Chinese troops fought a battle along the Ussuri River. The Russians have historically feared a Chinese move into their Pacific maritime provinces. The Chinese have feared a Russian move into Manchuria and beyond.

Neither of these things happened because the logistical challenges involved were enormous and neither had an appetite for the risk of fighting the other. We would think that this caution will prevail under current circumstances. However, growing Chinese influence in Kazakhstan is not a minor matter for the Russians, who may choose to contest China there. If they do, and it becomes a serious matter, the secondary pressure point for both sides would be in the Pacific region, complicated by proximity to Korea.

But these are only theoretical possibilities. The threat of an American blockade on China's coast, of using Taiwan to isolate northern China, of conflict over Kazakhstan -- all are possibilities that the Chinese must take into account as they plan for the worst. In fact, the United States does not have an interest in blockading China and the Chinese and Soviets are not going to escalate competition over Kazakhstan.

China does not have a military-based geopolitical problem. It is in its traditional strong position, physically secure as it holds its buffer regions. It has achieved it three strategic imperatives. What is most vulnerable at this point is its first imperative: the unity of Han China. That is not threatened militarily. Rather, the threat to that is economic.

Economic Dimensions of Chinese Geopolitics

The problem of China, rooted in geopolitics, is economic and it presents itself in two ways. The first is simple. China has an export-oriented economy. It is in a position of dependency. No matter how large its currency reserves or how advanced its technology or how cheap its labor force, China depends on the willingness and ability of other countries to import its goods -- as well as the ability to physically ship them. Any disruption of this flow has a direct effect on the Chinese economy.

The primary reason other countries buy Chinese goods is price. They are cheaper because of wage differentials. Should China lose that advantage to other nations or for other reasons, its ability to export would decline. Today, for example, as energy prices rise, the cost of production rises and the relative importance of the wage differential decreases. At a certain point, as China's trading partners see it, the value of Chinese imports relative to the political cost of closing down their factories will shift.

And all of this is outside of China's control. China cannot control the world price of oil. It can cut into its cash reserves to subsidize those prices for manufacturers but that would essentially be transferring money back to consuming nations. It can control rising wages by imposing price controls, but that would cause internal instability. The center of gravity of China is that it has become the industrial workshop of the world and, as such, it is totally dependent on the world to keep buying its goods rather than someone else's goods.

There are other issues for China, ranging from a dysfunctional financial system to farm land being taken out of production for factories. These are all significant and add to the story. But in geopolitics we look for the center of gravity, and for China the center of gravity is that the more effective it becomes at exporting, the more of a hostage it becomes to its customers. Some observers have warned that China might take its money out of American banks. Unlikely, but assume it did. What would China do without the United States as a customer?

China has placed itself in a position where it has to keep its customers happy. It struggles against this reality daily, but the fact is that the rest of the world is far less dependent on China's exports than China is dependent on the rest of the world.

Which brings us to the second, even more serious part of China's economic problem. The first geopolitical imperative of China is to ensure the unity of Han China. The third is to protect the coast. Deng's bet was that he could open the coast without disrupting the unity of Han China. As in the 19^th century, the coastal region has become wealthy. The interior has remained extraordinarily poor. The coastal region is deeply enmeshed in the global economy. The interior is not. Beijing is once again balancing between the coast and the interior.

The interests of the coastal region and the interests of importers and investors are closely tied to each other. Beijing's interest is in maintaining internal stability. As pressures grow, it will seek to increase its control of the political and economic life of the coast. The interest of the interior is to have money transferred to it from the coast. The interest of the coast is to hold on to its money. Beijing will try to satisfy both, without letting China break apart and without resorting to Mao's draconian measures. But the worse the international economic situation becomes the less demand there will be for Chinese products and the less room there will be for China to maneuver.

The second part of the problem derives from the first. Assuming that the global economy does not decline now, it will at some point. When it does, and Chinese exports fall dramatically, Beijing will have to balance between an interior hungry for money and a coastal region that is hurting badly. It is important to remember that something like 900 million Chinese live in the interior while only about 400 million live in the coastal region. When it comes to balancing power, the interior is the physical threat to the regime while the coast destabilizes the distribution of wealth. The interior has mass on its side. The coast has the international trading system on its. Emperors have stumbled over less.

Conclusion

Geopolitics is based on geography and politics. Politics is built on two foundations: military and economic. The two interact and support each other but are ultimately distinct. For China, securing its buffer regions generally eliminates military problems. What problems are left for China are long-term issues concerning northeastern Manchuria and the balance of power in the Pacific.

China's geopolitical problem is economic. Its first geopolitical imperative, maintain the unity of Han China, and its third, protect the coast, are both more deeply affected by economic considerations than military ones. Its internal and external political problems flow from economics. The dramatic economic development of the last generation has been ruthlessly geographic. This development has benefited the coast and left the interior -- the vast majority of Chinese -- behind. It has also left China vulnerable to global economic forces that it cannot control and cannot accommodate. This is not new in Chinese history, but its usual resolution is in regionalism and the weakening of the central government. Deng's gamble is being played out by his successors. He dealt the hand. They have to play it.

The question on the table is whether the economic basis of China is a foundation or a balancing act. If the former, it can last a long time. If the latter, everyone falls down eventually. There appears to be little evidence that it is a foundation. It excludes most of the Chinese from the game, people who are making less than $100 a month. That is a balancing act and it threatens the first geopolitical imperative of China: protecting the unity of the Han Chinese.

Your working hard to understand China Analyst,

John Mauldin